1. CENTURY 21 ACCOUNTING © Thomson/South-Western LESSON 17-2 Calculating Earnings Performance and Efficiency Analysis

2. CENTURY 21 ACCOUNTING © Thomson/South-Western EARNINGS PERFORMANCE ANALYSIS The amount & consistency of earnings are important measures of a business’s success. Managers, owners, & creditors are interested in an analysis of earnings performance Five earnings performance ratios: Rate earned on average total assets Rate earned on average stockholders equity Rate earned on net sales Earnings per share Price-earnings ratio 2 LESSON 17-2

3. CENTURY 21 ACCOUNTING © Thomson/South-Western 3 LESSON 17-2 page 503 RATE EARNED ON AVERAGE TOTAL ASSETS December 31 Total Assets January 1 Total Assets Average Total Assets +=÷2 ($1,759,700.00 += $1,913,700.00$2,067,700.00) ÷2 The rate found by dividing net income after federal income tax by average total assets is known as the rate earned on average total assets To find average total assets add the beginning assets and the ending assets and divide by 2 Current YearPrior Year January 1 Total Assets$1,759,700.00$1,437,600.00 December 31 Total Assets2,067,700.001,759,700.00 Average Total Assets1,913,700.001,598,650.00

4. CENTURY 21 ACCOUNTING © Thomson/South-Western 4 LESSON 17-2 CALCULATING THE RATE EARNED ON AVERAGE TOTAL ASSETS page 504 Current YearPrior Year Net Income after Federal Income Tax$ 222,300.00$128,400.00 Average Total Assets1,913,700.001,598,650.00 Rate Earned on Average Total Assets11.6%8.0% Average Total Assets Net Income after Federal Income Tax Rate Earned on Average Total Assets ÷= $222,300.00÷=11.6%$1,913,700.00 The rate found by dividing net income after federal income tax by average total assets is known as the rate earned on average total assets Shows how well a business is using its assets to earn net income

5. CENTURY 21 ACCOUNTING © Thomson/South-Western 5 LESSON 17-2 CALCULATING THE RATE EARNED ON AVERAGE TOTAL ASSETS page 504 Current YearPrior Year Net Income after Federal Income Tax$ 222,300.00$128,400.00 Average Total Assets1,913,700.001,598,650.00 Rate Earned on Average Total Assets11.6%8.0% An 11.6% rate earned on average total assets means that for each $1 of assets, the business earned 11.6 cents in the current year. The company will compare this rate to rates of return on alternative investments (bonds, etc.) Goal is to earn a rate of return that is at least as high as other types of investments. If the average investment sources available to this company are earning 10% then the rate earned on total assets is satisfactory

6. CENTURY 21 ACCOUNTING © Thomson/South-Western RATE OF RETURN ON AVERAGE STOCKHOLDER’S EQUITY 6 LESSON 17-2  Investors compare the rate earned on stockholders’ equity for several businesses to determine the best investment  If a business’s rate earned on stockholders’ equity increases significantly and is at or above industry comparisons then the rate is considered satisfactory

7. CENTURY 21 ACCOUNTING © Thomson/South-Western 7 LESSON 17-2 RATE OF RETURN EARNED ON AVERAGE STOCKHOLDERS’ EQUITY Average Total Stockholders’ Equity Net Income after Federal Income Tax Rate Earned on Average Stockholders’ Equity ÷= $222,300.00÷=23.4%$950,450.00 December 31 Stockholders’ Equity January 1 Stockholders’ Equity Average Total Stockholders’ Equity +=÷2 ($849,300.00 += $950,450.00$1,051,600.00) ÷2 page 505 Calculate average stockholders’ equity (Jan. 1 total stockholders’ equity is the same as the total stockholders’ equity on the prior year’s Dec. 31 balance sheet) Divide net income after federal income taxes by average total stockholders’ equity to determine the rate earned on average total assets.

8. CENTURY 21 ACCOUNTING © Thomson/South-Western RATE EARNED ON NET SALES 8 LESSON 17-2 A business that carefully controls costs should earn a consistent rate on net sales from year to year. The rate found by dividing net income after federal income tax by net sales is called the rate earned on net sales When determining what is normal businesses that are similar are compared. If the rate on net sales is lower than the industry standard it is considered unsatisfactory If the rate is unsatisfactory the business must increase sales or reduce costs to maintain an acceptable rate

9. CENTURY 21 ACCOUNTING © Thomson/South-Western 9 LESSON 17-2 page 506 RATE EARNED ON NET SALES Net Income after Federal Income Tax ÷ Net Sales = Rate Earned on Net Sales ÷ $4,767,200.00 = 4.7%$222,300.00 The component percentage for net income after federal income tax is the same percentage as the rate earned on net sales

10. CENTURY 21 ACCOUNTING © Thomson/South-Western EARNINGS PER SHARE 10 LESSON 17-2  The amount of net income earned on one share of common stock during a fiscal period is known as earnings per share  Stockholders & management frequently use earnings per share as a measure of success  As earnings per share increase, more people become interested in buying stock and stock prices go up  Increases in earnings per share signal stockholders that the company is continuing to increase the net income earned for each share.

