Analyzing Financial Statements | Horizontal, Common-Size and Trend Analysis

Table of Contents

1. Horizontal, Common-size and Trend Analysis
2. Horizontal Analysis
3. Common-size Analysis
4. Trend Analysis
5. Corporate Illustration: Britannia Industries

Check out Taxmann's Financial Accounting & Analysis which serves as a guide to understanding the essential accounting principles, offering an in-depth exploration of the subject. It achieves its objectives through financial statement analyses, supplemented by practical examples and real-world scenarios, all delivered in a clear, concise, and comprehensive manner. Further enhancing your learning experience, the book includes research topics, key takeaways, multiple choice questions with accompanying answers, and review questions and answers to consolidate your knowledge.

1. Horizontal, Common-size and Trend Analysis

These simple techniques use percentages to analyze changes taking place in the financial performance and financial condition of firms, either over time or in comparison to other competing firms. The beauty of these techniques lies in the fact that they are very simple to understand and require little financial training to calculate and interpret. They can supplement financial ratios analysis or used on a stand-alone basis depending on the desired depth of analysis. These techniques are horizontal analysis, common-size analysis and trend analysis.

2. Horizontal Analysis

Horizontal analysis involves comparing the same entity’s financial statements of two (or more) periods to analyze changes that have taken place over the period. Such analysis may be carried out both for items of profit & loss account as well as the balance sheet. A comparison of items in the profit & loss account would reveal the increase or decrease in incomes and expenses, while analysis of balance sheet items would reveal the changes in assets, capital and liabilities that have taken place in the current period as compared to the previous one.

The changes between the two periods may be calculated in absolute amounts as well as in percentages. Between the two, differences reported in percentages are sometimes considered more useful as they highlight the relative extent or magnitude of change that has occurred during the period. However, differences in both amounts and percentages have their own usefulness and percentage changes should not be considered in isolation as they may sometime present a misleading picture, particularly when the previous year figure, used as base, is small or nil.

Horizontal analysis is a basic and simple technique which can bring out very useful information without requiring complex formulae or calculations. For example, if a horizontal analysis of profit & loss account shows that sales increased by 10% over the previous year, but selling expenses rose by 25%, it may be a cause of concern to the management and may highlight an area that needed investigation.

Illustration: The financial statements of MegaNuts Limited for two years are given below. The last two columns have been added to show changes that has taken place between the two years: in absolute amounts and in percentage.

Summarised Balance Sheets as of 31 December

Profit & Loss Accounts for the Year Ended 31 December

The percentage change has been calculated as follows:

Change % = (20X7 figure – 20X6 figure)*100/20X6 figure. For example, percentage change in net fixed assets

= (62000 – 49000)*100/49000 = 26.53%.

The calculations shown in the ‘change’ columns reveal several interesting findings. Sales increased by 25% but manufacturing cost increased by a whopping 35.42%, putting a huge pressure on profit margins. However, a less than proportionate rise in sales & administration expenses helped the company in reporting a small increase in profits.

Changes in balance sheet items show that fixed assets increased by 26.53% while sales rose by only 25%, which meant a little less efficient use of fixed assets than previous year. But more striking was the huge increase in inventory by 62.5%, which would normally be difficult to justify. Debtors management was relatively better which rose by 9.52% only.

3. Common-size Analysis

Common-size analysis, also called vertical analysis, is another simple way of making a comparative analysis of two companies for the same period or of two periods of the same organization. This analysis is performed by expressing each line in the financial statement as a percentage of a total value. In a common-size profit & loss account, each line is expressed as a percentage of the total net sales, while in a common-size balance sheet, each line is expressed as a percentage of the total assets (which would be same as the total of capital plus liabilities).

Information in absolute amounts provided in the financial statement is difficult to compare but the same information converted into percentages of a base value lends itself to easy and more meaningful comparisons. For example, consider the normal and common-size balance sheets of MegaNuts Limited for two years, given below:

All line items in the common-size balance sheets are stated in terms of a percentage of the total assets of the respective years (each asset and liability item is divided by total assets and multiplied by 100). A comparison of the two years’ common-size balance sheets reveals changes in the relative composition of assets, as well as the changes in the relative mix of equity and debt financing. On the assets side, the relative investment in inventory has increased from 28.37% to 36.31% of total assets, but the investment in debtors and particularly cash has significantly reduced. The relative size of net fixed assets remained almost stable at about 34% of the total assets. On the capital & liabilities side, the proportional financing from equity has increased from 39.01% to 45.53% of total assets, while the relative extent of financing from long term debt (debentures) and current liabilities has reduced.

It is clear from the common-size analysis of MegaNuts Limited that the management needs to pay greater attention to management of inventory and cash among assets, and review its equity-focused financing policy on the other side of the balance sheet.

