Chapter 13 - PowerPoint Presentation

Slide1

Chapter 13

Measuring and EvaluatingFinancial Performance

PowerPoint

Author

:

Brandy Mackintosh, CASlide2

Learning Objective 13-1

Describe the purpose and uses of horizontal, vertical, and ratio analyses.Slide3

Horizontal, Vertical, and Ratio Analyses

Horizontal (trend) analyses are conducted to help financial statement users recognize important

financial

changes that unfold over time.

Gross Profit

in

2013

Δ in Gross Profit

$ and/or % from 2013

12/31/13

12/31/14

Gross Profit

in

2014

Trend Analysis

Vertical analyses focus on important relationships between items on the same financial statement.

Sales

Cost of Goods Sold

Gross Profit

$200,000 100%

150,000 75%

$ 50,000 25%

Amount

Percent

2014Slide4

Horizontal, Vertical, and Ratio Analyses

Ratio analyses are conducted to understand relationships among various items reported in one or more of the financial statements.

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

Receivable

Turnover

Ratio

=

Net Sales Revenue

Average Net ReceivablesSlide5

Learning Objective 13-2

Use horizontal (trend) analysis to recognize financial changes that unfold over time.Slide6

Horizontal (Trend) Computations

Trend analyses are usually calculated in terms of year-to-year dollar and percentage changes.

Let’s look at an exampleSlide7

Now let’s look at the remainder of the trend analysis of the Income Statement.

Can you calculate the dollar and percentage change for Cost of Sales?

Now let’s calculate the

percentage

change in Net Sales Revenue between

fiscal 2013

and fiscal 2012.

Horizontal (Trend) Computations

Calculate the change in dollars for Net Sales Revenue between fiscal 2013 and

fiscal 2012.

$53,417

–

$50,521

$50,521

× 100Slide8

Learning Objective 13-3

Use vertical (common size) analysis to understand important relationships within financial statements.Slide9

Vertical (Common Size) Computations

Vertical, or common size, analysis focuses on important relationships

within

financial statements.

Income Statement

Balance Sheet

Sales = 100%

Total Assets = 100%

Cost of Sales

Net Sales Revenue

× 100Slide10

Learning Objective 13-4

Calculate financial ratios to assess profitability, liquidity, and solvency.Slide11

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 . . .

Profitability ratios

examine a company’s

ability to generate income.

Liquidity ratios

help us determine if a

company

has

sufficient

current assets to repayliabilities when due.

Solvency ratios

examine a company’sability to payinterest and repaydebt when due.Slide12

Common Profitability RatiosSlide13

Common Liquidity RatiosSlide14

Common Solvency RatiosSlide15

Learning Objective 13-5

Interpret the results of financial analyses.Slide16

Interpreting Horizontal and Vertical Analyses

Lowe’s

assets grew only by 0.2%

in fiscal

2013.

Lowe’s began relying more on debt and less equity financing.

Total

liabilities increased 11 percent and stockholders’ equity decreased by 14.5%.Slide17

Interpreting Horizontal and Vertical Analyses

Cost of sales and operating expenses 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.Slide18

Interpreting Horizontal and Vertical Analyses

Lowe’s has experienced

a small 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.

Lowe’s did

a better job

of controlling its Operating Expenses

between 2012 and 2013. Slide19

Ratio

CalculationsSlide20

Ratio CalculationsSlide21

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. Slide22

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.Slide23

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.Slide24

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

=

Net Sales Revenue

Average Net Receivables

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.Slide25

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 liabilitiesSlide26

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.Slide27

Learning Objective 13-6

Describe how analyses depend on key accounting decisions and concepts.Slide28

Underlying Accounting Decisions and Concepts

Accounting Decisions

Difference in Strategies,

e.g

.,

type of financing.

