McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 13
Measuring and Evaluating
Financial Performance
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Fred Phillips, Ph.D., CA
Learning Objective 1
Describe the purpose and
uses of horizontal, vertical,
and ratio analyses.
13-3
Horizontal, Vertical, and Ratio
Analyses
Horizontal (trend) analyses are conducted to help financial statement
users recognize important financial changes that unfold over time.
12/31/09
Gross Profit in 2009
Trend Analysis
12/31/10
Gross Profit in 2010
Δ in Gross Profit $
and/or % from 2009
Vertical analyses focus on important relationships between items on the
same financial statement.
2010
Amount
Sales
Cost of Goods Sold
Gross Profit
13-4
$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
13-5
Learning Objective 2
Use horizontal (trend) analysis
to recognize financial changes
that unfold over time.
13-6
Horizontal (Trend) Computations
Trend analyses are usually calculated in terms of
year-to-year dollar and percentage changes.
(Current Year’s Total – Prior Year’s Total)
Year-to-Year
Change This Year
=
× 100
Change (%)
Prior Year’s Total
Let’s look at an example
13-7
Horizontal (Trend) Computations
$48,230 – $48,283
× 100
$48,283
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
2009Statement.
ofand
Sales?
2008.
2009 and 2008.
13-8
Learning Objective 3
Use vertical (common size)
analysis to understand
important relationships within
financial statements.
13-9
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
13-10
Learning Objective 4
Calculate financial ratios to
assess profitability, liquidity,
and solvency.
13-11
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.
13-12
Common Profitability Ratios
13-13
Common Liquidity Ratios
13-14
Common Solvency Ratios
13-15
Learning Objective 5
Interpret the results of
financial analyses.
13-16
Interpreting Horizontal and Vertical
With 60 new stores opened, Lowe’s had
Analyses
a 7.9% increase in inventory, and a 6.4%
increase in Property and Equipment.
Lowe’s grew
by 5.9% in
fiscal 2009.
13-17
Interpreting Horizontal and Vertical
Analyses
The Company’s cash position
weakened significantly between
fiscal 2007 and 2008.
13-18
There was a
large increase in
the inventory
carried by the
company. The
accumulation of
inventory is a
sign of a
weakening
business
outlook.
Interpreting Horizontal and Vertical
Analyses
Cost of sales and operating expenses
Much of the decline in
fiscal 2008 Net Income
is explained by the
increase in Cost of
Sales and Operating
Expenses.
13-19
are the most important determinants of
the company’s profitability.
Interpreting Horizontal and Vertical
Analyses
Lowe’s has experienced a 0.4% increase
Lowe’s did not do a good
job of controlling its
operating expenses
between 2007 and 2008.
The company is faced with
lower gross profit and poor
operating expense control.
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in its cost of goods sold from fiscal 2007
to 2008. Increasing cost of sales means
lower gross profit.
Ratio
Calculations
13-21
Ratio Calculations
13-22
Profitability Ratios
Net Profit Margin – Lowe’s faced a challenging economic
environment in 2008 as shown by the decline 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.
13-23
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 2008 fixed asset turnover ratio was 2.65
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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.
13-25
Profitability Ratios
Quality of Income – Quality of income ratio relates operating cash
flows (from the Statement of Cash Flows) to net income.
Home Depot 2008 Quality of Income Ratio was 2.45
Price /Earnings (P/E) Ratio – Shows the relationship between EPS
and the market price of one share of the company’s stock.
13-26
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
13-27
=
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 87 days in 2008.
Current Ratio – The current ratio measures the company’s ability to
pay its current liabilities
13-28
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 2008, 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, to repay debt when it matures, pay interest until that time,
and finance the replacement and/or expansion of long-term assets.
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Solvency Ratios
Debt to Assets Ratio – indicates the proportion of total assets that
creditors finance.
In 2008, The Home Depot had a debt-to-assets ratio of 57 percent.