Similarly, a common-size profit & loss account may reveal significant changes in the cost of goods sold, expenses and profit margins between the two periods. For example, consider the normal and common-size profit & loss accounts of MegaNuts Limited given below:

Meganuts’ Normal and Common-size Profit & Loss Accounts

The common-size profit & loss account is prepared by reporting each line item as a percentage of the total net sales (each line item is divided by net sales and multiplied by 100). MegaNuts’ common-size profit & loss accounts clearly show why the company’s profitability declined in 20X7 as compared to 20X6. Manufacturing expenses increased significantly from 60% to 65% of the sales value, putting heavy pressure on profit margins. The situation was largely saved by a decline in sales and administrative expenses, but still the pre-tax profit margin declined from 5.0% to 4.17% of sales.

The common-size analysis is simple to understand and easy to perform. It is frequently used to compare changes in financial statements of two (or more) periods of an organization, for inter-firm comparisons or comparing a company’s performance with the rest of the industry. It is particularly helpful when comparing companies of different sizes.

4. Trend Analysis

The trend analysis is an extension of the horizontal analysis and is useful in studying changes that have taken place in the business over a longer period than just two years. Therefore, trend analysis would require comparable data for at least three years, though 5 to 10 years’ trend analysis is more common and perhaps more useful.

To perform a trend analysis, a past year (normally the first year of the period under consideration) is chosen as the ‘base year’ and all items in the financial statement of the base year are assigned a value of 100%. Then, items in the subsequent years are expressed as a percentage of the base year value, using the following formula:

Trend % for any year = (Current year value/Base year value)* 100

If the trend percentage for any item in a subsequent year is greater than 100%, it indicates an increase over the base year, and if the trend analysis percentage is lesser than 100%, it would mean a decrease over the base year.

5. Corporate Illustration: Britannia Industries

Given below are the balance sheet and profit and loss account of the company for two years. Calculate relevant ratios related to liquidity, profitability, working capital, turn- over and capital structure and return on investment for the two years. Comment on the company’s financial performance in the year 2010 as compared to the previous year.

Britannia Annual Report 2010

Profit and loss account for the year ended 31st March

(₹ in ’000)

Note: Schedules stated above included in the Annual Report of the company provide detailed information. They are not included here.

Britannia Annual Report 2009-10

(₹ in ’000)

Britannia Industries Limited Ratios Analysis

Financial Ratios Analysis of the company’s performance for the year 2010.

1.  Return on Net Worth [Return on Equity] %
= (PAT – Preference Dividend) x 100/Net Worth

Where:

1. PAT (profit after taxes) must be adjusted for extraordinary or exceptional items of incomes and expenses as such items are not likely to recur on a regular basis. To make this adjustment, extraordinary incomes are deducted (to cancel their previous inclusion) and extraordinary expenses are added back (because earlier they were deducted in the calculation of profits);
2. Net worth = Equity capital + reserves & surplus – Miscellaneous Expenditure Not yet written off. The reason for deducting the “Miscellaneous Expenditure Not yet written off” is that such expenditure would be a charge against the claims of equity holders in the case of winding up of the
3. If the company had any preference capital during the period under consideration, preference dividends should be deducted from PAT, and also, the amount of preference capital should be excluded to calculate net-worth or

Britannia Industries Limited’s RONW for 2010 and 2009 are calculated below: BASIC FORMULA: RONW % = (PAT/Net worth) x 100

Explanation: Before calculating the ratio, following adjustments would be required:

1. PAT here will have to be adjusted for ‘extraordinary items’ (profit/losses).
2. Net worth (shareholders’ funds) has to be adjusted for ‘miscellaneous expenditure not yet written off’.

Expanded Formula:

RONW = Profit After Taxes But ‘before’ Extraordinary Items X 100
Shareholders’ Funds – Miscellaneous Expenditure Not Yet Written Off

RONW for Britannia Industries is calculated below.

The RONW of the company showed a remarkable increase in 2010 as compared to 2009, mainly because of the reduction in the net worth caused by issue of bonus debentures out of the general reserves of the company.

2. Earning Per Share (EPS)

Formula:

                      PAT – Preference Dividend                     
Weighted average number of Equity Shares

Britannia Industries’ EPS is calculation:

PAT: as calculated for the RONW ratio for the two years.

Weighted number of equity shares: The number of equity shares outstanding during 2008, 2009 and 2010 was same = 23890163 or 23890.16 thousands. Note that since PAT figure is ‘000, the number of equity shares outstanding should also be in ‘000 to calculate EPS.

There was a decline in the company’s earnings per share in 2010 as compared to 2009, as a result of a lower PAT in 2010.

3. Cash Earnings Per Share (CEPS)

As compared to the EPS which is calculated using the accrual basis of accounting, the CEPS reports cash profits earned per share. CEPS derives its importance from the fact that it is cash and liquid resources that would be required to settle outside liabilities such as paying the creditors and repaying bank loans. No doubt then that the CEPS is given more importance by lending institutions in appraisal of creditworthiness of their clients.

