Financial data, along with other pertinent information, assist company managers in investment and financial decision-making. This information equally provides very useful signals to customers and creditors in determining the financial performance of a firm in which they have either extended credit, invested their funds, or even consider viable in future investments in the ever-unpredictable economic conditions. There are different financial and accounting ratios calculated from the financial statements of a firm. The choices of any particular financial ratios for analysis primarily depends on the needs the parties involved are interested in finding out concerning a particular company.
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In addressing the issues facing Ivory Furniture Company, Danna, a university graduate in finance and accounting with five years of banking called upon and given the job to perform her own analysis of the company’s financial statements for the last two years, has performed several analysis. In particular, she has calculated DuPont ratio as performance indicators to show to the bankers, in her efforts to assist her boss CEO Robert Bradley to fight back his case with the First National Bank Loan Officer and long time associate Mr. John Pratt.
Value of DuPont ratio
Donnas’ findings in the calculation of DuPont ratio can be proven valuable to Ivory’s President. This is because these ratios focus on Ivory’s measurement of the return on invested or employed capital. According to Bragg (2006, p.53), the DuPont ratio has been used in corporate and business settings since the 1970s. The formula focuses management’s attention on three critical elements. That is good financial condition- operating management, asset management, and capital structure management. The formula moves beyond strict ratio analysis to show the interrelationship between key financial ratios. It can enable Ivory’s CEO to gauge the financial health of the company in relation to the following: Operating efficiency, asset use efficiency, and financial leverage.
Interpretation of Donnas’ findings in the calculation of DuPont ratio
In the year 2006, the company’s Return on Investment was 29.0 percent and 29.4 percent in the year 2007. These findings, therefore, show that the firm’s return on investment rose by 0.4 percent for the period of one year. Although the increase is of a small margin, it is evident that the company’s operating management is effective; that is, it is producing sales and controlling costs. It is also a good sign that asset management is effective, meaning that the firm is able to produce sales from its assets, and to some extent, the company is trying to manage its debt.
Justification of the stagnant changes in Ivory’s returns on investment
The stagnant changes in the firm’s returns on investment may be due to the increase in its financial leverage. It is not desirable for the company to have an increase in financial leverage over time. An increase means that debt is being used primarily to finance the firm in lieu of the effective use of all capital instruments like cash, assets, debt, and equity. It can also be a result of the economic conditions and the nature of the industry in which Ivory is in.
Banks decision based on Dona’s financial analysis
Based on Donna’s financial analysis, I believe that the bank should not demand full repayment of the loans granted to Ivory. This is because of the following: first, the firm’s financial data are average in line with the corresponding ones in the furniture industry. This, therefore, means that the firm can improve its performance if the prevailing economic conditions can change. The bank should, therefore, allow the firm to use the loan since this can boost its operations and yield better returns.
The liquidity ratios of the firm are low compared to the industry; for example, in the year 2007, the current ratio of the firm is 0.5 compared to the industry ratio of 1.8. This low current ratio indicates a relatively weak liquidity position, which means that it will be hard for the firm to pay the loan the bank demands. This rule has not been achieved by the average industry ratio. The operating efficiency ratio is positive and rises across time; it is a good sign for effective management operating. Equally, it is also a good sign of effective management when total assets return positive arising period to period.
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A rising ratio means that the firm is able to produce more and more sales from its assets; thus, their firm has, on average good asset intensity comparing to the industry.
The analysis only involves the comparison of the company’s performance using the financial data of two periods. The analysis, therefore, can only be successful when financial data is available for more periods. Equally, the analysis may only be a reflection of the company’s past performance, which may not be a reflection of its future at the same time. The company, therefore, should not demand full repayment of the loan based only on this analysis.
Credit extension by the firm
Donna’s financial analysis would not make it possible for the bank to extend credit. Although from the calculations, the firm’s trade seems to be increasing, the rate of the increase is very low. The bank needs money to run its operations. Like any other institution that joins the business to earn profits, the bank aims to earn a substantial amount of income in order to continue the operations. Currently, the bank is concerned with the loan, which is already outstanding. It is, therefore, aiming to recover this amount first and being reasonably assured that it can recover the amount before granting an additional loan to Ivory, whose financial positions signal a possible financial crisis if not handled properly.
Company owners and investors often use financial ratios to analyze a company’s performance. Ratios are compared from period to period, industry surveys, and benchmarks to assess the company’s performance in its industry sector. The financial analysis done by Danna on Ivory’s financial data shows that the firm’s performance is not so much attractive to investors. Investors that are risk-averse can hardly extend credit to the firm.
This can lead to the firm’s bankruptcy. This, therefore, means that First banks’ concerns are right since if the firm cannot manage its operations well, it might be hard for it to continue with the business. Financial ratios are only comparative tools that can be used show the firm that something is different from other firms or, through time, point to potential problems, but probably not what is wrong and also the firms can use the analysts can use these measurements to decide the next course of action.
In deciding on how to treat Ivory Company concerning its creditworthiness, First Bank should take into consideration some other factors apart from the financial analysis information. Factors like the economic conditions, the firm’s plans in the future, and its potential to grow in the future. This is because the analysis is not sufficient to enable the bank to make a sound decision. The bank may be running away from a business partner that can be of greater value in the future.
Finally, the DuPont ratio calculated will equally help Ivory’s equity shareholders and other investors to assess the value and quality of an investment in the ordinary shares of a company. The value of an investment in ordinary shares of the firm will thus be influenced greatly.
Bragg, Steven. Business Ratios and Formulas: A Comprehensive Guide. Minneapolis: Wiley, 2006.