14-1 PowerPoint Presentation by Douglas Cloud Professor Emeritus of Accounting Pepperdine University © Copyright 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star Logo, and South-Western are trademarks used herein under license. Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc. F13 14 Analysis of Operating Activities Financial Accounting A Bridge to Decision Making Ingram and Albright 6 th edition

14-2ObjectivesObjectives Once you have completed this chapter, you should be able to—

Explain the relationship between product pricing and sales volume in creating revenues and profits. ObjectivesObjectives ContinuedContinued 2.Explain how operating strategy affects a company’s return on assets. 3.Define cost leadership and product differentiation and explain how companies use their strategies to create profits.

Evaluate operating performance by using accrual and cash flow measures. ObjectivesObjectives 5.Examine the return on equity and explain how operating, investing, and financing activities are interconnected. 6.Describe the primary components of an accounting system and how they are useful for understanding business activities.

14-51 ObjectiveObjective Explain the relationship between product pricing and sales volume in creating revenues and profits.

14-6 Operating Decisions Net income = revenues – expenses Return on assets net income operating revenues operating revenues total assets = x total assets Return on assets net income = OR

14-7 Exhibit 1 Summary of Expected Assets and Expected Operating Results for Favorite Cookie Company (in thousands) Assets Initial Investment Operating Results Year 1 Year 2 Assets Initial Investment Operating Results Year 1 Year 2 Current assets $1,000Sales revenues$3,000$,3600 Plant assets 4,000Cost of ingredients(800)(960) Total assets$5,000Depreciation(300)(300) Wages and benefits(700)(700) Other operating exp.(1,000)(1,000) Operating income Interest expense (20) (20) Pretax income Income taxes (54) (186) Net income$ 126$ 434

Explain how operating strategy affects a company’s return on assets. ObjectiveObjective

14-9 Developing an Operating Strategy Profit margin = Net income Sales revenue Profit margin is a measure of a company’s ability to create profit from its sales.

14-10 Developing an Operating Strategy Asset turnover = Sales revenue Total assets Asset turnover is a measure of a company’s ability to generate sales from its investment in assets.

14-11 Developing an Operating Strategy Return on assets is a combination of profit margin and asset turnover. Return on assets = Profit margin x Asset turnover

14-12 Developing an Operating Strategy If return on assets is low, a company must sell a lot of its products to earn a reasonable profit.

14-13 Developing an Operating Strategy Favorite Cookie Company’s primary challenge in the first couple of years is to get the product into the hands of customers. Once customers are sold on the product’s value, then the company can consider higher prices.

14-14 Expected Return on Assets for Favorite Cooking Company in Year 2 (Based on Exhibit 3) Profit margin = Net income Sales revenue = $434,000 $3,600,000 = 12.06%

14-15 Expected Return on Assets for Favorite Cooking Company in Year 2 (Based on Exhibit 3) = $3,600,000 $5,000,000 = Asset turnover = Sales revenue Total assets

14-16 Expected Return on Assets for Favorite Cooking Company in Year 2 (Based on Exhibit 3) Return on assets = Profit margin x Asset turnover = 12.06% x = 8.68%

Define cost leadership and product differentiation, and explain how companies use these strategies to create profits. ObjectiveObjective

14-18 Exhibit 4 Profit Margin, Asset Turnover, and Return on Assets for Microsoft and Proctor & Gamble Microsoft Proctor & Gamble Microsoft Proctor & Gamble (in millions) Net income$ 8,168$ 7,531$ 6,481$ 5,186 Total revenues36,83532,18751,40743,377 Total assets92,38981,73257,04843,706 Asset turnover Profit margin Return on assets %% %% %% %%

14-19 Cost Leadership and Product Differentiation Strategies Companies that keep their prices low to generate high sales volume use a cost leadership strategy.

14-20 Cost Leadership and Product Differentiation Strategies Companies that keep their prices low to generate high sales volume use a cost leadership strategy. High profit margin companies use a product differentiation strategy.

14-21 Exhibit 5 Cost Leadership and Product Differentiation as Alternative Operating Strategies Operating Strategy Profit Margin Asset Turnover Operating Strategy Profit Margin Asset Turnover Cost LeadershipLowHigh Product DifferentiationHighLow

14-22 Cost Leadership and Product Differentiation Strategies Cost leadership and product differentiation are two ends of a competitive spectrum.

