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Engineering ManagementEngineering Management

Accounting – Lecture 4Accounting – Lecture 4

ELE 2EMTELE 2EMT

George AlexanderG.Alexander@latrobe.edu.auhttp://www.latrobe.edu.au/eemanage/

17 August, 2007

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Last weekLast week

• A closer look at why we classify certain expenditure as capital expenditure - assets

• The importance of accurately valuing assets• The role of depreciation and how it works• Types of Depreciation• Depreciation Terminology• Straight Line Depreciation• Declining Balance Depreciation

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This weekThis week

• Need for Business Analysis

• The Profit & Loss Statement

• Performance Ratios

• Return on Investment

• Break-Even Calculations

• Price Elasticity

• Economic Order Quantity

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Need for Business AnalysisNeed for Business Analysis

• Stakeholders and potential stakeholders need to know how to evaluate an organisation’s financial success.

• The evaluation process requires a good understanding of financial statements and performance ratios.

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Balance SheetBalance SheetStatement of Financial PositionStatement of Financial Position

• Every company publishes a balance sheet at the end of each fiscal year (FY)– Assets - a summary of all resources owned by

or owed to the company– Liability - a summary of all financial

obligations of the company– Net Worth - a summary of the financial value

of ownership

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Balance Sheet RelationshipBalance Sheet Relationship

Assets = Liabilities + Net WorthNet Worth = Assets - Liabilities

Net Worth also called:Owner’s Equity or Proprietorship

A = L + PP = A - L

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Profit & Loss StatementProfit & Loss StatementStatement of Financial PerformanceStatement of Financial Performance

• The basic equation for profit is:

Profit = Sales - Costs

• P & L Statement shows an organisation’s sales revenues and costs over a given period, typically a year, quarter or month.

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• A well-written statement can help in identifying the areas of the business associated with profit or loss.

• Assessment can be based on a division, department, business unit, product line, etc.

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Net Sales $ 707,500 Less cost of goods sold $ 340,000Gross Margin (gross profit) $ 367,500 Less operating expenses $ 325,500Net Profit $ 42,000

Note: Tax is calculated on the Net Profit

Example Profit & Loss StatementExample Profit & Loss Statement

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Cost of Goods

48%

Operating Expenses

46%

Net Profit6%

Cost of Goods

OperatingExpenses

Net Profit

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Performance RatiosPerformance Ratios

• The gross margin percentage

• The net profit percentage

• The operating expenses ratio

• Market ratios

• Other financial ratios

• Employee ratios

• The stock turnover ratio

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The Gross Margin PercentageThe Gross Margin Percentage

Gross Margin Percentage is the percentage of revenue available to cover expenses and provide profit after the cost of goods sold has been paid.

Gross Margin Percentage =Net Sales

Gross Margin

$707,500

$367,500= = 0.52 or 52%

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The Net Profit PercentageThe Net Profit Percentage

The Net Profit Percentage (Net Income ratio) identifies the percentage of profit from each sales dollar.

Net Profit Percentage =Net Sales

Net Profit

$707,500

$42,000= = 0.06 or 6%

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The Operating Expenses RatioThe Operating Expenses Ratio

The Operating Expenses Percentage is the percentage of operating expenses needed from each sales dollar.

Operating Expenses Ratio =Net Sales

Total Operating Expenses

$707,500

$325,500= = 0.46

or in percentage 46%

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Company financial reportsCompany financial reports

All publicly listed companies provide access to their financial reports on their web sites –

http://www.telstra.com.au/abouttelstra/investor/index.cfm

http://www.qantas.com.au/info/about/investors/index

http://www.wesfarmers.com.au/default.aspx?MenuID=33

and so on.

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Improving Net ProfitImproving Net Profit

• Increasing prices– Pricing objectives– Supply v demand, etc.– Price Elasticity (refer later slides)

• Reducing cost of goods sold– Alternative sources– Make or buy, etc.

• Reducing operating expenses– Efficient use of resources– Management policies, etc.

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Financial Ratio Analysis Financial Ratio Analysis • Financial ratios are somewhat limited in

meaning when viewed in isolation.• They are more useful when used to compare

similar companies (benchmarking), or when examining trends.

• Some ratios are available on financial websites such as Commsec and InvestorWeb.

• More detailed data is available on individual company websites.

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Return on AssetsReturn on Assets

• Defined as the ratio of net profit to assets of an organisational segment (company, division, business unit, or the like), product line or brand.

• It is a measure of financial efficiency that is often used to set marketing objectives.

• The information required for calculating return on assets is obtained from the organisation’s balance sheet and profit and loss statement.

