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

CHAPTER 3
FUNDAMENTAL
INTERPRETATIONS
MADE FROM
FINANCIAL
STATEMENT DATA
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Learning Objectives
1.
2.
3.

4.

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
5.
6.

7.

What does liquidity mean and why
is it important?
How are working capital, current
ratio, and acid-test ratio calculated
and why are they significant?
How can trend analysis be used
most effectively?

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Learning Objective 1
ã

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Why are financial statement
ratios important?

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Financial Ratios and Trend
Analysis
•
•
•
•
•

A ratio is the relationship between two numbers
Ratios are useful for comparing different sized
firms
Average ratios for an industry are useful for
comparisons
A trend is comparing ratios over several time
periods
Trend analysis provides are more meaningful
comparisons
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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:
Interest = Principal x Rate x Time

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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

ã

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
May also be calculated as Operating Income /
Average Operating Assets
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Learning Objective 3
•

What is the DuPont model and what
do margin and turnover mean?

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The DuPont Model
•

An expansion of the basic return on investment
calculation

•

Return on Investment =
Net Income
Sales
x
Sales
Average Total Assets

•

Net Income / Sales = Margin

ã

Sales / Average Total Assets = Asset Turnover
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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
What is the significance of return on
equity and how is it calculated?

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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
ã

What does liquidity mean and
why is it important?

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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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Measures of Liquidity
•

Working Capital =
Current Assets less Current Liabilities

•

Current Ratio =
Current Assets divided by Current Liabilities

•

Acid-Test Ratio =
Cash and Accounts Receivable divided by
Current Liabilities
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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
useful in judging a firm’s current bill-paying
ability

•

As a general rule, a current ratio of 2.0 is
considered adequate

•

The higher the current ratio, the better –
up to a point
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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 in its calculation

•

As a general rule, an Acid-Test Ratio of 1.0
is considered adequate
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Learning Objective 7
ã

How can trend analysis be used
most effectively?

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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

ã

See following graph of margin and
turnover for Intel Corporation
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1.2

30

1.0

27

0.8

24

0.6

21
1995

1996

1997

1998

Margin

Turnover

Intel Corporation
Margin and Turnover, 1995 - 1999

1999

Years ended the last Saturday in December

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