Looking at a company’s performance over a long period of time is called trend analysis. In addition to having a handle on how well a company covers its current debt with current assets, just about all financial statement users want to be able to evaluate the relative robustness of a company’s income over a series of years or financial periods.
A single profitability measure standing alone doesn’t really tell you much about a company or how it’s performing compared to its competitors. This is true for two reasons:
The company may have had an exceptionally good or bad year. Unless a company’s performance is static from year to year, looking at only one year of financial statement results is misleading. The statement user sees an inaccurate vision of the company’s performance over time.
Consider a personal example. Suppose you win $50,000 in the lottery this year, making your total income (after adding in your earnings from your part-time job) $62,000. The next year and the year after that, you don’t have any winning lottery tickets (darn it!), and your average income is $33,000 per year.
Clearly, looking at your income for only the year you won the lottery gives an inaccurate indication of your typical annual income, because that year’s income includes an unusual, nonrepeating event.
Under generally accepted accounting principles (GAAP), companies are allowed to use various methods to estimate some expenses. If a financial statement user is trying to compare Company A to Company B by applying a single set of profitability ratios, he’s not going to see the whole picture.
For example, two equally profitable companies using different inventory valuation methods may report big differences in net income. The same holds true for depreciation of long-term assets. Different options are also available for booking an estimate for bad debt expense, which is the money the company reckons it won’t be able to collect from credit customers. Many more differences may arise by using allowable GAAP methods, but you get the picture.
Trend analysis gives much more meaningful information to the financial statement user because differences in accounting methods tend to smooth out over time. For example, although the method a company uses for depreciation affects the amount of depreciation expense by year, it never affects original cost.
In other words, an asset costing $1,000 can never be depreciated for more than $1,000. After the asset is fully depreciated, total depreciation expense is the same, regardless of the method used. Analyzing ratios over a period of several years should be somewhat consistent, which permits the financial statement user to do some useful trend comparisons.
Using trend analysis means looking at profitability ratios over a number of years. Doing so is usually more helpful to the financial statement user than any single ratio is because everything is relative.
Seeing how profitability ratios go up and down (when comparing current performance to past performance and when comparing the company with other companies in the same industry) is more meaningful than just looking at one stand-alone ratio. Most investors consider at least five years — sometimes up to ten.