Page 44 - DCOM302_MANAGEMENT_ACCOUNTING

Unit 3: Analysis of Financial Statements

Return on Assets Notes
Return on assets is a very good profitability ratio. It is comprehensive when compared
to profit margin and asset turnover. Return on assets overcomes the deficiency of profit
margin by relating the assets necessary to produce income and it overcomes the deficiency
of asset turnover by taking into account the amount of income produced. Mathematically,
return on assets is equal to net income divided by average total assets, or more simply put,
profit margin times asset turnover. Ford can improve it’s overall profitability by increasing
it’s profit margin, the asset turnover, or both. Looking at the numbers, it was actually
Ford’s increase in profit margin that really gave it the boost it needed to raise the return on
assets from the black to the red. A steady increase in return on assets from -1.3% in 1991 to
an acceptable 2.2% in 1994 is a good sign to investors. This steady climb of 169% resulted
in an overall increase in the earning power of Ford Motor Company. Ford’s increase in
profitability shows satisfactory earning power which results in investors continuing to
provide capital to it.
Debt to Equity
The debt to equity ratio shows the portion of the company financed by creditors in
comparison to that financed by the stockholders. It is total liabilities divided by stockholder’s
equity. Ford’s debt to equity ratio is relatively high. When measuring profitability, a high
debt to equity ratio means the company has high debt and must earn more profit to protect
the payment of interest to it’s creditors. This high debt to equity ratio would also interest
stockholders because it shows what part of the business is financed through borrowing or
in other words, is debt financed. Of the five years we analyzed, the lowest debt to equity
ratio was during 1991 (6.65) and the highest was in 1993 (11.71). In comparison to return
on assets, a higher creditor financed year such as 1991 did not have an positive effect on
profitability. It seemed that through increased borrowing in 1993, a higher debt to equity
ratio was produced, but overall profitability also went up. Debt to equity is only one part
in a full profitability analysis. The only real information that the debt to equity ratio can
produce is it can show how much expansion is possible through the borrowing of long-
term funds; basically it show’s a company’s long-term solvency. A higher debt to equity
ratio essentially means that the company will be able to borrow less money. The company
must rely more on stockholder investment. Ford was able to lower it’s borrowing of funds
from 1993 through 1994 and into 1995, while still effectively increasing it’s profit margin
and return on assets. This means Ford was able to use stockholder’s investments to increase
it’s profitability rather than borrow the funds to do it.
Return on Equity
Return on equity is the ratio of net income divided by the average stockholder’s equity. This
ratio is of great interest to stockholders because it shows how much they have earned on
their investment in the business. In the years of 1991 and 1992, stockholders lost money on
their investment in Ford Motor Company. No one likes to lose money, even if it is a couple
of cents on the dollar. A major stockholder could incur quite a loss because of this. In the
next three years, return on equity was on the positive side, the peak being in 1994 when
stockholders earned about 28% on every dollar invested. Quite a good return considering
some investors are happy with a steady 8% return. Considering the previous years, the
return on equity for Ford seems to be positive. Common knowledge dictates that most
companies experience a downturn every now and then. Ford’s investors are able to remain
invested in the company because it’s overall 5 year return on equity is high enough to give
investors the high returns they seek. A return on equity consistently above 16% with a few
negative years mixed in is certainly lucrative enough to maintain a strong profitability
measurement and project a positive image to the investors of Ford Motor Company.
Contd…

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