1. PowerPoint Presentation by Charlie Cook The University of West Alabama Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. Part 6 Understanding the Numbers Evaluating Financial Performance

2. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. Student 23–2 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 ability to pay its bills as they come due. 5. Assess a firm’s overall profitability on its asset base. 6. Measure a firm’s use of debt and equity financing. 7. Evaluate the rate of return earned on the owners’ investment.

3. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. Student 23–3 Accounting System Requirements An accounting system structures the flow of financial information to provide a complete picture of financial activities. –Financial reports should be computer-generated. –The system should be accurate and thorough, allow a quick comparison of data over the years of operation, provide financial statements, facilitate filing of reports and tax returns, and reveal internal problems such as fraud and record-keeping errors. –In addition to the balance sheet and income statement, an accounting system should provide internal records that show accounts receivable, accounts payable, inventories, payroll, cash, and fixed assets, as well as insurance policies, leaseholds, and outside investments.

4. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. Student 23–4 Alternative Accounting Options Accounting systems may use either cash or accrual methods and may be structured as either single-entry or double-entry systems. With the cash method of accounting, transactions are recorded only when cash is received or a payment is made; the accrual method of accounting matches revenue earned against expenses associated with it. A single-entry system is basically a checkbook system of receipts and disbursements; a double-entry system of accounting requires that each transaction be recorded twice.

5. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. Student 23–5 Internal Controls Internal control refers to a system of checks and balances designed to safeguard a firm’s assets and enhance the accuracy and reliability of its financial statements. Some examples of internal control procedures are separation of employees’ duties, limiting access to accounting records and computer facilities, and safeguarding blank checks. Building internal controls within a small business is difficult but important.

6. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. Student 23–6 Paying the Bills Liquidity is a firm’s capacity to meet its short-term obligations. One way of measuring a firm’s liquidity is to compare its liquid assets (cash, accounts receivable, and inventories) and its short-term debt, using the current ratio. A second way to measure liquidity is to determine the time it takes to convert accounts receivable and inventories into cash, by computing the accounts receivable turnover and the inventory turnover.

7. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. Student 23–7 Assessing a Firm’s Overall Profitability Operating profitability is evaluated by determining if the firm is earning a good return on its total assets, through computation of the return on assets. The return on assets can be separated into two components—the operating profit margin and the total asset turnover—to gain more insight into the firm’s operating profitability. The operating profit margin is determined by dividing operating profits by sales. The total asset turnover is computed by dividing sales by total assets.

8. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. Student 23–8 Measures of Debt and Equity Financing The debt ratio (total debt divided by total assets) can be used to measure how much debt a firm uses in its financing mix. A firm’s ability to cover interest charges on its debt can be measured by the times interest earned ratio (operating income divided by interest expense).

9. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. Student 23–9 Rate of Return on the Owner’s Investment The accounting return on the owner’s investment (return on equity) is measured by dividing net income by the common equity invested in the business. The return on equity is a function of: –(1) the firm’s return on assets less the interest paid –(2) the amount of debt used relative to the amount of equity financing

10. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. Student 23–10 Key Terms single-entry system double-entry system internal control financial ratios accounts receivable turnover inventory turnover operating profit margin total asset turnover fixed asset turnover financial leverage times interest earned ratio