1. McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Measuring and Evaluating Financial Performance
Chapter 13
Chapter 13: Measuring and Evaluating Financial Performance
Measuring and Evaluating Financial Performance
PowerPoint Authors:
Jon A. Booker, Ph.D., CPA, CIA
Charles W. Caldwell, D.B.A., CMA
Susan Coomer Galbreath, Ph.D., CPA

3. 13-3
Learning Objective 1
Describe the purposes and uses of horizontal, vertical, and ratio analyses.
Learning objective 1 is to describe the purposes and uses of horizontal, vertical, and ratio analyses.

4. Horizontal, Vertical, and Ratio Analyses
13-4
Horizontal, Vertical, and Ratio Analyses
Horizontal (trend) analyses are conducted to help financial statement users recognize important financial changes that unfold over time.
12/31/09
12/31/10
Gross Profit in 2009
Gross Profit in 2010
Δ in Gross Profit $ and/or % from 2009
Trend Analysis
Vertical analyses focus on important relationships between items on the same financial statement.
Part I
Horizontal (trend) analyses are conducted to help financial statement users recognize important financial changes that unfold over time.
Part II
A company will report gross profit each year on its income statement. In horizontal or trend analysis, we might calculate the change in gross profit from one year to the next. We could do this for all accounts on the financial statements.
Part III
Vertical analyses focus on important relationships between items on the same financial statement.
Part IV
Here is a partial income statement showing sales, cost of goods sold, and gross profit for the fiscal year While we know that the number amounts will appear on the income statement, we gain valuable insights by doing a vertical, or common size, analysis. Here we have calculated the percentages for each amount by expressing sales as 100 percent.
Sales
Cost of Goods Sold
Gross Profit
$200, %
150, %
$ 50, %
Amount
Percent
2010

5. Horizontal, Vertical, and Ratio Analyses
13-5
Horizontal, Vertical, and Ratio Analyses
Ratio analyses are conducted to understand relationships among various items reported in one or more of the financial statements.
Receivable Turnover
Ratio =
Net Sales Revenue
Average Net Receivables
Part I
Ratio analyses are conducted to understand relationships among various items reported in one or more of the financial statements.
Part II
Recall the calculation of the Receivable Turnover Ratio. By calculating this ratio we were able to determine the number of times per year receivable are collected.
Part III
It is essential to understand that no analysis is complete unless it leads to an interpretation that helps financial statement users understand and evaluate a company’s financial results
It is essential to understand that no analysis is complete unless it leads to an interpretation that helps financial statement users understand and evaluate a company’s financial results

6. 13-6
Learning Objective 2
Use horizontal (trend) analyses to recognize financial changes that unfold over time.
Learning objective 2 is to use horizontal (trend) analyses to recognize financial changes that unfold over time.

7. Horizontal (Trend) Computations
13-7
Horizontal (Trend) Computations
Trend analyses are usually calculated in terms of year-to-year dollar and percentage changes.
(Current Year’s Total – Prior Year’s Total)
Part I
Trend analyses are usually calculated in terms of year-to-year dollar and percentage changes.
Part II
Calculating the dollar change from one year to the next is relatively easy. However, calculating the year-to-year percentage change can be a challenge. We begin the process by subtracting the prior year’s total dollar amount from the current year’s total dollar amount. This is referred to as the “current year change.” We divide the current year change by the prior year’s total amount and multiply that amount by 100 to convert it to a percentage that is easy to read.
Year-to-Year
Change (%) =
Change This Year
Prior Year’s Total
× 100

