Chapter
17“How Well Am I Doing?”
Financial StatementAnalysis
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LEARNING OBJECTIVES
1. Explain the need for and limitations of financialstatement analysis.
2. Prepare financial statements in comparativeform and explain how such statements are used.
3. Place the balance sheet and the incomestatement in common-size form and properlyinterpret the results.
4. Identify the ratios used to measure the well-being of the common shareholder and stateeach ratio’s formula and interpretation.
After studying this chapter, you should be able to:
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LEARNING OBJECTIVES
5. Explain what is meant by the term financialleverage and show how financial leverage ismeasured.
6. Identify the ratios used to measure the well-being of the short-term creditor and state eachratio’s formula and interpretation.
7. Identify the ratios used to measure the well-being of the long-term creditor and state eachratio’s formula and interpretation.
After studying this chapter, you should be able to:
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Limitations of Financial StatementAnalysis
Differences in accounting methods betweencompanies sometimes make comparisons
difficult.
We use the FIFO method tovalue inventory.
We use the LIFO method tovalue inventory.
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Limitations of Financial StatementAnalysis
Analysts should look beyondthe ratios.
Economicfactors
Consumertastes
Industrytrends
Technologicalchanges
Changeswithin the firm
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Statements in Comparative andCommon-Size Form
! Dollar and percentage changes on statements
" Common-size statements
# Ratios
Analyticaltechniques used to
examinerelationships amongfinancial statement
items
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Dollar and Percentage Changes onStatements
Comparing statements underscoresmovements and trends and may provide
valuable clues about what to expect in thefuture.
Horizontalanalysis
Trendanalysis
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Horizontal Analysis
Horizontal analysis shows the changesbetween years in the financial data in
both dollar and percentage form.
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Horizontal Analysis
Example
The following slides illustrate a horizontalanalysis of Clover Corporation’s
December 31, 2000 and 1999 comparativebalance sheets and comparative income
statements.
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Horizontal AnalysisCLOVER CORPORATION
Comparative Balance SheetsDecember 31, 2000 and 1999
Increase (Decrease)2000 1999 Amount %
AssetsCurrent assets: Cash 12,000$ 23,500$ Accounts receivable, net 60,000 40,000 Inventory 80,000 100,000 Prepaid expenses 3,000 1,200 Total current assets 155,000 164,700
Property and equipment: Land 40,000 40,000 Buildings and equipment, net 120,000 85,000 Total property and equipment 160,000 125,000
Total assets 315,000$ 289,700$
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Horizontal Analysis
Calculating Change in Dollar Amounts
DollarChange
Current YearFigure
Base YearFigure
= –
The dollaramounts for1999 become
the “base” yearfigures.
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Calculating Change as a Percentage
PercentageChange
Dollar Change Base Year Figure
100%= ×
Horizontal Analysis
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Horizontal AnalysisCLOVER CORPORATION
Comparative Balance SheetsDecember 31, 2000 and 1999
Increase (Decrease)2000 1999 Amount %
AssetsCurrent assets: Cash 12,000$ 23,500$ (11,500)$ (48.9) Accounts receivable, net 60,000 40,000 Inventory 80,000 100,000 Prepaid expenses 3,000 1,200 Total current assets 155,000 164,700
Property and equipment: Land 40,000 40,000 Buildings and equipment, net 120,000 85,000 Total property and equipment 160,000 125,000
Total assets 315,000$ 289,700$
($11,500 ÷ $23,500) × 100% = 48.9%
$12,000 – $23,500 = $(11,500)
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Horizontal AnalysisCLOVER CORPORATION
Comparative Balance SheetsDecember 31, 2000 and 1999
Increase (Decrease)2000 1999 Amount %
AssetsCurrent assets: Cash 12,000$ 23,500$ (11,500)$ (48.9) Accounts receivable, net 60,000 40,000 20,000 50.0 Inventory 80,000 100,000 (20,000) (20.0) Prepaid expenses 3,000 1,200 1,800 150.0 Total current assets 155,000 164,700 (9,700) (5.9)
Property and equipment: Land 40,000 40,000 - 0.0 Buildings and equipment, net 120,000 85,000 35,000 41.2 Total property and equipment 160,000 125,000 35,000 28.0
Total assets 315,000$ 289,700$ 25,300$ 8.7
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Horizontal Analysis
We could do this for the liabilities& shareholders’ equity, but now
let’s look at the income statementaccounts.
