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Marshall,McManus,andViele11thEdition

AccountingWhattheNumbersMean

CHAPTER3:FundamentalInterpretationsMadefromFinancialStatementData

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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.

LearningObjectives

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FinancialRatiosandTrendAnalysis

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.

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TrendAnalysisTrend 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.

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RateofReturn

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.

Rate of return

Amount of return Amount of investment=

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

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ReturnonInvestment(R.O.I.)

This ratio describes the rate of return management was able to earn on the assets

that it had available during the year.

Return on investment

Net income Average total assets=

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

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TheDuPontModel

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.

Return on investment

Net income Sales= Sales

Average total assets×

Margin Turnover

Return on investment = ×

Learning Objective 3-3: Illustrate how to calculate and interpret margin and turnover using the DuPont model.

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TheDuPontModel

Emphasizes that from every dollar of sales revenue,

some amount must work its

way to net income.

Relates efficiency with

which the firm’s assets are used in the revenue-

generating process.

Return on investment

Net income Sales= Sales

Average total assets×

Margin Turnover

Return on investment = ×

Learning Objective 3-3: Illustrate how to calculate and interpret margin and turnover using the DuPont model.

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TheDuPontModel

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%.

Return on investment

Net income Sales= Sales

Average total assets×

Margin Turnover

Return on investment = ×

Learning Objective 3-3: Illustrate how to calculate and interpret margin and turnover using the DuPont model.

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ReturnonEquity(ROE)

Owners are interested in expressing the profits of the firm as a rate of return on the

amount of stockholders' equity.

Return on equity

Net income Average 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.

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MeasuresofLiquidityLiquidity 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.

•Working Capital

•Current Ratio

•Acid-Test Ratio

Liquidity is measured in three principal ways:

Learning Objective 3-5: Explain the meaning of liquidity and discuss why it is important.

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WorkingCapital

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.

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CurrentRatio

This ratio measures the abilityof the company to pay current

debts as they become due.

Currentratio

Current assets Current liabilities=

As a rule of thumb, a current ratio of2.0 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.

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Acid-TestRatio

Quick assets Current liabilities=Acid-test

ratio

Quick assets are cash (including temporary cash investments) and

accounts receivable.

This ratio provides information about an almost worst-case 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.

The acid-test ratio is also known as the quick ratio.

Learning Objective 3-6: Discuss the significance and calculation of working capital, the current ratio, and the acid-test ratio.

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TrendAnalysis

Remember our student’s grades example at the beginning of this presentation?

A trend analysis is an evaluation of selected data over time.

TABLE3.1 CAMPBELLSOUPCOMPANY(PROFITABILITY*ANDLIQUIDITYDATA,† 2010–2014)2014 2013 2012 2011 2010

Margin (net earnings‡/net sales) 9.9 5.7 10.8 11.3 11.9

Turnover (net sales/average total assets) 1.01 1.08 1.07 1.09 1.15

ROI (net earnings/average total assets) 10.0 6.2 11.6 12.3 13.7

ROE (net earnings/average total equity) 58.2 43.5 77.6 79.5 101.7Year-end position (in millions):Current assets $2,100 $2,221 $1,771 $1,963 $1,687Current liabilities 2,989 3,282 2,070 1,989 2,065Working capital (889) (1,061) (299) (26) (378)Current ratio 0.70 0.68 0.86 0.99 0.82

This table illustrates the trend analysis of return on investment, return on equity, and working capital for Campbell Soup over a five-year period.

Learning Objective 3-7: Generalize about how trend analysis can be used most effectively.

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TrendAnalysisWe 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.

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EndofChapter3