Measuring and Evaluating Financial Performance

Measuring and Evaluating Financial Performance
Chapter 13 Measuring and Evaluating Financial Performance PowerPoint Author: Brandy Mackintosh, CA Chapter 13: Measuring and Evaluating Financial Performance.

Learning Objective 13-1 Describe the purpose and uses of horizontal, vertical, and ratio analyses. Learning objective 13-1 is to describe the purpose and uses of horizontal, vertical, and ratio analyses.

Horizontal, Vertical, and Ratio Analyses
Horizontal (trend) analyses are conducted to help financial statement users recognize important financial changes that unfold over time. 12/31/13 12/31/14 Gross Profit in 2013 Gross Profit in 2014 Δ in Gross Profit $ and/or % from 2013 Trend Analysis Vertical analyses focus on important relationships between items on the same financial statement. Part I Horizontal (trend) analyses are conducted to help financial statement users recognize important financial changes that unfold over time. Part II A company will report gross profit each year on its income statement. In Horizontal or trend analysis, we might calculate the change in gross profit from one year to the next. We could do this for all accounts on the financial statements. Part III Vertical analyses focus on important relationships between items on the same financial statement. Part IV Here is a partial income statement showing sales, cost of goods sold, and gross profit for the fiscal year While we know that the number amounts will appear on the income statement, we gain insights to the values on the income statement by doing a vertical, or common size, analysis. Here we have calculated the percentages for each amount by expressing sales as 100 percent. Sales Cost of Goods Sold Gross Profit $200, % 150, % $ 50, % Amount Percent 2014

Horizontal, Vertical, and Ratio Analyses
Ratio analyses are conducted to understand relationships among various items reported in one or more of the financial statements. Receivable Turnover Ratio = Net Sales Revenue Average Net Receivables Ratio analyses are conducted to understand relationships among various items reported in one or more of the financial statements. Recall the calculation of the Receivable Turnover Ratio. By calculating this ratio we were able to determine the number of times per year receivable are collected. 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. 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

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

Horizontal (Trend) Computations
Trend analyses are usually calculated in terms of year-to-year dollar and percentage changes. Part I Trend analyses are usually calculated in terms of year-to-year dollar and percentage changes. Part II Calculating the dollar change from one year to the next is relatively easy. However, calculating the year-to-year percentage change can be a challenge. We begin the process by subtracting the prior year’s total dollar amount from the current year’s total dollar amount. This is referred to as the “current year change.” We divide the current year change by the prior year’s total amount and multiply that amount by 100 to convert it to a percentage that is easy to read. Part III Let’s look at an example of trend computation. Let’s look at an example

Horizontal (Trend) Computations
$53,417 – $50,521 $50,521 × 100 Part I Here is the income statement of Lowe’s for the fiscal years 2013 and See if you can calculate the dollar change in net sales revenue between 2013 and 2012. Part II There was a $2,896 million increase in Net Sales Revenue between the two years ($53,417 – $50,521). How did you do? Part III Now let’s calculate the percentage change in Net Sales Revenue between 2013 and 2012. Part IV The increase in Net Sales Revenue between the two years is 5.7 percent. How did you do? Part V You can see that we calculate the percentage by subtracting $50,521 (2012 amount) from $53,417 (2013 amount) and dividing the difference by $50,521 (2012 amount) and multiply the total times 100 to express the percent in a readable form of 5.7 percent increase. Part VI Why don’t you calculate the dollar and percentage change for Cost of Sales between 2013 and Don’t proceed until you have finished the computations. Part VII I hope you were able to get these answers. Between 2013 and 2012, Cost of Sales increased by $1,747 million, which means it increased by 5.3 percent. Here is the rest of the trend analysis for the Income Statement. We could apply the same techniques to the balance sheet to do a trend analysis of that financial statement. Calculate the change in dollars for Net Sales Revenue between fiscal 2013 and fiscal 2012. Now let’s look at the remainder of the trend analysis of the Income Statement. Now let’s calculate the percentage change in Net Sales Revenue between fiscal 2013 and fiscal 2012. Can you calculate the dollar and percentage change for Cost of Sales?

Learning Objective 13-3 Use vertical (common size) analysis to understand important relationships within financial statements. Learning objective 13-3 is to 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 Sales = 100% Balance Sheet Total Assets = 100% Cost of Sales Net Sales Revenue × 100 Part I Vertical, or common size, analysis focuses on important relationships within financial statements. We usually pick a value on the financial statement and express all other values on that statement as a percent of the selected amount. When preparing a common size income statement we normally let net sales equal 100 percent and express all other items on the income statement as a percent of net sales. When preparing a common size balance sheet we normally let total assets equal 100 percent and express all other balance sheet accounts as a percent of total assets. Let’s look at an example. Part II Here is the Income Statement of Lowe’s for the fiscal years 2013 and Notice, we have set Net Sales Revenue equal to 100 percent. Now, calculate Cost of Sales as a percent of Net Sales Revenue. Part III Here is the equation we will use to calculate the percentage. Part IV Cost of Sales is equal to 65.4 percent of Net Sales Revenue in 2013, and 65.7 percent in There as been a slight decrease in Cost of Sales as a percent of Net Sales Revenue. Why don’t you complete the common size income statements for the two years? Part V How did you do? Can you explain why there was a fairly significant increase in net income from 2012 (3.9 percent) to 2013 (4.3 percent)?

