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Chapter 13 Measuring and Evaluating Financial Performance PowerPoint Authors: Brandy Mackintosh Lindsay Heiser McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Learning Objective 13-1 Describe the purpose and uses of horizontal, vertical, and ratio analyses. 13-2 Horizontal, Vertical, and Ratio Analyses Horizontal (trend) analyses are conducted to help financial statement users recognize important financial changes that unfold over time. 12/31/12 Gross Profit in 2012 Trend Analysis 12/31/13 Gross Profit in 2013 Δ in Gross Profit $ and/or % from 2012 Vertical analyses focus on important relationships between items on the same financial statement. 2013 Amount Sales Cost of Goods Sold Gross Profit 13-3 $200,000 150,000 $ 50,000 Percent 100% 75% 25% Horizontal, Vertical, and Ratio Analyses Ratio analyses are conducted to understand relationships among various items reported in one or more of the financial statements. Receivable Turnover Ratio = Net Sales Revenue Average Net Receivables It is essential to understand that no analysis is complete unless it leads to an interpretation that helps financial statement users understand and evaluate a company’s financial results 13-4 Learning Objective 13-2 Use horizontal (trend) analysis to recognize financial changes that unfold over time. 13-5 Horizontal (Trend) Computations Trend analyses are usually calculated in terms of year-to-year dollar and percentage changes. Let’s look at an example 13-6 Horizontal (Trend) Computations $48,815 – $47,220 × 100 $47,220 Now let’s calculate the percentage Calculate Now Can let’s youlook the calculate change at the remainder the in dollars dollar and for of the Net change in Net Sales Revenue between Sales trend percentage analysis Revenue change ofbetween the Income for Cost 2010Statement. ofand Sales? 2009. 2009 and 2008. 13-7 Learning Objective 13-3 Use vertical (common size) analysis to understand important relationships within financial statements. 13-8 Vertical (Common Size) Computations Vertical, or common size, analysis focuses on important relationships within financial statements. Income Statement Sales = 100% Balance Sheet Total Assets = 100% Cost of Sales × 100 Net Sales Revenue 13-9 Learning Objective 13-4 Calculate financial ratios to assess profitability, liquidity, and solvency. 13-10 Ratio Computations Ratio analysis compares the amounts for one or more line items to the amounts for other line items in the same year. Ratios are classified into three categories . . . Solvency ratios examine a company’s ability to pay interest and repay debt when due. Profitability ratios examine a company’s ability to generate income. Liquidity ratios help us determine if a company has sufficient current assets to repay liabilities when due. 13-11 Common Profitability Ratios 13-12 Common Liquidity Ratios 13-13 Common Solvency Ratios 13-14 Learning Objective 13-5 Interpret the results of financial analyses. 13-15 Interpreting Horizontal and Vertical Analyses Lowe’s began relying more on debt and less equity financing. Long-term liabilities increased 28.7 percent and stockholders’ equity decreased by 5%. 13-16 Lowe’s assets grew only by 2.1% in fiscal 2010. Interpreting Horizontal and Vertical Cost of sales and operating expenses Analyses are the most important determinants of the company’s profitability. The increase in Net Income in fiscal 2010 is explained by the increase in Net Sales Revenue and the decreases in Cost of Sales and Operating Expenses as a percentage of sales. 13-17 Interpreting Horizontal and Vertical Analyses Lowe’s has experienced a small Lowe’s did a better job of controlling its Operating Expenses between 2009 and 2010. 13-18 decrease in its percentage of Cost of Sales in relation to Sales Revenue from fiscal 2009 to 2010. Decreasing cost of sales means higher Gross Profit. Ratio Calculations 13-19 Ratio Calculations 13-20 Profitability Ratios Net Profit Margin – The slowly improving economy helped boost Lowe’s profits in 2010 as shown by the increase in Net Profit Margin. Gross Profit Percentage – Lowe’s gross profit percentage indicates how much profit was made on each dollar of sales after deducting the Cost of Goods Sold. 13-21 Profitability Ratios Asset Turnover Ratio – indicates the amount of sales revenue generated for each dollar invested in assets during the period. Fixed Asset Turnover – indicates how much revenue the company generates in sales for each dollar invested in fixed assets, Home Depot 2010 fixed asset turnover ratio was 2.69 13-22 Profitability Ratios Return on Equity (ROE) – Compares the amount of net income to average stockholders’ equity. ROE reports the net amount earned during the period as a percentage of each dollar contributed by stockholders and retained in the business. Earnings Per Share (EPS) – Shows the amount of earnings generated for each share of outstanding common stock. 