8. Horizontal (Trend) Computations
13-8
Horizontal (Trend) Computations
Can you calculate the dollar and percentage change for Cost of Sales?
Now let’s calculate the percentage change in Net Sales Revenue between 2009 and 2008.
Calculate the change in dollars for Net Sales Revenue between 2009 and 2008.
Now let’s look at the remainder of the trend analysis of the Income Statement.
$48,230 – $48,283
$48,283
× 100
Part I
Here is the income statement of Lowe’s for the fiscal years 2009 and See if you can calculate the dollar change in net sales revenue between 2009 and 2008.
Part II
There was a $53 million decrease in Net Sales Revenue between the two years ($48,283 – $48,230). How did you do?
Part III
Now let’s calculate the percentage change in Net Sales Revenue between 2009 and 2008.
Part IV
The decrease in Net Sales Revenue between the two years is one-tenth of 1 percent decrease. How did you do?
Part V
You can see that we calculate the percentage by subtracting $48,283 (2008 amount) from $48,230 (2009 amount) and dividing the difference by $48,283 (2008 amount) and multiply the total times 100 to express the percent in a readable form of one-tenth of 1 percent decrease.
Part VI
Why don’t you calculate the dollar and percentage change for Cost of Sales between 2009 and Don’t proceed until you have finished the computations.
Part VII
Between 2008 and 2009, Cost of Sales increased by $173 million, which means it increased by one-half of one percent.
Part VIII
Here is the rest of the trend analysis for the Income Statement. We could apply the same techniques to the balance sheet to do a trend analysis of that financial statement.

9. 13-9
Learning Objective 3
Use vertical (common size) analyses to understand important relationships within financial statements.
Learning objective 3 is to use vertical (common size) analysis to understand important relationships within financial statements.

10. Vertical (Common Size) Computations
13-10
Vertical (Common Size) Computations
Vertical, or common size, analysis focuses on important relationships within financial statements.
Income Statement
Sales = 100%
Balance Sheet
Total Assets = 100%
Cost of Sales
Net Sales Revenue
× 100
Part I
Vertical, or common size, analysis focuses on important relationships within financial statements. We usually pick a value on the financial statement and express all other values on that statement as a percent of the selected amount.
Part II
When preparing a common size income statement we normally let net sales equal 100 percent and express all other items on the income statement as a percent of net sales. When preparing a common size balance sheet we normally let total assets equal 100 percent and express all other balance sheet accounts as a percent of total assets. Let’s look at an example.
Part III
Here is the income statement of Lowe’s for the fiscal years 2008 and Notice, we have set Net Sales Revenue equal to 100 percent. Now, calculate Cost of Sales as a percent of Net Credit Sales.
Part IV
Here is the equation we will use to calculate the percentage.
Part V
Cost of Sales is equal to 65.8 percent of Net Sales Revenue in 2008, and 65.4 percent in There as been a slight increase in Cost of Sales as a percent of Net Sales Revenue.
Part VI
The rest of the common size income statements for the two years is presented on the slide.

11. 13-11
Learning Objective 4
Calculate financial ratios to assess profitability, liquidity, and solvency.
Learning objective 4 is to calculate financial ratios to assess profitability, liquidity, and solvency.

12. 13-12
Ratio Computations
Ratio analysis compares the amounts for one or more line items to the amounts for other line items in the same year.
Profitability ratios
examine a company’s
ability to generate income.
Solvency ratios
examine a company’s ability to pay interest and repay debt when due.
Ratio analysis compares the amounts for one or more line items to the amounts for other line items in the same year. Most analysts classify ratios into three categories:
Profitability ratios, which relate to the company’s performance in the current period—in particular, the company’s ability to generate income.
Liquidity ratios, which relate to the company’s short-term survival—in particular, the company’s ability to use current assets to repay liabilities as they become due.
Solvency ratios, which relate to the company’s long-run survival—in particular, the company’s ability to repay lenders when debt matures and to make the required interest payments prior to the date of maturity.
Liquidity ratios
help us determine if a company has sufficient current assets to repay liabilities when due.

13. Common Profitability Ratios
13-13
Common Profitability Ratios
We have listed some common profitability ratios. These ratios relate to the company’s performance in the current period—in particular, the company’s ability to generate income. The list includes net profit margin, gross profit percentage, asset turnover, fixed asset turnover, return on equity, earnings per share, quality of income and price/earnings ratio.

14. Common Liquidity Ratios
13-14
Common Liquidity Ratios
Here is a list of four common liquidity ratios: receivables turnover (and the related days to collect ratio), inventory turnover (and the related days to sell ratio) current ratio, and quick ratio. These ratios relate to the company’s short-term survival—in particular, the company’s ability to use current assets to repay liabilities as they become due.

15. Common Solvency Ratios
13-15
Common Solvency Ratios
We are going to compute three common solvency ratios: debt to assets, times interest earned, and capital acquisitions. Solvency ratios relate to the company’s long-run survival—in particular, the company’s ability to repay lenders when debt matures and to make the required interest payments prior to the date of maturity.

