Chapter 13Copyright © 2010 by Nelson Education Ltd. Evaluating and Managing Financial Performance 13 PowerPoint Presentation by Ian Anderson, Algonquin College

Chapter 13Copyright © 2010 by Nelson Education Ltd. Looking Ahead After studying this chapter, you should be able to: 1.Describe the purpose and content of financial statements. 2.Identify the basic requirements for an accounting system. 3.Explain two alternative accounting options. 4.Describe the purpose of and procedures related to internal control. 5.Evaluate a firm’s operating liquidity. …continued 13-2

Chapter 13Copyright © 2010 by Nelson Education Ltd. Looking Ahead 6.Assess a firm’s profitability. 7.Measure a firm’s use of debt or equity financing. 8.Evaluate the rate of return earned on the owner’s investment. 9. Describe the working capital cycle of a small business. 10. Identify the important issues in managing a firm’s cash flows. 11. Explain the key issues in managing accounts receivable, inventory, and accounts payable.

Chapter 13Copyright © 2010 by Nelson Education Ltd. Understanding Financial Statements Financial Statements (Accounting Statements) –Reports of a firm’s financial performance and resources, including an income statement, a balance sheet and a cash flow Helps determine a start-up’s financial requirements Assesses the financial implications of a business plan 13-4

Chapter 13Copyright © 2010 by Nelson Education Ltd. Income Statement –A report showing the profit or loss from a firm’s operations over a given period of time. –“How profitable is the business?” Sales – Expenses = ProfitsSales – Expenses = Profits –Revenue from product or service sales –Costs of producing product or service –Operating expenses (marketing, selling, general and administrative expenses, and depreciation) –Financing costs (interest paid) –Tax payments 13-5

Chapter 13Copyright © 2010 by Nelson Education Ltd. Some Accounting Terms Cost of Goods Sold (COGS) - the cost of producing or acquiring goods or services to be sold by a firm. Operating expenses - consisting of both selling and marketing expenses and administrative expanses. Operating income - earnings before interest and taxes Gross profit - sales less the COGS Financing costs – the amount of interest owed to lenders on borrowed money Net income available to owners (net income) – income that may be distributed to owners or re-invested in the company 13-6

Chapter 13Copyright © 2010 by Nelson Education Ltd. The Income Statement: An Overview 13-7

Chapter 13Copyright © 2010 by Nelson Education Ltd. Income Statement for Computer World Ltd. for the Year Ending December 31, 2008 Exhibit

Chapter 13Copyright © 2010 by Nelson Education Ltd. The Balance Sheet Balance Sheet –Report showing a firm’s assets, liabilities (debt), and owners’ equity at a specific point in time –Outstanding debt + Owner’s equity = Total assets –Snapshot of a business’s financial position at a specific point in time 13-9

Chapter 13Copyright © 2010 by Nelson Education Ltd. The Balance Sheet: Types of Assets Current assets (working capital) –Assets that can be converted to cash within the firm’s operating cycle—cash, accounts receivable, and inventories. Fixed Assets –Relatively permanent resources intended for the use of the firm. –Net fixed assets = gross fixed assets – accumulated depreciation Other Assets –Intangible assets (patents, copyrights, goodwill) 13-10

Chapter 13Copyright © 2010 by Nelson Education Ltd. The Balance Sheet: Types of Financing Debt Capital –Financing provided by a creditor Short-term (current) Debt Accounts payable Accrued expenses Short-term notes Long-Term Debt –Loans and mortgages from banks and other lenders with maturities greater than one year …continued 13-11

Chapter 13Copyright © 2010 by Nelson Education Ltd. The Balance Sheet: Types of Financing Owners’ Equity Capital –Money that the owners invest in the business –Owners are “residual owners” of the firm Creditors have first claim on the assets of the firm. Owners’ Equity = Owners’ investment – Owners’ cash withdrawals Cumulative profits + Owners’ Equity = Owners’ investment + Earnings retained within the firm 13-12

Chapter 13Copyright © 2010 by Nelson Education Ltd. Balance Sheets for Computer World Ltd. for December 31, 2007 and 2008 Exhibit

Chapter 13Copyright © 2010 by Nelson Education Ltd. Balance Sheets for Computer World Ltd. for December 31, 2007 and 2008 Exhibit

Chapter 13Copyright © 2010 by Nelson Education Ltd. The Fit of the Income Statement and the Balance Sheet Exhibit

Chapter 13Copyright © 2010 by Nelson Education Ltd. Cash Flow Measurement: Key Terms Statement of Cash Flows  A financial report that shows changes in a firm’s cash position over a given period of time. Accrual-Basis Accounting  A method of accounting that matches revenues when they are earned against the expenses associated with those revenues

Chapter 13Copyright © 2010 by Nelson Education Ltd. 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

Chapter 13Copyright © 2010 by Nelson Education Ltd. 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 13-18

