Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter 13 Measuring and Evaluating Financial Performance

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 1 Describe the purposes and uses of trend and ratio analyses.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Trend and Ratio Analyses Trend analyses are conducted to help financial statement users recognize important financial changes that unfold over time. Ratio analyses, on the other hand, are conducted to understand relationships among various items reported in the financial statements.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objectives 2 & 3 LO 2 Calculate financial trends and ratios. LO3 Interpret the results of trend and ratio analyses.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Calculating Trends Horizontal Analyses Time-Series Analyses

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Calculating Trends Calculating Change in Dollar Amounts Dollar Change Dollar Change Current Year Figure Current Year Figure Base Year Figure Base Year Figure =–

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Calculating Trends Calculating Change as a Percentage Percentage Change Percentage Change Dollar Change Base Year Figure Dollar Change Base Year Figure 100% = ×

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Horizontal Analysis The following slides illustrate a trend analysis for Matrix, Inc. for the years ended December 31, 2006 and We will begin with the asset section of the company’s comparative balance sheets.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Horizontal Analysis

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Horizontal Analysis ($11,500 ÷ $23,500) × 100% = 48.9% $12,000 – $23,500 = $(11,500)

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Horizontal Analysis

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Horizontal Analysis We could do this for the liabilities & stockholders’ equity, but now let’s look at the income statement accounts.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Horizontal Analysis

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Horizontal Analysis Sales increased by 8.3% yet net income decreased by 21.9%. Can you determine what happened? Sales increased by 8.3% yet net income decreased by 21.9%. Can you determine what happened?

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Calculating Ratios 1.Profitability – relates to performance in the current period. The focus is on the company’s ability to generate income during the period. 2.Liquidity – relates to the company’s short-term survival. The focus is on the company’s ability to use current assets to repay liabilities as they become due. 3.Solvency – relates to the company’s long-run survival. The focus is on the company’s ability to repay lenders when debt matures. 1.Profitability – relates to performance in the current period. The focus is on the company’s ability to generate income during the period. 2.Liquidity – relates to the company’s short-term survival. The focus is on the company’s ability to use current assets to repay liabilities as they become due. 3.Solvency – relates to the company’s long-run survival. The focus is on the company’s ability to repay lenders when debt matures.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Tests of Profitability Net profit margin Gross profit percentage Asset turnover Fixed asset turnover Return on equity (ROE) Earnings per share (EPS) Quality of income Price/earnings ratio We will use the financial statement of Western Gear to perform our ratio analysis. The financial statements are shown on the next screen.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Cash provided by operating activities is $65,000.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Profitability Ratios Net Profit Margin = = Net Income Net Sales Revenue Net Profit Margin = $53,690 $494,000 = 10.87% This ratio describes a company’s ability to earn a net income from sales.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Profitability Ratios Gross Profit Percentage = = Net Sales - Cost of Goods Sold Net Sales Gross Profit Percentage = $494,000 - $140,000 $494,000 = 71.66% This ratio describes the profit, as a percent of sales, before operating expenses.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Profitability Ratios Asset Turnover = = Net Sales Revenue Average Total Assets Asset Turnover = $494,000 $323,195 = 1.53 times ($346,390 + $300,000) 2 This ratio measures the efficiency of assets in producing sales.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Profitability Ratios Fixed Asset Turnover Net Asset Turnover = = Net Sales Revenue Average Net Fixed Assets Net Asset Turnover = $494,000 $266,195 = 1.86 times ($281,390 + $251,000) 2 This ratio indicates how much the company generates in sales for each dollar invested in fixed assets.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Profitability Ratios Return on Equity (ROE) ROE == Net Income Average Stockholders’ Equity ROE = $53,690 $207,195 = 25.91% ($234,390 + $180,000) 2 Shows the net amount earned this period as a percentage of each dollar contributed by stockholders, plus retained earnings.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Profitability Ratios Earnings Per Share (EPS) EPS= Net Income Average Number of Common Shares EPS= $53,690 (17, ,400) ÷ 2 =$2.42 This ratio shows the net income for each common share outstanding.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Profitability Ratios Quality of Income = = Net Cash From Operations Net Income Quality of Income = $65,000 $53,690 = 1.21 This ratio compares net income with cash flows from operating activities.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Profitability Ratios Price/Earnings Ratio = = Stock Price Earnings per Share Quality of Income = $20.00 $2.42 = 8.26 This ratio is an indication of what investors are willing to pay for a share of stock in the company.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Liquidity Ratios Receivables turnover Days to collect Inventory turnover Days to sell Current ratio

