CHAPTER 8 Analysis and interpretation of financial statements 337VALUE TO BUSINESS• The return on equity (ROE) calculates the profit that the entity has generated for its owners during
the period to the owners’ investments in the entity. It is a measure that reflects the return on an
equity investment.
• The return on assets (ROA) is a profitability ratio that compares an entity’s profits to the assets that
are available to generate the profits. It reflects an entity’s profitability from revenue and profitability
from investments in assets.
• The gross profit margin relates an entity’s gross profit to its revenue, reflecting the proportion of
sales revenue that ends up as gross profit.
• The profit margin compares profit to sales revenue and reveals what percentage of sales revenue ends up
as profit. The profit margin is a function of the entity’s gross profit margin and expense ratio margins.8.5 Asset efficiency analysis
LEARNING OBJECTIVE 8.5 Define, calculate and interpret the ratios that measure asset efficiency.
In this section, we introduce the ratios that assist in judging an entity’s efficiency in using its assets.
Asset turnover ratio
Entities invest in assets in anticipation that the investment will generate returns. Asset efficiency ratios
measure the effectiveness of an entity in generating sales revenue due to investments in current and
non-current assets. An entity’s overall efficiency in generating income per dollar of investment in assets
is referred to as the asset turnover ratio. The asset turnover ratio is calculated as:
Sales revenue
=x times
Average total assetsAn entity’s asset efficiency, as depicted by the asset turnover, will depend on the efficiency with which
it manages its current and non-current investments. A large component of an entity’s investments in
assets that requires significant management is inventory and accounts receivable. It is therefore useful
to assess management’s efficiency in managing these assets, and this is done by calculating the entity’s
inventory and accounts receivable turnover. The accounts receivable turnover is also referred to as the
debtors turnover. A largely cash-based service business, such as Advantage Tennis Coaching introduced
earlier in the text, does not have inventory and debtors to manage, so these ratios are not as applicable
to such an entity.
Days inventory and days debtors ratios
The days inventory indicates the average period of time it takes for an entity to sell its inventory. The
days debtors indicates the average period of time it takes for an entity to collect the money from its
trade-related accounts receivable. Funds invested in inventory and accounts receivable are earning a zero
rate of return, so it is advantageous for an entity to turn over its inventory and accounts receivable as
quickly as possible (i.e. convert them into sales revenue and receive the cash). Accordingly, lower days
inventory and days debtors generally reflect better management efficiency. However, lower days inven-
tory could also suggest that the entity is carrying insufficient levels of inventory. The calculation of these
ratios is as follows.
Days inventory:
Average inventory
× 365 =x days
Cost of sales