Evaluating Financial Performance Part 6 Understanding the Numbers

Looking Ahead After studying this chapter, you should be able to: Identify the basic requirements for an accounting system. Explain two alternative accounting options. Describe the purpose of and procedures related to internal control. Evaluate a firm’s ability to pay its bills as they come due. Assess a firm’s overall profitability on its asset base. Measure a firm’s use of debt and equity financing. Evaluate the rate of return earned on the owners’ investment. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

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 Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

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 Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

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 Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

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. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

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 Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

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 Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Evaluating Financial Performance Can a Firm Meet Its Financial Commitments? Can you pay your bills when they come due? Are you making a good return on your assets? How much debt are your using, and what are the implications for the firm’s future? Are you getting a good return on your investments? Financial Ratios Restatements of selected income statement and balance sheet data in relative terms Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Financial Ratios for Retail Computer and Software Stores, 2003 *Based on cost of goods sold. †Not reported in the RMA data, but computed by multiplying the operating profit margin times the total asset turnover. Note: RMA cautions that the Studies be regarded only as a general guideline and not as an absolute industry norm. This is due to limited samples within categories, the categorization of companies by their primary Standard Industrial Classification (SIC) number only, and different methods of operations by companies within the same industry. For these reasons, RMA recommends that the figures be used only as general guidelines in addition to other methods of financial analysis. Source: Adapted from RMA 2003–2004 Annual Statement Studies, published by Robert Morris Associates, Philadelphia, Pa. Copyright Robert Morris Associates, 2004. Exhibit 23.1 Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Income Statement for Petri & Associates Leasing Company for the Year Ending December 31, 2005 Exhibit 23.2 Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Balance Sheet for Petri & Associates Leasing Company for December 31, 2005 Exhibit 23.3 Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Can You Pay Your Bills? 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 Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Can You Pay Your Bills? (cont’d.) Account Receivable Turnover Ratio The number of time accounts receivable “roll over” during a year Industry norm for accounts receivable turnover = 10.43 Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Can You Pay Your Bills? (cont’d.) Inventory Turnover The number of times inventories “roll over” during the year Industry norm for inventory turnover = 4.00 Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Can You Pay Your Bills? (cont’d.) Acid-Test Ratio (Quick Ratio) A measure of a company’s liquidity that excludes inventories liabilities Current Inventories - assets ratio Acid-test = 1.30 $100,000 $220,000 - $350,000 ratio = Acid-test Industry norm for acid-test ratio = 1.25 Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Can You Pay Your Bills? (cont’d.) Average Collection Period The average time it takes a firm to collect its accounts receivable Industry norm for average collection period = 35 days Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Return on Invested Capital: An Overview Capital invested by the firm's creditors and equity investors (owners) Firm's total assets Profits and cash flows Rate of return on total capital becomes Creditors Equity investors Operating income Total assets Return on creditor's capital equity Interest rate charged on debt Net income Common equity compute equals Shared by Return on Invested Capital: An Overview Exhibit 23.4 Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Are You Making a Good Return on Your Assets? A measure of operating profits relative to total assets Industry norm for OIROI: 13.20% Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Are You Making a Good Return on Your Assets? (cont’d.) 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% Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Are You Making a Good Return on Your Assets? (cont’d.) 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 Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Are You Making a Good Return on Your Assets? (cont’d.) Operating Income Return on Assets Operating profit margin Total asset turnover = Return on Assets X = = .1176 x 0.92 10.82% Industry ROA = 11.0% x 1.2 = 13.20% Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Accounts receivable turnover Turnover Ratios Industry Norm Accounts receivable turnover 10.43 Inventory turnover 4.00 Fixed asset turnover 2.50 Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

How Much Debt Are You Using? 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% Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

How Much Debt Are You Using? Times Interest Earned Ratio The ratio of operating income to interest charges Industry norm for time interest earned = 4.00 Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Are You Getting a Good Rate of Return on Your Investment? Return on equity The rate of return that owners earn on their investment Industry norm for return on equity = 12.5% Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Financial Ratio Analysis for Petri & Associates Leasing Company Exhibit 23.5 Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Financial Ratio Analysis for Petri & Associates Leasing Company Exhibit 23.5 (cont’d) Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Financial Ratio Analysis for Petri & Associates Leasing Company Exhibit 23.5 (cont’d) Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

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 Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.