Vertical analysis on the income statement uses total or net revenues for the denominator Answers the question: How much of our total revenues were consumed by each expense?
Vertical analysis on the balance sheet uses total assets for the denominator Answers the question: How much of our total assets are represented by each asset category?
Horizontal analysis on the income statement and balance sheet use the previous period’s entry as the denominator and the difference between the current and previous periods for the numerator. (CashQ2 – CashQ1) X 100 CashQ1
Learning Objectives Understand the purpose of financial statement analysis. Perform a vertical analysis of a company’s financial statements by: –Comparing those accounts on the income statement as a percentage of net sales and comparing those accounts on the balance sheet as a percentage of total assets for a period of two or more accounting cycles. –Determining those areas within the company that require additional monitoring and control.
Learning Objectives (continued) –Perform a horizontal analysis of a company’s financial statements by: Comparing the percentage change of components on a company’s income statement and balance sheet for a period of two or more years. Determining those areas within the company that require additional monitoring and control. –Perform ratio analysis of a company and compare those ratios to other companies within the same industry using industry averages.
Learning Objectives (continued) –Analyze the relationships that exist between the several categories of ratios in determining the health of a business. –Distinguish between liquidity, activity, leverage, profitability, and market ratios. –Know how to obtain financial statements and financial information from various sources.
Three Methods of Analyzing Financial Statements Vertical analysis Horizontal analysis Ratio analysis
Vertical Analysis Vertical analysis is the process of using a single variable on a financial statement as a constant and determining how all of the other variables relate as a percentage of the single variable.
Vertical Analysis of an Income Statement The vertical analysis of the income statement is used to determine, specifically, how much of a company’s net sales consumed by each individual entry on the income statement. Constant is net sales. The formula is:
Horizontal Analysis Horizontal analysis is a determination of the percentage increase or decrease in an account from a base time period to successive time periods. The basic formula is:
Vertical Analysis of a Balance Sheet Vertical analysis of the balance sheet is always carried out by using total assets as a constant, or 100 percent, and dividing every figure on the balance sheet by total assets. The formula is:
Ratio Analysis Ratio analysis is used to determine the health of a business, especially as that business compares to other firms in the same industry or similar industries. A ratio is nothing more than a relationship between two variables, expressed as a fraction.
Types of Business Ratios Liquidity ratios determine how much of a firm’s current assets are available to meet short-term creditors’ claims. Activity ratios indicate how efficiently a business is using its assets. Leverage (debt) ratios indicate what percentage of the business assets is financed with creditors’ dollars.
Types of Business Ratios (continued) Profitability ratios are used by potential investors and creditors to determine how much of an investment will be returned from either earnings on revenues or appreciation of assets. Market ratios are used to compare firms within the same industry. They are primarily used by investors to determine if they should invest capital in the company in exchange for ownership.
Liquidity Ratios Current Ratio: The current ratio is calculated by dividing total current assets by total current liabilities. The current ratio is given by the following:
Liquidity Ratios (continued) Quick, or Acid Test, Ratio: This ratio does not count the sale of the company’s inventory or prepaids. It measures the ability of the firm to meet its short-term obligations without liquidating its inventory. The acid test ratio is given by the following:
Activity Ratios Inventory turnover ratio (or, simply, inventory turnover) indicates how efficiently a firm is moving its inventory. It basically states how many times per year the firm moves it average inventory. Inventory turnover is given as follows:
Activity Ratios (continued) Accounts receivable turnover ratio allows us to determine how fast our company is turning its credit sales into cash. Accounts receivable turnover is given by the following:
Activity Ratios (continued) Average collection period is the average number of days that it takes the firm to collect its accounts receivable. Average collection period is given by the following:
Activity Ratios (continued) Fixed asset turnover ratio indicates how efficiently fixed assets are being used to generate revenue for a firm. Fixed asset turnover is given by the following:
Activity Ratios (continued) Total asset turnover ratio indicates how efficiently our firm uses its total assets to generate revenue for the firm. Total asset turnover is given by the following:
Leverage Ratios Debt-to-equity ratio indicates what percentage of the owner’s equity is debt. Debt-to-equity is given by the following: or
Leverage Ratios (continued) Debt-to-total-assets ratio indicates what percentage of a business’s assets is owned by creditors. Debt-to-total-assets is given by the following:
Leverage Ratios (continued) Times-interest-earned ratio shows the relationship between operating income and the amount of interest in dollars the company has to pay to its creditors on an annual basis. Times-interest-earned is given by the following:
