The Mathematics of Money

510 Chapter 12 Financial Statements

Example 12.3.2 Calculate Thomas Hydrometer Sales’ return on assets and return on

equity for 2007. Explain what these ratios tell you about the company’s performance.

ROA 

$4,780,851

____________

$33,250,000

 14.38%

ROE 

$4,780,851

____________

$20,535,025

 23.28%

The company’s profi ts for 2007 represented a 14.38% return on the balance sheet value of

its total assets. As a return on equity, that is, the original capital and retained earnings of the

investors in the company, the rate of return was 23.28%.

Return on assets is based on the company’s assets, without consideration of how much

debt the company may have taken on to acquire those assets. By using the owners’ equity

instead of assets, return on equity takes into account the company’s debt. Both numbers can

be misleading, though, if the company’s assets have a market value that differs substantially

from the balance sheet value—for example, if the company has a large amount of land

bought many years ago that has appreciated in value over the years but is still listed at cost

on the balance sheet.

Like profit margins, a reasonable value for these ratios can vary quite a bit, depend-

ing on the type of business. A software development company might be expected to have

higher returns on assets and equity than a manufacturer, since manufacturing requires larger

investments in factories and equipment.

Conversion ratios are measurements of how quickly inventory is converted in to sales,

or receivable are converted into receipts.

Definitions 12.3.5 and 12.3.6

Ratio Formula What It Tells You

Inventory turnover

Cost of goods sold

________________Average inventory

How many times the company turned

over its inventory in the period reported

on the fi nancial statements. A high

inventory turnover ratio indicates that

the business is moving its merchandise

quickly, on average.

Average collection

days

Accounts receivable__________________Net sales per day How many days’ worth of sales the

receivables represent. A high value of

this ratio indicates that the business is

taking a long time to collect payment for

purchases.

Each of these ratios requires some preliminary work. Both require a quantity that is not

usually listed on the financial statements.

To calculate the average inventory, required for the inventory turnover ratio, we take

the average of the starting and ending inventories.

Average inventory 

Starting inventory  Ending inventory

________________________________

2

To find the net sales per day, we take the net sales from the income statement and divide

by the number of days in the period covered by the financial statement. If the income state-

ment is annual, we might divide by 365 days per year (or 366 days if it is a leap year);

however, it is common practice to use bankers’ rule and divide by 360. If the financial

statement is quarterly, we divide by an assumed 90 days per quarter.

Net sales per day  Annual net sales______________

360

or

Quarterly net sales

________________

90