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Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter 13 Measuring and Evaluating Financial Performance

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13-2 Learning Objective 1 Describe the purposes and uses of trend and ratio analyses.

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13-3 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.

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13-4 Learning Objectives 2 & 3 LO 2 Calculate financial trends and ratios. LO3 Interpret the results of trend and ratio analyses.

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13-5 Calculating Trends Horizontal Analyses Time-Series Analyses

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13-6 Calculating Trends Calculating Change in Dollar Amounts Dollar Change Dollar Change Current Year Figure Current Year Figure Base Year Figure Base Year Figure =–

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13-7 Calculating Trends Calculating Change as a Percentage Percentage Change Percentage Change Dollar Change Base Year Figure Dollar Change Base Year Figure 100% = ×

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13-8 Horizontal Analysis The following slides illustrate a trend analysis for Matrix, Inc. for the years ended December 31, 2006 and 2005. We will begin with the asset section of the company’s comparative balance sheets.

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13-9 Horizontal Analysis

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13-10 Horizontal Analysis ($11,500 ÷ $23,500) × 100% = 48.9% $12,000 – $23,500 = $(11,500)

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13-11 Horizontal Analysis

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13-12 Horizontal Analysis We could do this for the liabilities & stockholders’ equity, but now let’s look at the income statement accounts.

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13-13 Horizontal Analysis

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13-14 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?

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13-15 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.

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13-16 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.

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13-17

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13-18

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13-19 Cash provided by operating activities is $65,000.

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13-20 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.

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13-21 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.

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13-22 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.

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13-23 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.

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13-24 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.

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13-25 Profitability Ratios Earnings Per Share (EPS) EPS= Net Income Average Number of Common Shares EPS= $53,690 (17,000 + 27,400) ÷ 2 =$2.42 This ratio shows the net income for each common share outstanding.

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13-26 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.

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13-27 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.

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13-28 Liquidity Ratios Receivables turnover Days to collect Inventory turnover Days to sell Current ratio

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13-29 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 = 26.70 times Receivables Turnover = $494,000 $18,500 This ratio tells us how many times receivables are collected each period.

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13-30 Liquidity Ratios Days to Collect = = 365 Receivable Turnover 365 Receivable Turnover Days to Collect = 13.67 days Days to Collect = 365 26.70 This ratio tells us how quickly the company is able to collect its receivables.

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13-31 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 = 12.73 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.

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13-32 Liquidity Ratios Days to Sell = = 365 Inventory Turnover 365 Inventory Turnover Days to Sell = 28.67 days Days to Sell = 365 12.73 This ratio tells us how long it takes the company to sell its inventory.

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13-33 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.

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13-34 Solvency Ratios Debt-to-assets Times interest earned Cash coverage Capital acquisitions ratio

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13-35 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.

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13-36 Solvency Ratios Times Interest Earned = 11.51 times = 11.51 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.

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13-37 Solvency Ratios Cash Coverage = = Net Cash from Operations + Interest Paid + Income Taxes Paid Interest Paid Cash Coverage = 12.79 times = 12.79 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.

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13-38 Solvency Ratios Capital Acquisitions Ratio Capital Acquisitions = = Net Cash from Operations Cash Paid for PPE $281,390 - $251,000 Capital Acquisitions = $65,000 $30,390 2.14 = 2.14 This ratio relates cash flows from operating activities to cash paid for property, plant, and equipment.

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13-39 Learning Objective 4 Describe how trend and ratio analyses depend on key accounting decisions and concepts.

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13-40 Accounting Decisions and Concepts Maintain consistency among accounting standards. Resolve new accounting problems. Provide user benefits.

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13-41 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

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13-42 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

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13-43 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

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13-44 RelevanceReliability Predictive Value Feedback Value TimelinessNeutrality Verifiability Representational Faithfulness ComparabilityConsistency Qualitative Characteristics - Understandability Decision Usefulness

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13-45 Accounting Constraints Cost Effectiveness MaterialityMateriality ConservatismConservatism

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Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter 13 Supplement Nonrecurring and Other Special Items

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13-47 Nonrecurring Items Nonrecurring items include the impact of discontinued operations and extraordinary items. Reported Net of Taxes Reported After Income from Operations

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13-48 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.

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13-49 End of Chapter 13

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