Chap003 Revised

8/22/2019 Chap003 Revised

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

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CHAPTER 3

Fundamental Interpretations

Made from Financial

Statement Data



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Financial Ratios and Trend Analysis

A ratio is simply the

relationship between

two numbers.

The large dollar amountsreported on the financial

statements of many

companies, and thevarying size of

companies, make ratioanalysis the only sensible

method of evaluatingvarious financialcharacteristics.

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Trend Analysis

Trend analysis

compares a singleobservation over

several years.

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Rate of Return

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.

Rate of

Return

Amount of Return

Amount of Investment=

L O 2

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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Return on Investment (R.O.I)

This ratio describes the rate of returnmanagement was able to earn on the assets

that it had available during the year.

Return on

Investment

Net Income

Average Total Assets=

L O 2

An informed judgment about the firmsprofitability requires relating net income to

the assets used to generate that net income.


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The DuPont Model

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.

Return onInvestment

Net IncomeSales

= SalesAverage Total Assets

Margin Turnover

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The DuPont Model

Return onInvestment

Net IncomeSales


Margin Turnover

Emphasizes that

from every dollar

of sales revenue,

some amountmust work its

way to net

income.

Relates

efficiency with

which the firms

assets are usedin the revenue-

generating

process.

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The DuPont Model

Return onInvestment

Net IncomeSales


Margin Turnover

A rule of thumb useful for putting ROI

in perspective is that average ROI,

based on net income, for most

American merchandising andmanufacturing companies is between

8% and 12%.

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Return on Equity

Owners are interested in expressing the

profits of the firm as a rate of return on the

amount of owners equity.

Return on

Equity

Net Income

Average Owners Equity=

L O 4

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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Working Capital

Current assets

- Current liabilities

Working capital

Working capital is the excess of a firmscurrent assets over its current liabilities.

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Current Ratio

This ratio measures the ability

of the company to pay current

debts as they become due.

Current

Ratio

Current Assets

Current Liabilities=

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As a rule of thumb, a current

ratio of 2.0 is considered

indicative of adequate liquidity.

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Acid-Test Ratio

Quick Assets

Current Liabilities=

Acid-Test

Ratio

Quick assets are cash

(including temporary cash

investments) and accountsreceivable.

This ratio provides information about an almost worst-

case situationthe firms ability to meet its currentobligations 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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Trend Analysis

This table illustrates the trend analysis of

return on investment, return on equity and

working capital.

Berry Products

Income Information

For the Years Ended December 31

Year

Item 2007 2006 2005 2004 2003

Return on Investment 18.50% 19.40% 22.50% 22.10% 20.60%

Return on Equity 26.50% 27.50% 33.20% 34.30% 33.40%

Working Capital 15,752$ 8,523$ 7,950$ 8,625$ 6,745$

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Trend Analysis

0.00%

10.00%

20.00%

30.00%

40.00%

2003 2004 2005 2006 2007Year

Return(%) Return on

Investment

Return on Equity

$0

$5,000

$10,000

$15,000

$20,000

2003 2004 2005 2006 2007

Year

WorkingCa

pital($)

We can use thetrend analysis to

construct graphs

so we can see

trends over time.

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Chap003 Revised