13-23 Profitability Ratios Price /Earnings (P/E) Ratio – Shows the relationship between EPS and the market price of one share of the company’s stock. 13-24 Liquidity Ratios Let’s change our attention to an examination of liquidity ratios. The analyses in this section focus on the company’s ability to survive in the short term, by converting assets to cash that can be used to pay current liabilities as they come due. Receivable Turnover Ratio – Most retail home improvement companies have low levels of accounts receivable relative to sales revenue because they collect the majority of their sales immediately in cash. Receivable Turnover Ratio 13-25 = Net Sales Revenue Average Net Receivables Liquidity Ratios Inventory Turnover Ratio – The inventory turnover ratio indicates how frequently inventory is bought and sold. The “days to sell” indicates the average number of days needed to sell each purchase of inventory. Home Depot sells its inventory in an average of 85 days in 2010. Current Ratio – The current ratio measures the company’s ability to pay its current liabilities 13-26 Liquidity Ratios Quick Ratio – The quick ratio is a much more stringent test of short-term liquidity than is the current ratio. Lowe’s quick ratio increased slightly in 2010, just as its current ratio did. Referred to as “quick assets.” Let’s examine some Solvency Ratios Solvency ratios focus on a company’s ability to survive over the long term, that is, its ability to repay debt at maturity and pay interest prior to that time. 13-27 Solvency Ratios Debt to Assets Ratio – indicates the proportion of total assets that creditors finance. In 2010, The Home Depot had a debt-to-assets ratio of 53 percent. Times Interest Earned – indicates how many times the company’s interest expense was covered by its operating results. 13-28 Learning Objective 13-6 Describe how analyses depend on key accounting decisions and concepts. 13-29 Underlying Accounting Decisions and Concepts Accounting Decisions Difference in Strategies, e.g. type of financing. Difference in Operations, e.g. quality of items sold. Difference in Accounting Methods, e.g. FIFO vs. LIFO. 13-30 Accounting Concepts Companies may elect to use any acceptable generally accepted accounting principle (GAAP) as long as they apply the principle consistently. 13-31 Conceptual Framework for Financial Accounting and Reporting 13-32 Factors Contributing to Going-Concern Problems Factors that commonly contribute to going-concern problems are listed below. 13-33 Chapter 13 Supplement 13A Nonrecurring and Other Special Items McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Nonrecurring Items 13-35 Extraordinary Items Very few events qualify as extraordinary items. Cumulative Effect of Changes in Accounting Methods Direct adjustment to Retained Earnings rather than income reporting. Discontinued Operations For discontinued component two items are reported: 1. Operating income prior to the date of disposal. 2. Gain or loss on sale or disposal of net assets. Nonrecurring Items NONRECURING ITEM Discontinued Operations. 13-36 Other Special Items Comprehensive Income includes: 1. Gains or losses from certain foreign currency exchange rate changes. 2. Gains or losses resulting from the change in value of certain types of investments. Excluded from net income because they are likely to disappear before they are ever realized. 13-37 Chapter 13 Supplement 13B Reviewing and Contrasting IFRS and GAAP McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Overview At a basic level both IFRS and GAAP are concerned with accounting rules that describe 1) when an item should be recognized in the accounting system, 2) how that item should be classified (asset , liability, equity, expense, or revenue), and 3) the amount at which each item should be measured. IFRS 13-39 Yes Report fixed assets at fair value. No GAAP Chapter 13 Solved Exercises M13-1, M13-2, M13-6, E13-1, E13-3, E13-4, E13-10, E13-13 McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. M13-1 Calculations for Horizontal Analyses Using the following income statements, perform the calculations needed for horizontal analyses. Round percentages to one decimal place. 