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Horizontal AnalysisCLOVER CORPORATION
Comparative Income StatementsFor the Years Ended December 31, 2000 and 1999
Increase (Decrease)
2000 1999 Amount %Net sales 520,000$ 480,000$ 40,000$ 8.3Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)Operating expenses 128,600 126,000 2,600 2.1Net operating income 31,400 39,000 (7,600) (19.5)Interest expense 6,400 7,000 (600) (8.6)Net income before taxes 25,000 32,000 (7,000) (21.9)Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income 17,500$ 22,400$ (4,900)$ (21.9)
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Horizontal AnalysisCLOVER CORPORATION
Comparative Income StatementsFor the Years Ended December 31, 2000 and 1999
Increase (Decrease)
2000 1999 Amount %Net sales 520,000$ 480,000$ 40,000$ 8.3Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)Operating expenses 128,600 126,000 2,600 2.1Net operating income 31,400 39,000 (7,600) (19.5)Interest expense 6,400 7,000 (600) (8.6)Net income before taxes 25,000 32,000 (7,000) (21.9)Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income 17,500$ 22,400$ (4,900)$ (21.9)
Sales increased by 8.3% yetnet income decreased by 21.9%.
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Horizontal AnalysisCLOVER CORPORATION
Comparative Income StatementsFor the Years Ended December 31, 2000 and 1999
Increase (Decrease)
2000 1999 Amount %Net sales 520,000$ 480,000$ 40,000$ 8.3Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)Operating expenses 128,600 126,000 2,600 2.1Net operating income 31,400 39,000 (7,600) (19.5)Interest expense 6,400 7,000 (600) (8.6)Net income before taxes 25,000 32,000 (7,000) (21.9)Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income 17,500$ 22,400$ (4,900)$ (21.9)
There were increases in both cost of goodssold (14.3%) and operating expenses (2.1%).These increased costs more than offset the
increase in sales, yielding an overalldecrease in net income.
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Trend Percentages
Trend percentagesstate several years’
financial data in termsof a base year, whichequals 100 percent.
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Trend Analysis
TrendPercentage
Current Year Amount Base Year Amount
100%= ×
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Trend Analysis
Example
Look at the income information forBerry Products for the years 1998through 2002. We will do a trend
analysis on these amounts to seewhat we can learn about the company.
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Trend Analysis
Berry ProductsIncome Information
For the Years Ended December 31,
The baseyear is 1998, and its amounts
will equal 100%.
YearItem 2002 2001 2000 1999 1998
Sa les 400,000$ 355,000$ 320,000$ 290,000$ 275,000$Cost of goods sold 285,000 250,000 225,000 198,000 190,000 Gross margin 115,000 105,000 95,000 92,000 85,000
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Trend Analysis
Berry ProductsIncome Information
For the Years Ended December 31,Year
Item 2002 2001 2000 1999 1998Sa les 105% 100%Cost of goods sold 104% 100%Gross margin 108% 100%
1999 Amount ÷ 1998 Amount × 100% ( $290,000 ÷ $275,000 ) × 100% = 105%( $198,000 ÷ $190,000 ) × 100% = 104%( $ 92,000 ÷ $ 85,000 ) × 100% = 108%
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Trend Analysis
By analyzing the trends for Berry Products, wecan see that cost of goods sold is increasing
faster than sales, which is slowing the increasein gross margin.
Berry ProductsIncome Information
For the Years Ended December 31,Year
Item 2002 2001 2000 1999 1998Sa les 145% 129% 116% 105% 100%Cost of goods sold 150% 132% 118% 104% 100%Gross margin 135% 124% 112% 108% 100%
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Trend Analysis
We can use the trendpercentages to construct a
graph so we can see thetrend over time.
