Topic 4.
Fundamental Interpretations Made
from Financial Statement Data
Financial Ratios and Trend Analysis
• A ratio is simply the relationship between
two numbers.
• The large currency amounts reported in the
financial statements of many companies, and
the varying sizes of companies, make ratio
analysis the only sensible method of evaluating
various financial characteristics of a company.
Trend Analysis
Trend analysis compares a single
observation over several years.
Trend analysis example: Suppose a student’s grade point
average for last semester was 3.5 on a 4.0 scale. That
GPA may be interesting, but it says little about the
student’s work. However, suppose you learn that this
student’s GPA was 1.9 four semesters ago, 2.7 three
semesters ago, and 3.0 two semesters ago. The upward
trend of grades suggests that the student is working
“smarter and harder.”
Rate of Return
Rate of Amount of return
=
return Amount invested
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.
The rate of return calculation is derived
from the interest calculation.
Interest = Principal × Rate × Time
Higher rates of return are associated
with greater risk.
Return on Investment (ROI)
Return on Net income
=
investment Average total assets
The ROI of a firm describes the rate of
return that management was able to earn on
the assets it had available to use during the
year.
An informed judgment about the firm’s
profitability requires relating net income to
the assets used to generate that net income.
Return on Investment (ROI)
Return on Operating income
=
investment Average operating assets
Some financial analysts prefer to use income from
operations (or earnings before interest and income
taxes) and average operating assets in the ROI
calculation.
Return on Equity (ROE)
Return on Net income
=
equity Average stockholders' equity
Stockholders are interested in expressing
the profits of the firm as a rate of return on
the amount of stockholders' equity.
A rule for putting ROE in perspective is that
average ROE for most merchandising and
manufacturing companies has historically
ranged from 12 percent to 18 percent.
Measures of Liquidity
Liquidity refers to a firm’s ability to meet its current
obligations and is measured by relating its current assets
and current liabilities as reported on the balance sheet.
Liquidity is measured in
three principal ways:
•Working Capital
•Current Ratio
•Acid-Test Ratio
Working Capital
Current assets
- Current liabilities
Working capital
Working capital is the excess of a firm’s
current assets over its current liabilities.
Working Capital
Working capital is calculated by subtracting current liabilities
from current assets.
Working capital is the excess of a firm's current assets over its
current liabilities.
Current Ratio
Current Current assets
=
ratio Current liabilities
This ratio is most useful in
judging a company’s current
bill-paying ability.
As a rule of thumb, a current ratio of
2.0 is considered indicative of
adequate liquidity.
Current Ratio
To calculate the current ratio, divide current assets by current
liabilities.
The trend of a company’s current ratio is most useful in
judging its current bill-paying ability.
As a rule, a current ratio of two is considered indicative of
adequate liquidity.
Acid-Test Ratio
The acid-test ratio is also known as the quick ratio.
Acid-test Cash (including temporary
=
ratio cash investments) +
Accounts receivable
Current liabilities
Acid-Test Ratio
The acid-test ratio, also called quick ratio, is calculated by
dividing the sum of Cash (including temporary cash
investments) and Accounts Receivable by current liabilities.
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, an acid-test
ratio of 1.0 is considered indicative of adequate liquidity.
Trend Analysis
A trend analysis is an evaluation of selected data over time.
This table illustrates the trend analysis of return on
investment, return on equity, and working capital for
Campbell Soup over a five-year period.
TABLE 3.1 CAMPBELL SOUP COMPANY (PROFITABILITY* AND LIQUIDITY DATA,† 2013–2017)
2017 2016 2015 2014 2013
Margin (net earnings‡/net sales) 11.2 7.1 8.2 10.5 8.8
Turnover (net sales/average total assets) 1.01 1.00 1.00 1.01 1.09
ROI (net earnings/average total assets) 11.4 7.1 8.2 10.6 9.6
ROE (net earnings/average total equity) 55.8 38.7 44.7 62.0 67.8
Year-end position (in millions):
Current assets $1,900 $1,908 $2,093 $2,100 $2,221
Current liabilities 2,395 2,555 2,806 2,989 3,282
Working capital (495) (647) (713) (889) (1,061)
Current ratio 0.79 0.75 0.75 0.70 0.68
Trend Analysis
Profitability and Liquidity calculations were made from the data presented
in the five-year selected financial data.
A trend analysis is an evaluation of selected data over time. The data in this
table come from the five-year “selected financial data” of Campbell’s 2017
annual report and from balance sheets of prior annual reports.
Trend Analysis
Trend analysis
can be used to
construct graphs
so that trends
over time can be
seen.
Trend Analysis
We can also use the trend analysis to construct graphs, so we
can see trends over time.
Campbell’s ROI and ROE results were generally downward
trending during the five-year period presented, although 2017
was certainly an encouraging year. Campbell’s ROI trend was
clearly more stable than its ROE trend during the five-year
period from 2013 to 2017, as is typically the case for many
companies.
Trend Analysis
Trend Analysis
Campbell’s turnover has been remarkably stable in recent years, although
slightly downward trending; this suggests that the company has had a
relatively flat or even falling sales growth trend and that total asset growth
has been minimal as well. Note that the range of turnover results during
this period, 1.00–1.09, is not significant in absolute terms and is graphically
depicted as a virtual flat-line representation.
Campbell’s maintained a highly consistent current ratio in the range of
0.68–0.79 throughout the five-year period, meaning that current liabilities
exceeded current assets by substantial amounts in all years presented.
Working capital peaked at ($495) million in 2017 after having reached a low
point of ($1,061) million in 2013, meaning that current liabilities exceeded
current asset by more than $1 billion at that point in time.