13-41 M13-1 Calculations for Horizontal Analyses ($100,000 – $75,000) × 100 = 33.3% $75,000 13-42 M13-2 Calculations for Vertical Analyses Refer to M13-1 . Perform the calculations needed for vertical analyses. Round percentages to one decimal place. $21,000 $100,000 13-43 × 100 = 21.0% M13-6 Inferring Financial Information Using Gross Profit Percentage and Year-over-Year Comparisons A consumer products company reported a 25 percent increase in sales from 2012 to 2013. Sales in 2012 were $200,000. In 2013, the company reported Cost of Goods Sold in the amount of $150,000. What was the gross profit percentage in 2013? Round to one decimal place. Sales ($200,000 x 1.25) Cost of Goods Sold (given) Gross Profit $250,000 (150,000) $100,000 100.0% -60.0% 40.0% $100,000 × 100 = 40.0% $250,000 13-44 E13-1 Preparing and Interpreting a Schedule for Horizontal and Vertical Analyses The average price of a gallon of gas in 2010 jumped $0.43 (18 percent) from $2.36 in 2009 (to $2.79 in 2010). Let’s see whether these changes are reflected in the income statement of Chevron Corporation for the year ended December 31, 2010 (amounts in billions). Required: 1. Conduct a horizontal analysis by calculating the year-over-year changes in each line item, expressed in dollars and in percentages (rounded to one decimal place). How did the change in gas prices compare to the changes in Chevron Corp.’s total revenues and costs of crude oil and products? 2. Conduct a vertical analysis by expressing each line as a percentage of total revenues (round to one decimal place). Excluding income tax and other operating costs, did Chevron earn more profit per dollar of revenue in 2010 compared to 2009? 13-45 E13-1 Preparing and Interpreting a Schedule for Horizontal and Vertical Analyses Req. 1 The 18% increase in the average gas price was less than the 19.2% increase in total revenues and more than the 16.0% increase in cost of crude oil and products. It appears from this analysis that the increase in gas prices explains only part of Chevron’s increase in total revenues. Note that the percentage increase in total revenues was similar to the percentage increase in the cost of crude oil and products, suggesting the costs of crude oil really did increase a lot in 2010, necessitating the increase in gas prices. 13-46 E13-1 Preparing and Interpreting a Schedule for Horizontal and Vertical Analyses Req. 2 As a percent of total revenues, Chevron’s cost of crude oil and products was higher in 2009 (58.1%) than in 2010 (56.6%). This implies that Chevron earned more profit (excluding income tax and other operating costs) per dollar of revenues in 2010 than in 2009. 13-47 E13-3 Preparing and Interpreting a Schedule for Horizontal and Vertical Analyses According to the producer price index database maintained by the Bureau of Labor Statistics, the average cost of computer equipment fell 4.8 percent between 2009 and 2010. Let’s see whether these changes are reflected in the income statement of Computer Tycoon Inc. for the year ended December 31, 2010. Required: 1. Conduct a horizontal analysis by calculating the year-over-year changes in each line item, expressed in dollars and in percentages (rounded to one decimal place). How did the change in computer prices compare to the changes in Computer Tycoon’s sales revenues? 2. Conduct a vertical analysis by expressing each line as a percentage of total revenues (round to one decimal place). Excluding income tax, interest, and operating expenses, did Computer Tycoon earn more profit per dollar of sales in 2010 compared to 2009? 13-48 E13-3 Preparing and Interpreting a Schedule for Horizontal and Vertical Analyses Req. 1 The 4.8% decrease in the average price of computer equipment was less than the 16.7% decrease in total revenues. It appears from this analysis that the 4.8% decrease in computer prices was not offset by an increase in Computer Tycoon’s sales volume. In fact, the sales volume also decreased, leaving an overall decrease in sales revenues of 16.7%. 13-49 E13-3 Preparing and Interpreting a Schedule for Horizontal and Vertical Analyses Req. 2 Excluding income tax, interest, and operating expenses (i.e., looking at gross profit), we see that Computer Tycoon earned 40.0% gross profit in 2010, which is down from 40.4% in 2009. In other words, Computer Tycoon earned 0.4 cents less (40.0 – 40.4) per dollar of revenues in 2010 than in 2009. 13-50 E13-4 Computing Profitability Ratios Use the information in E13-3 to complete the following requirements. Required: 1. Compute the gross profit percentage for each year (one decimal place). Assuming that the change for 2009 to 2010 is the beginning of a sustained trend, is Computer Tycoon likely to earn more or less gross profit from each dollar of sales in 2011? 2. Compute the net profit margin for each year (expressed as a percentage with one decimal place). Given your calculations here and in requirement 1, explain whether Computer Tycoon did a better or worse job of controlling operating expenses in 2010 relative to 2009. 3. Computer Tycoon reported average net fixed assets of $54,200 in 2010 and $45,100 in 2009. Compute the fixed asset turnover ratios for both years (round to two decimal places). Did the company better utilize its investment in fixed assets to generate revenues in 2010 or 2009? 