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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

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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?...

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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?

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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?

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Financial Ratios and Trend

Analysis

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Learning Objective 2

- How Is return on investment

calculated and why Is It

important?

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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:

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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

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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

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Learning Objective 3

¢ What is the DuPont model and what

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The DuPont Model

An expansion of the basic return on investment calculation

Return on Investment =

Net Income Sales

Sales Average Total Assets

Net Income / Sales = Margin

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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

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Learning Objective 4

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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

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Learning Objective 5

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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

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Learning Objective 6

* How are working capital,

current ratio, and acid-test ratio

calculated and why are they significant?

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Current Ratio

- The trend in the current ratio is the most

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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

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Learning Objective 7

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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

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