100
110
120
130
140
150
160
1998 1999 2000 2001 2002
Year
Per
cen
tag
e
SalesCOGSGM
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Common-Size Statements
Common-sizeCommon-sizestatements use
percentages to expressthe relationship of
individual components toa total within a singlesingleperiod. This is alsoknown as verticalvertical
analysisanalysis.
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Common-Size Statements
Example
Let’s take another look at theinformation from the comparative
income statements of CloverCorporation for 2000 and 1999.
This time let’s prepare common-sizestatements.
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Common-Size StatementsCLOVER CORPORATION
Comparative Income StatementsFor the Years Ended December 31, 2000 and 1999
Common-Size Percentages
2000 1999 2000 1999Net sales 520,000$ 480,000$ 100.0 100.0 Cost of goods sold 360,000 315,000
Gross margin 160,000 165,000 Operating expenses 128,600 126,000 Net operating income 31,400 39,000 Interest expense 6,400 7,000 Net income before taxes 25,000 32,000 Less income taxes (30%) 7,500 9,600
Net income 17,500$ 22,400$
Net sales Net sales isusually thebase and isexpressedas 100%.
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Common-Size StatementsCLOVER CORPORATION
Comparative Income StatementsFor the Years Ended December 31, 2000 and 1999
Common-Size Percentages
2000 1999 2000 1999Net sales 520,000$ 480,000$ 100.0 100.0 Cost of goods sold 360,000 315,000 69.2 65.6
Gross margin 160,000 165,000 Operating expenses 128,600 126,000 Net operating income 31,400 39,000 Interest expense 6,400 7,000 Net income before taxes 25,000 32,000 Less income taxes (30%) 7,500 9,600
Net income 17,500$ 22,400$ 1999 COGS ÷ 1999 Net Sales × 100% ( $315,000 ÷ $480,000 ) × 100% = 65.6%
2000 COGS ÷ 2000 Net Sales × 100% ( $360,000 ÷ $520,000 ) × 100% = 69.2%
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Gross Margin Percentage
Gross Margin Percentage
Gross Margin Sales
=
This measure indicates how muchof each sales dollar is left after
deducting the cost of goods sold tocover operating expenses and a profit.
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Common-Size StatementsCLOVER CORPORATION
Comparative Income StatementsFor the Years Ended December 31, 2000 and 1999
Common-Size Percentages
2000 1999 2000 1999Net sales 520,000$ 480,000$ 100.0 100.0 Cost of goods sold 360,000 315,000 69.2 65.6
Gross margin 160,000 165,000 30.8 34.4 Operating expenses 128,600 126,000 24.8 26.2 Net operating income 31,400 39,000 6.0 8.2 Interest expense 6,400 7,000 1.2 1.5 Net income before taxes 25,000 32,000 4.8 6.7 Less income taxes (30%) 7,500 9,600 1.4 2.0
Net income 17,500$ 22,400$ 3.4 4.7
What conclusions can we draw?
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Now, let’s look atNorton
Corporation’s2000 and 1999
financialstatements.
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NORTON CORPORATIONBalance Sheets
December 31, 2000 and 1999
2000 1999Assets
Current assets: Cash 30,000$ 20,000$ Accounts receivable, net 20,000 17,000 Inventory 12,000 10,000 Prepaid expenses 3,000 2,000 Total current assets 65,000 49,000 Property and equipment: Land 165,000 123,000 Buildings and equipment, net 116,390 128,000 Total property and equipment 281,390 251,000 Total assets 346,390$ 300,000$
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December 31, 2000 and 1999
2000 1999Liabilities and Shareholders' Equity
Current liabilities: Accounts payable 39,000$ 40,000$ Notes payable, short-term 3,000 2,000
Total current liabilities 42,000 42,000
Long-term liabilities: Notes payable, long-term 70,000 78,000
Total liabilities 112,000 120,000
Shareholders' equity: Common stock, $1 par value 27,400 17,000 Contributed surplus 158,100 113,000
Total capital 185,500 130,000 Retained earnings 48,890 50,000
Total shareholders' equity 234,390 180,000 Total liabilities and shareholders' equity 346,390$ 300,000$
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NORTON CORPORATION
Income Statements
For the Years Ended December 31, 2000 and 1999
2000 1999Net sales 494,000$ 450,000$ Cost of goods sold 140,000 127,000 Gross margin 354,000 323,000 Operating expenses 270,000 249,000
Net operating income 84,000 74,000 Interest expense 7,300 8,000
Net income before taxes 76,700 66,000 Less income taxes (30%) 23,010 19,800
Net income 53,690$ 46,200$
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Now, let’s calculatesome ratios based
on NortonCorporation’s
financialstatements.