14-23 Cost Leadership and Product Differentiation Strategies Cost leadership and product differentiation are two ends of a competitive spectrum. Microsoft falls closer toward the product differentiation end than does Proctor & Gamble.

14-24 Partial Exercise 14-9 Click the button to skip this exercise. If you experience trouble making the button work, type 27 and press “Enter.” The numbers below are from the 2004 annual reports of two major airlines. Southwest Airlines Delta Air Lines Southwest Airlines Delta Air Lines (in millions) Sales$6,530$5,937$15,002$14,087 Net income (loss)313442(5,198)(773) Total assets11,3379,87821,80125,939 ContinuedContinued

14-25 Partial Exercise 14-9 Southwest Airlines Delta Air Lines Southwest Airlines Delta Air Lines (in millions) Sales$6,530$5,937$15,002$14,087 Net income (loss)313442(5,198)(773) Total assets11,3379,87821,80125,939 Calculate return on assets, asset turnover, and profit margin. Which airline appears to be more successful? Press “Enter” or left click the mouse for solution.

14-26 Partial Exercise 14-9 Southwest Airlines Delta Air Lines Southwest Airlines Delta Air Lines (in millions) Profit margin 4.79%7.44%–34.65%–5.49% Asset turnover Return on assets2.76%4.47%–23.84%–2.98% The airlines have similar asset turnover ratios. Southwest has positive profit margins, while Delta’s profit margins are negative. Thus, our ratio analysis suggests Southwest is doing a better job of controlling costs.

Evaluate operating performance by using accrual and cash flow measures. ObjectiveObjective

14-28 Comparing Accrual and Cash Flow Measures of Operating Performance The ratio of operating cash flow to total assets is useful for comparing the operating cash flows of different companies. It is a measure of cash flow generated during a period through the use of assets to produce and sell goods and services.

14-29 Exhibit 6 A Comparison of Operating Cash Flows for Microsoft and Proctor & Gamble. Microsoft Proctor & Gamble Microsoft Proctor & Gamble (in millions) Net income$8,168$7,531$6,481$5,186 Depreciation and amortization1,1861,3931,7331,703 Other adjustments5,2726,8731,1481,811 Net cash from operations Operating cash flows to total assets15.8%19.3%16.4%19.9%

14-30 Further Evaluation of Operating Strategy Inventory turnover is the ratio of cost of goods sold to inventory. It measures the success of a company in converting its investment in inventory into sales.

14-31 Inventory turnover = Cost of goods sold Inventories $6,716,000,000 $640,000, = Microsoft—2004 Further Evaluation of Operating Strategy

14-32 Inventory turnover = Cost of goods sold Inventories $25,076,000,000 $4,400,000, = Proctor & Gamble—2004 Further Evaluation of Operating Strategy

14-33 Further Evaluation of Operating Strategy A ratio related to inventory turnover is days’ sales in inventory, the ratio of inventory to average daily cost of goods sold.

14-34 Further Evaluation of Operating Strategy Microsoft—2004 Days’ sales in inventory Inventories Cost of good sold ÷ 365 $640,000,000 $18,400, = = $6,716,000,000 ÷ 365

14-35 Further Evaluation of Operating Strategy Proctor & Gamble—2004 Days’ sales in inventory Inventories Cost of good sold ÷ 365 $4,400,000,000 $68,701, = = $25,076,000,000 ÷ 365

14-36 Accounts receivable turnover measures the success of a company’s ability to convert revenues into cash. Further Evaluation of Operating Strategy

14-37 $36,835,000,000 $5,890,000, = Further Evaluation of Operating Strategy Sales revenue Receivables = Accounts receivable turnover Microsoft—2004

14-38 $51,407,000,000 $4,062,000, = Further Evaluation of Operating Strategy Sales revenue Receivables = Accounts receivable turnover Proctor & Gamble—2004

14-39 Further Evaluation of Operating Strategy A ratio related to accounts receivable turnover is average collection period, the ratio of accounts receivable to average daily sales.

14-40 Further Evaluation of Operating Strategy $5,890,000,000 $100,917, days = Receivables Sales revenue ÷ 365 = Average Collection Period Microsoft—2004 $36,835,000,000 ÷ 365

14-41 Further Evaluation of Operating Strategy $4,062,000,000 $140,841, days = Receivables Sales revenue ÷ 365 = Average Collection Period Proctor & Gamble—2004 $51,407,000,000 ÷ 365

14-42 Further Evaluation of Operating Strategy The fixed asset turnover measures the effectiveness of a company in using its investment in fixed assets to create sales.

