Chapter 13 Measuring and Evaluating Financial Performance McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Learning Objective 1 Describe the purposes and uses of trend and ratio analyses. 13-2 Trend and Ratio Analyses Trend analyses are conducted to help financial statement users recognize important financial changes that unfold over time. Ratio analyses, on the other hand, are conducted to understand relationships among various items reported in the financial statements. 13-3 Learning Objectives 2 & 3 LO 2 Calculate financial trends and ratios. LO3 Interpret the results of trend and ratio analyses. 13-4 Calculating Trends Horizontal Analyses Time-Series Analyses 13-5 Calculating Trends Calculating Change in Dollar Amounts Dollar Change = Current Year Figure – Base Year Figure 13-6 Calculating Trends Calculating Change as a Percentage Percentage Change = Dollar Change Base Year Figure × 100% 13-7 Horizontal Analysis The following slides illustrate a trend analysis for Matrix, Inc. for the years ended December 31, 2006 and 2005. We will begin with the asset section of the company’s comparative balance sheets. 13-8 Horizontal Analysis Matrix, Inc. Comparative Balance Sheet December 31 Assets Current assets: Cash Accounts receivable, net Inventory Prepaid expenses Total current assets Property and equipment Land Building and equipment, net Total property and equipment Total assets 2006 2005 12,000 60,000 80,000 3,000 155,000 $ 23,500 40,000 100,000 1,200 164,700 40,000 120,000 160,000 $ 315,000 40,000 85,000 125,000 $ 289,700 $ Increase (Decrease) % Amount $ (11,500) 20,000 (20,000) 1,800 (9,700) 35,000 35,000 25,300 -48.9% 50.0% -20.0% 150.0% -5.9% 0.0% 41.2% 28.0% 8.7% 13-9 Horizontal Analysis Matrix, Inc. Comparative Balance Sheet December 31 Increase (Decrease) % Amount 2005 2006 Assets Current assets: -48.9% $ (11,500) $ 23,500 $ 12,000 Cash 50.0% 20,000 40,000 60,000 Accounts receivable, net -20.0% (20,000) 100,000 80,000 Inventory 150.0% 1,800 1,200 3,000 Prepaid expenses -5.9% (9,700) 164,700 Total current assets $12,000155,000 – $23,500 = $(11,500) Property and equipment 0.0% 40,000 40,000 Land 41.2% 35,000 85,000 120,000 Building and equipment, net($11,500 ÷ $23,500) × 100% = 48.9% 28.0% 35,000 125,000 160,000 Total property and equipment 8.7% 25,300 $ 289,700 $ 315,000 Total assets 13-10 Horizontal Analysis Matrix, Inc. Comparative Balance Sheet December 31 Assets Current assets: Cash Accounts receivable, net Inventory Prepaid expenses Total current assets Property and equipment Land Building and equipment, net Total property and equipment Total assets 2006 2005 12,000 60,000 80,000 3,000 155,000 $ 23,500 40,000 100,000 1,200 164,700 40,000 120,000 160,000 $ 315,000 40,000 85,000 125,000 $ 289,700 $ Increase (Decrease) % Amount $ (11,500) 20,000 (20,000) 1,800 (9,700) 35,000 35,000 25,300 -48.9% 50.0% -20.0% 150.0% -5.9% 0.0% 41.2% 28.0% 8.7% 13-11 Horizontal Analysis We could do this for the liabilities & stockholders’ equity, but now let’s look at the income statement accounts. 13-12 Horizontal Analysis Matrix, Inc. Comparative Income Statements For the Years Ended December 31 Increase (Decrease) 2006 2005 Amount % Sales $520,000 $480,000 $ 40,000 8.3% Cost 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 2.1% Net 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% Income taxes (30%) 7,500 9,600 (2,100) -21.9% $17,500 $22,400 Net income $ (4,900) -21.9% 13-13 Horizontal Analysis Matrix, Inc. Sales increased by 8.3% yet Statements Comparative Income For the Years Ended December 31 net income decreased by 21.9%. Increase (Decrease) Can you determine what happened? 2006 2005 Amount % Sales $520,000 $480,000 $ 40,000 8.3% Cost 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 2.1% Net 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% Income taxes (30%) 7,500 9,600 (2,100) -21.9% $17,500 $22,400 Net income $ (4,900) -21.9% 13-14 Calculating Ratios 1. Profitability – relates to performance in the current period. The focus is on the company’s ability to generate income during the period. 2. Liquidity – relates to the company’s short-term survival. The focus is on the company’s ability to use current assets to repay liabilities as they become due. 3. Solvency – relates to the company’s long-run survival. The focus is on the company’s ability to repay lenders when debt matures. 