PowerPoint Presentation by Charlie Cook The University of West Alabama Longenecker Moore Petty Palich © 2008 Cengage Learning. All rights reserved. CHAPTER 23 Evaluating Firm Performance Understanding What the Numbers Mean Part 6

© 2008 Cengage Learning. All rights reserved.23–2 Looking AHEAD 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. After you have read this chapter, you should be able to:

© 2008 Cengage Learning. All rights reserved.23–3 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.

© 2008 Cengage Learning. All rights reserved.23–4 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

© 2008 Cengage Learning. All rights reserved.23–5 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

© 2008 Cengage Learning. All rights reserved.23–6 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.

© 2008 Cengage Learning. All rights reserved.23–7 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.

© 2008 Cengage Learning. All rights reserved.23–8 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:  Identify transactions requiring owner authorization  Ensure checks have supporting documentation  Limit access to accounting records and computers  Send bank statements directly to the owner  Safeguard blank checks  Require employees to take vacations

© 2008 Cengage Learning. All rights reserved.23–9 Evaluating The Firm’s Financial Performance Can a Firm Meet Its Financial Commitments?  Can it pay its bills when they come due?  Is it making a good return on your assets?  How much debt is it using, and what are the implications for the firm’s future?  Is it creating a good return on equity investments? Financial Ratios  Restatements of selected income statement and balance sheet data in relative terms

© 2008 Cengage Learning. All rights reserved.23–10 Financial Ratios for Retail Computer and Software Stores, 2006– Source: Adapted from RMA 2006–2007 Annual Statement Studies, published by Robert Morris Associates, Philadelphia, Pa. Copyright Robert Morris Associates, *Not applicable. Firms in this group have a negative equity on average, preventing computation of return on equity. 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.

© 2008 Cengage Learning. All rights reserved.23–11 Income Statement for Trimble & Associates Leasing, Inc., for the Year Ending December 31,

© 2008 Cengage Learning. All rights reserved.23–12 Balance Sheet for Trimble & Associates Leasing, Inc., for December 31,

© 2008 Cengage Learning. All rights reserved.23–13 Can the Firm Pay Its Bills as They Come Due? 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

© 2008 Cengage Learning. All rights reserved.23–14 Can the Firm Pay Its Bills as They Come Due? (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

© 2008 Cengage Learning. All rights reserved.23–15 Can the Firm Pay Its Bills as They Come Due? (cont’d) Inventory Turnover  The number of times inventories “roll over” during the year. Industry norm for inventory turnover = 4.00

© 2008 Cengage Learning. All rights reserved.23–16 Can the Firm Pay Its Bills as They Come Due? (cont’d) Acid-Test Ratio (Quick Ratio)  A measure of a company’s liquidity that excludes inventories. Industry norm for acid-test ratio = 1.25 liabilitiesCurrent Inventories - assetsCurrent ratio Acid-test  1.30 $100,000 $220,000 - $350,000 ratio  Acid-test

© 2008 Cengage Learning. All rights reserved.23–17 Can the Firm Pay Its Bills as They Come Due? (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

© 2008 Cengage Learning. All rights reserved.23–18 Return on Assets: An Overview 23-4

© 2008 Cengage Learning. All rights reserved.23–19 Return on Equity: An Overview 23-5

© 2008 Cengage Learning. All rights reserved.23–20 Is the Business Providing a Good Return on Its Assets? Return on Assets  A measure of operating profits relative to total assets Industry norm for OIROI: 13.20%

© 2008 Cengage Learning. All rights reserved.23–21 Is the Business Providing a Good Return on Its 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%

© 2008 Cengage Learning. All rights reserved.23–22 Is the Business Providing a Good Return on Its 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

© 2008 Cengage Learning. All rights reserved.23–23 Is the Business Providing a Good Return on Its Assets? (cont’d) Operating Income Return on Assets Return on Assets = Operating profit margin X Total asset turnover.1176 x 0.92 = = 10.82% Industry ROA = 11.0% x 1.2 = 13.20%

© 2008 Cengage Learning. All rights reserved.23–24 Turnover Ratios Accounts receivable turnover Inventory turnover Fixed asset turnover Industry Norm

© 2008 Cengage Learning. All rights reserved.23–25 How Much Debt Is the Firm 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%

© 2008 Cengage Learning. All rights reserved.23–26 How Much Debt Is the Firm Using? (cont’d) Times Interest Earned Ratio  The ratio of operating income to interest charges Industry norm for time interest earned = 4.00

© 2008 Cengage Learning. All rights reserved.23–27 Are the Owners Getting a Good Rate of Return on Their Equity Investment? Return on equity  The rate of return that owners earn on their investment. Industry norm for return on equity = 12.5%

© 2008 Cengage Learning. All rights reserved.23–28 Financial Ratio Analysis for Trimble & Associates Leasing, Inc. 23-6

© 2008 Cengage Learning. All rights reserved.23–29 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