Difference in Accounting Methods, e.g., FIFO vs. LIFO.Difference in Operations,e.g.,

quality of items sold.Slide29

Accounting Concepts

Companies may elect to use any acceptable generally accepted accounting principle (GAAP) as long as they apply the principle consistently.Slide30

Conceptual Framework for Financial Accounting and ReportingSlide31

Factors Contributing to Going-Concern Problems

Factors that commonly contribute to going-concern problems are listed below.Slide32

Chapter 13

Supplement 13ANonrecurring and Other Special ItemsSlide33

Learning Objective 13-S1

Describe how

nonrecurring and other comprehensive income items are reported.Slide34

Nonrecurring Items

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:

Operating income prior to the date of disposal.

Gain or loss on sale or disposal of net assets.



Slide35

Nonrecurring Items

NONRECURRING

I

TEM

Discontinued Operations.Slide36

Other Special Items

Comprehensive Income includes:

Gains or losses from certain foreign currency exchange rate changes.

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.Slide37

Chapter 13

Supplement 13BReviewing and Contrasting IFRS and GAAPSlide38

Learning Objective 13-S2

Describe

significant differences between GAAP and IFRS.Slide39

Overview

At a basic level both IFRS and GAAP are concerned with accounting rules that describe

when an item should be recognized in the accounting system,

how that item should be classified (asset , liability, equity, expense, or revenue), and

the amount at which each item should be measured.

Report fixed assets at fair value.

IFRS

Yes

GAAP

NoSlide40

Chapter 13

Solved ExercisesM13-1, M13-2, M13-6, E13-1, E13-3, E13-4, E13-10, E13-13Slide41

M13-1 Calculations for Horizontal Analyses

Using the following income statements, perform the calculations needed for horizontal analyses. Round percentages to one decimal place.Slide42

M13-1 Calculations for Horizontal Analyses

($100,000 – $75,000)

$75,000

× 100 = 33.3%

Current

PreviousSlide43

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

× 100 = 21.0%

Current

PreviousSlide44

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.

$100,000

$250,000

× 100 = 40.0%

Sales ($200,000 x 1.25) $250,000 100.0%

Cost of Goods Sold (given)

(150,000)

-60.0%Gross Profit $100,000 40.0%Slide45

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?Slide46

E13-1 Preparing and Interpreting a Schedule for Horizontal

and Vertical Analyses

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.

Req. 1Slide47

E13-1 Preparing and Interpreting a Schedule for Horizontal

and Vertical Analyses

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.

Req. 2Slide48

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?Slide49

E13-3 Preparing and Interpreting a Schedule for Horizontal and Vertical Analyses

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%.

Req. 1Slide50

E13-3 Preparing and Interpreting a Schedule for Horizontal and Vertical Analyses

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.

Req. 2Slide51

E13-4 Computing Profitability Ratios

Use the information in E13-3 to complete the following requirements.

Required:

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?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.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?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?Slide52

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.Slide53

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%). Slide54

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.Slide55

E13-4 Computing Profitability Ratios

Req. 4

The company generated better returns for stockholders in

2012

(14.8%) than in

2013

(4.6%). Slide56

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: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.Is this an improvement from the gross profit percentage of 31.7 percent earned during the previous year?Slide57

E13-10

Inferring Financial Information from Profitability and Liquidity Ratios

Req. 1

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%

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 8.14 = Net sales ÷ $2,080,000,000 8.14 x $2,080,000,000 = Net sales $16,931,200,000 = Net sales   Inventory turnover = Cost of goods sold ÷ Average inventory 4.89 = Cost of goods sold ÷ $2,475,000,000 4.89 x $2,475,000,000 = Cost of goods sold $12,102,750,000 = Cost of goods soldSlide58

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:paid $6,000 on accounts payable, purchased a delivery truck for $10,000 cash, wrote off a bad account receivable for $2,000, and paid previously declared dividends in the amount of $25,000.Required:Compute the updated current ratio rounded to two decimal places, after each transaction.Slide59

E13-13 Analyzing the Impact of Selected Transactions on the

Current RatioSlide60

End of Chapter 13