Question

If we divide users of ratios into short-term lenders, long-term lenders, and stockholders, which ratios would each group be most interested in, and for what reasons? Explain how the Du Pont system of analysis breaks down return on assets. Also explain how it breaks down return on stockholders’ equity. If the accounts receivable turnover ratio is decreasing, what will be happening to the average collection period?  

Answer 1

Short-term lenders

They would be most interested in short-term liquidity ratios - current ratio, quick ratio and cash ratio. This is because short-term lenders are owed their dues within one year. Therefore, they are most interested in whether the short term assets of the firm are adequate to meet its short-term liabilities. The above mentioned ratios best indicate the short term solvency position of a firm.

Long-term lenders

They would be most interested in financial leverage ratios and interest coverage ratios - debt ratio, debt-equity ratio and interest coverage ratio. This is because long-term lenders are owed their dues over the long term. Therefore, they are most interested in whether the firm is over-leveraged, and whether its operating income is adequate to meet its interest expenses.

Stockholders

Stockholders would be interested in profitability ratios and market ratios - profit margin, return on assets, return on equity, price to earnings ratio, price to cash flow ratio. This is because stockholders expect the firm to be profitable consistently over time, and generate adequate cash flows to distribute to stockholders. Market ratios indicate whether the firm is fairly valued relative to its own historical valuation, and relative to its peers in the same industry.

As per the DuPont system, return on assets is broken down as :

return on assets = net profit margin * total asset turnover

As per the DuPont system, return on equity is broken down as :

return on assets = net profit margin * total asset turnover * equity multiplier

Accounts receivable turnover = credit sales / accounts receivable

Average collection period = 365 / accounts receivable turnover

Therefore, if the accounts receivable turnover ratio is decreasing, it means that the average collection period is increasing

Answer 2

Short term