Learning Objective 13-4 Calculate financial ratios to assess profitability, liquidity, and solvency. Learning objective 13-4 is to 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. Solvency ratios examine a company’s ability to pay interest and repay debt when due. Ratio analysis compares the amounts for one or more line items to the amounts for other line items in the same year. Most analysts classify ratios into three categories: Profitability ratios, which relate to the company’s performance in the current period—in particular, the company’s ability to generate income. Liquidity ratios, which relate to the company’s short-term survival—in particular, the company’s ability to use current assets to repay liabilities as they become due. Solvency ratios, which relate to the company’s long-run survival—in particular, the company’s ability to repay lenders when debt matures and to make the required interest payments prior to the date of maturity. Liquidity ratios help us determine if a company has sufficient current assets to repay liabilities when due.

Common Profitability Ratios
We have listed some common profitability ratios. These ratios relate to the company’s performance in the current period—in particular, the company’s ability to generate income. We will calculate each of these ratios later in this presentation. Note that we are going to cover in detail six common profitability ratios.

Common Liquidity Ratios
Here is a list of three common liquidity ratios. These ratios relate to the company’s short-term survival—in particular, the company’s ability to use current assets to repay liabilities as they become due.

Common Solvency Ratios
We are going to compute two common solvency ratios. Solvency ratios relate to the company’s long-run survival—in particular, the company’s ability to repay lenders when debt matures and to make the required interest payments prior to the date of maturity.

Interpret the results of financial analyses.
Learning Objective 13-5 Interpret the results of financial analyses. Learning objective 13-5 is to interpret the results of financial analyses.

Interpreting Horizontal and Vertical Analyses
Lowe’s began relying more on debt and less equity financing. Total liabilities increased 11 percent and stockholders’ equity decreased by 14.5%. Lowe’s assets grew only by 0.2% in fiscal 2013. Part I Financial statement analyses are not complete unless they lead to interpretations that help users understand and evaluate a company’s financial results. Part II Horizontal (trend) analysis of Lowe’s balance sheet shows that the company grew only a little in fiscal Overall, total assets increased by a mere 0.2 percent. Part III The most significant change indicated by the balance sheet is that the company began relying more on debt and less on equity financing. During 2013, Lowe’s total liabilities increased by 11 percent, which resulted from issuing $1.0 billion in new bonds, as explained in its financial statement notes. Also, stockholders’ equity decreased by 14.5 percent, largely the result of Lowe’s repurchasing common shares.

Cost of sales and operating expenses are the most important determinants of the company’s profitability. Much of the increase in Net Income in fiscal 2013 is explained by greater control of the Cost of Sales and Operating Expenses. Part I Vertical analysis of Lowe’s income statement shows that Cost of Sales and Operating Expenses are the most important determinants of the company’s profitability. Part II Cost of Sales consumed 65.4 percent of Sales in fiscal 2013 and Operating Expenses consumed an additional 26.8 percent. Part III Much of the increase in Net Income (from 3.9 percent of Sales in 2012 to 4.3 percent in 2013) is explained by greater control of these two categories of expenses.

Lowe’s has experienced a small decrease in its percentage of Cost of Sales in relation to Sales Revenue from fiscal 2012 to Decreasing cost of sales means higher Gross Profit. Lowe’s did a better job of controlling its Operating Expenses between 2012 and 2013. Part I Lowe’s has experienced a small decrease in its percentage of Cost of Sales in relation to Sales Revenue from fiscal 2012 to Decreasing Cost of Sales results in higher Gross Profit. Part II The management at Lowe’s was able to control operating expenses from 2012 to Operating expenses decreased by point 5 percent during the period. One piece of data to help a financial statement reader evaluate the effectiveness of management is to see how well the management controls operating expense. Control of operating expenses is extremely important in periods of slow or no economic growth.

Ratio Calculations Here is the balance sheet information that we will use in the calculation of our ratios. It is a good idea to print this slide and the next as we compute the various ratios. An alternative is to look at Exhibits 13-1 and 13-2 in your textbook.

Ratio Calculations We will use Lowe’s Income Statement for many of the ratio calculations we will complete in the following slides. Let’s get started with the calculation of profitability ratios.

Profitability Ratios Net Profit Margin – The slowly improving economy helped boost Lowe’s profits in 2013 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. Part I Profitability ratios focus on the level of profits the company generated during the period. In our analyses, we compare Lowe’s financial ratios to the prior year and in some cases to those for The Home Depot. (Lowe’s and The Home Depot’s annual reports are printed in Appendix A and B.) The Net Profit Margin Ratio represents the percentage of sales revenues that ultimately make it into net income, after deducting expenses. In 2013, Lowe’s generated 4.3 cents in net profit margin for each dollar of sales, up from 3.9 cents the previous year. Part II The increase in the gross profit percentage from 2012 to 2013 (34.6% %) means that Lowe’s made 0.3¢ more gross profit on each dollar of sales in 2013 than in There are two potential explanations for this increase: (1) Lowe’s charged higher selling prices without experiencing a corresponding increase in the cost of merchandise and (2) Lowe’s obtained merchandise at a lower unit cost. The Management Discussion & Analysis section of Lowe’s annual report explains that the increase in gross profit percentage came from both higher selling prices and a decrease in product costs.

