Understanding Financial Statements: How to analyse and interpret (Part 4)

Financial statements are a summary of the financial records of an organisation that shows its financial performance over a given period and financial position as at a point in time. The previous articles focused on Common-Size Analysis and Financial ratios (published on 13th November); this article focuses on Trend Analysis using the financial statements of banks.

TREND ANALYSIS

Trend analysis is basically comparing the financial statements of a period to one or more other periods’ financial statements. In this analysis, the financial statements of several years (mostly 3 to 5 years) are compared to determine the changes over time. The changes identified help users of financial statements to assess financial performance, growth patterns and detect red flags. Trend analysis is essential for performance monitoring, decision making, as well as performance forecasting based on historical data.

CATEGORIES OF TREND ANALYSIS

This comparison can be carried out in several ways depending on what the user of the financial statements is focused on. There are three (3) main ways to carry out trend analysis of financial statements. These are Line-item trends, Common size trends and financial ratio trends. These categories of trend analysis are elaborated upon in the following paragraphs.

Line-Item Trends: This type of trend analysis compares the actual line items in the financial statements over several years to identify changes. The changes, which are mostly presented in percentages, are estimated by dividing the difference of the current year and the previous year by the previous years.

Line-item trend analysis is performed to assess revenue growth, changes in profit margins, movements in expenses, asset and liability growth and cash flow trends. This helps investors to assess the past performance and growth potential of a company. Management of organisations also use line-item trend analysis to monitor financial performance and make strategic decision.

In relation to the financial statement of banks, line-item trend analysis does not only help in performance monitoring, decision making, and performance forecasting but also in risk management. Risk management of banks can be assessed by undertaking a line-item trend analysis on non-performing loans and provisions for loan losses which indicate the credit risk of banks.

Key line-items that need to be given critical look are interest income, interest expense, net interest income, non-interest income (fees and commission income), loan loss provisions, operating expenses, net profit, cash and cash equivalent growth, investment growth, loan growth, deposits and growth in shareholders’ fund.

Common-Size Trends: This form of trend analysis first converts the financial statements for several years into common size or percentages using a common base as indicated in the previous article on common size. As a recap, the Income Statements line items use total revenue as the common base whiles the Statement of Financial Position uses total assets as the common base.

The percentages are then compared over the period under consideration. The main strength of common size trend analysis is the fact that it helps in the identification of structural changes in a bank’s financial statement regardless of the size or growth of the bank.

In the Income Statement, a decrease in the interest income as a percentage of total revenue may indicate increased competition or a shift in the Bank’s revenue generation strategy. An increase in non-interest income as a percentage of total revenue could mean diversification into fee-based services.

Interest income can be improved by offering competitive loans and investing in high yield investments whereas non-interest income can be increased by promoting digital banking and other fee-based services. An increase in Interest expense as a percentage of total revenue could mean increased cost of funding (i.e. wholesale deposits) whiles an increase in operating expenses as a percentage of total revenue is an indication of inefficiency or high cost of fixed assets. Increased interest expense as a percentage of total revenue can be addressed by reducing reliance on high-cost funding (i.e. wholesale deposits) and increasing low-cost funding (i.e. retail deposits).

Focus on controlling operational cost by streamlining processes, outsourcing non-core activities, and leveraging technology can reduce operating expenses as a percentage of total revenue and subsequently, increase efficiency. A decline in the net profit as a percentage of total revenue could indicate increasing cost pressures or margin erosion. This could be salvaged by implementing revenue boosting strategies including expanding loan portfolios or investing in high yield securities whiles optimising operating expenses to improve the bottom line.

Concerning the Statement of Financial Position, a reduction in loans as a percentage of total assets could be indicative of the Bank reducing its lending activities either due to risk concerns or increased focus on other asset classes (e.g., investments). An increase in investments as a percentage of total assets could suggest a shift toward more liquid or safer assets, potentially at the cost of higher yields from loans.

To improve declining loans as a percentage of total assets, banks must focus on rebalancing their portfolio and target profitable but safe lending opportunities. In relation to investments as a percentage of total assets, whiles maintaining liquidity, banks must diversify investment portfolios to improve returns without taking on excessive risk. A declining deposit as a percentage of total assets trend might indicate an over-reliance on wholesale funding, which can be more expensive and riskier. Increasing borrowings as a percentage of total assets may indicate a growing dependence on external financing, which can increase the Bank’s leverage and risk profile.

A declining deposit as a percentage of total assets can be addressed by implementing strategies to attract more retail deposits such as offering competitive interest rates or innovative savings products. Increased borrowings as a percentage of total assets can be resolved by increasing equity or generating higher profits that can be retained to strengthen the Balance Sheet. A declining equity as a percentage of total assets may indicate a weak Capital base which could affect the Bank’s ability to absorb losses. This can be fixed by raising new capital through equity issuance or retained earnings to improve the Capital Adequacy ratio.

Financial Ratios Trends: Like the Common-size Trend Analysis, Financial ratios Trend Analysis requires the computation of the financial ratios for the financial statements of each year under review. The Financial ratios are then compared over the given periods. The Trend analysis can be conducted using the ratios under the categories of profitability, efficiency, liquidity, solvency and investor ratios.

A decline in profitability ratios can be addressed by diversifying revenue streams, improving loan portfolio quality, and reducing operating costs whiles focusing on expanding fee-based services and non-interest income to cushion the impact of fluctuating interest margins. Declining efficiency ratios can also be resolved by optimizing operations to reduce costs and improve efficiency.

The utilization of assets must also be improved by eliminating underperforming assets and increasing earning assets in profitable segments. Poor liquidity ratios trend can also be improved by increasing customer deposits, reducing reliance on short-term borrowings and maintaining sufficient high-quality liquid assets. Cash management must be taken very seriously to reduce cash outflows through better cost control.

To improve solvency ratios, reduce leverage by issuing more equity, retain more earnings, or refinancing existing debt. Focus on strengthening the capital base through prudent asset management and ensuring the capital adequacy ratio remains above regulatory requirements also help in improving solvency ratios. In relation to investor ratios, these can be improved by increasing profitability, distributing dividends when financially appropriate, and managing share buybacks. Strategic growth, transparency and consistent performance also go a long way to improve investor confidence in the Bank.

Trend analysis in financial statement analysis is essential for evaluating a company’s financial performance over time by comparing data across multiple periods. This analysis is typically conducted through three main methods: Line-item trends, Common-size trends, and financial ratio trends.

Line-item analysis identifies changes in specific financial items, facilitating performance monitoring and decision-making, particularly in sectors like banking where it also supports risk management. Common-size analysis standardizes financial data for easier comparison whiles financial ratio trends provide insights into profitability, efficiency, liquidity, solvency and investor confidence.

FINANCIAL INTERPRETATION PITFALLS

The effectiveness of the methods outline in this publication and previous publications are limited by several pitfalls. Over-reliance on historical data can distort future projections, especially in volatile markets whiles qualitative factors such as management quality, market changes and regulatory shifts are often overlooked, potentially leading to incomplete assessments. Additionally, misinterpretation can arise if underlying business strategies are not considered and financial statements are manipulated through creative accounting, necessitating careful scrutiny of reported figures to ensure accuracy.

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