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Ratio Analysis – The CommonShareholder
Use this informationto calculate ratios
to measure the well-being of the
commonshareholders of
Norton Corporation.
NORTON CORPORATION
2000Number of common shares outstanding Beginning of year 17,000 End of year 27,400
Net income 53,690$
Shareholders' equity
Beginning of year 180,000
End of year 234,390
Dividends per share 2
Dec. 31 market price per share 20
Interest expense 7,300
Total assets
Beginning of year 300,000
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Earnings Per Share
Earnings per ShareNet Income – Preferred Dividends
Average Number of CommonShares Outstanding
=
Earnings per Share $53,690 – $0 (17,000 + 27,400)/2
= = $2.42
This measure indicates how muchincome was earned for each share of
common stock outstanding.
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Price-Earnings Ratio
Price-EarningsRatio
Market Price Per Share Earnings Per Share
=
Price-EarningsRatio
$20.00 $2.42
= = 8.26 times
This measure is often used by investorsas a general guideline in gauging stockvalues. Generally, the higher the price-earnings ratio, the more opportunity a
company has for growth.
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Dividend Payout Ratio
DividendPayout Ratio
Dividends Per Share Earnings Per Share
=
DividendPayout Ratio
$2.00 $2.42
= = 82.6%
This ratio gauges the portion of currentearnings being paid out in dividends.
Investors seeking current income wouldlike this ratio to be large.
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Dividend Yield Ratio
DividendYield Ratio
Dividends Per Share Market Price Per Share
=
DividendYield Ratio
$2.00 $20.00
= = 10.00%
This ratio identifies the return, in terms ofcash dividends, on the current market
price of the stock.
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Return on Total Assets
Return on
Total Assets
Net Income + [Interest Expense × (1 – Tax Rate)]
Average Total Assets=
Whenever a ratio divides an income statementbalance by a balance sheet balance, the average
for the year is used in the denominator.
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Return on Total Assets
This ratio measures how well assetshave been employed.
Return on
Total Assets
$53,690 +[7,300 × (1 – 0.30)]
($300,000 + $346,390) ÷ 2= = 18.19%
Return on
Total Assets
Net Income + [Interest Expense × (1 – Tax Rate)]
Average Total Assets=
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Return on Common Shareholders’Equity
Return on CommonShareholders’ Equity
Net Income – Preferred DividendsAverage Shareholders’ Equity
=
Return on CommonShareholders’ Equity
$53,690 – $0 ($180,000 + $234,390) ÷ 2
= = 25.91%
This measure indicates how well thecompany employed the owners’
investments to earn income.
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Financial Leverage
Financial leverage Financial leverage involves acquiringassets with funds at a fixed rate of
interest.
Return oninvestment in
assets>
Fixed rate ofreturn onborrowed
funds
Positivefinancialleverage
=
Return oninvestment in
assets<
Fixed rate ofreturn onborrowed
funds
Negativefinancialleverage
=
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Book Value Per Share
Book Valueper Share
Common Shareholders’ Equity Number of Common Shares Outstanding
=
This ratio measures the amount that would bedistributed to holders of each share of common
stock if all assets were sold at their balance sheetcarrying amounts and if all creditors were paid off.
= $ 8.55Book Valueper Share
$234,390 27,400
=
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Ratio Analysis – The Short– TermCreditor
NORTON CORPORATION
2000
Cash 30,000$
Accounts receivable , ne t
Beginning of year 17,000
End of ye ar 20,000
Inventory
Beginning of year 10,000
End of ye ar 12,000
Tota l current assets 65,000
Tota l current liabilitie s 42,000
Sales on account 500,000
Cost of goods sold 140,000
Use this informationto calculate ratios
to measure thewell-being of the
short-termcreditors for Norton
Corporation.