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Liquidity Ratios Receivables Turnover Receivables Turnover = = Net Sales Revenue Average Net Receivables Net Sales Revenue Average Net Receivables Receivables Turnover ($17,000 + $20,000) 2 = times Receivables Turnover = $494,000 $18,500 This ratio tells us how many times receivables are collected each period.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Liquidity Ratios Days to Collect = = 365 Receivable Turnover 365 Receivable Turnover Days to Collect = days Days to Collect = This ratio tells us how quickly the company is able to collect its receivables.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Liquidity Ratios Inventory Turnover Inventory Turnover = = Cost of Goods Sold Average Inventory Cost of Goods Sold Average Inventory Inventory Turnover ($12,000 + $10,000) 2 = times Inventory Turnover = $140,000 $11,000 This ratio tells us how many times a company’s inventory was sold and replaced during the year.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Liquidity Ratios Days to Sell = = 365 Inventory Turnover 365 Inventory Turnover Days to Sell = days Days to Sell = This ratio tells us how long it takes the company to sell its inventory.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Liquidity Ratios Current Ratio Current Ratio = = Current Assets Current Liabilities Current Assets Current Liabilities Current Ratio = 1.55:1 = 1.55:1 $65,000 $42,000 Current Ratio This ratio measures the short-term debt-paying ability of the company.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Solvency Ratios Debt-to-assets Times interest earned Cash coverage Capital acquisitions ratio

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Solvency Ratios Debt to Assets = = Total Liabilities Total Assets Debt-to-Assets Debt to Assets = 32.33% = 32.33% $112,000 $346,390 This ratio indicates the proportion of total assets that are financed by creditors.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Solvency Ratios Times Interest Earned = times = times $53,690 + $7,300 + $23,010 $7,300 Times Interest Earned = Net Income + Interest Expense + Income Tax Expense Interest Expense This is the most common measure of the ability of a firm’s operations to provide protection to the long-term creditor.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Solvency Ratios Cash Coverage = = Net Cash from Operations + Interest Paid + Income Taxes Paid Interest Paid Cash Coverage = times = times $65,000 + $7,000 + $17,500 $7,000 Cash Coverage Ratio This ratio is similar to times interest earned but measure cash from operations rather than net income.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Solvency Ratios Capital Acquisitions Ratio Capital Acquisitions = = Net Cash from Operations Cash Paid for PPE $281,390 - $251,000 Capital Acquisitions = $65,000 $30, = 2.14 This ratio relates cash flows from operating activities to cash paid for property, plant, and equipment.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 4 Describe how trend and ratio analyses depend on key accounting decisions and concepts.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Accounting Decisions and Concepts Maintain consistency among accounting standards. Resolve new accounting problems. Provide user benefits.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Conceptual Framework Recognition and Measurement Criteria Recognition and Measurement Criteria Environment Implementation Implementation assumptions principles constraints Recognition and Measurement Criteria Recognition and Measurement Criteria Environment Implementation Implementation assumptions principles constraints Objectives of Financial Reporting Qualitative Characteristics of Accounting Information Qualitative Characteristics of Accounting Information Elements of Financial Statements Elements of Financial Statements

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin To provide information:  Useful for decisions.  That helps predict cash flows.  About economic resources, claims to resources, and changes in resources and claims. Elements Recognition and Measurement Concepts Constraints Conceptual Framework Objectives Qualitative Characteristics Financial Statements Continued Exhibit 13-7

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Elements Assets Liabilities Equity Investments by Owners Distributions to owners Revenues Expenses Gains Losses Comprehensive Income Recognition and Measurement Concepts Assumptions Economic entity Going concern Periodicity Monetary unit Principles Historical cost Realization Matching Full Disclosure Objectives Financial Statements Balance sheet Income statement Statement of cash flows Statement of shareholders’ equity Related disclosures Constraints Cost effectiveness Materiality Conservatism Qualitative Characteristics Understandability Primary Relevance Reliability Secondary Comparability Consistency

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin RelevanceReliability Predictive Value Feedback Value TimelinessNeutrality Verifiability Representational Faithfulness ComparabilityConsistency Qualitative Characteristics - Understandability Decision Usefulness

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Accounting Constraints Cost Effectiveness MaterialityMateriality ConservatismConservatism

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter 13 Supplement Nonrecurring and Other Special Items

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Nonrecurring Items Nonrecurring items include the impact of discontinued operations and extraordinary items. Reported Net of Taxes Reported After Income from Operations

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Other Special Items Comprehensive Income Gains and losses that are excluded from income are included in “comprehensive” income. The balance in comprehensive income appears in the stockholders’ equity section of the balance sheet.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin End of Chapter 13