1. 1 Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola CHAPTER 10 Fundamental Interpretations made from Financial Statement Data

2. 2 Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola Learning Objectives Explain why financial statement ratios are important. Explain the importance of and calculate the return on assets (ROA). Calculate and interpret margin and turnover using the adapted DuPont model. Explain the significance of and calculate the return on equity (ROE). Explain the meaning and importance of liquidity. Calculate working capital, the current ratio and the quick ratio and explain their significance. Demonstrate the effective use of trend analysis.

3. 3 Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola Overview Current and potential shareholders are interested in making their own assessments about management’s stewardship of the resources made available by the owners. Creditors assess the ability of the entity to repay loans and pay for products and services. These relationships about profitability and debt- paying ability involve interpreting the relationships between amounts reported in the financial statements.

4. 4 Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola Financial Statement Ratios The large dollar amounts reported in the financial statements and the varying size of companies make ratio analysis the only sensible method of evaluating the various financial characteristics of companies. A ratio is simply the relationship between 2 numbers. A single ratio will not tell us very much. Need to undertake trend analysis (using industry averages).

5. 5 Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola Return on assets Which is better - a profit of $75 on investment A or a profit of $90 on investment B? This is not as easy as it may sounds as it also depends upon how much money has been invested? If the amounts invested were the same, then investment B is the better investment but if the amounts invested are not the same, then would need to calculate a rate of return on each investment.

6. 6 Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola Rate of Return on Assets Rate of Return = Amount of return Amount invested 90 600= 15% 75 500= 15% Assuming $500 invested in investment A and $600 in investment B. Same ROA. ROA- inv A ROA– inv B

7. 7 Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola Return on Assets Often referred to as a return on investments Use EBIT- earnings before interest and tax. Not appropriate to use profit as total assets could have been financed by a variety of sources. EBIT shows total return without the complications of tax.

8. 8 Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola Return on Assets Better measure of management activities as: Interest is a function of capital structure. Tax is a function of the tax laws. Points to remember: ROA is based on EBIT (earnings before interest and tax).

9. 9 Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola Return on Assets The ROA describes the rate of return management was able to earn on the assts that it had available to use during the year. Many analysts regard ROA as the most meaningful measure of a company’s profitability. Some analysts also exclude depreciation and goodwill amortisation and use EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation). Whatever method is used it is important to be consistent when comparing results.

10. 10 Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola The DuPont Model- Expansion of ROA Calculation ROA = EBIT x Sales Sales Ave Total Assets = Operating x Turnover Margin The DuPont model was developed in the 1930s. Turnover is often used in the calculation for assessing activity of:

11. 11 Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola The DuPont Model Under this model the Sales terms cancel out leaving us with EBIT. Average Total Assets Using Exhibit 10-1 ROA = 61336 (364 720 + 402 654)/2 = 16% The DuPont model has focused management to consider the utilisation of assets.

12. 12 Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola Return on Equity (ROE) Profit for the period after tax Average Owners’ Equity Return on Equity = Using Exhibit 10-1 = 14.1% = $34 910 ($230 320 + $265 230) ÷ 2 ROE relates the earnings to the owners’ investment

13. 13 Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola Working Capital and Measures of Liquidity Current AssetsCurrent Ratio Liquidity refers to a firm’s ability to meet its current obligations. Working capital is the excess of a firm’s current assets over its current liabilities. Working Capital Current Assets-Inventory Current Liabilities = Quick Ratio Current Liabilities = Current Assets-Current Liabilities

14. 14 Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola Liquidity Measures As a general rule a current ratio of 2.0 times (or 2:1) and a quick ratio of 1.0 times are considered indicative of adequate liquidity. In terms of debt-paying ability, the higher the current ratio the better. If the current ratio is too high it can mean the company has not made the most productive use of its assets. If less money is held in inventory or accounts receivable, the money freed up can be used to purchase new production equipment or expand marketing efforts.

15. 15 Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola Trend Analysis In undertaking any financial analysis, it is the trend of these calculations over time that is important.

16. 16 Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola Profitability Measures Evaluations more valid when based on the trend of one company’s ROA and ROE relative to: Trends in industry Trends of competitors

17. 17 Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola Trend Analysis Results of any ratio analysis from a single balance sheet are not as meaningful as trend results over several periods. For example if a short-term loan were repaid just before balance date - working capital would not change but current ratio would.

18. 18 Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola Trend Analysis *Incorporate exhibit 10-2 (table of results over five years for Medical and Health Care Ltd). Commentary: The data shown above has been compiled from the financial statements for five years for Medical Health care Ltd (MHC).

19. 19 Copyright  2010 & 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Accounting: What the Numbers Mean 2e (revised) by Marshall, McCartney & Van Rhyn PowerPoint presentation prepared by John Tretola Trend Analysis *Incorporate exhibit 10-3 (trend analysis graph of results over five years for Medical and Health Care Ltd). Commentary: The graph reveals that both ROA and ROE declined from 2004. The performance continued to decline but at a less dramatic rate until 2007, when the first improvement was recorded. Important to look also at the returns of the industry.