chapter 13copyright © 2010 by nelson education ltd. evaluating and managing financial performance...

Chapter 13 Copyright © 2010 by Nelson Education Ltd.

Evaluating and Evaluating and Managing Financial Managing Financial PerformancePerformance

Evaluating and Evaluating and Managing Financial Managing Financial PerformancePerformance

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PowerPoint Presentation by PowerPoint Presentation by

Ian Anderson, Algonquin CollegeIan Anderson, Algonquin College


Looking AheadLooking AheadLooking AheadLooking Ahead

After studying this chapter, you should be able to:

1. Describe the purpose and content of financial statements.

2. Identify the basic requirements for an accounting system.

3. Explain two alternative accounting options.

4. Describe the purpose of and procedures related to internal control.

5. Evaluate a firm’s operating liquidity. …continued

13-2


Looking AheadLooking AheadLooking AheadLooking Ahead

6. Assess a firm’s profitability.

7. Measure a firm’s use of debt or equity financing.

8. Evaluate the rate of return earned on the owner’s investment.

9. Describe the working capital cycle of a small business.

10. Identify the important issues in managing a firm’s cash flows.

11. Explain the key issues in managing accounts receivable, inventory, and accounts payable.


Understanding Financial StatementsUnderstanding Financial StatementsUnderstanding Financial StatementsUnderstanding Financial Statements

• Financial Statements (Accounting Statements)–Reports of a firm’s financial performance and

resources, including an income statement, a balance sheet and a cash flow• Helps determine a start-up’s financial requirements

• Assesses the financial implications of a business plan

13-4


Income StatementIncome StatementIncome StatementIncome Statement

• Income Statement–A report showing the profit or loss from a firm’s operations

over a given period of time.

–“How profitable is the business?”

• SalesSales –– ExpensesExpenses = = ProfitsProfits– Revenue from product or service sales– Costs of producing product or service– Operating expenses (marketing, selling, general and administrative

expenses, and depreciation)– Financing costs (interest paid)– Tax payments

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Some Accounting TermsSome Accounting TermsSome Accounting TermsSome Accounting Terms

• Cost of Goods Sold (COGS) - the cost of producing or acquiring goods or services to be sold by a firm.

• Operating expenses - consisting of both selling and marketing expenses and administrative expanses.

• Operating income - earnings before interest and taxes• Gross profit - sales less the COGS• Financing costs – the amount of interest owed to lenders

on borrowed money• Net income available to owners (net income) – income

that may be distributed to owners or re-invested in the company

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Operating Activities

Sales Revenue

=

= =

Operating Income

Earnings Before Taxes Net Income Availableto Owners

Cost of producing or acquiring product or service(cost of goods sold)

Gross profit

Marketing and selling expenses, general and administrative expenses and depreciation(operating expenses)

,

–

=

–

Financing Activities

Operating Income

Interest expense on debt (financing costs)

–

Taxes

Earnings Before Taxes

Income taxes–

The Income Statement: An OverviewThe Income Statement: An OverviewThe Income Statement: An OverviewThe Income Statement: An Overview

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Income Statement for Computer World Ltd. Income Statement for Computer World Ltd. for the Year Ending December 31, 2008for the Year Ending December 31, 2008

Income Statement for Computer World Ltd. Income Statement for Computer World Ltd. for the Year Ending December 31, 2008for the Year Ending December 31, 2008

Exhibit 13 -1 13-8


The Balance SheetThe Balance SheetThe Balance SheetThe Balance Sheet

• Balance Sheet–Report showing a firm’s assets, liabilities (debt),

and owners’ equity at a specific point in time–Outstanding debt + Owner’s equity = Total assets–Snapshot of a business’s

financial position at a specific

point in time

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The Balance Sheet: The Balance Sheet: Types of AssetsTypes of Assets

The Balance Sheet: The Balance Sheet: Types of AssetsTypes of Assets

• Current assets (working capital)–Assets that can be converted to cash within the firm’s

operating cycle—cash, accounts receivable, and inventories.

