1. part 7 PowerPoint Presentation by Charlie Cook Copyright © 2003 South-Western College Publishing. All rights reserved. All rights reserved. Evaluating Financial Performance 22 Financial Management in the Entrepreneurial Firm 12e

2. Copyright © by South-Western College Publishing. All rights reserved. 22–2 Looking Ahead After studying this chapter, you should be able to: 1. Identify the basic requirements for an accounting system. 2. Explain two alternative accounting options. 3. Describe the purpose of and procedures related to internal control. 4. Evaluate a firm’s liquidity. 5. Assess a firm’s profitability. 6. Measure a firm’s use of debt or equity financing. 7. Evaluate the rate of return earned on the owner’s investment.

3. Copyright © by South-Western College Publishing. All rights reserved. 22–3 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.

4. Copyright © by South-Western College Publishing. All rights reserved. 22–4 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

5. Copyright © by South-Western College Publishing. All rights reserved. 22–5 Small Business Accounting Resources Computer Accounting Software Packages –Checkbook functions –Automatic financial statements preparation –Cash budget tracking –Subsidiary journal accounts preparation Outside Accounting Services –Convenience –Competence –Cost

6. Copyright © by South-Western College Publishing. All rights reserved. 22–6 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.

7. Copyright © by South-Western College Publishing. All rights reserved. 22–7 Accounting Method Alternatives Single-Entry Versus Double-Entry Systems –Single-entry system  A checkbook system of accounting reflecting only receipts and disbursements. –Double-entry system  A self-balancing accounting system that uses journals and ledgers.

8. Copyright © by South-Western College Publishing. All rights reserved. 22–8 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 checks issued have supporting documentation  Limiting access to accounting records and computers  Sending bank statements directly to the owner  Safeguarding blank checks  Requiring employees to take vacations

9. Copyright © by South-Western College Publishing. All rights reserved. 22–9 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 (stockholders) receiving an acceptable return on their equity?

10. Copyright © by South-Western College Publishing. All rights reserved. 22–10 Financial Ratios for Retail Computer and Software Stores (Industry Code No. 5734) Source: Adapted from RMA 2001–2002 Annual Statement Studies published by Robert Morris Associates, Philadelphia, Pa. Copyright Robert Morris Associates, 2001.

11. Copyright © by South-Western College Publishing. All rights reserved. 22–11 Income Statement for Bates & Associates Leasing Company for the Year Ending December 31, 2002 Sales revenue$850,000 Cost of goods sold_550,000 Gross profit$300,000 Operating expenses: Marketing expenses$90,000 General and administrative expenses 80,000 Depreciation _30,000 Total operating expenses$200,000 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. 22.1

12. Copyright © by South-Western College Publishing. All rights reserved. 22–12 Balance Sheets for Bates & Associates Leasing Company for December 31, 2001 and 2002 Assets Current assets: Cash$ 45,000$ 50,000$ 5,000 Accounts receivable75,00080,0008,000 Inventories180,000220,00040,000 Total current assets$300,000$350,000$ 50,000 Fixed assets: Gross plant and equipment $790,000$890,000$ 100,000 Accumulated depreciation ( 360,000)( 390,000)( 30,000) Net plant and equipment$430,000$500,000$ 70,000 Land 70,000 0 Total fixed assets$500,000$570,000$ 70,000 TOTAL ASSETS$800,000$920,000$120,000 Changes20022001 70,000 Fig. 22.2a

13. Copyright © by South-Western College Publishing. All rights reserved. 22–13 Balance Sheets for Bates & Associates Leasing Company for December 31, 2001 and 2002 (cont’d) Debt (Liabilities) and Equity Current liabilities: Accounts payable and accruals$ 15,000$ 20,000$ 5,000 Short-tern notes 60,000 80,000 20,000 Total current liabilities$ 75,000$100,000$ 25,000 Long-term notes payable 150,000 200,000 50,000 Total liabilities$225,000$300,000$ 75,000 Common stock$300,000$300,000$ 0 Retained earnings 275,000 320,000 5,000 Total stockholders’ equity$575,000$620,000$ 45,000 TOTAL DEBT AND EQUITY $800,000$920,000$120,000 Changes20022001 Fig. 22.2b

14. Copyright © by South-Western College Publishing. All rights reserved. 22–14 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 = 2.70

15. Copyright © by South-Western College Publishing. All rights reserved. 22–15 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 = 1.25 liabilitiesCurrent Inventories - assetsCurrent ratio Acid-test  1.30 $100,000 $220,000 - $350,000 ratio  Acid-test

16. Copyright © by South-Western College Publishing. All rights reserved. 22–16 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 = 35 days

17. Copyright © by South-Western College Publishing. All rights reserved. 22–17 Measuring Liquidity: Approach II Account Receivable Turnover Ratio –The number of time accounts receivable “roll over” during a year. Industry norm for accounts receivable turnover = 10.43

18. Copyright © by South-Western College Publishing. All rights reserved. 22–18 Measuring Liquidity: Approach II Inventory turnover –The number of times inventories “roll over” during the year. Industry norm for inventory turnover = 4.00

19. Copyright © by South-Western College Publishing. All rights reserved. 22–19 Fig. 22-3 Return on Invested Capital: An Overview

20. Copyright © by South-Western College Publishing. All rights reserved. 22–20 Measuring Return on Investment (ROI) A measure of operating profits relative to total assets Industry norm for OIROI: 13.20% assets Total Sales X profits Operating Operating income return on investment  AssetsTotal income Operating  Operating income return on investment 10.87% 000 $920, $100,000  Operating income return on investment

21. Copyright © by South-Western College Publishing. All rights reserved. 22–21 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: 11.0%

22. Copyright © by South-Western College Publishing. All rights reserved. 22–22 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 = 1.20

23. Copyright © by South-Western College Publishing. All rights reserved. 22–23 Measuring Return on Investment (ROI) Operating Income Return on Investment Operating income return on investment = Operating profit margin X Total asset turnover.1176 x 0.92 Operating income return on investment = = 10.82% Industry norm for OIROI = 13.20%

24. Copyright © by South-Western College Publishing. All rights reserved. 22–24 Turnover Ratios Accounts receivable turnover Inventory turnover Fixed asset turnover Industry Norm 10.43 4.00 2.50

25. Copyright © by South-Western College Publishing. All rights reserved. 22–25 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%

26. Copyright © by South-Western College Publishing. All rights reserved. 22–26 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

27. Copyright © by South-Western College Publishing. All rights reserved. 22–27 Return on Investment Return on equity –The rate of return that owners earn on their investment. Industry norm for return on equity = 12.5%