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McGraw-Hill/Irwin

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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
two numbers.

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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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24

Trend Analysis

LO 1

Trend analysis compares a single

observation over several years.

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25

LO 2

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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26

LO 2

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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27

The DuPont Model

LO 3

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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28

The DuPont Model

LO 3

Return on
Net income
=
investment
Sales

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Sales
Average total assets

Margin

Turnover

Emphasizes that
from every dollar
of sales revenue,
some amount
must work its
way to net
income.

Relates
efficiency with
which the firms
assets are used
in the revenuegenerating
process.

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29

The DuPont Model

LO 3

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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210

Return on Equity (ROE)

LO 4

Return on
=
equity

Net income
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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211

Measures of Liquidity

LO 5

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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212

Working Capital

LO 6

Current assets

- Current liabilities
Working capital
Working capital is the excess of a firms
current assets over its current liabilities.

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213

LO 6

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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214

Acid-Test Ratio

LO 6

The acid-test ratio is also known as the quick 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 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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215

LO 7

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Trend Analysis

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216

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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217

End of Chapter 3

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