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CHAPTER 3

Fundamental Interpretations Made from Financial Statement Data

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LO1

Financial Ratios and Trend Analysis

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.
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A ratio is simply the relationship between two numbers.

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LO1

Trend Analysis

Trend analysis compares a single observation over several years.

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LO2

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!
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LO2

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

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LO3

The DuPont Model

Return on Net Income = Investment Sales Margin

Sales Average Total Assets 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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LO3

The DuPont Model

Return on Net Income = Investment Sales Margin Emphasizes that from every dollar of sales revenue, some amount must work its way to net income.

Sales Average Total Assets Turnover Relates efficiency with which the firms assets are used in the revenuegenerating process.

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LO3

The DuPont Model

Return on Net Income = Investment Sales Margin

Sales Average Total Assets 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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LO4

Return on Equity
Return on = Equity Net Income Average Owners Equity

Owners are interested in expressing the profits of the firm as a rate of return on the amount of owners 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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LO5

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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LO6

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.

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LO6

Acid-Test 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 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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LO7

Trend Analysis
Berry Products Income Information For the Years Ended December 31

Item Return on Investment Return on Equity Working Capital

Year 2007 2006 2005 2004 2003 18.50% 19.40% 22.50% 22.10% 20.60% 26.50% 27.50% 33.20% 34.30% 33.40% $ 15,752 $ 8,523 $ 7,950 $ 8,625 $ 6,745

This table illustrates the trend analysis of return on investment, return on equity and working capital.
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LO7

Trend Analysis
Return on Investment Return on Equity

40.00%
Return (%)

30.00% 20.00% 10.00% 0.00% 2003 2004 2005 Year 2006 2007

We can use the trend analysis to construct graphs so we can see trends over time.

Working Capital ($)

$20,000 $15,000 $10,000 $5,000 $0 2003 2004 2005 Year 2006 2007

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End of Chapter 3

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