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Capitalization Trends

The best method for interpreting a particular trend is to check other trends to find verification or contradiction. For example, if sales are growing strongly but long-term debt is also rising or rises and falls from one year to the next, it is a puzzle. A well-controlled financial plan will probably include growth in sales, maintenance of gross margin and expense levels, and steady net earnings; it will also include level and consistent long-term debt, healthy working capital, and other financial ratios in line with what you would expect.

Danger signals can appear in many places. For example, if the level of accounts receivable is outpacing growth in sales, you would expect to see the effects in working capital. However, if working capital remains strong but is offset by increases in long-term debt, that is a warning sign. It indicates that the company is bolstering working capital by committing itself to debt, which adversely affects working capital in the long term. As more payments go toward debt service and interest, there is less profit remaining from future earnings to continue funding operations or to pay dividends.


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