Trend Analysis

Until now, our concern has been with introducing the various financial ratios, explaining their uses in analysis, and comparing the ratios computed for our sample company with industry averages. As we pointed out earlier, it is important to compare the financial ratio for a given company over time. In this way, the analyst is able to detect any improvemen: or deterioration in a firm's financial condition and performance.

To illustrate, Table 6.3 shows selected financial ratios for Aldine Manufacturing Compaiv over the 20X0-20X2 period along with industry median figures for 20X2. As can be seen, the current and acid-test ratios have fallen off somewhat over time but still exceed industry norrrin 20X2. The figures for average collection period and inventory turnover in days have growsince 20X0 and exceed the current industry median levels. The trends here tell us that there ha; been a relative buildup in receivables and inventories. The turnover of each has slowed, which raises questions as to the quality and liquidity of these assets. When a trend analysis of receivables and inventory is coupled with a comparison with median ratios for the industry, the on conclusion possible is that a problem exists. The analyst would want to investigate the crec policies of Aldine, the company's collection experience, and its bad-debt losses. Moreover, on should investigate inventor)' management, obsolescence of inventory, and any imbalances ir.

the makeup of inventory (i.e., raw material versus work-in-process versus finished goods Thus, despite above average levels of current and acid-test ratios, the apparent deterioratior. in receivables and inventory is a matter of concern and needs to be investigated in depth. The stability of the firm's leverage (debt) ratios coupled with a present relative debt leve. typical of the industry would be viewed favorably by creditors. The gross profit margin an net profit margin have generally shown improvement over the recent past, and current 1 eve are stronger than for the typical firm in the industry. Return on investment has been relative stable over time, but at a level below the industry standard. Sluggish asset turnover over tiir.r has dampened any positive effects of above-average sales profitability. From our analysis of activity ratios, we know that the primary cause has been the large and growing relative amounts of receivables and inventory.

We see, then, that the analysis of the trend of financial ratios over time, coupled with a comparison with industry averages, can give the analyst valuable insight into changes that have occurred in a firm's financial condition and performance. Additional insight can be provided if we extend our analysis to include comparisons with similar competitors in the industrv.