Chapter 14 Financial Statement Analysis 655GLOSSARY
Calculate and interpret the rate earned on stockhold-
ers’ equity and the rate earned on total assets. The rate
earned on stockholders’ equity, which is net income divided
by average stockholders’ equity, is a widely acknowledged
summary measure of financial performance from the stock-
holders’ perspective. The rate earned on total assets, which is
net income divided by average total assets, is an acknowl-
edged summary measure of management performance.
Analyze the rate earned on total assets by evaluating
the profit margin and the asset efficiency of a busi-
ness.The rate earned on total assets is the product of the
profit margin and the total asset turnover, as shown below.
Rate Earned on
=Profit
Asset
Total Assets Margin TurnoverNet Income
=Net Income
Net SalesAverage Total Assets Net Sales Average Total Assets
Management can evaluate the rate earned on total assets by
conducting a margin analysis, which segments the profit
margin into a vertical analysis of the income statement.
Alternatively, management may evaluate the rate earned
on total assets by conducting an asset efficiency analysis,
which segments the total asset turnover into sub-asset
categories.
Determine and interpret leverage. Leverage measures
the amount of debt used by the firm to finance its as-
sets. The proper use of leverage can cause the rate earned
on stockholders’ equity to exceed the rate earned on total
assets. A firm must be careful to avoid excess leverage, since
debt requires fixed periodic interest payments, and the debt
must eventually be repaid. The rate earned on stockholders’
Accounts receivable turnoverThe relationship between
net sales and accounts receivable, computed by dividing net
sales by the average net accounts receivable.
Asset turnoverThe number of sales dollars earned for each
dollar of total assets, calculated as the ratio of net sales to to-
tal assets.
Common-size statementA financial statement in which
all items are expressed only in percentages.
Cost of capitalThe cost of financing operations from both
debt and common stock, expressed as a percentage rate.
Current ratioThe ratio of current assets to current liabilities.
Dividend yieldThe rate of return to common stockholders
in terms of cash dividends.
DuPont formulaA formula that states that the rate earned
on total assets is the product of two factors, the profit margin
and the total asset turnover.
Earnings per share (EPS)The profitability ratio of net in-
come available to common shareholders to the number of
common shares outstanding.
Fixed asset turnoverThe number of dollars of sales that
are generated from each dollar of average fixed assets during
the year, computed by dividing the net sales by the average
net fixed assets.
Horizontal analysisThe percentage of increases and decreases
in corresponding items in comparative financial statements.
Inventory turnoverThe relationship between the volume
of goods sold and inventory, computed by dividing the cost
of goods sold by the average inventory.equity can be compared to the rate earned on total assets by
using the leverage formula, as follows:Rate Earned on Stockholders’ Equity = Rate Earned on Total
AssetsLeverageLeverage analysis can be used to examine additional mea-
sures of current and long-term relationships, using the cur-
rent ratio, the quick ratio, the ratio of fixed assets to
long-term liabilities, the ratio of liabilities to stockholders’
equity, and the number of times interest charges are earned.Calculate and interpret shareholder ratios: earnings
per share, price-earnings ratio, and dividend yield.
Shareholders are interested in making money on their stock
investment. This return can come from stock appreciation or
from dividends. Thus, earnings per share, the price-earnings
ratio, and dividend yield, which relate to stock price and
dividend information, are of interest to shareholders.Summarize the uses and limitations of analytical
measures.In selecting and interpreting analytical mea-
sures, conditions peculiar to a business or its industry
should be considered. For example, the type of industry,
capital structure, and diversity of the business’s operations
affect the measures used. Thus, most analysts will compare
a firm’s ratios with competitors and averages for an indus-
try. In addition, the influence of the general economic and
business environment should be considered.Describe the contents of corporate annual reports.
Corporate annual reports normally include financial
statements and the following sections: Management
Discussion and Analysis, reports on the adequacy of
internal control, and a report on the fairness of financial
statements.