Profitability Ratios Gross profit margin ratio is used to determine how much gross profit is generated by each dollar in net sales. Gross profit margin is given by the following:
Profitability Ratios (continued) Operating profit margin ratio is used to determine how much each dollar of sales generates in operating income. Operating profit margin is given by the following:
Profitability Ratios (continued) Net profit margin ratio tells us how much a firm earned on each dollar in sales after paying all obligations including interest and taxes. Net profit margin is given by the following:
Profitability Ratios (continued) Operating return on assets ratio is also referred to as operating return on investment and allows us to determine how much we are actually earning on each dollar in assets prior to paying interest and taxes. Operating return on assets is given by the following:
Profitability Ratios (continued) Net return on assets (ROA) ratio is also referred to as net return on investment and tells us how much a firm earns on each dollar in assets after paying both interest and taxes. Net return on assets is given by the following:
Profitability Ratios (continued) Return on equity (ROE) ratio tells the stockholder, or individual owner, what each dollar of his or her investment is generating in net income. Return on equity (ROE) is given by the following: or
Profitability Ratios (continued) Return on equity (ROE) can also use the relationship between the return on assets and the amount of debt to assets. It can be expressed with the following formula:
Market Ratios Earnings per share ratio is nothing more than the net profit or net income of the firm, less preferred dividends (if the company has preferred stock), divided by the number of shares of common stock outstanding (issued). Earnings per share is given by the following:
Market Ratios (continued) Price earnings ratio is a magnification of earnings per share in terms of market price of stock. Price earnings ratio is given by the following:
Market Ratios (continued) Operating cash flow per-share ratio compares the operating cash flow on the statement of cash flows to the number of shares of common stock outstanding.
Chapter 5 Profit, Profitability, and Break-Even Analysis
Learning Objectives Understand the difference between efficiency and effectiveness. Distinguish between profit and profitability. Compare accounting and entrepreneurial profit. Understand the relationship of profit margin and asset turnover on the earning power of a company.
Learning Objectives (continued) Given the variable costs, revenue, and fixed costs of a business, determine the break- even point and contribution margin. Construct and analyze a break-even chart when given variable costs, revenue, and fixed costs of a business.
Learning Objectives (continued) Understand the use of leverage and its relationship to profitability and loss. Distinguish between Chapters 11, 13, and 7 bankruptcy. Compare and contrast the degree of operating, financial, and combined leverage and their effect on the profitability of a corporation.
Efficiency and Effectiveness Efficiency is obtaining the highest possible return with the minimum use of resources. Effectiveness, on the other hand, is accomplishing a specific task or reaching a goal.
Profit Versus Profitability Profit is an absolute number that is earned on an investment. –Accounting profit, for a business, is typically shown at the bottom of an income statement as net income. –Entrepreneurial profit is the amount that is earned above and beyond what the entrepreneur would have earned if he or she had chosen to invest time and money in some other enterprise.
Profit Versus Profitability (continued) Profitability can be measured in a business by using a ratio that is obtained by dividing net profit by total assets. Profitability, therefore, is our Return on Assets.
Earning Power The earning power of a company can be defined as the product of two factors: –The company’s ability to generate income on the amount of revenue it receives, which is also known as net profit margin; and –Its ability to maximize sales revenue from proper asset employment, also known as total asset turnover.
Earning Power Formulas Earning power is equal to net profit margin multiplied by total asset turnover which is equal to return on investment (total assets).
Break-Even Analysis Break-even analysis is a process of determining how many units of production must be sold, or how much revenue must be obtained, before we begin to earn a profit. For break-even quantity:
Break-Even Analysis (continued) Break-even dollars: Where VC is variable cost expressed as a percentage of sales (revenue). –For retail firm: VC percentage =(Cost of Goods Sold)/(Net Sales) –For manufacturing firm: VC percentage = (Variable cost of a unit)/(Selling price)
Break-Even Analysis (continued) Contribution margin is the amount of profit that will be made by a company on each unit that is sold above and beyond the break-even quantity. Contribution margin is also the amount the company will lose for each unit of production by which it falls short of the break-even point.
Profit and Break-Even Desired profit with break-even analysis in quantity to produce. –VC is variable cost per unit Desired profit with break-even analysis in dollars. –VC is a percentage of sales dollar (e.g., cost of goods sold as a percent).
Leverage Leverage uses those items that have a fixed cost to magnify the return to a company. Fixed costs can be related to company operations or related to the cost of financing. –Interest expenses paid on the amount of debt incurred is the fixed cost of financing. –A firm is heavily financially leveraged if the fixed costs of financing are high.
