Chapter 13
Measuring and Evaluating
Financial Performance
PowerPoint Author:
Brandy Mackintosh, CA
Copyright © 2016 by McGraw-Hill Education
Learning Objective 13-1
Describe the purpose and
uses of horizontal, vertical,
and ratio analyses.
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Horizontal, Vertical, and Ratio
Analyses
Horizontal (trend) analyses are conducted to help financial statement
users recognize important financial changes that unfold over time.
12/31/13
Gross Profit in 2013
Trend Analysis
12/31/14
Gross Profit in 2014
Δ in Gross Profit $
and/or % from 2013
Vertical analyses focus on important relationships between items on the
same financial statement.
2014
Amount
Sales
Cost of Goods Sold
Gross Profit
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$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
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Learning Objective 13-2
Use horizontal (trend) analysis
to recognize financial changes
that unfold over time.
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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
$53,417 – $50,521
× 100
$50,521
Now let’s calculate the percentage
Calculate
Now
Can
let’s
the
youlook
change
calculate
at the
in remainder
dollars
the dollar
forand
Net
of the
Sales
change in Net Sales Revenue between
Revenue
trend
percentage
analysis
between
change
offiscal
the Income
for
2013
Cost
and
Statement.
of Sales?
fiscal 2012.
fiscal 2013 and fiscal 2012.
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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
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Learning Objective 13-4
Calculate financial ratios to
assess profitability, liquidity,
and solvency.
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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.
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Common Profitability Ratios
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Common Liquidity Ratios
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Common Solvency Ratios
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Learning Objective 13-5
Interpret the results of
financial analyses.
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Interpreting Horizontal and Vertical
Analyses
Lowe’s began relying more on debt and
less equity financing. Total liabilities
increased 11 percent and stockholders’
equity decreased by 14.5%.
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Lowe’s assets
grew only by
0.2% in fiscal
2013.
Interpreting Horizontal and Vertical
Cost of sales and operating expenses
Analyses are the most important determinants of
the company’s profitability.
Much of the increase
in Net Income in fiscal
2013 is explained by
greater control of the
Cost of Sales and
Operating Expenses.
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Interpreting Horizontal and Vertical
Analyses
Lowe’s has experienced a small
Lowe’s did a better job of
controlling its Operating
Expenses between 2012
and 2013.
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decrease in its percentage of Cost of
Sales in relation to Sales Revenue from
fiscal 2012 to 2013. Decreasing cost of
sales means higher Gross Profit.
Ratio
Calculations
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Ratio Calculations
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Profitability Ratios
Net Profit Margin – The slowly improving economy helped boost
Lowe’s profits in 2013 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.
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Profitability Ratios
Fixed Asset Turnover – indicates how much revenue the company
generates in sales for each dollar invested in fixed assets,
Home Depot 2013 fixed asset turnover ratio was 3.32
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.
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Profitability Ratios
Earnings Per Share (EPS) – Shows the amount of earnings
generated for each share of outstanding common stock.
Price /Earnings (P/E) Ratio – Shows the relationship between EPS
and the market price of one share of the company’s stock.
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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
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=
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 77 days in 2013.
Current Ratio – The current ratio measures the company’s ability to
pay its current liabilities
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Solvency Ratios
Debt to Assets Ratio – indicates the proportion of total assets that
creditors finance.
In 2013, The Home Depot had a debt-to-assets ratio of 69 percent.
Times Interest Earned – indicates how many times the company’s
interest expense was covered by its operating results.
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Learning Objective 13-6
Describe how analyses
depend on key accounting
decisions and concepts.
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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.
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Accounting Concepts
Companies may elect to use any acceptable generally
accepted accounting principle (GAAP) as long as they
apply the principle consistently.
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Conceptual Framework for Financial
Accounting and Reporting
13-30
Factors Contributing to Going-Concern
Problems
Factors that commonly contribute to
going-concern problems are listed below.
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Chapter 13
Supplement 13A
Nonrecurring and Other Special
Items
Copyright © 2016 by McGraw-Hill Education
Learning Objective 13-S1
Describe how nonrecurring
and other comprehensive
income items are reported.
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Nonrecurring Items




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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
NONRECURRING ITEM
Discontinued Operations.
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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.
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Chapter 13
Supplement 13B
Reviewing and
Contrasting IFRS and
GAAP
Copyright © 2016 by McGraw-Hill Education
Learning Objective 13-S2
Describe significant
differences between GAAP
and IFRS.
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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
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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
Copyright © 2016 by McGraw-Hill Education
M13-1 Calculations for Horizontal Analyses
Using the following income statements, perform the calculations
needed for horizontal analyses. Round percentages to one decimal
place.
