12-1 analysis of investing activities electronic presentation by douglas cloud pepperdine university...

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Analysis of Analysis of Investing Investing ActivitiesActivities

Analysis of Analysis of Investing Investing ActivitiesActivitiesElectronic Presentation by Douglas Cloud

Pepperdine University

Electronic Presentation by Douglas Cloud

Pepperdine University

Chapter Chapter F12F12

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1. Explain why investing decisions are important to a company and how they can affect its profits.

2. Explain how operating leverage affects a company’s risk and profits.

3. Use financial statements to evaluate investing activities for various companies.

ObjectivesObjectivesObjectivesObjectives

Once you have Once you have completed this chapter, completed this chapter, you should be able to:you should be able to:

Once you have Once you have completed this chapter, completed this chapter, you should be able to:you should be able to:

ContinuedContinuedContinuedContinued

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4. Explain how investing activities affect company value, and use accounting information to measure value-increasing activities.

5. Identify ways in which a company can use its assets to improve effectiveness and efficiency.

6. Explain why accounting information about long-term assets is useful for creditors.

ObjectivesObjectivesObjectivesObjectives

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11ObjectiveObjectiveObjectiveObjective

Explain why investing decisions are important to a company and how they can affect its profits.

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Exhibit 1Exhibit 1Exhibit 1Exhibit 1 The Production Process for Mom’s Cookie Company

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Obviously, we need equipment.

Obviously, we need equipment.

Investing Decisions and ProfitInvesting Decisions and ProfitInvesting Decisions and ProfitInvesting Decisions and Profit

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Can’t we just buy what we need?

Can’t we just buy what we need?


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We have to decide how much of each type of equipment we need.

We can start small and add equipment as demand increases.

We have to decide how much of each type of equipment we need.

We can start small and add equipment as demand increases.


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Perhaps the biggest decision we have to make is how much

automation we want in the production process.

Perhaps the biggest decision we have to make is how much

automation we want in the production process.


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As an alternative, we can purchase more sophisticated equipment. Exhibit 2 shows

this alternative.

As an alternative, we can purchase more sophisticated equipment. Exhibit 2 shows

this alternative.


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Exhibit 2Exhibit 2Exhibit 2Exhibit 2 An Alternative Production Process for Mom’s Cookie Company

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Thus, our basic choice is manual or automated equipment. If we select manual equipment, we

can start with less investment and add equipment as demand increase, but we will

have the capacity we expect to need.

Thus, our basic choice is manual or automated equipment. If we select manual equipment, we

can start with less investment and add equipment as demand increase, but we will

have the capacity we expect to need.


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Also, we will be able to produce a higher quality product because the automated process is more reliable.

Also, we will be able to produce a higher quality product because the automated process is more reliable.


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What effect do the choices have on our expected profits if we anticipate sales of $3,000,000?

What effect do the choices have on our expected profits if we anticipate sales of $3,000,000?


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(in thousands) Manual Automated(in thousands) Manual Automated

Assets:Current assets $1,000 $1,000Plant assets 3,500 4,000

Total assets $4,500 $5,000Sales $3,000 $3,000Cost of ingredients (800) (800)Depreciation (250) (300)Wages and benefits (780) (700)Other operating expenses (1,000) (1,000)Operating income 170 200Interest expense (170) (170)Pretax income --- 30Income taxes --- (9)Net income $ --- $ 21

Sales of $3.0 Million

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In the second year of operations we anticipate sales of $3.6 million. What would be our projected net income if

our expectations are correct?

In the second year of operations we anticipate sales of $3.6 million. What would be our projected net income if

our expectations are correct?


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If we select manual equipment, we will have to purchase an

additional $250,000 of equipment to meet the higher demand.

If we select manual equipment, we will have to purchase an

additional $250,000 of equipment to meet the higher demand.