16. Interpret the results of financial analyses.
13-16
Learning Objective 5
Interpret the results of financial analyses.
Learning objective 5 is to interpret the results of financial analyses.

17. Interpreting Horizontal and Vertical Analyses
13-17
Interpreting Horizontal and Vertical Analyses
With 60 new stores opened, Lowe’s had a 7.9% increase in inventory, and a 6.4% increase in Property and Equipment.
Lowe’s grew by 5.9% in fiscal 2009.
Part I
Financial statement analyses are not complete unless they lead to interpretations that help users understand and evaluate a company’s financial results.
Part II
Horizontal (trend) analysis of Lowe’s balance sheet shows that the company grew in fiscal Overall, total assets increased approximately 5.9 percent.
Part III
In fiscal 2008, Lowe’s opened 60 new stores, resulting in significant increases in Inventories (7.9 percent) and Property and Equipment (6.4 percent).

18. Interpreting Horizontal and Vertical Analyses
13-18
Interpreting Horizontal and Vertical Analyses
The Company’s cash position weakened significantly between fiscal 2007 and 2008.
There was a large increase in the inventory carried by the company. The accumulation of inventory is a sign of a weakening business outlook.
Part I
Let’s see if we can identify some of the warning signs facing Lowe’s.
Part II
Lowe’s cash position weakened between fiscal 2007 and The weakening hurt the liquidity of the company.
As a general rule, retail companies are in business to sell, not hold, inventory. When we see a build-up in inventory we know that the company is facing a soft business environment. We cannot generate cash unless we sell inventory.

19. Interpreting Horizontal and Vertical Analyses
13-19
Interpreting Horizontal and Vertical Analyses
Cost of sales and operating expenses are the most important determinant of the company’s profitability.
Much of the decline in fiscal 2008 Net Income is explained by the increase in Cost of Sales and Operating Expenses.
Part I
Vertical analysis of Lowe’s income statement shows that Cost of Sales and Operating Expenses are the most important determinants of the company’s profitability.
Part II
Cost of Sales consumed 65.8 percent of Sales in fiscal 2008 and Operating Expenses consumed an additional 26.3 percent.
Part III
Much of the reduction in the company’s Net Income (from 5.8 percent of Sales in 2007 to 4.6 percent in 2008) is explained by these two categories of expenses.

20. Interpreting Horizontal and Vertical Analyses
13-20
Interpreting Horizontal and Vertical Analyses
Lowe’s has experienced a 0.4% increase in its cost of goods sold from fiscal 2007 to Increasing cost of sales means lower gross profit.
Lowe’s did not do a good job of controlling its operating expenses between 2007 and The company is faced with lower gross profit and poor operating expense control.
Part I
Lowe’s is facing some serious problems relating to its ability to generate future income. Let’s see where the current problems can be located.
Part II
Cost of sales increased by four-tenths of one percent from fiscal 2007 to fiscal Higher cost of goods sold, given relatively stable sales, results in a lower gross profit. This can be a disturbing trend in a retail business.
Part III
The management at Lowe’s was unable to effectively control operating expenses from 2007 to Operating expenses increased by one point 4 percent during the period. One piece of data to help a financial statement reader evaluate the effectiveness of management is to see how well the management controls operating expense. Control of operating expenses is extremely important in periods of slow or no economic growth.

21. Interpreting Ratio Analyses
13-21
Interpreting Ratio Analyses
Here is the balance sheet information that we will use in the calculation of our ratios. It might be helpful to print this slide to use as we compute the various ratios. An alternative is to look at Exhibit 13-1 in your textbook.

22. Interpreting Ratio Analyses
13-22
Interpreting Ratio Analyses
We will use Lowe’s Income Statement presented on this slide for many of the ratio calculations we will complete in the following slides. It might be helpful to print this slide to use as we compute the various ratios. An alternative is to look at Exhibit 13-2 in your textbook.