13-15 Tests of Profitability •Net profit margin •Gross profit percentage •Asset turnover •Fixed asset turnover •Return on equity (ROE) •Earnings per share (EPS) •Quality of income We will use the financial statement of Western Gear to perform our ratio analysis. The financial statements are shown on the next screen. •Price/earnings ratio 13-16 Western Gear, Inc. Balance Sheets December 31 2006 Assets Current assets: Cash Accounts receivable, net Inventory Prepaid expenses Total current assets Property and equipment: Land Buildings and equipment, net Total property and equipment Total assets $ 30,000 20,000 12,000 3,000 65,000 165,000 116,390 281,390 $ 346,390 2005 $ 20,000 17,000 10,000 2,000 49,000 123,000 128,000 251,000 $ 300,000 13-17 Western Gear, Inc. Balance Sheets December 31 2006 Liabilities and Stockholders' Equity Current liabilities: Accounts payable Notes payable, short-term Total current liabilities Long-term liabilities: Notes payable, long-term Total liabilities Stockholders' equity: Common stock, $1 par value Additional paid-in capital Total paid-in capital Retained earnings Total stockholders' equity 2005 $ 39,000 $ 40,000 3,000 2,000 42,000 42,000 70,000 112,000 78,000 120,000 27,400 158,100 185,500 48,890 234,390 17,000 113,000 130,000 50,000 180,000 Total liabilities and stockholders' equity $ 346,390 $ 300,000 13-18 Western Gear, Inc. Income Statements For the Years Ended December 31 Sales Cost of goods sold Gross profit Operating expenses Net operating income Interest expense Net income before taxes Less income taxes (30%) Net income 2006 $ 494,000 140,000 354,000 270,000 84,000 7,300 76,700 23,010 $ 53,690 2005 $ 450,000 127,000 323,000 249,000 74,000 8,000 66,000 19,800 $ 46,200 Cash provided by operating activities is $65,000. 13-19 Profitability Ratios Net Profit Margin Net Profit Net Income = Margin Net Sales Revenue Net Profit $53,690 = = 10.87% Margin $494,000 This ratio describes a company’s ability to earn a net income from sales. 13-20 Profitability Ratios Gross Profit Percentage Gross Profit Net Sales - Cost of Goods Sold = Percentage Net Sales Gross Profit $494,000 - $140,000 = = 71.66% Percentage $494,000 This ratio describes the profit, as a percent of sales, before operating expenses. 13-21 Profitability Ratios Asset Turnover Asset = Turnover Net Sales Revenue Average Total Assets ($346,390 + $300,000) 2 Asset $494,000 = = 1.53 times Turnover $323,195 This ratio measures the efficiency of assets in producing sales. 13-22 Profitability Ratios Fixed Asset Turnover Net Asset Net Sales Revenue = Turnover Average Net Fixed Assets ($281,390 + $251,000) 2 Net Asset $494,000 = = 1.86 times Turnover $266,195 This ratio indicates how much the company generates in sales for each dollar invested in fixed assets. 13-23 Profitability Ratios Return on Equity (ROE) Net Income ROE = Average Stockholders’ Equity ($234,390 + $180,000) 2 $53,690 ROE = = 25.91% $207,195 Shows the net amount earned this period as a percentage of each dollar contributed by stockholders, plus retained earnings. 13-24 Profitability Ratios Western Gear, Inc. 2006 Earnings Per Share (EPS) Number of common shares outstanding January 1, 2006 December 31, 2006 Net Income 17,000 27,400 EPS = Average Number$ of December 31 market price per share 20.00 Common Shares Cash taxes paid $ 17,500 Cash interest paid $ 7,000 $53,690 EPS = = $2.42 (17,000 + 27,400) ÷ 2 This ratio shows the net income for each common share outstanding. 13-25 Profitability Ratios Quality of Income Quality of Net Cash From Operations = Income Net Income Quality of $65,000 = = 1.21 Income $53,690 This ratio compares net income with cash flows from operating activities. 13-26 Profitability Ratios Price/Earnings Ratio Price/Earnings = Ratio Quality of = Income Stock Price Earnings per Share $20.00 $2.42 = 8.26 This ratio is an indication of what investors are willing to pay for a share of stock in the company. 13-27 Liquidity Ratios •Receivables turnover •Days to collect •Inventory turnover •Days to sell •Current ratio 13-28 Liquidity Ratios Receivables Turnover Receivables = Turnover Net Sales Revenue Average Net Receivables ($17,000 + $20,000) 2 Receivables = Turnover $494,000 = 26.70 times $18,500 This ratio tells us how many times receivables are collected each period. 