1. CHAPTER 3 Fundamental Interpretations Made from Financial Statement Data

2. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 3-2 Overview Financial ratios and trend analysis Return on assets ROA - The Dupont model Return on equity Liquidity, working capital and ratios Trend analysis

3. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 3-3 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.

4. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 3-4 Financial Ratios and Trend Analysis Trend analysis compares a single observation over several years. A single ratio is not very useful in describing a company.

5. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 3-5 Financial Ratios and Trend Analysis Trend Analysis Also used for comparison of company ratios with those of other companies in same industry Industry average ratios Company’s relative standing in the industry

6. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 3-6 Return on Assets 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 = Useful to compare different and unequal investments.

7. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 3-7 Return on Assets Higher risk – investor anticipates higher ROR RISK Range of possible outcomes

8. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 3-8 Return on Assets The rate of return calculation is derived from the interest calculation. Interest = Principal × Rate × Time Rate of Return Amount of Return Amount of Investment =

9. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 3-9 Return on Assets rate of return using data from financial statements sometimes called return on investments RETURN ON ASSETS

10. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 3-10 Return on 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. Return on Assets Income from operations Average Total Assets =

11. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 3-11 Return on Assets Income from operations EBIT – Earnings Before Income and Tax Total return to all providers of finance without the complications of tax

12. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 3-12 ROA - The DuPont Model Return on Assets EBIT Sales = Average Total Assets × Profitability from sales and utilisation of assets to generate sales revenue are both important factors to be considered when evaluating profitability. MarginTurnover The DuPont Model is an expansion of the basic ROA calculation.

13. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 3-13 The DuPont Model Return on Assets EBIT Sales = Average Total Assets × Margin Turnover Emphasises that from every dollar of sales revenue, some amount must work its way to net profit. Relates efficiency with which the firm’s assets are used in the revenue- generating process.

14. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 3-14 The DuPont Model Return on Assets = × EBIT Sales Average Total Assets MarginTurnover 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%.

15. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 3-15 Return on 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%. Return on Equity Net Profit (after tax) Average Owners’ Equity =

16. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 3-16 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

17. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 3-17 Liquidity and Working Capital Working capital is the excess of a firm’s current assets over its current liabilities. Working capital

18. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 3-18 Liquidity and Working Capital 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. Current ratio Current assets Current liabilities = Current ratio

19. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 3-19 Liquidity and Working Capital Current ratio – need to balance: Debt- paying ability Most productive use of assets

20. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 3-20 Liquidity and Working Capital 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. Acid-test ratio

21. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 3-21 Trend Analysis Figures come from the published financial statements. Data is presented in tables and graphs on the following slides: Example PRIMARY HEALTH CARE LTD

22. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 3-22 Trend Analysis

23. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 3-23 Trend Analysis Declining profitability with slight improvement in 2003, although not as high as returns before the company went public in 1999.

24. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 3-24 Trend Analysis Be aware of the impact of scales selected. Steady decline of turnover and margin until 2002, with slight recovery in 2003.

25. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd 3-25 Trend Analysis Decline in working capital and current ratio in 2003, but increase in turnover, margins and returns.