23. 13-23
Profitability Ratios
Net Profit Margin – Lowe’s faced a challenging economic environment in 2008 as shown by the decline in Net Profit Margin.
Gross Profit Percentage – Lowe’s gross profit percentage indicates how much profit was made on each dollar of sales after deducting the Cost of Goods Sold.
Part I
Profitability ratios focus on the level of profits the company generated during the period. In our analyses, we compare Lowe’s financial ratios to the prior year and in some cases to those for The Home Depot. (Lowe’s and The Home Depot’s annual reports are printed in Appendix A and B.) The Net Profit Margin Ratio represents the percentage of sales revenues that ultimately make it into net income, after deducting expenses. In 2008, Lowe’s generated 4.6 cents in net profit margin for each dollar of sales, down from 5.8 cents the previous year.
Part II
The decrease in the gross profit percentage from 2007 to 2008 (34.2% %) means that Lowe’s made 0.4 cents less gross profit on each dollar of sales in 2008 than in This decline means that Lowe’s charged lower selling prices without experiencing a decrease in the cost of merchandise or Lowe’s paid a higher unit cost for merchandise purchased.

24. 13-24
Profitability Ratios
Asset Turnover Ratio – indicates the amount of sales revenue generated for each dollar invested in assets during the period.
Fixed Asset Turnover – indicates how much revenue the company generates in sales for each dollar invested in fixed assets,
Part I
The asset turnover ratio suggests that Lowe’s assets did not generate sales as efficiently in 2008 as in the prior year. To understand why, it is helpful to focus on the key assets used to generate sales. For a retailer such as Lowe’s, the key asset is store properties, which we can compare to sales using the fixed asset turnover ratio discussed next.
Part II
The fixed asset turnover ratio shows that Lowe’s had $2.19 of sales in 2008 for each dollar invested in fixed assets. Although the decline from 2007 was not good, it is understandable because 2008 was a difficult year for retailers. Lowe’s 2008 fixed asset turnover also suffered because the company added stores during the year. Those stores will likely need some time to establish a strong customer base and begin generating sales at full capacity.
Part III
The Home Depot reported a fixed asset turnover ratio of 2.65 in In terms of using fixed assets to generate sales revenue, The Home Depot has a competitive advantage over Lowe’s. In other words, Lowe’s is operating less efficiently than its major competitor.
Home Depot 2008 fixed asset turnover ratio was 2.65.

25. 13-25
Profitability Ratios
Return on Equity (ROE) – Compares the amount of net income to average stockholders’ equity. ROE reports the net amount earned
during the period as a percentage of each dollar contributed by stockholders and retained in the business.
Part I
Return on Equity (ROE) compares the amount of net income to average stockholders’ equity. ROE reports the net amount earned during the period as a percentage of each dollar contributed by stockholders and retained in the business. Lower ROE was predictable because the company had increased its stockholders’ equity to finance store expansion. But store expansion failed to increase sales in Lower sales resulted in lower net income. Lower income and the increase in the stockholders’ equity results in a lower ROE.
Part II
Earnings Per Share (EPS) shows the amount of earnings generated for each share of outstanding common stock. Lowe’s was bound to experience a decline in EPS because lower sales resulted in lower net income. In addition, Lowes issued more shares of stock to finance the new stores that were opened in But these stores have yet to increase sales revenue. As a result of these two factors, Lowes experiences a rather significant decline in EPS.
Earnings Per Share (EPS) – Shows the amount of earnings generated for each share of outstanding common stock.

26. 13-26
Profitability Ratios
Quality of Income – Quality of income ratio relates operating cash flows (from the Statement of Cash Flows) to net income.
Home Depot 2008 Quality of Income Ratio was 2.45.
Price /Earnings (P/E) Ratio – Shows the relationship between EPS and the market price of one share of the company’s stock.
Part I
The Quality of Income ratio relates operating cash flows (from the Statement of Cash Flows) to net income. In 2008, Lowe’s generated $1.88 of operating cash flow for every dollar of net income. Because the ratio is much greater than 1.0, it is interpreted as “high quality” income.
Part II
In 2008, The Home Depot reported 2.45 as the Quality of Income ratio.
Part III
Using the going price for Lowe’s stock, $18.25 in 2008 and $23.00 in 2007, the P/E ratio was 12.1 in both years. This means investors were willing to pay 12.1 times earnings to buy a share of Lowe’s stock. The Home Depot’s P/E ratio at that time was around 18.5, suggesting that investors were less willing to buy stock in Lowe’s than in The Home Depot.