Leverage (continued) Degree of operating leverage (DOL) is the percentage change in operating income divided by the percentage change in sales.
Leverage (continued) Degree of financial leverage (DFL) is the percentage change in earnings per share divided by the percentage change in operating income.
Leverage (continued) Degree of combined leverage (DCL) is the percentage change in earnings per share divided by the percentage change in sales.
Learning Objectives Understand the general concept of working capital management. Describe the asset categories that are included in working capital management. Determine the methods of managing disbursement and collection of cash to increase business profitability. Understand how a business balances extending credit and its ability to manage increased accounts receivable.
Learning Objectives (continued) Explain how accounts receivable are analyzed. Understand the role that proper inventory management plays in the profitability of a business enterprise. Understand how a business’s current liabilities are managed. Understand the relationship of accrued liabilities management and obligations to federal and local government agencies. Understand the relationship of trade and cash discounts to the minimization of accounts payable.
Working Capital Working capital consists of the current assets and the current liabilities of a business. Current assets are gross working capital. –Cash, marketable securities, accounts receivable, and inventory Net working capital is the difference between a business’s total current assets and its total current liabilities.
Working Capital Management Working capital management is our ability to effectively and efficiently control current assets and current liabilities in a manner that will provide our firm with maximum return on its assets and will minimize payments for its liabilities.
Cash Management The goal of cash management is to obtain the highest return possible on cash. Cash consists of: –Petty cash –Cash on hand –Cash in bank, checking –Cash in bank, savings
Cash Management (continued) Float –The disbursement float is the time that elapses between payment by check and the check’s actually clearing the bank, at which point funds are removed from our checking account. –Collections float is the amount of time that elapses between your depositing a debtor’s check in your account and the check’s clearing, at which point the funds are actually placed in your account.
Cash Management (continued) Float (continued) –Managing collection float: A lockbox is a post office box that is opened by an agent of the bank, and checks received there are immediately deposited in our account. Electronic funds transfer is accomplished when funds are immediately transferred from one bank account to another via computer.
Marketable Securities Management Marketable securities normally are those investment vehicles that include U.S. treasury bills, government and corporate bonds, and stocks. Excess cash should be placed in the above vehicles because they increase in value more than cash itself.
Accounts Receivable Management The goal of accounts receivable management is to increase sales by offering credit to customers. –Options to offering credit include: The business issuing its own credit card or line of credit. Factoring—selling accounts receivable to another firm at a discount off of the original sales price.
Accounts Receivable Management (continued) The 3 C’s of credit: –A customer’s character is favorable if that customer has paid his or her bills on time in the past and has favorable credit references from other creditors. –Capacity to pay refers to whether the customer has enough cash flow or disposable income to pay back a loan or pay off a bill. –Collateral is the ability to satisfy a debt or pay a creditor by selling assets for cash.
Accounts Receivable Management (continued) Credit terms are the requirements that our business establishes for payment of a loan (the use of credit by a customer). –To speed up collections, cash discounts are often offered to a business customer. An example would be 2/10 net 30. If the customer pays the bill within 10 days of the invoice a 2 percent discount is given. Otherwise the entire net is due 20 days later or at the 30th day.
Accounts Receivable Management (continued) Analyzing accounts receivable: –Accounts receivable turnover: –Example: –Collection days is 365 days in a year divided by accounts receivable turnover:
Use of collection days: –If collection days exceed our credit terms, then we have to speed up collections. Example: If we give terms of 30 days and we collect in 61 days as previously shown, then we have to speed up collections in order to better manage accounts receivable. We may also have to re- evaluate our credit policies. –If collection days are less then our terms, then we have increased our liquidity. May also consider loosening credit policy. Accounts Receivable Management (continued)
Aging of accounts receivable is accomplished by determining the amounts of accounts receivable, the various lengths of time for which these accounts have been due, and the percentage of accounts that falls within each time frame. Accounts Receivable Management (continued)
Inventory Management The overall goal of inventory management is to minimize total inventory costs while maximizing customer satisfaction. Two primary decisions must be made: –Establish the reorder quantity (the number of items to order) –Establish the reorder point (that level of inventory at which a new order will be placed).