• Fixed Assets–Relatively permanent resources intended for the use of the

firm.–Net fixed assets =

gross fixed assets – accumulated depreciation

• Other Assets– Intangible assets (patents, copyrights, goodwill)

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The Balance Sheet: The Balance Sheet: Types of FinancingTypes of Financing


• Debt Capital–Financing provided by a creditor

• Short-term (current) Debt• Accounts payable• Accrued expenses• Short-term notes

• Long-Term Debt–Loans and mortgages from

banks and other lenders with maturities greater than one year

…continued

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• Owners’ Equity Capital–Money that the owners invest in the business–Owners are “residual owners” of the firm

• Creditors have first claim on the assets of the firm.

Owners’Owners’EquityEquity ==

Owners’Owners’investmentinvestment ––

Owners’ cashOwners’ cashwithdrawalswithdrawals

CumulativeCumulativeprofitsprofits++

Owners’Owners’EquityEquity ==

Owners’Owners’investmentinvestment ++ Earnings retained Earnings retained

within the firmwithin the firm13-12


Balance Sheets for Computer World Ltd. for Balance Sheets for Computer World Ltd. for December 31, 2007 and 2008December 31, 2007 and 2008


Exhibit 13-2

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Exhibit 13-2

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The Fit of the Income Statement The Fit of the Income Statement and the Balance Sheetand the Balance Sheet

The Fit of the Income Statement The Fit of the Income Statement and the Balance Sheetand the Balance Sheet

Exhibit 13-3

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Cash Flow Measurement: Key TermsCash Flow Measurement: Key TermsCash Flow Measurement: Key TermsCash Flow Measurement: Key Terms

• Statement of Cash Flows A financial report that shows

changes in a firm’s cash position over a given period of time.

• Accrual-Basis Accounting A method of accounting that

matches revenues when they are earned against the expenses associated with those revenues.

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Basic Requirements for Basic Requirements for Accounting SystemsAccounting Systems

Basic Requirements for Basic Requirements for Accounting SystemsAccounting Systems

• Provide an accurate picture of operating results.

• Permit a quick comparison of current data with prior years’ operations.

• Furnish financial statements for use by management, bankers, and prospective creditors.

• Facilitate prompt filing of reports and tax returns to regulatory and tax-collecting agencies.

• Reveal employee fraud, waste, and record-keeping errors.

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The Record-Keeping SystemThe Record-Keeping SystemThe Record-Keeping SystemThe Record-Keeping System

• Major Types of Internal Accounting Records–Accounts receivable records–Accounts payable records–Inventory records–Payroll records–Cash records–Fixed asset records–Other accounting records

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Computer Software PackagesComputer Software PackagesComputer Software PackagesComputer Software Packages

–Chequebook functions

–Automatic financial statements preparation

–Cash budget tracking

–Subsidiary journal accounts preparation

• Outside Accounting Services–Convenience

–Competence

–Cost

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Alternative Accounting OptionsAlternative Accounting OptionsAlternative Accounting OptionsAlternative Accounting Options

• Cash Versus Accrual Accounting–Cash method

• Revenues and expenses are recognized only when payments are received or expenses are paid.

–Accrual method• Revenue and expenses are reported when they are

incurred, regardless of when they are received or paid.

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Accounting Method AlternativesAccounting Method AlternativesAccounting Method AlternativesAccounting Method Alternatives

• Single-Entry Versus Double-Entry Systems–Single-entry system

• A chequebook system of accounting reflecting only receipts and disbursements.

–Double-entry system• A self-balancing accounting

system that uses journals and ledgers.

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Internal Accounting ControlsInternal Accounting ControlsInternal Accounting ControlsInternal Accounting Controls

• Internal Control–A system of checks and balances that safeguards assets

and enhances the accuracy and reliability of financial statements.