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M13-1 Calculations for Horizontal Analyses
Current
Previous
($100,000 – $75,000)
× 100 = 33.3%
$75,000
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M13-2 Calculations for Vertical Analyses
Refer to M13-1 . Perform the calculations needed for vertical analyses.
Round percentages to one decimal place.
Current
$21,000
$100,000
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× 100 = 21.0%
Previous
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 last year to this year. Sales last year were $200,000. This year, the
company reported Cost of Goods Sold in the amount of $150,000. What
was the gross profit percentage this year? 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 2013 dropped $0.12 (3 percent) from $3.61 in
2012 (to $3.49 in 2013). Let’s see whether these changes are reflected in the income
statement of Chevron Corporation for the year ended December 31, 2013 (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 2013 compared to 2012?
13-45
E13-1 Preparing and Interpreting a Schedule for Horizontal
and Vertical Analyses
Req. 1
The 3% decrease in the average gas price was less than the 4.8%
decrease in revenues and less than the 4.0% decrease in cost of crude oil
and products. It appears from this analysis that the decrease in gas prices
explains only part of Chevron’s decrease in revenues. Note that the
percentage decrease in revenues was similar to the percentage decrease
in the cost of crude oil and products, suggesting the costs of crude oil really
did decrease a lot in 2013, consistent with the decrease in gas prices.
13-46
E13-1 Preparing and Interpreting a Schedule for Horizontal
and Vertical Analyses
Req. 2
As a percent of revenues, Chevron’s cost of crude oil and
products was higher in 2013 (65.0%) than in 2012 (64.5%).
This implies that Chevron earned less profit (excluding
income tax and other operating costs) per dollar of
revenues in 2013 than in 2012.
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 8.1 percent between 2012 and
2013. Let’s see whether these changes are reflected in the income statement of
Computer Tycoon Inc. for the year ended December 31, 2013.
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 2013
compared to 2012?
13-48
E13-3 Preparing and Interpreting a Schedule for Horizontal and
Vertical Analyses
Req. 1
The 8.1% 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 8.1% 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 2013, which is down from
40.4% in 2012. In other words, Computer Tycoon earned
0.4 cents less (40.0 – 40.4) per dollar of revenues in 2013
than in 2012.
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 2012 to 2013 is the beginning of a
sustained trend, is Computer Tycoon likely to earn more or less gross
profit from each dollar of sales in 2014?
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 2013 relative to 2012.
3. Computer Tycoon reported average net fixed assets of $54,200 in 2013
and $45,100 in 2012. 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 2013 or 2012?
4. Computer Tycoon reported average stockholders’ equity of $54,000 in
2013 and $40,800 in 2012. 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 2013 or 2012?
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E13-4 Computing Profitability Ratios
Req. 1
The gross profit percentage of 40.0% means that the
company generated 40.0 cents of gross profit on each
dollar of sales in 2013, which was down almost half of one
cent from 2012. If this continues, the company could be
expected to generate even less gross profit from each
dollar of sales in 2014.
13-52
E13-4 Computing Profitability Ratios
Req. 2
Computer Tycoon did a worse job of controlling expenses (other than
the cost of goods sold) in 2013 relative to 2012 because the net profit
margin decreased 2.5% (5.0 – 2.5), of which only 0.4% was
attributable to the gross profit percentage decrease (from 40.4% to
40.0%).
13-53
E13-4 Computing Profitability Ratios
Req. 3
The company better utilized its investment in fixed assets in
2012. Its fixed asset turnover ratio fell from 2.66 in 2012 to
1.85 in 2013. The 2013 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
The company generated better returns for
stockholders in 2012 (14.8%) than in 2013 (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 31, 2014, the company
reported average inventories of $2,475 (in millions) and an inventory turnover
of 4.89. Average total fixed assets were $2,080 (million), and the fixed asset
turnover ratio was 8.14.
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 31.7 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 =
8.14
=
8.14 x $2,080,000,000 =
$16,931,200,000
=
Net sales ÷ Average fixed assets
Net sales ÷ $2,080,000,000
Net sales
Net sales
Inventory turnover
4.89
4.89 x $2,475,000,000
$12,102,750,000
Cost of goods sold ÷ Average inventory
Cost of goods sold ÷ $2,475,000,000
Cost of goods sold
Cost of goods sold
=
=
=
=
So, Gross profit percentage = (Net sales – Cost of goods sold) ÷ Net sales
= ($16,931,200,000 – $12,102,750,000) ÷ $16,931,200,000
= 0.285 or 28.5%
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
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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