Financial Analysis Fundamentals: How to Analyze Financial Statements Like a Pro Part 6 | CFI Course

So now let's look at trend analysis. Trend analysis is often referred to as horizontal analysis, and it is a critical component of our financial analysis. It involves comparing results across different periods. Those periods could be months, quarters, or most commonly, years. Now, we could just compare one year with the next, and that's important, but it's even better to conduct the analysis over multiple years, This extended time frame allows trends to emerge, which provides valuable insights that we can use to project future performance. Now, let's look at some examples. So, for example, through trend analysis, we may observe consistent growth, represented here by a line indicating a constant year-over-year growth rate. We might identify a declining revenue trend over time, depicted by a downward-sloping curve. Alternatively, significant strategic changes or shifts within an industry may lead to steeper growth, deviating from linear growth patterns seen in the previous examples. This exponential growth curve would be characteristics, let's say, of a company or industry undergoing a major transformation. On the other hand, if an industry is experiencing disruption, we may witness rapidly declining revenue, illustrated by a steep downward-sloping curve. It's worth noting that this pattern can also apply to costs, when a company drastically reduces its expenses, resulting in a declining cost curve. Further analysis may reveal a situation where revenue or expenses remain flat, with no growth or change over time, and that's represented here by a straight, flat line. Lastly, we may encounter volatility, where a company's revenue and expenses fluctuate, exhibiting periods of growth followed by decline and vice versa. Now, regardless of the shape of the results, the key is to assess trends over several years and use them to make projections about future performance. This forward-looking analysis is essential for gaining insights into the company's prospects. Ultimately, this process captures the essence of horizontal or trend analysis. Let's explore together the benefits of visualizing trends. A picture does speak a thousand words. There are two commonly used tools that financial analysts use to make their trends visual, that is, conditional formatting and, even better, charting. So, let's imagine that we have a table with the following data. With data over eight years on return on equity, gross margin, and EBITDA margin. Can you see trends? The answer is maybe yes, but the reader has to do a lot of work trying to extract the trends from the data. Now, with a bit of conditional formatting, we can actually make those trends a bit more evident. But, even better, we should be looking at charts. So, here's the same data, but presented in a graph or chart format. And I'm hoping you can see how much clearer it is to see those trends. We have the dark blue line, which is representing the return on equity, gross margin, EBITDA margin, and EBIT margin. We then have a blue dotted line, which is the underlying trend line. And then we have a horizontal line, which is showing the average. In all instances, the reader immediately sees the trend without having to do any hard work analyzing the individual numbers. Okay, now we're going to explore trends with Small Retailer. And we're going to highlight, again, the importance of visualizing trends. So, we've laid out the trend analysis using CFI's modeling best practices. So, you can see there's a title page. And if we go, I've organized the ratios into profitability ratios, utilization ratios, leverage ratios, and then growth ratios. Now, what you'll also notice is in each column A, I've left that column blank, and that's intentional. And it's so that I can navigate between schedules relatively easily. And all I do is I put a little space in where I want the schedule to start or to stop. So, to show you what I mean, if I'm up at the top here in A1, and I go control arrow down, it goes to that first title. If I wanted to go to the second title, I go control arrow down, and it takes me to the profitability and return charts. Again, control up, and I go back to the profitability and return ratios. And again, we're going to look at those charts in a second. If I was somewhere down here, I could go control with an arrow up. And again, I go to the heading. And how have I done that? Again, putting a space where you want to stop. Okay. Also, just a couple of other things. Anything in blue font is an input. Anything in black font is a formula or a title. So, you can see the averages are formulas, and the blue font is actually a hard-coded input. Now, with trends, recall, it's really hard to see the trends if we're not visualizing them. So, again, we've used CFI best practices. And let's go look at the profitability charts. We have return on equity, then the various margin ratios, all the way down to net profit margin. Okay. So, let me just talk to... Let's start here. We'll start with return on equity. What I've drawn is the dark blue line is the actual numbers. So, the return on equity for the various years one through eight. The blue dotted line was actually automatically plotted by Excel. You can ask Excel to plot a trend line. Trend lines are particularly useful when there's a lot of volatility. And then the light blue line that's horizontal, that's the average return on equity or the average gross margin, and so on. Now, you probably can quickly see the trends here where they weren't self-evident just looking at the numbers. We have a return on equity trend up, a gross margin that's going up, EBITDA margins, EBIT margins, and net profit margins that are all going up, which is great news for this small retailer. Now, let's look at asset utilization ratios. So, I'm going to go to the next page, and I'm going to go control with the arrow down. And you can see I can go right to the charts. Again, if I want to go back to the asset utilization ratios, harder to see the trends. You can see I've done asset turnover, then cash