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(in thousands) Manual Automated(in thousands) Manual AutomatedAssets:

Current assets $1,200 $1,440Plant assets 3,750 4,000

Total assets $4,950 $5,440Sales $3,600 $3,600Cost of ingredients (960) (960)Depreciation (275) (300)Wages and benefits (936) (700)Other operating expenses (1,000) (1,000)Operating income 429 640Interest expense (170) (170)Pretax income 259 470Income taxes (78) (141)Net income $ 181 $ 329


Depreciation for Depreciation for manual increases manual increases due to additional due to additional

equipment required equipment required costing $250,000costing $250,000

Depreciation for Depreciation for manual increases manual increases due to additional due to additional

equipment required equipment required costing $250,000costing $250,000

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22Explain how operating leverage affects a company’s risk and profits.

ObjectiveObjectiveObjectiveObjective

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What would happen to net income if sales are only

$2.8 the first year?

What would happen to net income if sales are only

$2.8 the first year?

Investment Decisions and RiskInvestment Decisions and RiskInvestment Decisions and RiskInvestment Decisions and Risk

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(in thousands) Manual Automated(in thousands) Manual AutomatedAssets:

Current assets $ 900 $ 900Plant assets 3,400 4,000

Total assets $4,300 $4,900Sales $2,800 $2,800Cost of ingredients (747) (747)Depreciation (233) (300)Wages and benefits (728) (700)Other operating expenses (1,000) (1,000)Operating income 92 53Interest expense (170) (170)Pretax income (78) (117)Income taxes 23 35Net income $ (55) $ (82)


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Exhibit 6Exhibit 6Exhibit 6Exhibit 6 A Comparison of the Effects of Investment Decisions on Profits of Mom’s Cookie Company

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Fixed costs are costs that do not increase in proportion to

increases in sales.

Fixed costs are costs that do not increase in proportion to

increases in sales.

Investing Decisions and RiskInvesting Decisions and RiskInvesting Decisions and RiskInvesting Decisions and Risk

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Variable costs are costs that do increase in proportion to

increases in sales.

Variable costs are costs that do increase in proportion to

increases in sales.


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The use of fixed costs to increase net income as sales increase is known as operating leverage.

The use of fixed costs to increase net income as sales increase is known as operating leverage.


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33Use financial statements to evaluate investing activities for various companies.


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Identifying Investing ActivitiesIdentifying Investing ActivitiesIdentifying Investing ActivitiesIdentifying Investing Activities

As a first step in our analysis, we want to identify the companies’ long-term assets and the changes in these assets

resulting from investing activities.

As a first step in our analysis, we want to identify the companies’ long-term assets and the changes in these assets

resulting from investing activities.

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Exhibit 7Exhibit 7Exhibit 7Exhibit 7 Selected Financial Statement Information for Krispy Kreme and Starbucks

Plant and equipment accounts for most of

the long-term assets of both companies.

Plant and equipment accounts for most of

the long-term assets of both companies.

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Krispy Kreme’s total assets grew by 63%.

Krispy Kreme’s total assets grew by 63%.

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Starbucks’ total assets grew by 24%.

Starbucks’ total assets grew by 24%.

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Krispy Kreme’s plant and equipment grew by 29%.

Krispy Kreme’s plant and equipment grew by 29%.

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Starbucks’ plant and equipment grew by 22%.

Starbucks’ plant and equipment grew by 22%.

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Krispy Kreme’s revenue grew by 37%.





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Starbucks’ revenue grew by 22%.

Starbucks’ revenue grew by 22%.

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44Explain how investing activities affect company value, and use accounting information to measure value-increasing activities.


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The Importance of Asset GrowthThe Importance of Asset GrowthThe Importance of Asset GrowthThe Importance of Asset Growth

Growth in assets is important to the value of a company and the

wealth of its stockholders.

Growth in assets is important to the value of a company and the

wealth of its stockholders.

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Krispy Kreme’s net income increased 147%.

Krispy Kreme’s net income increased 147%.

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Starbucks’ net income increased 92%.

Starbucks’ net income increased 92%.