–Types of internal controls• Identifying transactions requiring owner authorization• Ensuring cheques issued have supporting documentation• Limiting access to accounting records and computers• Sending bank statements directly to the owner• Safeguarding blank cheques• Requiring employees to take vacations• Controlling access to computer facilities

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Assessment of Financial PerformanceAssessment of Financial PerformanceAssessment of Financial PerformanceAssessment of Financial Performance

• Methods to Interpret Financial Statements– Liquidity - does the firm have the capacity to meet its short-term

(one year or less) financial commitments?– Profitability - is the firm producing adequate operating profits on its

assets?– Stability - how is the firm financing its assets?– Return - are the owners (shareholders) receiving an acceptable

return on their equity?

• Financial Ratios– Restatements of selected income statement and balance sheet date in

relative terms

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Financial Ratios for Financial Ratios for Retail Electronics and Appliance Stores Retail Electronics and Appliance Stores

(Industry SIC Code 5731 and NAICS Code 443)(Industry SIC Code 5731 and NAICS Code 443)

Financial Ratios for Financial Ratios for Retail Electronics and Appliance Stores Retail Electronics and Appliance Stores

(Industry SIC Code 5731 and NAICS Code 443)(Industry SIC Code 5731 and NAICS Code 443)

Exhibit 13-4

13-24


Measures of LiquidityMeasures of LiquidityMeasures of LiquidityMeasures of Liquidity

• Current Ratio–Comparing cash and near-cash current assets against

the debt (current liabilities) coming due and payable within one year.

3.45 $100,000

$345,000 ratioCurrent

Industry norm for 2008 current ratio = 1.6

sliabilitieCurrent

assetsCurrent ratioCurrent

…continued

13-25



• Acid-test ratio (quick ratio)– A measure of a company’s liquidity that excludes

inventories.

Industry norm for 2007 acid-test ratio = 0.7

liabilitiesCurrent

Inventories - assetsCurrent ratio Acid-test

1.35 $100,000

$210,000 - $345,000 ratio Acid-test

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• Average Collection Period–The average time it takes a firm to collect its accounts

receivable.

salescredit Daily

receivable Accounts period collection Average

days 34.30 365 $830,000

$78,000 period collection Average

Industry norm for average collection period = 16 days

…continued

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• Inventory turnover–The number of times inventories “roll over” during the

year.

Inventory

sold goods ofCost turnover Inventory

2.57 $210,00

$540,000 turnover Inventory

Industry norm for inventory turnover = 3.77 times

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Calculate Return on Investment (ROI)Calculate Return on Investment (ROI)Calculate Return on Investment (ROI)Calculate Return on Investment (ROI)

• A measure of operating profits relative to total assets

Industry norm for OIROI: 3.0%

assets Total

Sales X

Sales

profits Operating

Operating incomereturn on investment

(OIROI)

AssetsTotal

income Operating


0.1087 or 10.87% 000 $920,

$100,000


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Return on Return on Invested Capital:Invested Capital:

An OverviewAn Overview

Return on Return on Invested Capital:Invested Capital:

An OverviewAn Overview

Exhibit 13-5


Measuring Return on Investment Measuring Return on Investment (ROI)(ROI)


• Operating Profit Margin–The ratio of operating profits to sales, showing how well

a firm manages its income statement.

Sales

profits Operating marginprofit Operating

12.05% $830,000

000 $100, margin profit Operating

Industry norm for operating profit margin: 1.8%…continued

13-31




• Total Asset Turnover–A ratio of sales to total assets, showing the efficiency

with which the firm’s assets are used to generate sales.