Economic Order Quantity Formula: –Attempts to balance ordering costs against storage costs and provide us with the most economic quantity to order to minimize overall inventory costs. –Where Inventory Management (continued)
–Determining EOQ with quantity discounts requires the following procedures: Compute EOQ for each discounted price. If the computed EOQ falls within the discounted quantity area, then order the EOQ. If the EOQ does not fall within the discounted quantity area, then compute total inventory costs. Order the minimum quantity that provides the lowest overall total inventory costs.
Inventory Management (continued) Reorder Point Calculations –The reorder point (ROP) has three factors that are used in determining the quantity of an item that exists when we actually place an order: Lead-time (L) is the time that lapses from order placement to order receipt. Daily demand (d) is the quantity of a product that is used per day. Safety Stock (ss) the quantity of stock you keep for variations in demand.
Current Liabilities Management Current liabilities management consists of minimizing our obligations and payments for short-term debt, accrued liabilities, and accounts payable. It consists of: –Short-term debt management –Accrued liabilities management (servicing long-term debt) –Accounts payable management
Current Liabilities Management (continued) Short-term debt management –Short-term debt consists of business obligations that will be paid within the current accounting period. They consist of the following: Current payments on long-term debt Bank lines of credit Notes payable Accounts payable Short-term loan for one year or less
Current Liabilities Management (continued) Lines of credit: –A line of credit is similar to a credit card. With it, we obtain a credit limit, but we are not obligated to make payments unless we actually borrow the money. A line of credit is normally obtained from our primary bank. A line of credit is used when our cash outflow exceeds our cash inflow.
Accrued Liabilities Management (continued) Accrued liabilities are those obligations of the firm that are accumulated during the normal course of business and are primarily payroll taxes and benefits, property taxes, and sales taxes.
Accounts Payable Management Accounts payable are the debts of a business which are owed to vendors. Vendors offer several types of discounts. They are: –Trade discounts –Cash discounts –Quantity discounts
Accounts Payable Management (continued) Trade discounts are amounts deducted from list prices of items when specific services are performed by the trade customer. –Trade discounts may be expressed as a single amount, such as 30 percent, or in a series, such as 30/20/10.
Accounts Payable Management (continued) Trade discount examples –2/10 net 30 - buyer must pay within 30 days of the invoice date, but will receive a 2% discount if they pay within 10 days of the invoice date. –3/7 EOM - buyer will receive a cash discount of 3% if the bill is paid within 7 days after the end of the month indicated on the invoice date. –3/7 EOM net 30 - buyer must pay within 30 days of the invoice date, but will receive a 3% discount if they pay within 7 days after the end of the month indicated on the invoice date –2/15 net 40 ROG - buyer must pay within 40 days of receipt of goods, but will receive a 2% discount if paid in 15 days of the invoice date. –Trade discounts may be expressed as a single amount, such as 30 percent, or in a series, such as 30/20/10.
Accounts Payable Management (continued) Calculation of trade discounts: –Calculation of trade discounts can be accomplished by moving backward from the list price.
Accounts Payable Management (continued) Calculation of trade discounts (continued) –The net cost rate factor is the actual percentage of the list price paid after taking all successive trade discounts—50.4 percent in this case. –One minus the net cost rate factor is the single equivalent discount.
Accounts Payable Management (continued) Calculation of trade discounts (continued) –A second simpler way of determining the net cost rate factor and the invoice price is to multiply the complements of the trade discounts as shown below:
Accounts Payable Management (continued) Calculation of trade discounts (continued) –The invoice price (the price that you actually pay the vendor) can be simply calculated by the following formula:
Accounts Payable Management (continued) Cash discounts are offered to credit customers to entice them to pay promptly. –The seller views a cash discount as a sales discount. –The customer views it as a purchase discount. – The terms of a cash discount play an important role in determining how the invoice will be paid. “Preferred payment” method discount –Some retailers (particularly small retailers with low margins) offer discounts to customers paying with cash, to avoid paying fees on credit card transactions.
Accounts Payable Management (continued) Cash discounts will normally appear on an invoice in terms such as 2/10 n30. –This means that the customer may deduct 2 percent off of the invoice price if he or she pays within 10 days. –If the customer does not pay within 10 days, he has the use of 98% of the money owed for the next 20 days. –If the customer pays within 30 days, the net, or total amount, of the invoice is due. –If he or she pays after 30 days, the credit agreement with the seller normally stipulates that a monthly interest charge be added to the unpaid balance.
