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Financial analysis often looks at previous information and compares it to current data. This process — called trend analysis — helps a company understand what it does well and what it does not. The connection between trend and ratio analysis comes from ratios being one tool for conducting financial reviews or profitability analyses. Another use for ratios is to conduct benchmark analysis, where a company compares its financial data to that of another business. Trend and ratio analysis typically occur at month end, year-end, or at any point when a business decides a review is necessary to assess financial information.
Trend and ratio analysis use the same inputs: financial statements. These statements represent the final output of the accounting office for a particular time period. Trend analysis typically measures the change in dollars between each line on a financial statement. Another column may list the percentage change between the items as well. This provides a quick view of financial improvement in certain areas of a business.
Ratios take a bit more time to compute. Many financial statements used in trend analysis do not have automatic ratios computed by accounting software. Accountants, therefore, need to use a series of mathematical formulas to create the indicators or percentages indicative from ratios. The ratios can, however, draw a connection between trend and ratio analysis. For example, an accountant can keep a record for each ratio computed for a period of time; this then creates a trend for financial comparison.
Another connection between trend and ratio analysis is their use for picking stocks. Many investors look for trends on stock price charts as this can provide an indication of when to purchase a stock. Fundamental analysis then requires a look at the company behind the stock. Ratios can help meet this need and match the stock price trend with a financially strong company. One way to complete this analysis is to compute a small set of ratios and determine how well the company operates in terms of profitability, asset turnover, and financial leverage.
Ratios also help companies compare themselves to businesses with different operations. For example, a small business is simply unable to have the sales or other operating capabilities of a much larger organization. Ratios, however, strip away these differences and provide indicators that show how well the small business operates compared to the large competitor. The small business can also turn this into a trend and ratio analysis report. This provides information on how the small business can improve itself to be like a much larger operation.
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