Page 138 - DMGT403_ACCOUNTING_FOR_MANAGERS

Unit 6: Financial Statements: Analysis and Interpretation

Notes
Return on Assets
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
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