After reading this chapter, you should be able to answer the following questions: What are generally accepted accounting principle? What kind of information is reported on each financial

After reading this chapter, you should be able to answer the following questions: Why are financial statement ratios important? How is return on investment calculated and why is it important? What is the DuPont model and what do margin and turnover mean? What is the significance of return on equity and how is it calculated?...

CHAPTER 3

FUNDAMENTAL

INTERPRETATIONS

MADE FROM FINANCIAL STATEMENT DATA

Learning Objectives

1 Why are financial statement ratios

Important?

2 How Is return on investment

calculated and why Is it important?

3 What is the DuPont model and

what do margin and turnover

mean?

4 What is the significance of return on

equity and how Is It calculated?

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Learning Objectives

5 What does liquidity mean and why

is It Important?

6 How are working capital, current

ratio, and acid-test ratio calculated and why are they significant?

7 Howcan trend analysis be used

most effectively?

Financial Ratios and Trend

Learning Objective 2

- How Is return on investment

calculated and why Is It

important?

cGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Return on Investment

Calculations

¢ Rate of return =

Amount of return / Amount of investment

Return on investment is a measure of

profitability

Derived from the interest calculation of:

Interest = Principal x Rate x Time

Return on Investment

and Risk

- In evaluating Investments, risk must also

be considered

- Risk relates to the range of outcomes from

an activity; wider range = greater risk

- In general, higher risk = higher return

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Financial Statements and

Return on Investment

¢ Also called Return on Assets

- The amount of return = Net Income

- The amount of the Investment = Average Total

Assets

- Describes the rate of return management was able

to earn on the assets available to use during the

year

- May also be calculated as Operating Income /

Average Operating Assets

Learning Objective 3

¢ What is the DuPont model and what

do margin and turnover mean?

The DuPont Model

An expansion of the basic return on investment calculation

Return on Investment =

Sales Average Total Assets

Net Income / Sales = Margin

Sales / Average Total Assets = Asset Turnover

Margin and Asset Turnover

- Margin indicates that some sales

revenues must result in net income if the

firm Is to be profitable

- Turnover indicates how efficiently the firm

IS uSing Its assets to generate revenue

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Learning Objective 4

What Is the significance of return on equity and how Is It calculated?

Return on Equity

- Return on Equity is a special case

application of the rate of return concept

- Return on Equity =

Net Income

Average Owners’ Equity

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Learning Objective 5

° What does liquidity mean and

why Is It important?

Working Capital and Measures

of Liquidity

* Liquidity is the firm’s ability to meet Its current obligations

* Working capital is the excess of a firm’s

current assets over Its current liabilities

— Current assets are cash and other assets

likely to be converted to cash within a year

— Current liabilities are those obligations

expected to be paid within a year

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Learning Objective 6

* How are working capital,

current ratio, and acid-test ratio

calculated and why are they

significant?

cGraw-Hill/Irwin

Current Ratio

- The trend in the current ratio is the most

useful in judging a firm’s current bill-paying ability

- As ageneral rule, a current ratio of 2.0 Is

considered adequate

- The higher the current ratio, the better —

up to a point

Acid-Test Ratio

- Also known as the Quick Ratio

° The Acid-Test Ratio is a more conservative

measure of liquidity since Inventory Is not

included tn its calculation

- As ageneral rule, an Acid-Test Ratio of 1.0

Is considered adequate

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Learning Objective 7

*- How can trend analysis be used

most effectively?

Trend Analysis

- Graph return against the year, with the

years listed on the horizontal axis

- The more compressed the graph, the

more pronounced the peaks and

valleys

- See following graph of margin and

turnover for Intel Corporation

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Intel Corporation Margin and Turnover, 1995 - 1999