4. Computer Tycoon reported average stockholders’ equity of $54,000 in 2010 and $40,800 in 2009. Compute the return on equity ratios for both years (expressed as a percentage with one decimal place). Did the company generate greater returns for stockholders in 2010 or 2009? 13-51 E13-4 Computing Profitability Ratios Req. 1 Gross Profit Percentage = Net Sales Revenue - Cost of Goods Sold Net Sales Revenue 2009 = $120,000 - $71,500 $120,000 = 0.404 or 40.4% 2010 = $100,000 - $60,000 $100,000 = 0.40 or 40.0% If these results are the beginning of a sustained trend, then it is likely that Computer Tycoon will have lower total revenues in 2011, and a decline in gross profit percentage. The gross profit percentage of 40.0% means that the company generated 40.0 cents of gross profit on each dollar of sales in 2010, which was down almost half of one cent from 2009. If this continues, the company could be expected to generate even less gross profit from each dollar of sales in 2011. 13-52 E13-4 Computing Profitability Ratios Req. 2 Net Profit Margin = Net Income Total Revenue 2009 = $6,025 $120,000 = 0.050 or 5.0% 2010 = $2,500 $100,000 = 0.025 or 2.5% Computer Tycoon did a worse job of controlling expenses (other than the cost of goods sold) in 2010 relative to 2009 because the net profit margin decreased 2.5% (5.0 – 2.5) at the same time that the gross profit percentage decreased only 0.4% (from 40.4% to 40.0%). 13-53 E13-4 Computing Profitability Ratios Req. 3 Fixed Asset Turnover = Total Revenue Average Net Fixed Assets 2009 = $120,000 $45,100 = 2.66 2010 = $100,000 $54,200 = 1.85 The company better utilized its investment in fixed assets in 2009. Its fixed asset turnover ratio fell from 2.66 in 2009 to 1.85 in 2010. The 2010 ratio means that the company generated $1.85 of sales revenue for every dollar invested in fixed assets. 13-54 E13-4 Computing Profitability Ratios Req. 4 Return on Equity (ROE) = Net Income Average Stockholders' Equity 2009 = $6,025 $40,800 = 0.148 or 14.8% 2010 = $2,500 $54,000 = 0.046 or 4.6% The company generated better returns for stockholders in 2009 (14.8%) than in 2010 (4.6%). 13-55 E13-10 Inferring Financial Information from Profitability and Liquidity Ratios Dollar General Corporation operates approximately 9,400 general merchandise stores that feature quality merchandise at low prices to meet the needs of middle-, low-, and fixed-income families in southern, eastern, and mid-western states. For the year ended January 28, 2011, the company reported average inventories of $1,643 (in millions) and an inventory turnover of 5.39. Average total fixed assets were $1,427 (million), and the fixed asset turnover ratio was 9.13. Required: 1. Calculate Dollar General’s gross profit percentage (expressed as a percentage with one decimal place). What does this imply about the amount of gross profit made from each dollar of sales? TIP: Work backward from the fixed asset turnover and inventory turnover ratios to compute the amounts needed for the gross profit percentage. 2. Is this an improvement from the gross profit percentage of 31.3 percent earned during the previous year? 13-56 E13-10 Inferring Financial Information from Profitability and Liquidity Ratios Req. 1 We can get the net sales number from the fixed assets turnover ratio and the cost of goods sold number from the inventory turnover ratio, as shown below. Fixed asset turnover = Net sales ÷ Average fixed assets 9.13 = Net sales ÷ $1,427,000,000 9.13 x $1,427,000,000 = Net sales $13,028,510,000 = Net sales Inventory turnover = Cost of goods sold ÷ Average inventory 5.39 = Cost of goods sold ÷ $1,643,000,000 5.39 x $1,643,000,000 = Cost of goods sold $8,855,770,000 = Cost of goods sold So, Gross profit percentage = (Net sales – Cost of goods sold) ÷ Net sales = ($13,028,510,000 – $8,855,770,000) ÷ $13,028,510,000 = 0.320 or 32.0% 13-57 E13-13 Analyzing the Impact of Selected Transactions on the Current Ratio The Sports Authority, Inc., is a private full-line sporting goods retailer. Assume one of the Sports Authority stores reported current assets of $88,000 and its current ratio was 1.75, and then completed the following transactions: 1) paid $6,000 on accounts payable, 2) purchased a delivery truck for $10,000 cash, 3) wrote off a bad account receivable for $2,000, and 4) paid previously declared dividends in the amount of $25,000. Required: Compute the updated current ratio rounded to two decimal places, after each transaction. 13-58 E13-13 Analyzing the Impact of Selected Transactions on the Current Ratio Start Transaction (1) Subtotal Cash Transaction (2) Subtotal Transaction (3) Cash Subtotal Transaction (4) Subtotal 13-59 Current Current Assets Current Liabilities Ratio (CA) (CL) (CA ÷ CL) $88,000 ($88,000 ÷ 1.75) $50,286 1.75 –6,000 Accts. pay. 82,000 –10,000 72,000 –6,000 44,286 1.85 44,286 1.63 44,286 –25,000 $19,286 1.63 No impact* Cash 72,000 –25,000 Dividends pay. $ 47,000 2.44 End of Chapter 13 13-60