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 FUNDAMENTAL INTERPRETATIONS MADE FROM FINANCIAL STATEMENT DATA McGraw­Hill/Irwin ©The McGraw­Hill Companies, Inc., 2002 Learning Objectives Why are financial statement ratios important? How is return on investment calculated and why is it important? What is the DuPont model and what margin and turnover mean? What is the significance of return on equity and how is it calculated? McGraw­Hill/Irwin ©The McGraw­Hill Companies, Inc., 2002 Learning Objectives What does liquidity mean and why is it important? How are working capital, current ratio, and acid-test ratio calculated and why are they significant? How can trend analysis be used most effectively? McGraw­Hill/Irwin ©The McGraw­Hill Companies, Inc., 2002 Learning Objective • McGraw­Hill/Irwin Why are financial statement ratios important? âTheMcGrawưHillCompanies,Inc.,2002 Financial Ratios and Trend Analysis ã ã ã • • A ratio is the relationship between two numbers Ratios are useful for comparing different sized firms Average ratios for an industry are useful for comparisons A trend is comparing ratios over several time periods Trend analysis provides are more meaningful comparisons McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 Learning Objective ã How is return on investment calculated and why is it important? McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 Return on Investment Calculations ã 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 McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 Return on Investment and Risk ã 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 McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 Financial Statements and Return on Investment ã • • • • 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 McGraw­Hill/Irwin ©The McGraw­Hill Companies, Inc., 2002 Learning Objective • What is the DuPont model and what margin and turnover mean? McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 The DuPont Model ã An expansion of the basic return on investment calculation • Return on Investment = Net Income Sales x Sales Average Total Assets • Net Income / Sales = Margin • Sales / Average Total Assets = Asset Turnover McGraw­Hill/Irwin ©The McGraw­Hill Companies, Inc., 2002 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 McGraw­Hill/Irwin ©The McGraw­Hill Companies, Inc., 2002 Learning Objective What is the significance of return on equity and how is it calculated? McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 Return on Equity ã Return on Equity is a special case application of the rate of return concept • Return on Equity = Net Income Average Owners Equity McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 Learning Objective ã What does liquidity mean and why is it important? McGraw­Hill/Irwin ©The McGraw­Hill Companies, Inc., 2002 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 McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 Measures of Liquidity ã Working Capital = Current Assets less Current Liabilities • Current Ratio = Current Assets divided by Current Liabilities • Acid-Test Ratio = Cash and Accounts Receivable divided by Current Liabilities McGraw­Hill/Irwin ©The McGraw­Hill Companies, Inc., 2002 Learning Objective • How are working capital, current ratio, and acid-test ratio calculated and why are they significant? McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 Current Ratio ã The trend in the current ratio is the most useful in judging a firm’s current bill-paying ability • As a general rule, a current ratio of 2.0 is considered adequate • The higher the current ratio, the better – up to a point McGraw­Hill/Irwin ©The McGraw­Hill Companies, Inc., 2002 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 in its calculation • As a general rule, an Acid-Test Ratio of 1.0 is considered adequate McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 Learning Objective ã How can trend analysis be used most effectively? McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 Trend Analysis ã 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 McGraw­Hill/Irwin ©The McGraw­Hill Companies, Inc., 2002 1.2 30 1.0 27 0.8 24 0.6 21 1995 1996 1997 1998 Margin Turnover Intel Corporation Margin and Turnover, 1995 - 1999 1999 Years ended the last Saturday in December McGraw­Hill/Irwin ©The McGraw­Hill Companies, Inc., 2002 ... Objectives Why are financial statement ratios important? How is return on investment calculated and why is it important? What is the DuPont model and what margin and turnover mean? What is the significance... 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... trend analysis be used most effectively? McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 Trend Analysis ã Graph return against the year, with the years listed on the horizontal axis • The more