Chapter 4 Using Financial Statements to Analyze Value Creation

Value Creation Management’s goal is to generate a return on the owners’ investment that exceeds the cost of equity. Return on equity (ROE) is used to make the comparison between an enterprise’s return on investment and the cost of that investment.

Return on Equity Return on Net Income Equity Average Shareholders’ Equity This ratio measures the effectiveness at managing capital provided by the shareholders.

Return on Assets Return on Net Income + Interest Expense (1-tax rate) Assets Average Total Assets This ratio measures the effectiveness at managing capital provided by all investors (stockholders and creditors).

Return on Sales Return on Net Income + Interest Expense (1-tax rate) Sales Net Sales This ratio provides an indication of a company’s ability to generate and market profitable products and control its costs; also called the Profit Margin.

Asset Turnover Ratios Asset turnover ratios are typically computed for total assets, accounts receivable, inventory, and fixed assets. These ratios measure the speed with which assets move through operations or reflect the number of times during a given period that these specific assets are acquired, used, and replaced.

Total Asset Turnover Ratio Total Asset Sales Turnover Average Total Assets This ratio measures the speed with which all assets are used up in operations.

Fixed Asset Turnover Ratio Fixed Assets Sales Turnover Average Fixed Assets This ratio measures the speed with which fixed assets are used up.

Receivables Turnover Ratio Receivables Net Credit Sales Turnover Average Accounts Receivable This ratio reflects the number of times the trade receivables were recorded, collected, and recorded again during the period.

Inventory Turnover Ratio Inventory Cost of Goods Sold Turnover Average Inventory This ratio measures the speed with which inventories move through operations.

Accounts Payable Turnover Accounts Cost of Goods Sold Payable Average Accounts Payable Turnover This ratio measures the extent to which accounts payable is used as a form of financing.

Solvency Ratios Solvency refers to a company’s ability to meet its current debts as they come due. There is pressure on companies with high levels of leverage to manage their solvency.

Current Ratio Current Current Assets Ratio Current Liabilities This ratio measures solvency in the sense that current assets can be used to meet current liabilities.

Quick Ratio Quick Cash + Marketable Securities + A/R Ratio Current Liabilities Similar to the current ratio, this ratio provides a more stringent test of a company’s solvency.

Leverage Leverage refers to using borrowed funds to generate returns for stockholders. Leverage is desirable because it creates returns for shareholders without using any of their money. Leverage increases risk by committing the company to future cash obligations.

Capital Structure Leverage Capital Average Total Assets Structure Average Stockholders’ Equity Leverage This ratio measures the extent to which a company relies on borrowings (liabilities).

Debt to Equity Ratio Debt to Equity Average Total Liabilities Ratio Average Shareholders’ Equity This ratio compares liabilities to shareholders’ equity and is another measure of capital structure leverage.

Long-term Debt Ratio Long-term Long-Term Debt Debt Ratio Total Assets This ratio measures the importance of long-term debt as a source of asset financing.

Common Equity Leverage Common Net Income Equity Net Income + Interest Expense (1-tax rate) Leverage This ratio compares the return available to the shareholders to returns available to all capital providers.

Interest Coverage Ratio Interest Net Income + Tax Expense + Interest Expense Coverage Interest Expense This ratio compares the annual funds available to meet interest to the annual interest expense.

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