Chapter 13Copyright © 2010 by Nelson Education Ltd. Computer Software Packages –Chequebook functions –Automatic financial statements preparation –Cash budget tracking –Subsidiary journal accounts preparation Outside Accounting Services –Convenience –Competence –Cost 13-19

Chapter 13Copyright © 2010 by Nelson Education Ltd. 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

Chapter 13Copyright © 2010 by Nelson Education Ltd. Accounting Method Alternatives Single-Entry Versus Double-Entry Systems –Single-entry system A chequebook system of accounting reflecting only receipts and disbursements. –Double-entry system A self-balancing accounting system that uses journals and ledgers

Chapter 13Copyright © 2010 by Nelson Education Ltd. 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 cheques issued have supporting documentation Limiting access to accounting records and computers Sending bank statements directly to the owner Safeguarding blank cheques Requiring employees to take vacations Controlling access to computer facilities 13-22

Chapter 13Copyright © 2010 by Nelson Education Ltd. Assessment of Financial Performance Methods to Interpret Financial Statements –Liquidity - does the firm have the capacity to meet its short-term (one year or less) financial commitments? –Profitability - is the firm producing adequate operating profits on its assets? –Stability - how is the firm financing its assets? –Return - are the owners (shareholders) receiving an acceptable return on their equity? Financial Ratios –Restatements of selected income statement and balance sheet date in relative terms 13-23

Chapter 13Copyright © 2010 by Nelson Education Ltd. Financial Ratios for Retail Electronics and Appliance Stores (Industry SIC Code 5731 and NAICS Code 443) Exhibit

Chapter 13Copyright © 2010 by Nelson Education Ltd. Measures of Liquidity Current Ratio –Comparing cash and near-cash current assets against the debt (current liabilities) coming due and payable within one year. Industry norm for 2008 current ratio = 1.6 …continued 13-25

Chapter 13Copyright © 2010 by Nelson Education Ltd. Measures of Liquidity Acid-test ratio (quick ratio) –A measure of a company’s liquidity that excludes inventories. Industry norm for 2007 acid-test ratio = 0.7 liabilitiesCurrent Inventories - assetsCurrent ratio Acid-test  1.35 $100,000 $210,000 - $345,000 ratio  Acid-test 13-26

Chapter 13Copyright © 2010 by Nelson Education Ltd. Measures of Liquidity Average Collection Period –The average time it takes a firm to collect its accounts receivable. Industry norm for average collection period = 16 days …continued 13-27

Chapter 13Copyright © 2010 by Nelson Education Ltd. Measures of Liquidity Inventory turnover –The number of times inventories “roll over” during the year. Industry norm for inventory turnover = 3.77 times 13-28

Chapter 13Copyright © 2010 by Nelson Education Ltd. Calculate Return on Investment (ROI) A measure of operating profits relative to total assets Industry norm for OIROI: 3.0% assets Total Sales X profits Operating Operating income return on investment (OIROI)  AssetsTotal income Operating  Operating income return on investment or 10.87% 000 $920, $100,000  Operating income return on investment 13-29

Chapter 13Copyright © 2010 by Nelson Education Ltd. Return on Invested Capital: An Overview Exhibit 13-5

Chapter 13Copyright © 2010 by Nelson Education Ltd. Measuring Return on Investment (ROI) 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: 1.8% …continued 13-31

Chapter 13Copyright © 2010 by Nelson Education Ltd. Measuring Return on Investment (ROI) 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 = 3.7 …continued 13-32

Chapter 13Copyright © 2010 by Nelson Education Ltd. Measuring Return on Investment (ROI) Operating Income Return on Investment Operating income return on investment = Operating profit margin X Total asset turnover.1205 x 0.90 Operating income return on investment = = 10.85% Industry norm for OIROI = 1.33% 13-33

Chapter 13Copyright © 2010 by Nelson Education Ltd. Turnover Ratios Accounts receivable turnover Inventory turnover Fixed asset turnover Industry Norm

Chapter 13Copyright © 2010 by Nelson Education Ltd. How is the Firm Financing Its Assets 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 = 42% …continued 13-35

Chapter 13Copyright © 2010 by Nelson Education Ltd. How is the Firm Financing Its Assets Times Interest Earned Ratio –The ratio of operating income to interest charges Industry norm for time interest earned =

Chapter 13Copyright © 2010 by Nelson Education Ltd. Return on Investment Return on equity –The rate of return that owners earn on their investment. Industry norm for return on equity = 0.4% 13-37

Chapter 13Copyright © 2010 by Nelson Education Ltd. Working-CapitalWorking-Capital Working Capital Management –The management of current assets and current liabilities Net Working Capital –The sum of a firm’s current assets (cash, accounts receivable, and inventories) less current liabilities (short-term notes, accounts payable, and accruals)

Chapter 13Copyright © 2010 by Nelson Education Ltd. The Working- Capital Cycle Illustrated Exhibit

Chapter 13Copyright © 2010 by Nelson Education Ltd. Working-Capital Time Line Cash conversion period— the time required to convert paid-for inventories and accounts receivable into cash. Exhibit