Times Interest Earned – indicates how many times the company’s
interest expense was covered by its operating results.
13-30
Solvency Ratio
Capital Acquisition Ratio – compares cash flows from operations
with cash paid for property and equipment.
13-31
Learning Objective 6
Describe how analyses
depend on key accounting
decisions and concepts.
13-32
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.
13-33
Accounting Concepts
Companies may elect to use any acceptable generally
accepted accounting principle (GAAP) as long as they
apply the principle consistently.
13-34
Conceptual Framework for Financial
Accounting and Reporting
Objective of External Financial Reporting
To provide useful financial information to external users for decision making
(Ch. 1)
•It must be relevant and a faithful representation of the business.
•It is more useful if it is comparable, verifiable, timely, and understandable.
Elements to be Measured and Reported
•Assets, Liabilities, Stockholders’ Equity, Revenue, Expenses (Ch. 1)
Concepts for Measuring and Reporting Information
•Assumptions:
•Unit of Measure (Ch. 1), Separate Entity (Ch. 1) Going Concern,
Time Period (Ch. 3)
•Principles:
•Cost (Ch. 2), Revenue Recognition (Ch. 3), Matching (Ch. 3), Full
Disclosure
•Exceptions
•Cost-Benefit, Materiality (Ch. 5), Industry Practices
13-35
Factors Contributing to Going-Concern
Problems
Factors that commonly contribute to
going-concern problems are listed below.
13-36
Chapter 13
Supplement 13A
Nonrecurring and Other Special
Items
Nonrecurring Items




13-38
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.
13-39
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.
13-40
Chapter 13
Supplement 13B
Reviewing and
Contrasting IFRS and
GAAP
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
IFRS
13-42
Yes
Reverse inventory
Lower of Cost or
Market write-down.
No
Yes
Report fixed assets at
fair value.
No
GAAP
GAAP
Chapter 13
Solved Exercises
M13-1, M13-2, M13-6, E13-1, E13-3,
E13-4, E13-10, E13-13
M13-1 Calculations for Horizontal Analyses
Using the following income statements, perform the calculations
needed for horizontal analyses. Round percentages to one decimal
place.
13-44
M13-1 Calculations for Horizontal Analyses
($100,000 – $75,000)
× 100 = 33.3%
$75,000
13-45
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
13-46
× 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 2009 to 2010. Sales in 2009 were $200,000. In 2010, the company
reported Cost of Goods Sold in the amount of $150,000. What was the
gross profit percentage in 2010? Round to one decimal place.
Sales ($200,000 × 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
13-47
E13-1 Preparing and Interpreting a Schedule for Horizontal
and Vertical Analyses
The average price of a gallon of gas in 2008 jumped $0.45 (16 percent) from $2.81 in
2007 (to $3.26 in 2008). Let’s see whether these changes are reflected in the income
statement of Chevron Corporation for the year ended December 31, 2008 (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 2008 compared to 2007?
13-48
E13-1 Preparing and Interpreting a Schedule for Horizontal
and Vertical Analyses
Req. 1
The 16% increase in the average gas price was less than the 23.5%
increase in total revenues and the 28.6% 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 less than the percentage
increase in the cost of crude oil and products, suggesting the costs of crude
oil really did increase a lot in 2008, necessitating the increase in gas prices.
13-49
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 2008 (62.6%) than in 2007
(60.2%). This implies that Chevron earned less profit
(excluding income tax and other operating costs) per dollar
of revenues in 2008 than in 2007.
13-50
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 20.9 percent between 2007
and 2008. Let’s see whether these changes are reflected in the income statement of
Computer Tycoon Inc. for the year ended December 31, 2008.
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 2008
compared to 2007?
13-51
E13-3 Preparing and Interpreting a Schedule for Horizontal and
Vertical Analyses
Req. 1
The 20.9% decrease in the average price of computer equipment was more
than the 18.8% decrease in total revenues. It appears from this analysis
that the 20.9% decrease in computer prices was partially offset by an
increase in Computer Tycoon’s sales volumes, leaving an overall decrease
in sales revenues of 18.8%.
