2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

McGraw-Hill/Irwin Copyright 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter 3
Fundamental Interpretations Made
from Financial Statement Data
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA

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 23

LO 1
Financial Ratios and Trend
Analysis
A ratio is simply the
relationship between
The large dollar amounts
two numbers. 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.
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LO 1 Trend Analysis

Trend analysis compares a single

observation over several years.

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LO 2 Rate of Return
Rate of Amount of return
=
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!
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LO 2 Return on Investment (R.O.I.)

Return on Net income

=
investment 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 firms

profitability requires relating net income to
the assets used to generate that net income.

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LO 3 The DuPont Model

Return on Net income Sales
investment
=
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.
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LO 3 The DuPont Model

Return on Net income Sales
investment
=
Sales
Average total assets

Margin Turnover

Emphasizes that Relates

from every dollar efficiency with
of sales revenue, which the firms
some amount assets are used
must work its in the revenue-
way to net generating
income. process.

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LO 3 The DuPont Model

Return on Net income Sales
investment
=
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%.

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LO 4 Return on Equity (ROE)

Return on Net income

=
equity Average stockholders' equity

Stockholders 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%.
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LO 5 Measures of Liquidity
Liquidity refers to a firms 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

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LO 6 Working Capital

Current assets
- Current liabilities
Working capital

Working capital is the excess of a firms

current assets over its current liabilities.

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LO 6 Current Ratio
Current Current assets
=
ratio 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.

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LO 6 Acid-Test Ratio
The acid-test ratio is also known as the quick ratio.
Acid-test Quick assets
=
ratio Current liabilities

Quick assets are cash (including

temporary cash investments) and
accounts receivable.

This ratio provides information about an almost worst-case

situationthe firms 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.
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LO 7 Trend Analysis

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LO 7 Trend Analysis
We can also use
the trend analysis
to construct
graphs so we can
see trends over
time.

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End of Chapter 3

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