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2 Accounting What the Numbers Mean CHAPTER 3: Fundamental Interpretations Made from Financial Statement Data Marshall, McManus, and Viele 11th Edition 3-2

3 Learning Objectives After studying this chapter you should understand and be able to: LO 3-1: Discuss why financial statement ratios are important. LO 3-2: Explain the importance and show the calculation of return on investment. LO 3-3: Illustrate how to calculate and interpret margin and turnover using the DuPont model. LO 3-4: Explain the importance and show the calculation of return on equity. LO 3-5: Explain the meaning of liquidity and discuss why it is important. LO 3-6: Discuss the significance and calculation of working capital, the current ratio, and the acid-test ratio. LO 3-7: Generalize about how trend analysis can be used most effectively. 3-3

4 Financial Ratios and Trend Analysis A ratio is simply the relationship between two numbers. The large dollar amounts reported on the financial statements of many companies, and the varying size of companies, make ratio analysis the only sensible method of evaluating various financial characteristics. Learning Objective 3-1: Discuss why financial statement ratios are important. 3-4

5 Trend Analysis Trend analysis compares a single observation over several years. Trend analysis example: Suppose a student s grade point average for last semester was 3.5 on a 4.0 scale. That GPA may be interesting, but it says little about the student s work. However, suppose you learn that this student s GPA was 1.9 four semesters ago, 2.7 three semesters ago, and 3.0 two semesters ago. The upward trend of grades suggests that the student is working smarter and harder. Learning Objective 3-1: Discuss why financial statement ratios are important. 3-5

6 Rate of Return Rate of return = Amount of return Amount of investment This ratio provides the return on a given investment alternative. All other things being equal, the higher the rate of return, the more profitable the alternative. The rate of return calculation is derived from the interest calculation. Interest = Principal Rate Time Higher rates of return are associated with greater risk! Learning Objective 3-2: Explain the importance and show the calculation of return on investment 3-6

7 Return on Investment (R.O.I.) Return on investment = Net income Average total assets This ratio describes the rate of return management was able to earn on the assets that it had available during the year. An informed judgment about the firm s profitability requires relating net income to the assets used to generate that net income. Learning Objective 3-2: Explain the importance and show the calculation of return on investment 3-7

8 The DuPont Model Return on Net income investment = Sales Sales Average total assets Margin Turnover The DuPont model is an expansion of the basic ROI calculation. The developers of the model reasoned that profitability from sales and utilization of assets to generate sales revenue were both important factors to be considered when evaluating profitability. Learning Objective 3-3: Illustrate how to calculate and interpret margin and turnover using the DuPont model. 3-8

9 The DuPont Model Return on Net income investment = Sales Sales Average total assets Margin Emphasizes that from every dollar of sales revenue, some amount must work its way to net income. Turnover Relates efficiency with which the firm s assets are used in the revenuegenerating process. Learning Objective 3-3: Illustrate how to calculate and interpret margin and turnover using the DuPont model. 3-9

10 The DuPont Model Return on Net income investment = Sales Sales Average total assets Margin Turnover A rule of thumb useful for putting ROI in perspective is that average ROI, based on net income, for most American merchandising and manufacturing companies is between 8% and 12%. Learning Objective 3-3: Illustrate how to calculate and interpret margin and turnover using the DuPont model. 3-10

11 Return on Equity (ROE) Return on equity = Net income Average stockholders' equity Owners are interested in expressing the profits of the firm as a rate of return on the amount of stockholders' equity. As a rule of thumb, average ROE for most American merchandising and manufacturing companies has historically ranged from 10% to 15%. Learning Objective 3-4: Explain the significance and calculation of return on equity. 3-11

12 Measures of Liquidity Liquidity refers to a firm s ability to meet its current obligations and is measured by relating its current assets and current liabilities as reported on the balance sheet. Liquidity is measured in three principal ways: Working Capital Current Ratio Acid-Test Ratio Learning Objective 3-5: Explain the meaning of liquidity and discuss why it is important. 3-12

13 Working Capital Current assets - Current liabilities Working capital Working capital is the excess of a firm s current assets over its current liabilities. Learning Objective 3-6: Discuss the significance and calculation of working capital, the current ratio, and the acid-test ratio. 3-13

14 Current Ratio Current ratio = Current assets Current liabilities This ratio measures the ability of the company to pay current debts as they become due. As a rule of thumb, a current ratio of 2.0 is considered indicative of adequate liquidity. Learning Objective 3-6: Discuss the significance and calculation of working capital, the current ratio, and the acid-test ratio. 3-14

15 Acid-Test Ratio The acid-test ratio is also known as the quick ratio. Acid-test ratio = Quick assets Current liabilities Quick assets are cash (including temporary cash investments) and accounts receivable. This ratio provides information about an almost worstcase situation the firm s ability to meet its current obligations even if none of the inventory can be sold. As a rule of thumb, an acid-test ratio of 1.0 is considered indicative of adequate liquidity. Learning Objective 3-6: Discuss the significance and calculation of working capital, the current ratio, and the acid-test ratio. 3-15

16 Trend Analysis A trend analysis is an evaluation of selected data over time. Remember our student s grades example at the beginning of this presentation? This table illustrates the trend analysis of return on investment, return on equity, and working capital for Campbell Soup over a five-year period. TABLE 3.1 CAMPBELL SOUP COMPANY (PROFITABILITY* AND LIQUIDITY DATA, ) Margin (net earnings /net sales) Turnover (net sales/average total assets) ROI (net earnings/average total assets) ROE (net earnings/average total equity) Year-end position (in millions): Current assets $2,100 $2,221 $1,771 $1,963 $1,687 Current liabilities 2,989 3,282 2,070 1,989 2,065 Working capital (889) (1,061) (299) (26) (378) Current ratio Learning Objective 3-7: Generalize about how trend analysis can be used most effectively. 3-16

17 Trend Analysis We can also use the trend analysis to construct graphs so we can see trends over time. Learning Objective 3-7: Generalize about how trend analysis can be used most effectively. 3-17

18 End of Chapter