Industry norm for total asset turnover = 3.7

assets Total

Sales over asset turn Total

0.90 $920,000

$830,000 over asset turn Total

…continued

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• Operating Income Return on Investment

Operating incomereturn on investment =

Operatingprofit margin X

Total assetturnover

.1205 x 0.90Operating income

return on investment = = 10.85%

Industry norm for OIROI = 1.33%

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Turnover RatiosTurnover RatiosTurnover RatiosTurnover Ratios

10.64 $78,000

$830,000

receivable Accounts

salesCredit

Accountsreceivableturnover

2.57 $210,000

$540,000

Inventory

sold goods ofCost Inventory

turnover

1.58 $525,000

$830,000

assets Fixed

Sales Fixed asset turnover

IndustryNorm

17.0

3.77

3.7

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How is the Firm Financing Its AssetsHow is the Firm Financing Its AssetsHow is the Firm Financing Its AssetsHow is the Firm Financing Its Assets

• Financial Leverage– The use of debt in financing a firm’s assets

• Debt-Equity Ratio– The ratio of total debt to total assets

Assets Total

debt Total ratioDebt

33.0% or 0.33, $920,000

$300,000 ratioDebt

Industry norm for debt ratio = 42% …continued

13-35


How is the Firm Financing Its AssetsHow is the Firm Financing Its AssetsHow is the Firm Financing Its AssetsHow is the Firm Financing Its Assets

• Times Interest Earned Ratio–The ratio of operating income to interest charges

ExpenseInterest

income Operating earnedinterest Times

5.0 $20,000

$100,000 earnedinterest Times

Industry norm for time interest earned = 2.913-36


Return on InvestmentReturn on InvestmentReturn on InvestmentReturn on Investment

• Return on equity–The rate of return that owners earn on their investment.

Equity Common

incomeNet equity on Return

26.7% $300,000

$80,000 equity on Return

Industry norm for return on equity = 0.4%

13-37


Working-CapitalWorking-CapitalWorking-CapitalWorking-Capital

• Working Capital Management–The management of current assets and current

liabilities

• Net Working Capital–The sum of a firm’s current assets (cash,

accounts receivable, and inventories) less current liabilities (short-term notes, accounts payable, and accruals).

13-38


The Working- The Working- Capital Cycle Capital Cycle

IllustratedIllustrated

The Working- The Working- Capital Cycle Capital Cycle

IllustratedIllustrated

Increasesaccounts payable

Increases inventory

Decreases inventory

2afor cash

3bPay

operatingexpensesand taxes

1Purchase

or produceinventory

2Sell the

inventory

2bon credit

Increasesaccountsreceivable

Decreasesaccountspayable

Decreasesaccountsreceivable

3aPay

accountspayable

4Collect

accountsreceivable

5Begin cycle

againCash

decreasesdecreases increasesincreases

Exhibit 13-8

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Working-Capital Time LineWorking-Capital Time LineWorking-Capital Time LineWorking-Capital Time Line

Cash conversion Cash conversion period—period—the time required to the time required to convert paid-for convert paid-for inventories and inventories and accounts receivable accounts receivable into cash.into cash.

OrderPlaced

InventoryReceived

Cash Paymentfor Inventory

Sale

Cash Collectionof Receivables

Days in InventoryDays in Accounts Receivable

Days in Accounts Payable Cash Conversion Period

a b c d e

Exhibit 13-913-40


Order

Placed

Inventory

Received

Cash Payment for Inventory

SaleCash Collection

of Receivables

Days in InventoryDays in Accounts Receivable

Days in Accounts Payable Cash Conversion Period

Pokey, Inc.

Oct. 15 Nov. 30Aug. 31 Aug. 15 Sept. 30

Working Capital Time LineWorking Capital Time Linefor Pokey, Inc.for Pokey, Inc.

Working Capital Time LineWorking Capital Time Linefor Pokey, Inc.for Pokey, Inc.