Accounts Payable Management (continued) Calculations used in cash discounts: –A $10,000 invoice with terms of 2/10 n30 –Option 1: Pay off the $10,000 with a payment of $9,800 within 10 days of the invoice date. This is computed by multiplying the invoice price by 1 minus the discount (1 - 0.02 = 0.98, and $10,000 x 0.98 = $9,800). Or by taking the invoice price times the discount and subtracting it from the invoice price ($10,000 x 0.02 = $200, and $10,000 - $200 = $9,800).
Accounts Payable Management (continued) Calculations used in cash discounts (continued): –A $10,000 invoice with terms of 2/10 n30 –Option 2: Pay the invoice price of $10,000 on the 30th day after the invoice date. If this option is chosen, he will pay the equivalent of 36.7 percent annual interest because of his delaying payment. The logic is shown on the following page.
Accounts Payable Management (continued) Calculations used in cash discounts (continued): –$200 is the cost paid on $9,800 for 20 days, or an interest rate of 2.04 percent ([$200 $9,800] x 100). –This will result in an effective annual interest rate of 36.7 percent (2.04 x [360 20days]). –The effective annual interest rate is obtained by multiplying the time period interest rate by the number of time periods in an accounting year (360 20).
Accounts Payable Management (continued) Quantity discounts are offered by vendors to increase their own cash flow when they offer discounts to customers who purchase items in large quantities.
Key terms Capital budgeting –The method used to justify the acquisition of capital goods Capital goods –Assets that have a useful life greater than 1 year
Why capital budgeting? A company should make the decision to enter into a specific project, acquire another company, or purchase a specific long-term asset if the present value of the benefits exceeds the the present value of the costs. Remember that assets are tools your business uses to help generate revenues Example: Capital budgeting helps a business to make the most profitable decisions regarding purchase of delivery vehicles.
Factors Affecting Capital Budgeting Changes in regulations (CFC banned in air conditioning) Research and Development investments (half of all new products fail) Changes in business strategy (when economy changes or opportunities/threats arise
Five Steps in Capital Budgeting 1.Write a proposal that identifies projected costs and benefits 2.Evaluate the data with respect to expected benefits and costs 3.Make a decision that provides greatest value while minimizing costs 4.Follow up on decision through post-audit to compare costs to benefits 5.Take corrective action if post-audit indicates benefits are not meeting expectations
Costs in capital budgeting Start-up costs – total $ spent to start a project (equipment, training costs, maintenance, service agreements, hiring new people, storage space, etc) Working capital costs – cash, investments, A/R, and inventory to show bank you can make monthly payments ($ is legally committed to lender, so it’s an opportunity cost) Tax factor costs – additional taxes that have to be paid
Benefits in capital budgeting Investments in capital equipment should increase cash flows Capital equipment investments can be written off and provide reduced tax liability MACRS! (see MACRS worksheet)
Techniques Payback Net present value (NPV) Profitability index (PI) Internal rate of return (IRR) Accounting rate of return (ARR) Lowest total cost (LTC)
Payback # of years it takes to get back the money it invested in project or asset Payback = C / ATB –C = cost of project –ATB = annual after-tax benefit of project Example – invest in $25,000 project that creates $3,000 in ATB Payback occurs in $25,000/$3,000 = 8.33 yrs
Net present value Uses time value of $ by discounting future costs and benefits to present Combines: –PV of stream of payments for even cash flows and –PV of future lump sum of unequal yearly cash flows Important considerations – (1) interest rate of lender and (2) interest rate you could make by investing in some other project or asset
Weighted Average Cost of Capital Multiplies cost of debt by its proportion of total funds raised and multiplies cost of equity (opportunity cost to owner) by its proportion of total funds raised Key terms: –Real rate of return (return received after factoring out inflation) –Inflation premium (expected average inflation for term of investment) –Risk premium (rate added to interest rate to account for risk of investment) (see Techniques)
Getting to NPV NPV = PVB - PVC NPV is net present value of investment PVB is present value of the benefit PVC is present value of the cost of the investment If NPV is negative, do not make the investment (see example)
Profitability Index PI = PVB / PVC From example: $170,394/$100,000 = 1.70 This project returns $1.70 for every $1 invested
Accounting rate of return ARR = (average annual income)/(average cost of investment over its life) Does not incorporate time value of $ Example: spend $10,000 on software that will help you earn $3,000/yr for 4 yrs ARR = $3,000/$10,000 = 30%
Lowest total cost Include all costs associated with two or more competing investments Calculate PVs of these costs Add the present value of any residual benefits (salvage value) that investment can provide Select investment with lowest total cost
Recommendations Use NPV for new projects or assets For existing operations (replacing equipment and service contracts) use LTC