PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter 13 Measuring and Evaluating Financial Performance

13- 3 Learning Objective 13-1 Describe the purpose and uses of horizontal, vertical, and ratio analysis.

13- 4 Horizontal, Vertical, and Ratio Analyses Horizontal (trend) analyses are conducted to help financial statement users recognize important financial changes that unfold over time. Gross Profit in 2012 Δ in Gross Profit $ and/or % from /31/1212/31/13 Gross Profit in 2013 Trend Analysis Vertical analyses focus on important relationships between items on the same financial statement. Sales Cost of Goods Sold Gross Profit $200, % 150,000 75% $ 50,000 25% AmountPercent 2013

13- 5 Horizontal, Vertical, and Ratio Analyses Ratio analyses are conducted to understand relationships among various items reported in one or more of the financial statements. It is essential to understand that no analysis is complete unless it leads to an interpretation that helps financial statement users understand and evaluate a company’s financial results

13- 6 Learning Objective 13-2 Use horizontal (trend) analysis to recognize financial changes that unfold over time.

13- 7 Horizontal (Trend) Computations Trend analyses are usually calculated in terms of year-to-year dollar and percentage changes.

13- 8 Now let’s look at the remainder of the trend analysis of the Income Statement. Can you calculate the dollar and percentage change for Cost of Sales? Now let’s calculate the percentage change in Net Sales Revenue between 2009 and Horizontal (Trend) Computations Calculate the change in dollars for Net Sales Revenue between 2010 and $48,815 – $47,220 $47,220 × 100

13- 9 Learning Objective 13-3 Use vertical (common size) analysis to understand important relationships within financial statements.

Vertical (Common Size) Computations Vertical, or common size, analysis focuses on important relationships within financial statements. Income Statement Balance Sheet Sales = 100% Total Assets = 100% Cost of Sales Net Sales Revenue × 100

Learning Objective 13-4 Calculate financial ratios to assess profitability, liquidity, and solvency.

Ratio Computations Ratio analysis compares the amounts for one or more line items to the amounts for other line items in the same year. Ratios are classified into three categories... Profitability ratios examine a company’s ability to generate income. Profitability ratios examine a company’s ability to generate income. Liquidity ratios help us determine if a company has sufficient current assets to repay liabilities when due. Liquidity ratios help us determine if a company has sufficient current assets to repay liabilities when due. Solvency ratios examine a company’s ability to pay interest and repay debt when due. Solvency ratios examine a company’s ability to pay interest and repay debt when due.

Common Profitability Ratios

Common Liquidity Ratios

Common Solvency Ratios

Learning Objective 13-5 Interpret the results of financial analyses.

Interpreting Horizontal and Vertical Analyses Lowe’s assets grew only by 2.1% in fiscal Lowe’s began relying more on debt and less equity financing. Long-term liabilities increased 28.7 percent and stockholders’ equity decreased by 5%.

Interpreting Horizontal and Vertical Analyses Cost of sales and operating expenses are the most important determinants of the company’s profitability. The increase in Net Income in fiscal 2010 is explained by the increase in Net Sales Revenue and the decreases in Cost of Sales and Operating Expenses as a percentage of sales.

Interpreting Horizontal and Vertical Analyses Lowe’s has experienced a small decrease in its percentage of Cost of Sales in relation to Sales Revenue from fiscal 2009 to Decreasing cost of sales means higher Gross Profit. Lowe’s did a better job of controlling its Operating Expenses between 2009 and 2010.

Ratio Calculations

Ratio Calculations

Profitability Ratios Net Profit Margin – The slowly improving economy helped boost Lowe’s profits in 2010 as shown by the increase in Net Profit Margin. Gross Profit Percentage – Lowe’s gross profit percentage indicates how much profit was made on each dollar of sales after deducting the Cost of Goods Sold.

Profitability Ratios Asset Turnover Ratio – indicates the amount of sales revenue generated for each dollar invested in assets during the period. Fixed Asset Turnover – indicates how much revenue the company generates in sales for each dollar invested in fixed assets, Home Depot 2010 fixed asset turnover ratio was 2.69

Profitability Ratios Return on Equity (ROE) – Compares the amount of net income to average stockholders’ equity. ROE reports the net amount earned during the period as a percentage of each dollar contributed by stockholders and retained in the business. Earnings Per Share (EPS) – Shows the amount of earnings generated for each share of outstanding common stock.

Profitability Ratios Price /Earnings (P/E) Ratio – Shows the relationship between EPS and the market price of one share of the company’s stock.

Liquidity Ratios Let’s change our attention to an examination of liquidity ratios. The analyses in this section focus on the company’s ability to survive in the short term, by converting assets to cash that can be used to pay current liabilities as they come due.

Liquidity Ratios Inventory Turnover Ratio – The inventory turnover ratio indicates how frequently inventory is bought and sold. The “days to sell” indicates the average number of days needed to sell each purchase of inventory. Home Depot sells its inventory in an average of 85 days in Current Ratio – The current ratio measures the company’s ability to pay its current liabilities

Liquidity Ratios Quick Ratio – The quick ratio is a much more stringent test of short- term liquidity than is the current ratio. Lowe’s quick ratio increased slightly in 2010, just as its current ratio did. Referred to as “quick assets.” Let’s examine some Solvency Ratios Solvency ratios focus on a company’s ability to survive over the long term, that is, its ability to repay debt at maturity and pay interest prior to that time.

Solvency Ratios Debt to Assets Ratio – indicates the proportion of total assets that creditors finance. In 2010, The Home Depot had a debt-to-assets ratio of 53 percent. Times Interest Earned – indicates how many times the company’s interest expense was covered by its operating results.

End of Chapter 13