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The Importance of Asset GrowthThe Importance of Asset GrowthThe Importance of Asset GrowthThe Importance of Asset Growth

Starbucks opened 1,208 new stores during 2001 and Krispy Kreme

opened 26 new stores during 2001.

Starbucks opened 1,208 new stores during 2001 and Krispy Kreme

opened 26 new stores during 2001.

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Measuring the Effects of GrowthMeasuring the Effects of GrowthMeasuring the Effects of GrowthMeasuring the Effects of Growth

A common measure of outcome of a company’s investment decisions

is return on assets (ROA).

A common measure of outcome of a company’s investment decisions

is return on assets (ROA).

Return on Assets =Net IncomeTotal Assets

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Return on Assets =Net Income

Total Assets

Krispy Kreme =$14,725

$171,493 = 8.6%

Starbucks =$181,210

$1,851,039= 9.8%

20012001


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Asset turnover is the ratio of revenues to total assets. It is a

measure of the ability of a company to use its assets to

sell its products.

Asset turnover is the ratio of revenues to total assets. It is a

measure of the ability of a company to use its assets to

sell its products.

Revenues

Total AssetsAsset

Turnover =

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A company with a high asset turnover is more effective in

using its assets than one with a low asset turnover.

A company with a high asset turnover is more effective in

using its assets than one with a low asset turnover.

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Profit margin (or return on sales) is the ratio of net income to sales. It is a

measure of the ability of a company to produce profits

from it sales.

Profit margin (or return on sales) is the ratio of net income to sales. It is a

measure of the ability of a company to produce profits

from it sales.

Net Income

Revenues

Profit Margin =

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A company with a high profit margin is more efficient in

controlling costs than one with a low profit margin.

A company with a high profit margin is more efficient in

controlling costs than one with a low profit margin.

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Once profit margin and asset turnover have been calculated,

return on assets can be determined by finding the

product of the two.

Once profit margin and asset turnover have been calculated,

return on assets can be determined by finding the

product of the two.

ROA = Asset Turnover x Profit Margin

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Exhibit 7Exhibit 7Exhibit 7Exhibit 7 Asset Turnover and Profit Margin for Krispy Kreme and Starbucks

Exhibit 8Exhibit 8Exhibit 8Exhibit 8

Asset Turnover and Profit Margin for Krispy Kreme and Starbucks

StarbucksStarbucksKrispy KremeKrispy Kreme 2001 2000 2001 20002001 2000 2001 2000

Asset Turnover 1.754 2.098 1.431 1.460Profit Margin 4.90% 2.70% 6.84% 4.34%Return on Assets 8.59% 5.67% 9.79% 6.34%

Krispy Kreme was able to generate

$1.75 of sales for every $1 invested

in assets.

Krispy Kreme was able to generate

$1.75 of sales for every $1 invested

in assets.

Starbucks was able to generate $1.43 of sales for every $1 invested in assets.

Starbucks was able to generate $1.43 of sales for every $1 invested in assets.

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Exhibit 7Exhibit 7Exhibit 7Exhibit 7 Asset Turnover and Profit Margin for Krispy Kreme and Starbucks



StarbucksStarbucksKrispy KremeKrispy Kreme 2001 2000 2001 20002001 2000 2001 2000

Asset Turnover 1.754 2.098 1.431 1.460Profit Margin 4.90% 2.70% 6.84% 4.34%Return on Assets 8.59% 5.67% 9.79% 6.34%

Krispy Kreme was able to generate $0.049 of net

income for every $1 of sales.

Krispy Kreme was able to generate $0.049 of net


Starbucks was able to generate over $0.068 of net


Starbucks was able to generate over $0.068 of net


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55Identify ways in which a company can use its assets to improve effectiveness and efficiency.


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The Effect of Investment on The Effect of Investment on Effectiveness and EfficiencyEffectiveness and EfficiencyThe Effect of Investment on The Effect of Investment on Effectiveness and EfficiencyEffectiveness and Efficiency

Effectiveness increases when the dollar amount of

sales increases more rapidly than the dollar amount of

additional investment.

