14-1 Analysis of Operating Activities Electronic Presentation by Douglas Cloud Pepperdine University Chapter F14

Explain the relationship between product pricing and sales volume in creating revenues and profits. 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. ObjectivesObjectives Once you have completed this chapter, you should be able to: ContinuedContinued

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

14-41 ObjectiveObjective Explain the relationship between product pricing and sales volume in creating revenues and profits.

14-5 Operating Decisions Net income = revenues – expenses Return on assets = total assets net income OR Return on assets sales net income revenues sales total assets = x revenues

14-6 Exhibit 1 Summary of Expected Assets and Expected Operating Results for Mom’s 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$3,600 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

14-8 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.

14-9 Developing an Operating Strategy Asset turnover = Sales revenue Total assets Asset turnover is a measure of of a company’s ability to generate sales from its investment in assets.

14-10 Developing an Operating Strategy Return on assets = Return on assets is the profit margin multiplied by the asset turnover. Profit margin x Asset turnover

14-11 Developing an Operating Strategy If return on assets is low, a company must sell a lot of its products to earn a reasonable profit.

14-12 Expected Profit Margin for Mom’s Cookie Company $126,000 $3,000,000 = 4.2% Year 1 Sales revenue Profit Margin Net income =

14-13 Expected Profit Margin for Mom’s Cookie Company Sales revenue Profit Margin Net income = Year 2 $434,000 $3,600,000 = 12.06% =

14-14 Expected Asset Turnover for Mom’s Cookie Company Year 1 Total assets Asset Turnover Sales revenue = $3,000,000 $5,000,000 = 0.60 =

14-15 Expected Asset Turnover for Mom’s Cookie Company Year 2 Total assets Asset Turnover Sales revenue = $3,600,000 $5,000,000 = 0.72 =

14-16 Year 1 $126,000 $5,000,000 = 2.52% = Total assets Return on assets Net income = Expected Return on Assets for Mom’s Cookie Company or 4.2% x 0.60 = 2.52%

14-17 Expected Return on Assets for Mom’s Cookie Company or 12.06% x 0.72 = 8.68% Year 2 Total assets Return on assets Net income = $434,000 $5,000,000 = 8.68% =

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

14-19 Exhibit 4 Profit Margin, Asset Turnover, and Return on Assets for Krispy Kreme and Starbucks

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 Cost Leadership and Product Differentiation Strategies They compete by offering products with special features or qualities that customers are willing to buy.

14-22 Cost Leadership and Product Differentiation Strategies Starbucks is closer to using product differentiation than is Krispy Kreme.

14-23 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

14-24 Cost Leadership and Product Differentiation Strategies Cost leadership companies typically buy and sell in high volume. Advertising often emphasizes low prices and convenient one- stop shopping.

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

14-26 Comparing Accrual and Cash Flow Measures of Operating Performance If a company does not convert its profits into cash, the profits are a misleading performance indicator.

14-27 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.

14-28 Exhibit 6 A Comparison of Operating Cash Flows for Krispy Kreme and Starbucks

14-29 Further Evaluation of Operating Strategy Inventory turnover is the ratio of cost of good sold to inventory. It measures the success of a company in converting its investment in inventory into sales.

14-30 Exhibit 7 Selected Financial Statement Information and Ratios

14-31 Inventory turnover = Cost of goods sold Inventories $150,414,000 $12,031, = Krispy Kreme—2001 Further Evaluation of Operating Strategy

14-32 Inventory turnover = Cost of goods sold Inventories $1,175,787,000 $221,253, = Starbucks—2001 Further Evaluation of Operating Strategy

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

14-34 Exhibit 7 Selected Financial Statement Information and Ratios

14-35 Further Evaluation of Operating Strategy Day’s sales in inventory Inventory Cost of good sold ÷ 365 $12,031,000 $412, = Krispy Kreme—2001 = $150,414,000 ÷ 365

14-36 Further Evaluation of Operating Strategy Day’s sales in inventory Inventory Cost of good sold ÷ 365 $221,253,000 $3,221, = Starbucks—2001 = $1,175,787,000 ÷ 365

14-37 Accounts receivable turnover measures the success of a company’s ability to convert revenues into cash. Further Evaluation of Operating Strategy

14-38 Exhibit 7 Selected Financial Statement Information and Ratios

14-39 Sales revenue Accounts receivable $300,715,000 $19,855, = = Further Evaluation of Operating Strategy Krispy Kreme—2001 Accounts receivable turnover

14-40 Accounts receivable turnover $2,648,980,000 $90,425, = = Further Evaluation of Operating Strategy Starbucks—2001 Sales revenue Accounts receivable

14-41 Gross profit margin measures efficiency in the production or purchase of goods for sale. Further Evaluation of Operating Strategy

14-42 Exhibit 7 Selected Financial Statement Information and Ratios

14-43 Further Evaluation of Operating Strategy Gross profit Sales revenue $150,301,000 $300,715, % = = Krispy Kreme—2001 Gross profit margin

14-44 Further Evaluation of Operating Strategy Gross profit Sales revenue $1,473,193,000 $2,648,980, % = = Starbucks—2001 Gross profit margin

14-45 Operating profit margin is an indicator of a company’s efficiency in controlling operating costs other than product costs. Further Evaluation of Operating Strategy

14-46 Exhibit 7 Selected Financial Statement Information and Ratios

14-47 Further Evaluation of Operating Strategy Operating income Sales revenue $23,507,000 $300,715, % = = Krispy Kreme—2001 Operating profit margin

14-48 Further Evaluation of Operating Strategy = Operating profit margin $281,094,000 $2,648,980, % = Starbucks—2001 Operating income Sales revenue

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

14-50 Net income Equity Net income Equity Linking Operating and Investing Activities with Financing Activities Return on Equity Profit Margin Financial Leverage Asset Turnover = xx Sales Revenues Total Assets Sales Revenues Total Assets Net income Sales Revenues Net income Sales Revenues Total Assets Equity Total Assets Equity =xx

14-51 Linking Operating and Investing Activities with Financing Activities Another ratio to measure financial risk is times interest earned.

14-52 Exhibit 7 Selected Financial Statement Information and Ratios

14-53 Linking Operating and Investing Activities with Financing Activities Operating income Interest expense $23,507,000 $607, = = Krispy Kreme—2001 Times interest earned

14-54 Linking Operating and Investing Activities with Financing Activities $281,094,000 $2,087, * = Starbucks—2001 Times interest earned Operating income Interest expense = *Rounded

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

14-56 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.

14-57 Exhibit 8 Accounting and Business Decisions Transformation ProcessActivities Investing FinancingOperating Accounting SystemInformation Investing FinancingOperating Decision MakersDecisions Investing FinancingOperating

14-58 Exhibit 9 The Accounting Information System

14-59 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:

14-60 Exhibit 10 Using Accounting Information to Make Decisions About Company Value

14-61 T HE E ND C HAPTER F14

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