13-52
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 40.1% gross profit in 2008, which is down from
41.2% in 2007. In other words, Computer Tycoon earned
1.1 cents less (40.1 – 41.2) per dollar of revenues in 2008
than in 2007.
13-53
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 2007 to 2008 is the beginning of a
sustained trend, is Computer Tycoon likely to earn more or less gross
profit from each dollar of sales in 2009?
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 2008 relative to 2007.
3. Computer Tycoon reported average net fixed assets of $54,200 in 2008
and $45,100 in 2007. 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 2008 or 2007?
4. Computer Tycoon reported average stockholders’ equity of $54,000 in
2008 and $40,800 in 2007. 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 2008 or 2007?
13-54
E13-4 Computing Profitability Ratios
Req. 1
If these results are the beginning of a sustained trend, then it is
likely that Computer Tycoon will have lower total revenues in 2009,
and a slight decline in gross profit percentage. The gross profit
percentage of 40.1% means that the company generated 40.1
cents of gross profit on each dollar of sales in 2008, which was
down a little more than one cent from 2007. If this continues, the
company could be expected to generate even less gross profit
from each dollar of sales in 2009.
13-55
E13-4 Computing Profitability Ratios
Req. 2
Computer Tycoon did a worse job of controlling expenses (other than
the cost of goods sold) in 2008 relative to 2007 because the net profit
margin decreased 4.8% (5.9 – 1.1) at the same time that the gross
profit percentage decreased only 1.1% (from 41.2% to 40.1%). This
also is evident from the horizontal analysis in E13-3, which indicates
that while sales and cost of sales decreased by 18.8% and 17.2%,
operating expenses actually increased slightly (by less than 0.1%).
13-56
E13-4 Computing Profitability Ratios
Req. 3
The company did not better utilize its investment in fixed
assets in 2008. Its fixed asset turnover ratio fell from 2.70 in
2007 to 1.82 in 2008. The 2008 ratio means that the
company generated $1.82 of sales revenue for every dollar
invested in fixed assets.
13-57
E13-4 Computing Profitability Ratios
Req. 4
No, the company did not generate better returns for
stockholders in 2008 (2.1%) than in 2007 (17.7%).
This decline in ROE is caused by the significant
decrease in net income (over 84% as shown in E13-3)
coupled with an increase in stockholders’ equity of
32.4% [($54,000 – 40,800) ÷ 40,800 x 100].
13-58
E13-10 Inferring Financial Information from Profitability and
Liquidity Ratios
Dollar General Corporation operates approximately 8,400 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 30,
2009, the company reported average inventories of $1,352 (in millions) and
an inventory turnover of 5.47. Average
total fixed assets were $1,272 (million), and the fixed asset turnover ratio
was 8.22.
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 28.2 percent
earned during the previous year?
13-59
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
8.22 = Net sales ÷ $1,272,000,000
8.22 x $1,272,000,000 = Net sales
$10,455,840,000 = Net sales
Inventory turnover = Cost of goods sold ÷ Average inventory
5.47 = Cost of goods sold ÷ $1,352,000,000
5.47x $1,352,000,000 = Cost of goods sold
$7,395,440,000 = Cost of goods sold
So, Gross profit percentage = (Net sales – cost of goods sold) ÷ Net sales
= 0.293 or 29.3%
13-60
E13-13 Analyzing the Impact of Selected Transactions on the
Current Ratio
The Sports Authority, Inc., is the country’s largest private full-line
sporting goods retailer. Stores are operated under four brand names:
Sports Authority, Gart Sports, Oshman’s, and Sportmart. Assume one
of the Sports Authority stores reported current assets of $88,000 and
its current ratio was 1.75. Assume that the following transactions were
completed:
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.
13-61
E13-13 Analyzing the Impact of Selected Transactions on the
Current Ratio
13-62
End of Chapter 13