Effectiveness increases when the dollar amount of

sales increases more rapidly than the dollar amount of

additional investment.

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Efficiency increases when a company is able to earn

greater profit for each additional dollar of

product it sells.

Efficiency increases when a company is able to earn

greater profit for each additional dollar of

product it sells.

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Mom’s Cookie Company invests $5 million in assets. It pays employees $700,000. Utilities and

other costs amount to $300,000 per year.

Mom’s Cookie Company invests $5 million in assets. It pays employees $700,000. Utilities and

other costs amount to $300,000 per year.

Sales $3,000,000 Cost of goods sold (60%) (1,800,000)Other operating expenses (1,000,000)Pretax income 200,000Income tax (60,000) Net income $ 140,000

Average cost of goods sold for its product is 60% of sales, and income taxes are 30% of pretax income.

In 2004, the store sold $3.0 million of goods.

Average cost of goods sold for its product is 60% of sales, and income taxes are 30% of pretax income.

In 2004, the store sold $3.0 million of goods.

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By changing some of its product line, the company can increase sales to $3.3 million without any

additional asset investment or increasing expenses.

By changing some of its product line, the company can increase sales to $3.3 million without any

additional asset investment or increasing expenses.

Sales $3,300,000 Cost of goods sold (60%) (1,980,000)Other operating expenses (1,000,000)Pretax income 320,000Income tax (96,000) Net income $ 224,000

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Exhibit 7Exhibit 7Exhibit 7Exhibit 7 The Effect of a Sales Increase on Return on Assets



AfterAfterBeforeBefore

Sales Revenues (in millions) $3.0 $3.3Asset Turnover 0.600 0.660Profit Margin 4.67% 6.79%Return on Assets 2.80% 4.48%

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If sales decrease for any length of time, a company

must find ways to reduce its investment so that it can

eliminate unnecessary costs.

If sales decrease for any length of time, a company

must find ways to reduce its investment so that it can

eliminate unnecessary costs.

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66Explain why accounting information about long-term assets is useful for creditors.


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Investing Activities and Investing Activities and Creditor DecisionsCreditor Decisions


Companies often borrow money to acquire long-term assets.

Accordingly, the ability of a company to repay creditors and…

Companies often borrow money to acquire long-term assets.

Accordingly, the ability of a company to repay creditors and…

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…to pay interest usually is connected to its ability to use it long-term assets to

generate profits and cash flows.

…to pay interest usually is connected to its ability to use it long-term assets to

generate profits and cash flows.

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Accounting measurement rules require companies to write

down their assets if the market values of the assets decrease

below their book value.

Accounting measurement rules require companies to write

down their assets if the market values of the assets decrease

below their book value.

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A company owns a building that it purchased for $1 million. Accumulated depreciation on the building at the end of 2004 was $600,000 (book value = $400,000). At that time, the

company determined that the market value of the building was $250,000. The company recognizes a loss by writing down the asset

by $150,000 ($400,000 – $250,000).

A company owns a building that it purchased for $1 million. Accumulated depreciation on the building at the end of 2004 was $600,000 (book value = $400,000). At that time, the

company determined that the market value of the building was $250,000. The company recognizes a loss by writing down the asset

by $150,000 ($400,000 – $250,000).

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This measurement rule is known as lower of cost or market and is intended to

protect investors, particularly creditors, by ensuring that assets are not overstated.

This measurement rule is known as lower of cost or market and is intended to

protect investors, particularly creditors, by ensuring that assets are not overstated.

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THE ENDTHE END

CCHAPTERHAPTER F12 F12

12-1 analysis of investing activities electronic presentation by douglas cloud pepperdine university...

Documents

profit slide

objectivesobjectives

continuedcontinued slide

manual equipment

automated equipment

current assets

plant assets

total assets