days, AR days, inventory days, and AP days, and then the cash conversion cycle. Now, when we go down to the asset utilization charts, one of the things you're going to see here is that a trend will, the trend line will automatically be drawn. But you have to be really thoughtful about whether that trend is truly self-evident or is just being influenced by a few data points. So, asset turnover, yes, does look like the trend is clearly up, which is great. But when I look at cash days, you can see the volatility. And that volatility, it looks like the trend lines up, but I would argue that no, that's not necessarily a self-evident trend. Same thing with accounts payable days, inventory days, and accounts receivable days. So, what we see here is, you know, you can see account receivable days is being probably influenced by that year eight. And that trend line probably wouldn't be as steep without that year eight data point. Same with inventory days. You can see there's a slight trend, but generally on average, it tends to be around that 55 days of average. And very similar with accounts payable days hovering around that 60. However, when we combine them together, the cash conversion cycle or working capital funding gap does definitely show a trend. It starts with negative working capital of between six and eight days and goes all the way to zero days over this eight-year period. Okay, so we do see a trend there. Let's go to the next set of ratios. And we have leverage ratios and liquidity ratios on this page. So, I've just pulled debt to equity and debt to EBITDA. Our debt to equity looks relatively volatile. It doesn't look like there's a clear trend. There's a slight upward trend. But debt to EBITDA definitely looks like it's come down. In fact, it looks like in year one, perhaps there was an acquisition which was debt funded. And since that acquisition, they've been paying off the debt. So, clear trend of debt to EBITDA. With liquidity ratios, if we scroll down to our current ratio and our quick ratio, again, we don't see much change there. Current ratio is almost sustainably steady. And the quick ratio has a bit of volatility. But again, it's staying very close to its average for the eight-year period. Finally, let's spend a bit of time looking at growth. And instead of looking at the numbers, let's go right to the charts. Here we have a lot of volatility. So, revenue growth, you can see there's no trend there. The trend is following the average line because of that volatility. There is a downward trend in EBITDA growth. Again, that looks more self-evident. There's definitely a downward trend, although it looks like it might be leveling out for net income growth. And total asset growth, yeah, it looks pretty stable. It doesn't look like it's changing very much. Okay, so now you've seen how to present a trend analysis. Okay, we're now looking at small retailer on its own. And we want to see if we can identify trends. One of the things about this workbook is that, again, we've been very intentional about the layout. Remember, blue font is for our inputs. Anything that's in black font is actually a formula or a calculation. And what we've done is we've tried to demonstrate best practice graphing and charting. First of all, we have our cover page again, where we can link right to what we want to see. We want to look at profitability, utilization, leverage, and growth. We calculated a ton of ratios when we did this for big retailer, mid retailer, and small retailer. Here, we want to be a bit more selective. Overwhelming someone with too many ratios may cloud the story. So we've been selective. We've also organized the ratios based on what we believe a reader may want to see. They want to analyze profitability, utilization, leverage, and growth. So let's actually look at the profitability ratios. One of the things you're going to see is I've calculated an average to use as a benchmark, but the stories and trends don't make themselves abundantly clear until we graph. Now, generally, the rule of thumb is to be very conservative in the way you approach your charts. And so what we have here is we have three lines, and these lines, again, are intentional. The dark blue line is the actual return on equity, gross margin, and so on. The flat line is the average for the period. And in Excel, we can graph a trend line so that if there is a lot of movement, Excel will find the trend if there's one that exists. When we look at small retailer, there's a lot of positive signs. When we look at profitability, return on equity is turning up. Gross margins are trending up. We have EBITDA margins trending up and similar with EBIT margins. Again, the graphs tell the story. So part of financial analysis really is about robust data visualization. When we look at utilization, let me just zoom in here. Again, do the stories make themselves evident? Well, it requires a lot of work. But when we look at the ratios here, we have our asset turn ratio, definitely trending upward in the right direction. Our cash days is a bit volatile. Looks like there is a slight trend up. We have our accounts receivable days. That trend may be there, but it looks like it's distorted by this very last year. So we may want to discount a bit of a trend there. And our inventory days are going up. Now, one of the things you want to think about is do you want inventory days to go up? That means that it's taking longer and longer to sell your inventory. So that inventory days trending up doesn't look great. Our AR, again, doesn't look like it's changing very much. But our asset utilization is positive. So that's how much revenue we're generating off our assets. Okay, so let's now look at leverage. And again, we've only done two here, debt to equity and debt to EBITDA. The debt to equity is a bit volatile. It looks like there's a tiny bit of a trend, but it's pretty stable. And it's pretty much the trend is at the average. And we have a positive trend debt to EBITDA going down, which suggests that the company is not taking on too much debt. Or if it had taken on too much debt, that is in decline. So that