11. CENTURY 21 ACCOUNTING © Thomson/South-Western 11 LESSON 17-2 page 507 EARNINGS PER SHARE Net Income after Federal Income Tax ÷= Earnings per Share Shares of Capital Stock Outstanding = $3.71 $222,300.00 ÷ 60,000.00

12. CENTURY 21 ACCOUNTING © Thomson/South-Western 12 LESSON 17-2 page 508 PRICE-EARNINGS RATIO Earnings per Share Market Price per Share Price-Earnings Ratio ÷= $43.50÷=11.7 times$3.71 Investors want to buy stock in companies that will earn a reasonable return on their investment The relationship between the market value per share of stock and the earnings per share is known as the price-earnings ratio Relates profitability to the amount that the investors currently pay for the stock Usually expressed as a ratio

13. CENTURY 21 ACCOUNTING © Thomson/South-Western 13 LESSON 17-2 page 508 PRICE-EARNINGS RATIO Earnings per Share Market Price per Share Price-Earnings Ratio ÷= $43.50÷=11.7 times$3.71 A comparison to last year’s price-earnings ratio indicates an increase from 9.5 to 11.7 The change indicates that investors considered the stock more valuable & were willing to pay more for the stock per dollar earned by the company in the current year. This is considered a favorable trend.

14. CENTURY 21 ACCOUNTING © Thomson/South-Western EFFICIENCY ANALYSIS 14 LESSON 17-2 The profitability & continued growth of a business are influenced by how efficiently the business utilizes its assets The operating cycle of a merchandising business consists of 3 phases: Purchase merchandise Sell merchandise, frequently on account Collect the accounts receivable The faster a business can convert accounts receivable and merchandise inventory into cash, the more efficient & profitable the business will be

15. CENTURY 21 ACCOUNTING © Thomson/South-Western ACCOUNTS RECEIVABLE TURNOVER RATIO 15 LESSON 17-2 A business accepts accounts receivable to encourage sales. However, the earnings process is not complete until the business receives cash for sales on account An efficient company closely monitors the length of time required to collect its receivables The number of times the average amount of accounts receivable is collected annually is known as the accounts receivable turnover ratio Monitors a business’s accounts receivable collection efficiency

16. CENTURY 21 ACCOUNTING © Thomson/South-Western 16 LESSON 17-2 page 509 ACCOUNTS RECEIVABLE TURNOVER RATIO Average Book Value of Accounts Receivable Net Sales on Account Accounts Receivable Turnover Ratio ÷= $4,767,200.00÷=9.1 times$521,600.00 Ending Book Value of Accounts Receivable Beginning Book Value of Accounts Receivable Average Book Value of Accounts Receivable +=÷2 ($569,200.00 += $521,600.00$474,000.00) ÷2 The turnover ratio indicates accounts receivable are being collected 9.1 times per year. If the terms are n/30 then this amount should be 12 times per year

17. CENTURY 21 ACCOUNTING © Thomson/South-Western 17 LESSON 17-2 page 510 AVERAGE NUMBER OF DAYS FOR PAYMENT Accounts Receivable Turnover Ratio Days in Year Average Number of Days for Payment ÷= 365÷=40 days9.1 To figure the average number of days customers are taking to pay their accounts receivable you would divide the number of days in a year by the accounts receivable turnover ratio. If the terms are n/30 then the 40 days would be considered unsatisfactory

18. CENTURY 21 ACCOUNTING © Thomson/South-Western MERCHANDISE INVENTORY TURNOVER RATIO 18 LESSON 17-2 A company earns income when it sells merchandise – the faster is sells the more efficient & generally more profitable the business The number of times the average amount of merchandise inventory is sold annually is known as the merchandise inventory turnover ratio An optimum merchandise inventory turnover ratio is determined by two factors: Amount of sales Number of days needed to replenish inventory

19. CENTURY 21 ACCOUNTING © Thomson/South-Western 19 LESSON 17-2 page 510 MERCHANDISE INVENTORY TURNOVER RATIO Average Merchandise Inventory Cost of Merchandise Sold Merchandise Inventory Turnover Ratio ÷= $2,602,800.00÷=5.4 times$485,850.00 December 31 Merchandise Inventory January 1 Merchandise Inventory Average Merchandise Inventory +=÷2 ($423,800.00 += $485,850.00$547,900.00) ÷2 The 5.4 turnover ratio indicates that the inventory is being sold 5.4 times in a year. The average number of days’ sales in merchandise inventory is 68 days (365 days\5.4 turnover ratio) If previous experience indicates an inventory turnover ratio of about 6.0 then the turnover ratio is unsatisfactory Would result in lost sales because some items were out of stock before new inventory arrived.

20. CENTURY 21 ACCOUNTING © Thomson/South-Western 20 LESSON 17-2 page 511 TERM REVIEW rate earned on net sales