Exhibit 13-10

13-41


Working Capital Time LineWorking Capital Time Linefor Quick-turn Companyfor Quick-turn Company

Working Capital Time LineWorking Capital Time Linefor Quick-turn Companyfor Quick-turn Company

OrderPlaced

InventoryReceived

Cash Payment for Inventory

SaleCash Collectionof Receivables

Days in Inventory Days in Accounts Receivable

Days in Accounts Payable

Quick-turn Company

Aug. 31 Aug. 15 Sept. 30 Oct. 31

Exhibit 13-10

13-42


Pokey, Inc.’s Beginning Balance SheetPokey, Inc.’s Beginning Balance SheetPokey, Inc.’s Beginning Balance SheetPokey, Inc.’s Beginning Balance Sheet

JulyCash 400Accounts receivable 0Inventory 0Fixed assets 600Accumulated depreciation 0TOTAL ASSETS 1,000

Accounts payable 0Accrued operating expenses 0Income tax payable 0Long-term debt 300Common debt 700Retained earnings 0TOTAL DEBT AND EQUITY 1,000

13-43


Pokey, Inc.’s Monthly Balance SheetsPokey, Inc.’s Monthly Balance SheetsPokey, Inc.’s Monthly Balance SheetsPokey, Inc.’s Monthly Balance Sheets

July Aug. Sept.Cash 400 400 (100)Accounts receivable 0 0 0Inventory 0 500 500Fixed assets 600 600 600Accumulated depreciation 0 0 0TOTAL ASSETS 1,000 1,500 1,000

Accounts payable 0 500 0Accrued operating expenses 0 0 0Income tax payable 0 0 0Long-term debt 300 300 300Common debt 700 700 700Retained earnings 0 0 0TOTAL DEBT AND EQUITY 1,000 1,500 1,000

Changes: August to September

–500

–500

…continued

13-44


Pokey, Inc.’s Monthly Balance SheetsPokey, Inc.’s Monthly Balance SheetsPokey, Inc.’s Monthly Balance SheetsPokey, Inc.’s Monthly Balance Sheets

July Aug. Sept. Oct.Cash 400 400 (100) (100)Accounts receivable 0 0 0 900Inventory 0 500 500 0Fixed assets 600 600 600 600Accumulated depreciation 0 0 0 (50)TOTAL ASSETS 1,000 1,500 1,000 1,350

Accounts payable 0 500 0 0Accrued operating expenses 0 0 0 250Income tax payable 0 0 0 25Long-term debt 300 300 300 300Common debt 700 700 700 700Retained earnings 0 0 0 75TOTAL DEBT AND EQUITY 1,000 1,500 1,000 1,350

Changes: September to

October

+900–500

–50

+250+25

+75

…continued

13-45


Pokey, Inc.’s Monthly Balance SheetsPokey, Inc.’s Monthly Balance SheetsPokey, Inc.’s Monthly Balance SheetsPokey, Inc.’s Monthly Balance SheetsChanges: October to November

+650–900

–250

July Aug. Sept. Oct. Nov.Cash 400 400 (100) (100) 550Accounts receivable 0 0 0 900 0Inventory 0 500 500 0 0Fixed assets 600 600 600 600 600Accumulated depreciation 0 0 0 (50) (50)TOTAL ASSETS 1,000 1,500 1,000 1,350 1,100

Accounts payable 0 500 0 0 0Accrued operating expenses 0 0 0 250 0Income tax payable 0 0 0 25 25Long-term debt 300 300 300 300 300Common debt 700 700 700 700 700Retained earnings 0 0 0 75 75TOTAL DEBT AND EQUITY 1,000 1,500 1,000 1,350 1,100

13-46


Changes in Pokey’s Balance SheetChanges in Pokey’s Balance SheetChanges in Pokey’s Balance SheetChanges in Pokey’s Balance Sheet

Change in the Balance Sheet Effect on Income Statement

Increase accounts receivable of $900 Sales $ 900

Decrease inventories of $500 Cost of goods sold $ 500

Increase in accrued operating Operating expenses $ 250

expenses of $250

Increase accumulated depreciation of $50Depreciation expense $ 50

Increase accrued taxes of $25 Tax expense $ 25

13-47


Pokey’s November Income StatementPokey’s November Income StatementPokey’s November Income StatementPokey’s November Income Statement

Sales revenue 900Cost of goods sold 500Gross Profit 400Operating expenses:

Cash 250Depreciation 50

Total operating expenses 300Operating income 100

Income tax (25%) 25Net income 75

13-48


Managing Cash FlowsManaging Cash FlowsManaging Cash FlowsManaging Cash Flows

• The Nature of Cash Flows–The flow of actual cash through a firm.

• Net Cash Flow–The difference between inflow and outflows

• Net Profit–The difference between revenue and expenses

• The Growth Trap–A cash shortage resulting from rapid growth

13-49


Flow of Cash Through A BusinessFlow of Cash Through A BusinessFlow of Cash Through A BusinessFlow of Cash Through A Business

BorrowedFunds

Collection ofAccounts

Receivable

Owner'sInvestment

BorrowedFunds

Sale ofFixed Assets

Collection ofAccounts

Receivable

Payment ofExpenses

Payment forInventory

Payment ofDividends

CashSales

Purchase ofFixed Assets

Exhibit 13-11

13-50


Candace Candace Corporation: Corporation: Cash Budget Cash Budget

(July -(July -September)September)

Candace Candace Corporation: Corporation: Cash Budget Cash Budget

(July -(July -September)September)

13-51


Managing Accounts ReceivableManaging Accounts ReceivableManaging Accounts ReceivableManaging Accounts Receivable

• How Accounts Receivable Affect Cash–Accounts receivable represent the firm’s decision

to delay the inflow of cash from customers who have been extended credit.

• Life Cycle of Accounts Receivable–Firm makes credit sale to customer.–Invoice is prepared and sent to customer.–Customer pays firm.

…continued

13-52


Managing Accounts Receivable Managing Accounts Receivable Managing Accounts Receivable Managing Accounts Receivable

• Accounts Receivable Financing–Financing speeds up immediate cash flow–Pledged accounts receivable

• Accounts receivable used as collateral for a loan.

–Factoring• Obtaining cash by selling accounts receivable at a

discount to another firm.

13-53


Managing InventoryManaging InventoryManaging InventoryManaging Inventory

• Inventory is a “necessary evil.”–Product supply and consumer demand don’t always match

up.

• Reducing Inventory to Free Cash–Monitoring current inventory

• Determine age and suitability for sale.

–Controlling stockpiles

• Match on-hand inventory with demand.

• Avoid personalizing the business-customer relationship.

• Avoid forward purchasing of inventory; the carrying cost for excess inventory may exceed any savings.

13-54

Chapter 13 Copyright © 2010 by Nelson Education Ltd. 13-55

Managing Accounts PayableManaging Accounts PayableManaging Accounts PayableManaging Accounts Payable

• Negotiation–Asks creditors for adjustments or additional time.

• Timing–Creditors’ funds can supply short-term cash needs

until payment is demanded.–Accounts with cash discounts for early payment

should be examined for their savings potential.–“Buy now, pay later”—pay early enough to get

cash discounts and timely enough to avoid late-payment fees.


An Accounts Payable for Terms 3/10, Net 30An Accounts Payable for Terms 3/10, Net 30An Accounts Payable for Terms 3/10, Net 30An Accounts Payable for Terms 3/10, Net 30

Timetable (days after invoice) Settlement Costs for $20,000 Purchase

Day 1 through 10 $19,400

Day 11 through 30 $20,000

Day 31 and thereafter $20,000 + possible late penalty + deterioration in credit standing

Annualizedinterest rate

discount% Cash - 100

%discount Cash x

perioddiscount Cash - periodNet

yearin Days

3-100

3 X

10-30

365

56.4% or 0.564, 0.030928 x 18.25 13-56

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