CHAPTER 3
Fundamental Interpretations Made from
Financial Statement Data
Overview
• Financial ratios and trend analysis
• Return on assets
• ROA - The Dupont model
• Return on equity
• Liquidity, working capital and ratios
• Trend analysis
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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.
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Financial Ratios and Trend Analysis
A single ratio is not very
useful in describing a
company.
Trend analysis
compares a single
observation over
several years.
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Financial Ratios and Trend Analysis
Trend Analysis
Also used for
comparison of
company ratios with
those of other
companies in same
industry
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Industry
average
ratios
Company’s
relative
standing in
the industry
3-5
Return on Assets
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.
Useful to compare different and unequal
investments.
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Return on Assets
Higher risk –
investor anticipates
higher ROR
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Return on Assets
Rate of
=
Return
Amount of Return
Amount of Investment
The rate of return calculation is derived
from the interest calculation.
Interest = Principal × Rate × Time
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Return on Assets
RETURN ON ASSETS
• rate of return using data from
financial statements
• sometimes called return on
investments
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Return on Assets
Return on
=
Assets
Income from operations
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 judgement about the firm’s
profitability requires relating income from
operations to the assets used to generate that
net profit.
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Return on Assets
Income from operations
EBIT –
Earnings
Before
Income and
Tax
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Total return to all
providers of finance
without the
complications of tax
3-11
ROA - The DuPont Model
The DuPont Model is an expansion of the basic
ROA calculation.
Return on
=
Assets
EBIT
Sales
Margin
×
Sales
Average Total Assets
Turnover
Profitability from sales and utilisation of assets to generate
sales revenue are both important factors to be considered
when evaluating profitability.
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The DuPont Model
Return on
=
Assets
EBIT
Sales
× AverageSales
Total Assets
Margin
Emphasises that
from every dollar of
sales revenue, some
amount must work
its way to net profit.
Turnover
Relates efficiency
with which the
firm’s assets are
used in the revenuegenerating process.
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The DuPont Model
Return on
=
Assets
EBIT
Sales
Sales
× Average Total Assets
Margin
Turnover
A rule of thumb useful for putting
ROA in perspective is that average
ROA, based on net profit, for most
global merchandising and
manufacturing companies is between
8% and 12%.
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Return on Equity
Return on
=
Equity
Net Profit (after tax)
Average Owners’ Equity
Owners are interested in expressing the profits of the
firm as a rate of return on the amount of owners’ equity.
As a rule of thumb, average ROE for most global
merchandising and manufacturing companies has
historically ranged from 10% to 15%.
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Liquidity and Working Capital
Liquidity
Firm’s ability to
meet current
obligations
Measured in three ways:
1. Working capital
2. Current ratio
3. Quick ratio
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Liquidity and Working Capital
Working capital
Current assets
- Current liabilities
Working capital
Working capital is the excess of a firm’s current
assets over its current liabilities.
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Liquidity and Working Capital
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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Liquidity and Working Capital
Current ratio – need to balance:
Debtpaying
ability
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Most
productive
use of
assets
3-19
Liquidity and Working Capital
Acid-test 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
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.
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Trend Analysis
Example
PRIMARY HEALTH
CARE LTD
Figures come from the published
financial statements.
Data is presented in tables and graphs
on the following slides:
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Trend Analysis
Primary Health Care Group
Profitability and Liquidity Data 1999-2003
2003
2002
2001
2000
1999
7%
0.63
4.40%
7%
6%
0.45
2.50%
5%
7%
0.47
3.30%
6%
8%
0.56
4.40%
7%
11%
0.59
6.60%
0%
66407
18158
48249
3.66
54070
15022
39048
3.60
23855
19249
4606
1.24
8684
18850
-10166
0.46
Ratios
Margin
Turnover
ROA
ROE
Year end position (millions)
Current assets
Current liabilities
Working Capital
Current ratio
22113
16464
5649
1.34
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Trend Analysis
PRIMARY HEALTH CARE GROUP LTD,
RETURN ON ASSETS (ROA) AND RETURN
ON EQUITY (ROE), 1999-2003
14%
Return (%)
12%
10%
8%
6%
4%
2%
0%
1999
2000
2001
2002
2003
Years ended 30 June
ROA
ROE
Declining profitability with slight improvement in 2003, although
not as high as returns before the company went public in 1999.
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Trend Analysis
Turnover
0.8
0.6
0.4
0.2
0
1999
2000
2001
2002
Years ended June 30
Margin
12%
10%
8%
6%
4%
2%
0%
2003
Margin (%)
PRIMARY HEALTH CARE GROUP LTD, MARGIN AND
TURNOVER, 1999-2003
Steady
decline of
turnover and
margin until
2002, with
slight
recovery in
2003.
Turnover
Be aware of the impact of scales selected.
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Trend Analysis
1999
2000
2001
2002
Current Ratio
-1 -0 0. 0. 1. 1. 2. 2. 3. 3. 4.
.0 .5 00 50 00 50 00 50 00 50 00
0 0
Working Capital
$m
80 70 60 50 40 30 20 10 0 -1 0 -2 0
PRIMARY HEALTH CARE LTD, WORKING CAPITAL AND
CURRENT RATIO, 1999-2003
2003
Years Ended June 30
Working Capital
Current ratio
Decline in working capital and current ratio in 2003, but increase
in turnover, margins and returns.
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