McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-1 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-1 CHAPTER 3 Fundamental Interpretations Made from Financial Statement Data McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-2 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-2 Financial Ratios and Trend Analysis A ratio is simply the relationship between two numbers. 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. L O 1

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-3 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-3 Trend Analysis Trend analysis compares a single observation over several years. L O 1

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-4 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-4 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!

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-5 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-5 Return on Investment (R.O.I) This ratio describes the rate of return management 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 firm’s profitability requires relating net income to the assets used to generate that net income.

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-6 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-6 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 on Investment Net Income Sales = Average Total Assets × MarginTurnover L O 3

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-7 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-7 The DuPont Model Return on Investment Net Income Sales = Average Total Assets × MarginTurnover Emphasizes that from every dollar of sales revenue, some amount must work its way to net income. Relates efficiency with which the firm’s assets are used in the revenue- generating process. L O 3

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-8 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-8 The DuPont Model Return on Investment Net Income Sales = Average Total Assets × MarginTurnover 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%. L O 3

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-9 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-9 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%.

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Working Capital Working capital is the excess of a firm’s current assets over its current liabilities. L O 5

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Current Ratio This ratio measures the ability of the company to pay current debts as they become due. Current Ratio Current Assets Current Liabilities = L O 6 As a rule of thumb, a current ratio of 2.0 is considered indicative of adequate liquidity.

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Acid-Test Ratio Quick Assets Current Liabilities = Acid-Test Ratio Quick assets are cash (including temporary cash investments) and accounts receivable. This ratio provides information about an almost worst- case situation—the firm’s 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. L O 6

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved 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 L O 7

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved Trend Analysis We can use the trend analysis to construct graphs so we can see trends over time. L O 7

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved End of Chapter 3