27. Average Net Receivables
13-27
Liquidity Ratios
Let’s change our attention to an examination of liquidity ratios. The analyses in this section focus on the company’s ability to survive in the short term, by converting assets to cash that can be used to pay current liabilities as they come due.
Receivable Turnover
Ratio =
Net Sales Revenue
Average Net Receivables
Receivable Turnover Ratio – Most retail home improvement companies have low levels of accounts receivable relative to sales revenue because they collect the majority of their sales immediately in cash.
Part I
Liquidity ratios focus on the company’s ability to survive in the short term, by converting assets to cash that can be used to pay current liabilities as they come due.
Part II
We will begin with the Receivable Turnover Ratio. Most home improvement companies have low levels of accounts receivable relative to sales revenue because they collect the majority of their sales immediately in cash. As a consequence, the receivable turnover ratio has little meaning to the financial statement reader of these companies.

28. 13-28
Liquidity Ratios
Inventory Turnover Ratio – The inventory turnover ratio indicates how frequently inventory is bought and sold. The “days to sell” indicates the average number of days needed to sell each purchase of inventory.
Home Depot sells its inventory in an average of 87 days in 2008.
Current Ratio – The current ratio measures the company’s ability to pay its current liabilities.
Part I
The inventory turnover ratio indicates how frequently inventory is bought and sold during the year. The measure “days to sell” converts the inventory turnover ratio into the average number of days needed to sell each purchase of inventory. Because of the weaker economy in 2008, Lowe’s inventory turned over less frequently. On average, its inventory took an additional 6.0 days to sell (91.3 – 85.3).
Part II
Although most retailers experienced a decline in inventory turnover in 2008, Lowe’s decline was disappointing because it prevented the company from catching up to The Home Depot (where inventory takes an average of 87 days to sell).
Part III
The current ratio measures the company’s ability to pay its current liabilities. Lowe’s ratio increased slightly from 2007 to 2008, ending the year with a ratio of In this industry, a current ratio greater than 1.0 is deemed acceptable.

29. 13-29
Liquidity Ratios
Quick Ratio – The quick ratio is a much more stringent test of short-term liquidity than is the current ratio. Lowe’s quick ratio increased slightly in 2008, just as its current ratio did.
Referred to as “quick assets.”
Part I
The quick ratio compares the sum of cash, short-term investments, and accounts receivable to current liabilities. The low quick ratio shown here is typical for industries where most customers buy with cash or credit card.
Part II
These assets are referred to as quick assets because they may be converted into cash on short notice. The quick ratio is a much more stringent test of short-term liquidity than is the current ratio. Lowe’s quick ratio increased slightly in 2008, just as its current ratio did. The average quick ratio in 2008 for the homebuilding industry was 0.66.

30. In 2008, The Home Depot had a debt-to-assets ratio of 57 percent.
13-30
Solvency Ratios
Debt to Assets Ratio – indicates the proportion of total assets that creditors finance.
In 2008, The Home Depot had a debt-to-assets ratio of 57 percent.
Times Interest Earned – indicates how many times the company’s interest expense was covered by its operating results.
Part I
Solvency ratios focus on a company’s ability to survive over the long term, that is, to repay debt when it matures, pay interest until that time, and finance the replacement and/or expansion of long-term assets. The Debt to Assets Ratio indicates the proportion of total assets that creditors finance. Lowe’s ratio of 0.45 in 2008 indicates that creditors contributed 45 cents per $1.00 of the company’s total assets, implying that stockholders’ equity was the company’s main source of financing at 55 cents for each $1.00 of total assets.
Part II
In 2008, The Home Depot has a debt-to-asset ratio of 57 percent. The Home Depot relies much more on debt financing.
Part III
Times Interest Earned indicates how many times the company’s interest expense was covered by its operating results. This ratio is calculated using accrual-based interest expense and net income before interest and income taxes. Lowe’s ratio of 13.5 indicates the company is generating more than enough profit to cover its interest expense. A ratio of 1.0 means that the company is able to cover its interest expense for the period.

31. 13-31
Solvency Ratio
Capital Acquisition Ratio – compares cash flows from operations with cash paid for property and equipment.
The Capital Acquisition Ratio compares cash flows from operations with cash paid for property and equipment. The 1.26 capital acquisitions ratio in 2008 indicates that Lowe’s was able to pay for all its store expansion using cash generated from operating activities. Lowe’s is financially well-positioned.

32. End of Chapter 13
End of chapter 13.