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Example ROA CalculationExample ROA Calculation

ROA = Net Profit / Total Assets

Suppose that the total assets for the organisation is $425,000 and the net profit is $42,000.

ROA = 42,000 / 425,000 = 0.0988 or 9.88 %

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ROI Return on investmentROI Return on investment

ROI = Net Profit / Net Worth

This shows the profitability of shareholders’ equity.

Suppose that the total assets for the organisation is $425,000, the net profit is $42,000 and the total liabilities are $200,000.

ROI = 42,000 /( 425,000 – 200,000) = 0.187

or 18.7%

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Market ratiosMarket ratios

• Dividend Yield % = Annual dividend Share price

• Price/Earnings P/E = Share price Earnings per share

• Dividend payout = Dividend per share Earnings per share

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Other financial ratiosOther financial ratios

• Debt/Equity measures proportions of financing by creditors and owners.

• Sales/Total assets measures how well the total assets are being used to generate sales.

similarly for

• Sales/Fixed assets

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Employee ratiosEmployee ratios

• Sales per employee• Earnings per employee

These need to be viewed cautiously as they are sensitive to initiatives such as outsourcing, and can vary greatly with the nature of the business – e.g.capital vs labour intensive.

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The Stock Turnover RatioThe Stock Turnover Ratio

The Stock (Inventory) Turnover Ratio indicates the number of times stock turns over (sold) during the period specified in the profit and loss statement. The calculation is done in two steps as follows:

Average Stock =2

Beginning Stock + Ending Stock

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$100,000 + 160,000= = $130,000

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The Stock Turnover Ratio - Cont.The Stock Turnover Ratio - Cont.

Stock Turnover Ratio (Retail) =Average Stock

Net Sales

$130,000

$707,500= = 5.44 times per period

Stock Turnover Ratio (Cost) =Average Stock

Cost of Goods Sold

$130,000

$340,000= = 2.62 times per period

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Break-Even Point =Fixed Costs

Selling Price - Variable Costs

Break-Even CalculationsBreak-Even Calculations

• The Break-Even Point is defined as the point at which costs and revenues meet (costs = revenue).

• The concept is best described graphically, mathematically it is written as:

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Example Break-Even CalculationExample Break-Even CalculationSuppose the following:

Selling price $ 10Variable cost $ 5Fixed cost $ 50,000

Break-Even Point =$ 50,000

$ 10 - $ 5= 10,000 units

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E =(Q1 - Q2) / Q1

(P1 - P2) / P1

E = ElasticityQ1 = Initial quantity demandedQ2 = New quantity demandedP1 = Initial priceP2 = new price

Price ElasticityPrice Elasticity

• Defined as the effect of a change in price on the quantity of product demanded.

• It involves calculating the ratio of the percentage change in quantity to the percentage change in price.

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Suppose that the initial price was $5 and the initial quantity demanded was 100 units. If the price was raised to $6 and the quantity demanded declined to 90 units, then the Price Elasticity would be:

E =(100 - 90) / 100

(5 - 6) / 5

0.1

- 0.2= = - 0.5

Normally stated as 0.5

Example Price Elasticity Example Price Elasticity CalculationCalculation

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Economic order QuantityEconomic order Quantity

• There are several factors to consider when deciding on the order size at which total costs can be minimised.

• The main factors include:– Annual demand in units,– unit cost of placing an order, and– Annual holding costs as a percentage of the

cost of one unit.

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Annual demand 5,000 unitsUnit cost of the merchandise $ 1.50Per-unit holding costs $ 0.30 (20% of unit cost)(warehousing, insurance, etc.)Cost of placing an order $ 5.00

2 x (Annual demand in units x Unit cost of placing an order)

Annual holding costs as a percentage of cost of one unitx Cost of one unit in dollars

EOQ =

ExampleExample

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Cont.Cont.

2 x ( 5000 x $5 )

0.2 x $1.50EOQ =

$50,000

$0.30= = 408.25 units per order

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time

triggerlevel

order orderorderorderorder

stocklevel

initialstock

Stock CycleStock Cycle

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Regulatory AuthoritiesRegulatory Authorities

• ASIC –Australian Investment & Securities Commission “enforces company and financial services laws to protect consumers, investors and creditors” http://www.asic.gov.au/asic/asic.nsf

• ACCC – Australian Competition and Consumer Commission – national competition policyhttp://www.accc.gov.au/content/index.phtml/itemId/142

• ACA – Australian Telecommunications Authorityhttp://www.aca.gov.au/

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Thanks for your attention