Chapter 14 Analysis of Operating Activities How do operations create value for our business?

Analysis of Operating Activities Operating Decisions –Determine how to price products –Determine how to create a return on assets that will satisfy stockholders –Determine how to generate as much revenue as possible from the products –Determine how to create value for its customers –Determine how to compete with other producers

Analysis of Operating Activities Developing an Operating Strategy –Profit margin is a measure of a company’s ability to create profit from its sales. –Asset turnover is a measure of of a company’s ability to generate sales from its investment in assets. –Return on assets is the profit margin multiplied by the asset turnover. If return on assets is low, a company must sell a lot of its products to earn a reasonable profit.

Developing an Operating Strategy Profit margin = Net income Sales revenue Asset turnover = Sales revenue Total assets Return on assets = Profit margin x Asset turnover

Analysis of Operating Activities Interpretation of Operating Activities –Asset Turnover and Profit Margin are not the same for all companies. –For Highly profitable firms Asset Turnover is high for some Profit Margin is high for others

Analysis of Operating Activities Business Strategy –The difference in profit margin and asset turnover is generated by the different strategies companies use. –Two primary strategies are Companies that keep their prices low to generate high sales volume use a cost leadership strategy. High profit margin companies use a product differentiation strategy. –Cost leadership and Product differentiation are two ends of a competitive spectrum.

Exhibit 5 Cost Leadership and Product Differentiation as Alternative Operating Strategies Operating Strategy Profit Margin Asset Turnover Operating Strategy Profit Margin Asset Turnover Cost LeadershipLowHigh Product DifferentiationHighLow

Analysis of Operating Activities Business Strategy –Product Differentiation Strategy They compete by offering products with special features or qualities that customers are willing to buy. They emphasize service quality and often use elaborate selling facilities. Advertising emphasizes the high quality or special features of their products and how these products are better than products offered by competitors. They attempt to build brand loyalty. Research & Development is critical for these companies.

Analysis of Operating Activities Business Strategy –Cost Leadership Strategy They compete by keeping their prices low and generating high sales volume. They keep their expenses low so they can earn a profit. They typically buy and sell in high volume. They offer few specialized customer services. They do not have elaborate sales facilities. Advertising often emphasizes low prices and convenience. They do not invest in research and development.

Analysis of Operating Activities Comparing Accrual and Cash Flow Measures of Operating Performance –If a company does not convert its profits into cash, the profits are a misleading performance indicator. –The ratio of operating cash flow to total assets is useful for comparing the operating cash flows of different companies.

Analysis of Operating Activities Inventory turnover is the ratio of cost of good sold to inventory. It measures the success of a company in converting its investment in inventory into sales. $150,414,000 $12,031, = Krispy Kreme—2001 $1,175,787,000 $221,253, = Starbucks—2001 Inventory turnover = Cost of goods sold Inventories

Analysis of Operating Activities A ratio related to inventory turnover is day’s sales in inventory, the ratio of inventory to average daily cost of goods sold. Day’s sales in inventory Inventory Cost of good sold ÷ 365 $12,031,000 $412, = Krispy Krme—2001 $150,414,000 ÷ 365

Analysis of Operating Activities A ratio related to inventory turnover is day’s sales in inventory, the ratio of inventory to average daily cost of goods sold. Day’s sales in inventory Inventory Cost of good sold ÷ 365 $1,175,789,000 ÷ 365 $221,253,000 $3,221, = Starbucks—2001

Analysis of Operating Activities Accounts receivable turnover measures the success of a company’s ability to convert revenues into cash. Sales revenue Accounts receivable = Accounts receivable turnover

Analysis of Operating Activities Gross profit margin measures efficiency in the production or purchase of goods for sale. Gross profit Sales revenue = Gross profit margin

Analysis of Operating Activities Operating profit margin is an indicator of a company’s efficiency in controlling operating costs other than product costs. Operating income Sales revenue = Operating profit margin

Analysis of Operating Activities Another ratio to measure financial risk is times interest earned. Operating income Interest expense = Times interest earned

Net income Equity Net income Equity Linking Operating and Investing Activities with Financing Activities Return on Equity Profit Margin Financial Leverage Asset Turnover = xx Sales Revenues Total Assets Sales Revenues Total Assets Net income Sales Revenues Net income Sales Revenues Total Assets Equity Total Assets Equity =xx

The Big Picture A business is a transformation process in which— (1)financial resources are obtained through financing activities, (2)financial resources are used to acquire other resources through investing activities, and (3)resources are used to produce and sell goods and services through operating activities.

The Accounting Cycle 1. Examining business activities 2.Recording transactions 3.Updating account balances 4.Making end-of-period adjustments 5.Preparing financial statements 6.Closing revenue and expense accounts Steps in the accounting cycle include: