Trend Analysis - Financial Management

Thus far, the analysis of the Drake Manufacturing Company has focused solely on the year 2006. This has provided a fairly complete, if rather static, picture of the company’s situation at that particular point in time in comparison with industry standards. To gain insight into the direction the company is moving, however, a trend analysis should be performed. A trend analysis indicates a firm’s performance over time and reveals whether its position is improving or deteriorating relative to other companies in the industry.

A trend analysis requires that a number of different ratios be calculated over several years and plotted to yield a graphic representation of the company’s performance. We depicts a trend analysis for the Drake Company for the years 2000 to 2006 and indicates the direction the firm has been taking for the past several years. Each of the four different categories of financial ratios is represented in the figure. For example, it is evident that the firm’s liquidity position—as measured by the quick ratio—has declined gradually over the 7-year period, falling to slightly below the industry average in 2006. Unless this downward trend continues, however, liquidity should not be a major problem for the firm.

The trend analysis tells another story about the firm’s leverage and profitability. Drake’s use of debt has exceeded the industry average since 2002. The asset management ratios— the total asset turnover ratio and the average collection period ratio —indicate that the company has used much of this new debt to finance additional assets, including a buildup in receivables.Unfortunately, the new assets have not produced offsetting increases in profits. As a result, returns on investment have dropped below the industry standards by increasing amounts over the past seven years.

In summary, the comparative financial ratio analysis and the trend analysis combined provide a fairly clear picture of Drake’s performance. As is evident from the analysis, Drake has employed excessive debt to finance asset additions that have not been sufficiently productive in generating sales revenues. The result is returns on investment and stockholders’ equity that are significantly lower than the industry average. If the firm intends to reverse these trends, it will have to make more effective use of assets and reduce the use of creditors’ funds. These steps will enable the firm to improve relations with creditors and potentially increase profitability and reduce risk for its owners.

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