13-29 Liquidity Ratios Days to Collect Days to Collect Days to Collect = 365 Receivable Turnover = 365 26.70 = 13.67 days This ratio tells us how quickly the company is able to collect its receivables. 13-30 Liquidity Ratios Inventory Turnover Inventory Cost of Goods Sold = Turnover Average Inventory ($12,000 + $10,000) 2 Inventory $140,000 = = 12.73 times Turnover $11,000 This ratio tells us how many times a company’s inventory was sold and replaced during the year. 13-31 Liquidity Ratios Days to Sell Days to Sell Days to Sell 365 = Inventory Turnover = 365 12.73 = 28.67 days This ratio tells us how long it takes the company to sell its inventory. 13-32 Liquidity Ratios Current Ratio Current = Ratio Current Assets Current Liabilities Current $65,000 = = 1.55:1 Ratio $42,000 This ratio measures the short-term debt-paying ability of the company. 13-33 Solvency Ratios •Debt-to-assets •Times interest earned •Cash coverage •Capital acquisitions ratio 13-34 Solvency Ratios Debt-to-Assets Total Liabilities Debt to = Total Assets Assets Debt to $112,000 = = 32.33% Assets $346,390 This ratio indicates the proportion of total assets that are financed by creditors. 13-35 Solvency Ratios Times Interest Earned Times Interest Earned = Net Income + Interest Expense + Income Tax Expense Interest Expense Times Interest $53,690 + $7,300 + $23,010 = 11.51 times = Earned $7,300 This is the most common measure of the ability of a firm’s operations to provide protection to the long-term creditor. 13-36 Solvency Ratios Cash Coverage Ratio Cash = Coverage Net Cash from Operations + Interest Paid + Income Taxes Paid Interest Paid Cash $65,000 + $7,000 + $17,500 = = 12.79 times Coverage $7,000 This ratio is similar to times interest earned but measure cash from operations rather than net income. 13-37 Solvency Ratios Capital Acquisitions Ratio Net Cash from Operations Capital = Cash Paid for PPE Acquisitions $281,390 - $251,000 $65,000 Capital = 2.14 = $30,390 Acquisitions This ratio relates cash flows from operating activities to cash paid for property, plant, and equipment. 13-38 Learning Objective 4 Describe how trend and ratio analyses depend on key accounting decisions and concepts. 13-39 Accounting Decisions and Concepts Maintain consistency among accounting standards. Resolve new accounting problems. Provide user benefits. 13-40 The Conceptual Framework Objectives of Financial Reporting Qualitative Characteristics of Accounting Information Elements of Financial Statements Recognition and Measurement Criteria Environment assumptions Implementation principles Implementation constraints 13-41 Exhibit 13-7 Conceptual Framework Objectives To provide information: Useful for decisions. That helps predict cash flows. About economic resources, claims to resources, and changes in resources and claims. Qualitative Characteristics Constraints Elements Financial Statements Recognition and Measurement Concepts Continued 13-42 Objectives Qualitative Characteristics Understandability Primary Relevance Reliability Secondary Comparability Consistency Elements Assets Liabilities Equity Investments by Owners Distributions to owners Revenues Expenses Gains Losses Comprehensive Income Recognition and Measurement Concepts Assumptions Economic entity Going concern Periodicity Monetary unit Principles Historical cost Realization Matching Full Disclosure Financial Statements Constraints Cost effectiveness Materiality Conservatism Balance sheet Income statement Statement of cash flows Statement of shareholders’ equity Related disclosures 13-43 Qualitative Characteristics Understandability Decision Usefulness Relevance Predictive Value Feedback Value Comparability Reliability Timeliness Verifiability Neutrality Representational Faithfulness Consistency 13-44 Accounting Constraints Conservatism Cost Effectiveness Materiality 13-45 Chapter 13 Supplement Nonrecurring and Other Special Items McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Nonrecurring Items Nonrecurring items include the impact of discontinued operations and extraordinary items. Reported Net of Taxes Reported After Income from Operations 13-47 Other Special Items Comprehensive Income Gains and losses that are excluded from income are included in “comprehensive” income. The balance in comprehensive income appears in the stockholders’ equity section of the balance sheet. 13-48 End of Chapter 13 13-49