1. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. PowerPoint Presentation by Thomas M c Kaig, Ryerson University Managing Financial Performance 13

2. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-2 Looking 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. 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.

3. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-3 Looking Ahead After studying this chapter, you should be able to: 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.

4. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-4 Understanding Financial Statements Financial Statements (Accounting Statements)  Reports of a firm’s financial performance and resources, including an income statement and a balance sheet Helps determine a start-up’s financial requirements Assesses the financial implications of a business plan

5. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-5 Understanding Financial Statements 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?” Sales – Expenses = ProfitsSales – Expenses = Profits  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

6. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-6 Some 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

7. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-7 The Income Statement: An Overview

8. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-8 Income Statement for Bates & Associates Leasing Company for the Year Ending December 31, 2002 Sales revenue$830,000 Cost of goods sold_550,000 Gross profit$290,000 Operating expenses: Marketing expenses$90,000 General and administrative expenses 72,000 Depreciation _28,000 Total operating expenses$190,000 Operating income$100,000 Interest expense__20,000 Earnings before taxes$ 80,000 Income tax (25%) 20,000 Net income $ 60,000 Dividends paid$_15,000 Change in retained earnings$ 45,000 Fig. 13 -1

9. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-9 The Balance Sheet Balance Sheet  A report showing a firm’s assets, liabilities, and owners’ equity at a specific point in time  Outstanding debt + Owner’s equity = Total assets

10. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-10 The Balance Sheet: Types 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)

11. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-11 The Balance Sheet: Types 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

12. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-12 The Balance Sheet:Types of Financing 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’ Equity = Owners’ investment – Owners’ cash withdrawals Cumulative profits + Owners’ Equity = Owners’ investment + Earnings retained within Business

13. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-13 Balance Sheets for Bates & Associates Leasing Company for December 31, 2001 and 2002 Assets Current assets: Cash$ 38,000$ 43,000$ 5,000 Accounts receivable70,00078,0008,000 Inventories 175,000210,00035,000 Total current assets$295,000$345,000$ 50,000 Fixed assets: Gross plant and equipment $760,000$890,000$ 78,000 Accumulated depreciation ( 355,000)( 383,000)( 28,000) Net plant and equipment$405,000$4550,000$ 50,000 Land 70,000 0 Total fixed assets$475,000$525,000$ 50,000 TOTAL ASSETS $800,000$920,000$120,000 Changes20022001 70,000 Fig. 13-2a Prepaid Expenses12,000 2,00014,000 Goodwill and patents 30,000 20,000 50,000

14. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-14 Balance Sheets for Bates & Associates Leasing Company for December 31, 2001 and 2002 Debt (Liabilities) and Equity Current liabilities: Accounts payable $ 61,000$ 76,000$ 15,000 Income tax payable 12,000 15,000 3,000 Accrued wages and salaries4,0005,0001,000 Interest payable 2,000 4,000 2,000 Total current liabilities$ 79,000$100,000$ 21,000 Long-term notes payable146,000200,000 54,000 TOTAL LIABILITIES $225,000$300,000$ 75,000 Changes20022001 Common Shares 300,000 300,000 0 Retained Earnings 275,000 320,000 45,000 Total shareholders’ equity $575,000 $620,000 $45,000 TOTAL DEBT AND EQUITY $800,000 $920,000 $120,000 Fig. 13-2b

15. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-15 The Fit of the Income Statement and the Balance Sheet Income statement reports the profits from January 1, 2002 through December 31, 2002 2002 Balance Sheet Reports a firm's financial position at end of 2002 January 1December 31 2001 Balance Sheet Reports a firm's financial position at beginning of 2002 (end of 2001) Figure 13-3

16. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-16 Cash 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.

17. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-17 Accounting Activities in Small Firms Basic Requirements for Accounting 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.

18. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-18 The 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

19. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-19 Small Business Accounting Resources Computer Accounting Software Packages  Chequebook functions  Automatic financial statements preparation  Cash budget tracking  Subsidiary journal accounts preparation Outside Accounting Services  Convenience  Competence  Cost

20. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-20 Alternative 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.

21. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-21 Accounting 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.

22. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-22 Internal 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

23. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-23 Assessment of Financial Performance Can a Firm Meet Its Financial Commitments?  Does the firm have the capacity to meet its short-term (one year or less) financial commitments? Is the liquidity of the firm’s assets sufficient?  Is the firm producing adequate operating profits on its assets?  How is the firm financing its assets?  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

24. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-24 Financial Ratios for Retail Computer Stores (Industry Code No. 5731) FIRM SIZE BY TOTAL ASSETS $250,000 to $1 Million $1 Million Plus Current ratio 1.5 1.2 Quick ratio.8.6 Accounts receivable turnover 31.4 26.2 Inventory turnover 12.3 10.7 Operating income ROI 3.6% 4.8% Operating profit margin 0.7 0.8 Fixed asset turnover 47.0 38.2 Total asset turnover 4.3 3.8 Debt/equity 2.57 2.3 Return on equity (before tax) 18.1% 13.9% Source: Adapted from D&B Industry Norms & Key Business Rations published by Dun & Bradstreet, 2002. Table 13-1

25. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-25 Measuring Liquidity: Approach I Current Ratio  Comparing cash and near-cash current assets against the debt (current liabilities) coming due and payable within one year. Industry norm for current ratio = 1.5 …continued

26. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-26 Measuring Liquidity: Approach I Acid-test ratio (quick ratio)  A measure of a company’s liquidity that excludes inventories. Industry norm for acid-test ratio = 0.8 liabilitiesCurrent Inventories - assetsCurrent ratio Acid-test  1.35 $100,000 $210,000 - $345,000 ratio  Acid-test

27. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-27 Measuring Liquidity: Approach II Average Collection Period  The average time it takes a firm to collect its accounts receivable. Industry norm for average collection period = 31.4 days …continued

28. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-28 Measuring Liquidity: Approach II Inventory turnover  The number of times inventories “roll over” during the year. Industry norm for inventory turnover = 4.00

29. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-29 Calculate Return on Investment (ROI) A measure of operating profits relative to total assets Industry norm for OIROI: 3.6% assets Total Sales X profits Operating Operating income return on investment (OIROI)  AssetsTotal income Operating  Operating income return on investment 0.1087 or 10.87% 000 $920, $100,000  Operating income return on investment

30. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-30 Return on Invested Capital: An Overview Figure 13-4

31. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-31 Measuring Return on Investment (ROI) Operating Profit Margin  The ratio of operating profits to sales, showing how well a firm manages its income statement. Industry norm for operating profit margin: 0.7% …continued

32. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-32 Measuring Return on Investment (ROI) 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 = 3.82 …continued

33. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-33 Measuring Return on Investment (ROI) Operating Income Return on Investment Operating income return on investment = Operating profit margin X Total asset turnover.1205 x 0.90 Operating income return on investment = = 10.85% Industry norm for OIROI = 2.67%

34. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-34 Turnover Ratios Accounts receivable turnover Inventory turnover Fixed asset turnover Industry Norm 10.43 4.00 2.50

35. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-35 How 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 Industry norm for debt ratio = 40.0% …continued

36. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-36 How is the Firm Financing Its Assets Times Interest Earned Ratio  The ratio of operating income to interest charges Industry norm for time interest earned = 4.00

37. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-37 Return on Investment Return on equity  The rate of return that owners earn on their investment. Industry norm for return on equity = 12.5%

38. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-38 Working-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).

39. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-39 The Working-Capital Cycle 1.Purchase or produce inventory for sale, which increases accounts payable. 2.a.Sell inventory for cash. b.Sell inventory for credit (accounts receivable). 3.Pay the accounts payable (decreases cash and accounts payable). 4.Collect the accounts receivable (decreases accounts payable and increases cash). 5.Begin cycle again

40. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-40 The Working Capital Cycle Illustrated Figure 13-6

41. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-41 Working-Capital Time Line Source: Adapted from Terry W. Maness and John T. Zeitlow, Short-Term Financial Management (New York: Dryden Press/Harcourt Brace, 1998), p. 4. Cash conversion period— the time required to convert paid-for inventories and accounts receivable into cash. Figure 13-7

42. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-42 Working Capital Time Line for Pokey, Inc. Figure 13-8a

43. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-43 Working Capital Time Line for Quick-turn Company Figure 13-8b

44. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-44 Pokey, Inc.’s Beginning Balance Sheet

45. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-45 Pokey, Inc.’s Monthly Balance Sheets JulyAug.Sept. Cash400 (100) Accounts receivable000 Inventory0500 Fixed assets600 Accumulated depreciation000 TOTAL ASSETS1,0001,5001,000 Accounts payable05000 Accrued operating expenses000 Income tax payable000 Long-term debt300 Common debt700 Retained earnings000 TOTAL DEBT AND EQUITY1,0001,5001,000 Changes: August to September –500 …continued

46. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-46 Pokey, Inc.’s Monthly Balance Sheets JulyAug.Sept.Oct. Cash400 (100) Accounts receivable000900 Inventory0500 0 Fixed assets600 Accumulated depreciation000(50) TOTAL ASSETS1,0001,5001,0001,350 Accounts payable050000 Accrued operating expenses000250 Income tax payable00025 Long-term debt300 Common debt700 Retained earnings00075 TOTAL DEBT AND EQUITY1,0001,5001,0001,350 Changes: September to October +900 –500 –50 +250 +25 +75 …continued

47. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-47 Pokey, Inc.’s Monthly Balance Sheets

48. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-48 Changes in Pokey’s Balance Sheet Change in the Balance SheetEffect on Income Statement Increase accounts receivable of $900Sales$ 900 Decrease inventories of $500Cost of goods sold$ 500 Increase in accrued operatingOperating expenses $ 250 expenses of $250 Increase accumulated depreciation of $50Depreciation expense$ 50 Increase accrued taxes of $25Tax expense$ 25

49. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-49 Pokey’s November Income Statement Sales revenue900 Cost of goods sold500 Gross Profit400 Operating expenses: Cash250 Depreciation50 Total operating expenses300 Operating income100 Income tax (25%)25 Net income75

50. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-50 Managing 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

51. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-51 Flow of Cash Through A Business Borrowed Funds Collection of Accounts Receivable Owner's Investment Borrowed Funds Sale of Fixed Assets Collection of Accounts Receivable Payment of Expenses Payment for Inventory Payment of Dividends Cash Sales Purchase of Fixed Assets …Figure 13-9

52. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-52 Candace Corporation: Cash Budget (July -September) May June JulyAugustSeptember Monthly Sales$100,000$120,000 $130,000 $130,000$120,000 Cash receipts Cash sales for month (40%) $ 52,000 $ 52,000 $ 48,000 1 month after sale (30%)36,000 39,000 39,000 2 months after sale (30%)30,000 36,00039,000 Step 1Total collections$118,000$127,000$126,000 Purchases (80% of sales)$104,000 $104,000 $ 96,000$ 80,000 Cash disbursements Step 2a Payments on purchases$104,000$104,000$ 96,000 Rent3,0003,0003,000 Wages and salaries18,00018,00016,000 Step 2bTax prepayment1,000 Utilities (2% of sales)2,600 2,600 2,400 Interest on long-term note800 Step 2cShort-term interest (1% of short-term debt)106113 Total cash disbursements$128,600$127,706$118,313 Step 3Net change in cash$ 10,600$ 706$ 7,687 Step 4Beginning cash balance5,0005,0005,000 Step 5Cash balance before borrowing$ 5,600$ 4,294$ 12,687 Step 6Short-term borrowing (payments)10,6007067,687 Ending cash balance$ 5,000$ 5,000$ 5,000 Step 7Cumulative short-term debt outstanding$ 10,600$ 11,306$ 3,619

53. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-53 Managing 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

54. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-54 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.

55. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-55 Managing 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.

56. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-56 Managing 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.

57. Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 13-57 An Accounts Payable for Terms 3/10, Net 30 Annualized interest rate discount% Cash - 100 %discount Cash x perioddiscount Cash - periodNet yearin Days  56.4% or 0.564, 0.030928 x 18.25 