14-43 Further Evaluation of Operating Strategy $36,835,000,000 $2,326,000, = Sales revenue Plant assets = Fixed asset turnover Microsoft—2004

14-44 Further Evaluation of Operating Strategy $51,407,000,000 $14,108,000, = Sales revenue Plant assets = Fixed asset turnover Proctor & Gamble—2004

14-45 Gross profit margin measures efficiency in the production or purchase of goods for sale. Further Evaluation of Operating Strategy

14-46 Further Evaluation of Operating Strategy Gross profit Sales revenue $30,119,000,000 $36,835,000, % = = Gross profit margin Microsoft—2004

14-47 Further Evaluation of Operating Strategy Gross profit Sales revenue $26,331,000,000 $51,407,000, % = = Gross profit margin Proctor & Gamble—2004

14-48 Operating profit margin is an indicator of a company’s efficiency in controlling operating costs other than product costs. Further Evaluation of Operating Strategy

14-49 Further Evaluation of Operating Strategy Operating income Sales revenue $27,801,000,000 $36,835,000, % = = Operating profit margin Microsoft—2004

14-50 Further Evaluation of Operating Strategy Operating income Sales revenue $9,827,000,000 $51,407,000, % = = Operating profit margin Proctor & Gamble—2004

14-51 Exercise Click the button to skip this exercise. If you experience trouble making the button work, type 55 and press “Enter.” Using the income statement for Crystal Corporation on the next slide, calculate three ratios that indicate the efficiency and interpret the results for Crystal Corporation. ContinuedContinued

14-52 Exercise Sales revenue$50,000 Less: Cost of goods sold 25,000 Gross profit$25,000 Other operating expenses: Advertising$3,000 Utilities3,500 Wages 2,500 9,000 Operating income$16,000 Less: Income taxes 5,600 Net income$10,400 Crystal Corporation Income Statement For the Year Ending December 31, 2007 Press “Enter” or left click the mouse for solution.

14-53 Exercise Gross profit margin= Gross profit ÷ Sales revenue = $25,000 ÷ $50,000 = 50%ContinuedContinued Operating profit margin = Operating income ÷ Sales revenue = $16,000 ÷ $50,000 = 32%

14-54 Exercise For every dollar of sales revenue that Crystal Corporation earns, it realizes $0.50 in gross profit, which includes $0.32 of operating profit, which in turn includes $0.21 in net income. Profit margin= Net income ÷ Sales revenue = $10,400 ÷ $50,000 = 20.8%

Examine return on equity and explain how operating, investing, and financing activities are interconnected. ObjectiveObjective

14-56 Net income Equity Net income Equity Linking Operating and Investing Activities with Financing Activities Return on Equity Profit Margin Financial Leverage Asset Turnover = xx Net income Sales Revenues Net income Sales Revenues Total Assets Sales Revenues Total Assets Equity Total Assets Equity = xx

14-57 Linking Operating and Investing Activities with Financing Activities Another ratio to measure financial risk is times interest earned. Microsoft had no interest expense in 2004, so times interest earned cannot be calculated.

14-58 Linking Operating and Investing Activities with Financing Activities $9,827,000,000 $629,000, = Operating income Interest expense = Times interest earned Proctor & Gamble—2004

Describe the primary components of an accounting system and how they are useful for understanding business activities. ObjectiveObjective

14-60 Exhibit 8 Accounting and Business Decisions Transformation ProcessActivities Investing FinancingOperating Accounting SystemInformation Investing FinancingOperating Decision MakersDecisions Investing FinancingOperating

14-61 The Big Picture A business is a transformation process in which— 1.financial resources are obtained through financing activities, 2.financial resources are used to acquire other resources through investing activities, and 3.resources are used to produce and sell goods and services through operating activities.

14-62 Exhibit 9 The Accounting Information System

14-63 The Accounting Cycle 1.Examining business activities 2.Recording transactions 3.Updating account balances 4.Making end-of-period adjustments 5.Preparing financial statements 6.Closing revenue and expense accounts Steps in the accounting cycle include:

14-64 Exhibit 10 Using Accounting Information to Make Decisions About Company Value

14-65 T HE E ND C HAPTER 14

14-66