looks relatively positive. Okay, so that's what a trend analysis looks like and the importance of data visualization. With growth ratio trends, the financial analysts should look at revenue, profitability, and asset growth. We also want to look at the relationship between these three, those being asset growth, revenue growth, and profitability growth. Imagine a scenario where our assets are growing faster than either our revenue and profitability. Here, our asset utilization or ability to generate revenues is declining. Now imagine a second scenario where revenue growth is greater than profitability growth. Here, we may have a problem managing our expenses. The ideal scenario is where we have asset growth leading to greater revenue growth that then leads to even higher profitability growth. So it's really important not just to look at ratios on their own, but to also compare ratios like revenue growth, profitability growth, and asset growth. Now let's explore growth with the degree of leverage. When we talk about degree of leverage, we're talking about an equation, which is the degree of total leverage, which equals the degree of operating leverage times the degree of financial leverage. So let's start with operating leverage. Operating leverage, which is the change in EBIT compared to the change in revenues, is really a story of fixed versus variable costs. Financial leverage, which is the change in net income compared to the change in EBIT, is really about how much the company utilizes debt financing. The premise is that without operating leverage and financial leverage, net income can only ever grow as fast as revenue growth. Now by applying operating leverage and financial leverage, we can accelerate net income growth much faster than revenue growth. So let's work through how this happens in practice. As I've already mentioned, operating leverage is a story about fixed versus variable costs. Variable costs, as the name suggests, move in line with revenue. So as revenue increases, variable costs increase. Conversely, when revenue decreases, variable costs decrease. If all costs are variable, then operating profit can only grow at the rate of revenue growth. However, if we turn some of these variable costs into fixed costs, we introduce operating leverage. Now as revenue increases, some costs remain constant, which allows us to increase operating profit faster than revenue growth. Let's work through an example in Excel. Okay, let's us work through an example together so you can see what we mean by operating leverage. We'll then move on to financial leverage. When we see this scenario, and I'm going to ask you to open the workbook, what we're going to do is I look at year one and year two. And in the basic scenario, all costs are variable. And so what we have is our variable costs are 55% of our revenues. And so as our revenues go from 100 to 120, our expenses are also increasing. The growth of revenues, which is just the formula that you see here, year two minus year one divided by year one, means that our earnings before interest and tax only grows by 20% because all costs are variable. As we get to the very bottom, since we're not touching anything else, like we're not touching financing and anything else, you'll see that our net income then grows by 20%. So our degree of operating leverage we say is one times. And our degree of financial leverage is one times because we have no financial leverage. So our degree of total leverage is one times. Now let's add fixed costs and see what happens. When we add fixed costs, what we're saying is we're going to take, I'm going to just sorry, let me scroll up so you can see it all. There's still our revenues going up by 20%. But we've taken the 55 that was all variable costs and made part of it fixed cost. So that the 35 that's left is a variable cost of 35%. Now what happens when we grow revenues? Well, our fixed costs don't change. Of course, our variable do. But now we have some operating leverage. Why? Because last time round, all costs increase. Now the fixed costs stay static. This gives us operating leverage such that a 20% growth in revenue leads to almost a 29% growth in our operating profit or EBIT. As we scroll down, there's no financing that's changed. So we now have a degree of operating leverage, which is allowing us to grow our net income faster than our revenues. And our degree of operating leverage is 1.44 times. Degree of financial leverage is one because we haven't changed anything with our finances. And our degree of total leverage is 1.44 times. See you in a sec and we'll cover financial leverage. Now let's turn to financial leverage. How can we magnify net profit growth through financial leverage? Recall that financial leverage is about funding the business with debt finance. Debt comes with interest expense, which reduces profit. However, debt also has a tax advantage as interest expense can be deducted for tax purposes. Let's work through an example to see how this works. To our same example, we're calling this Scenario 3. So we have a situation where revenues are growing by 20%. But we have fixed costs in row 72, such that our operating profit is growing by almost 29%. We've seen that already. But now we're actually going to add the complication of a loan. And the loan is for 100 with an interest rate of 5%. So we're actually paying interest expense of 5 for each of the two years. Our taxes relate to the effective tax rate. But you can see that we're now actually reducing our taxes because interest is allowable for tax. What that allows us to do is it allows us to grow our net income from 30 to 40, which is a 32.5% growth or increase. So now what we have is we have two things working together to give us degree of total leverage. We have degree of operating leverage, which is still the 1.44 times because we have the fixed costs. Plus, we have a degree of financial leverage due to the interest expense, which is 1.13 times, which is allowing us to have a degree of total leverage of 1.63 times. In other words, we have revenue growth of 20%, but our net income is growing by 32.5%.