Chapter 13Copyright © 2010 by Nelson Education Ltd. Working Capital Time Line for Pokey, Inc. Exhibit

Chapter 13Copyright © 2010 by Nelson Education Ltd. Working Capital Time Line for Quick-turn Company Exhibit

Chapter 13Copyright © 2010 by Nelson Education Ltd. Pokey, Inc.’s Beginning Balance Sheet 13-43

Chapter 13Copyright © 2010 by Nelson Education Ltd. Pokey, Inc.’s Monthly Balance Sheets JulyAug.Sept. Cash400 (100) Accounts receivable000 Inventory0500 Fixed assets600 Accumulated depreciation000 TOTAL ASSETS1,0001,5001,000 Accounts payable05000 Accrued operating expenses000 Income tax payable000 Long-term debt300 Common debt700 Retained earnings000 TOTAL DEBT AND EQUITY1,0001,5001,000 Changes: August to September –500 …continued 13-44

Chapter 13Copyright © 2010 by Nelson Education Ltd. Pokey, Inc.’s Monthly Balance Sheets JulyAug.Sept.Oct. Cash400 (100) Accounts receivable Inventory Fixed assets600 Accumulated depreciation000(50) TOTAL ASSETS1,0001,5001,0001,350 Accounts payable Accrued operating expenses Income tax payable00025 Long-term debt300 Common debt700 Retained earnings00075 TOTAL DEBT AND EQUITY1,0001,5001,0001,350 Changes: September to October +900 –500 – …continued 13-45

Chapter 13Copyright © 2010 by Nelson Education Ltd. Pokey, Inc.’s Monthly Balance Sheets 13-46

Chapter 13Copyright © 2010 by Nelson Education Ltd. Changes in Pokey’s Balance Sheet Change in the Balance SheetEffect on Income Statement Increase accounts receivable of $900Sales$ 900 Decrease inventories of $500Cost of goods sold$ 500 Increase in accrued operatingOperating expenses $ 250 expenses of $250 Increase accumulated depreciation of $50Depreciation expense$ 50 Increase accrued taxes of $25Tax expense$

Chapter 13Copyright © 2010 by Nelson Education Ltd. Pokey’s November Income Statement Sales revenue900 Cost of goods sold500 Gross Profit400 Operating expenses: Cash250 Depreciation50 Total operating expenses300 Operating income100 Income tax (25%)25 Net income

Chapter 13Copyright © 2010 by Nelson Education Ltd. Managing Cash Flows The Nature of Cash Flows –The flow of actual cash through a firm. Net Cash Flow –The difference between inflow and outflows Net Profit –The difference between revenue and expenses The Growth Trap –A cash shortage resulting from rapid growth 13-49

Chapter 13Copyright © 2010 by Nelson Education Ltd. Flow of Cash Through A Business Borrowed Funds Collection of Accounts Receivable Owner's Investment Borrowed Funds Sale of Fixed Assets Collection of Accounts Receivable Payment of Expenses Payment for Inventory Payment of Dividends Cash Sales Purchase of Fixed Assets Exhibit

Chapter 13Copyright © 2010 by Nelson Education Ltd. Candace Corporation: Cash Budget (July - September) 13-51

Chapter 13Copyright © 2010 by Nelson Education Ltd. Managing Accounts Receivable How Accounts Receivable Affect Cash –Accounts receivable represent the firm’s decision to delay the inflow of cash from customers who have been extended credit. Life Cycle of Accounts Receivable –Firm makes credit sale to customer. –Invoice is prepared and sent to customer. –Customer pays firm. …continued 13-52

Chapter 13Copyright © 2010 by Nelson Education Ltd. Managing Accounts Receivable Accounts Receivable Financing –Financing speeds up immediate cash flow –Pledged accounts receivable Accounts receivable used as collateral for a loan. –Factoring Obtaining cash by selling accounts receivable at a discount to another firm

Chapter 13Copyright © 2010 by Nelson Education Ltd. Managing Inventory Inventory is a “necessary evil.” –Product supply and consumer demand don’t always match up. Reducing Inventory to Free Cash –Monitoring current inventory Determine age and suitability for sale. –Controlling stockpiles Match on-hand inventory with demand. Avoid personalizing the business-customer relationship. Avoid forward purchasing of inventory; the carrying cost for excess inventory may exceed any savings

Chapter 13Copyright © 2010 by Nelson Education Ltd Managing Accounts Payable Negotiation –Asks creditors for adjustments or additional time. Timing –Creditors’ funds can supply short-term cash needs until payment is demanded. –Accounts with cash discounts for early payment should be examined for their savings potential. –“Buy now, pay later”—pay early enough to get cash discounts and timely enough to avoid late- payment fees.

Chapter 13Copyright © 2010 by Nelson Education Ltd. An Accounts Payable for Terms 3/10, Net 30 Annualized interest rate discount% Cash %discount Cash x perioddiscount Cash - periodNet yearin Days  56.4% or 0.564, x  13-56