The CEPS is considered more relevant for one more reason. In many capital intensive projects with long gestation period, the annual income in initial years could be small while the depreciation charge might be relatively huge, forcing the company to show nil or little net profits. The CEPS calculation indicates to the analysts how the EPS could be expected to rise as fixed assets get depreciated over time and true earning potential of the project surfaces. The CEPS is calculated as follows:

CEPS = (PAT – Preference Dividend) + Non cash charges
Weighted Average Number of Equity Shares Outstanding

Britannia Industries’ CEPS calculation follows:

PAT: as calculated for the RONW ratio for the two years.

Weighted number of equity shares: The number of equity shares outstanding during 2008, 2009 and 2010 was same = 23890163 or 23890.16 thousands. Note that since PAT figure is ‘000, the number of equity shares outstanding should also be in ‘000 to calculate EPS.

Non-cash charges = depreciation and amortization of ₹ 375434 thousands and ₹ 334560 thousands in 2010 and 2009 respectively.

There was a decline in the company’s cash earnings per share in 2010 as compared to 2009, mainly as a result of a lower PAT in 2010.

Britannia Ratios Measuring Profitability in Relation to Sales

It is absolutely necessary for the success of a business that its sales should be profitable. Sales are profitable when the selling price of a product or service not only covers its cost, but also leaves a profit margin. The higher the profit margin, more viable and sustainable the business.

Therefore, it is helpful to analyse how various cost elements and profit margins are changing over time or in relation to other companies in the same industry.

Analysts normally carry out two types of ratios analysis for this purpose:

1. Ratios of individual items of costs and expenses to sales, and
2. Multi-step profit margin ratios in relation to

1. Ratios of individual items of costs and expenses to sales: The ratios of individual costs and expenses to sales can be measured by preparing a common-size profit & loss account where all line items are expressed as a percentage of the annual net sales. Such analysis would highlight which costs and expenses are rising rapidly and need to be given attention, and controlled before they eat into the profit margins.

The common-size profit & loss account for Britannia Industries for the years 2009 and 2010 are given below.

Britannia Annual Report 2010

Profit and loss account for the year ended 31st March

The common-size profit & loss account shows a relatively steep rise in the cost of mate- rials, from 61.38% to 63.77% of the net sales, putting pressure on profit margins. In fact the net profit margin declined by almost the same extent as the rise in cost of materials, from 5.80% to 3.43% of the sales.

The general business expenses and extraordinary items also need to be watched.

Britannia Liquidity Ratios
Current Ratio

Current Ratio=Current Assets/Current Liabilities

Current assets include inventory, sundry debtors, cash and bank balances, loans and advances, other current assets + short term marketable investments. Current Liabilities include current liabilities and provisions + short term loans repayable within 12 months.

The current ratio has declined in year 2010 as compared to year 2009 indicating lesser amount of current assets available per rupee of current liabilities. This by itself could be a cause of concern to the creditors of the company as a lower current ratio could in- crease chances of a default in making timely payment of day-to-day dues, unless the company has a standby arrangement with banks for overdraft or short term loans facility.

Banks and financial institutions normally expect a current ratio of at least 1.33 times. While interpreting the current ratio, the structure of current assets should also be studied. A firm with greater portion of current assets in the form of inventory and debtors would not be considered as liquid as a firm with greater portion of current assets in the form of cash and bank balances. This is because inventories and debtors would take more time before they are converted into spendable funds, while cash and bank bal- ances represent ready purchasing power. In the case of Britannia Industries, the fact that inventories increased in 2010 as compared to 2009 while cash and bank balances declined during the same period, does not present a very positive picture about the company’s liquidity.

Quick Ratio = Current Assets + Short Term Investments – Inventories                                              Current Liabilities + Provisions + Short Term Loans

Inventories are excluded from the current assets because they would normally take the longest period to convert themselves into spendable cash resources, and thus represent the least liquid of current assets. A lower quick ratio in year 2010 as compared to the previous year indicates that the company would have lesser liquid resources (cash, bank balances and other current assets except inventories) per rupee of current liabilities. This shows a lower margin of safety available to creditors and increased possible risk of default in meeting short term dues.

Debtors’ Collection Period (Days)

= Sundry Debtors × 365/Annual sales

Applying the above formula to Britannia Industries data, the ratio would be calculated as follows:

Three comments need to be made about the calculation of this ratio.

• Firstly, the denominator in this ratio should ideally be the annual ‘credit’ sales because it is the credit sales that cause debtors or receivables. However, as credit sales are not disclosed in the published financial statements of companies, we have to manage with total annual
• Secondly, note that we have used ‘gross’ sales rather than net sales for this ratio. The reason is that it is the gross sales revenue (i.e., the invoice price) that is to be collected from the customers. The difference between the gross and net sales is caused by excise duty payable by the company to the Government, but that is independent of the collection of dues from the customers. Hence for the purpose of this ratio, it is better to use gross sales value if there is a difference between the two on account of excise duties