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Working Capital
December 31, 2000
Current assets 65,000$
Current liabilities (42,000)
W orking capital 23,000$
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Current Ratio
CurrentRatio
Current Assets Current Liabilities
=
CurrentRatio
$65,000 $42,000
= = 1.55 : 1
This ratio measures the abilityof the company to pay current
debts as they become due.
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Acid-Test (Quick) Ratio
Quick Assets Current Liabilities
=Acid-Test
Ratio
Quick assets are Cash,Marketable Securities,
Accounts Receivable andcurrent Notes Receivable.
Norton Corporation’s quickassets consist of cash of
$30,000 and accountsreceivable of $20,000.
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Acid-Test (Quick) Ratio
Quick Assets Current Liabilities
=Acid-Test
Ratio
This ratio is like the currentratio but excludes current assets suchas inventories that may be difficult to
quickly convert into cash.
$50,000 $42,000
= 1.19 : 1=Acid-Test
Ratio
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Accounts Receivable Turnover
Sales on Account Average Accounts Receivable
AccountsReceivableTurnover
=
This ratio measures how manytimes a company converts its
receivables into cash each year.
= 27.03 times $500,000 ($17,000 + $20,000) ÷ 2
AccountsReceivableTurnover
=
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Average Collection Period
AverageCollection
Period=
365 Days Accounts Receivable Turnover
This ratio measures, on average,how many days it takes to collect
an account receivable.
= 13.50 daysAverage
CollectionPeriod
= 365 Days 27.03 Times
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Inventory Turnover
Cost of Goods Sold Average Inventory
InventoryTurnover
=
This ratio measures the numberof times merchandise inventory
is sold and replaced during the year.
= 12.73 times $140,000 ($10,000 + $12,000) ÷ 2
InventoryTurnover
=
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Average Sale Period
AverageSale Period
= 365 Days Inventory Turnover
This ratio measures how manydays, on average, it takes to sell
the inventory.
= 28.67 daysAverage
Sale Period=
365 Days 12.73 Times
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Ratio Analysis – The Long– TermCreditor
Use this information to calculate ratiosto measure the well-being of the
long-term creditors for NortonCorporation.
NORTON CORPORATION
2000Earnings before interest 84,000$ expense and income taxes
Interest expense 7,300
Total shareholders' equity 234,390
Total liabilities 112,000
This is alsoreferred to as netoperating income.
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Times Interest Earned Ratio
This is the most commonmeasure of the ability of a firm’soperations to provide protection
to the long-term creditor.
TimesInterestEarned
$84,0007,300
= = 11.5 times
TimesInterestEarned
Earnings before Interest Expense and Income Taxes (EBIT)
Interest Expense=
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Debt-to-Equity Ratio
Total Liabilities Shareholders’ Equity
Debt–to–EquityRatio
=
This ratio measures the amount of assetsbeing provided by creditors for each dollarof assets being provided by the owners of
the company.
$112,000 $234,390
Debt–to–EquityRatio
= = 0.48 to 1
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Return on Investment (ROI)
Net Operating IncomeSalesROI =
This ratio measures the amountof income earned for each
dollar of assets.
x SalesAverage Operating
Assets
=Net Operating Income (EBIT)
Average Operating Assets
=84,000
(300,000+346,390) ÷÷÷÷ 2= 26%
© McGraw-Hill Ryerson Limited., 2001
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Published Sources of Financial RatiosSource Content
Industrial Corporations, Financial Statistics
Financial statements of different sectors
Moody's Bond RecordPerformance of corporate, convertible, government and municiple bonds
Corporate Taxation Statistics
Taxable income and taxes payable by Canadian corporations
Dun & Bradstreets' Canadian Key Directory
Business profile on top 3% of Canadian companies
Financial Post's Dividend Record
Record of dividends
Financial Post's "500"Largest 500 companies, by sales, in Canada
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End of Chapter 17