Profitability Ratios Fixed Asset Turnover – indicates how much revenue the company generates in sales for each dollar invested in fixed assets, Home Depot 2013 fixed asset turnover ratio was 3.32 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. Part I The fixed asset turnover ratio indicates how much revenue the company generates for each dollar invested in fixed assets. This analysis shows that Lowe’s had $2.52 of sales in 2013 for each dollar invested in fixed assets. By looking at the components of this ratio, we can see that an increase in 2013 sales and a decrease in net fixed assets both contributed to the ratio’s increase in Increased sales resulted from the slight improvement in the economy and decreased net fixed assets resulted from additional depreciation in 2013 coupled with a decision Lowe’s made to limit new store openings in 2013. Part II Although Lowe’s fixed asset turnover ratio improved in 2013, it is low compared to that of its main competitor, The Home Depot, whose fixed asset turnover ratio was 3.32 in The Home Depot has a competitive advantage over Lowe’s. In other words, Lowe’s is operating less efficiently than its major competitor. Part III 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. Lowe’s ROE increase from 12.9 to 17.7 percent was inevitable, given our previous analyses. Specifically, horizontal analysis indicated that the company had decreased its stockholders’ equity through a stock repurchase and it had increased its net income in 2013 through more profitable operations. Taken together, these results imply that net income as a percentage of average stockholders’ equity was sure to rise in 2013.

Profitability Ratios Earnings Per Share (EPS) – Shows the amount of earnings generated for each share of outstanding common stock. Price /Earnings (P/E) Ratio – Shows the relationship between EPS and the market price of one share of the company’s stock. Part I Earnings Per Share (EPS) shows the amount of earnings generated for each share of outstanding common stock. Consistent with the increase in ROE, the EPS ratio increased from $1.69 in 2012 to $2.14 in This represents an increase of $0.45 per share ($ $1.69). Part II Using the stock price immediately after Lowe’s announced its 2013 and 2012 earnings during the last week of February 2014 and 2013, the P/E ratio was 23.7 and 22.3, respectively. This means investors were willing to pay 23.7 times earnings to buy a share of Lowe’s stock in early 2014 (versus 22.3 times earnings a year earlier). The increase from the prior year suggests investors were more optimistic about the company’s future prospects than they were a year earlier. Improvement in the general economy combined with Lowe’s strategies for better inventory management contributed to this optimism. The Home Depot ’s P/E ratio fell slightly from 22.3 to 21.4 during this same period, largely because its most recent monthly sales had declined when Lowe’s had increased.

Average Net Receivables
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. Receivable Turnover Ratio = Net Sales Revenue Average Net Receivables Receivable Turnover Ratio – Most retail home improvement companies have low levels of accounts receivable relative to sales revenue because they collect the majority of their sales immediately in cash. Part I 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. Part II We will begin with the Receivable Turnover Ratio. Most home improvement companies have low levels of accounts receivable relative to sales revenue because they collect the majority of their sales immediately in cash. As a consequence, the receivable turnover ratio has little meaning to the Lowe’s financial statement reader.

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 77 days in 2013. Current Ratio – The current ratio measures the company’s ability to pay its current liabilities Part I The inventory turnover ratio indicates how frequently inventory is bought and sold during the year. The measure “days to sell” converts the inventory turnover ratio into the average number of days needed to sell each purchase of inventory. Lowe’s inventory turned over at the same rate in 2013 as in These results were encouraging to Lowe’s because the company had decided to carry more diverse lines of inventory in The goal in carrying more inventory was to better meet customer needs, but this strategy increased the risk that the new lines would not sell as quickly. The stable turnover in 2013 is a positive sign because almost every retailer’s success depends on its ability to offer customers the right product when they need it at a price that beats the competition. Part II Lowe’s inventory turnover still trails that of The Home Depot (where inventory takes an average of 77 days to sell), but The Home Depot has always had a faster inventory turnover because it carries fewer big-ticket items than Lowe’s. According to their 2013 annual reports, the average ticket price was $64.52 at Lowe’s and $56.78 at The Home Depot. Part III Lowe’s ratio decreased from 2012 to 2013, ending the year with a ratio of In some instances, a decrease in current ratio is a cause for concern. But in this industry, a current ratio greater than 1.0 is deemed acceptable.

In 2013, The Home Depot had a debt-to-assets ratio of 69 percent.
Solvency Ratios Debt to Assets Ratio – indicates the proportion of total assets that creditors finance. In 2013, The Home Depot had a debt-to-assets ratio of 69 percent. Times Interest Earned – indicates how many times the company’s interest expense was covered by its operating results. Part I Debt to Assets Ratio indicates the proportion of total assets that creditors finance. Lowe’s ratio of 0.64 in 2013 indicates that creditors contributed 64 percent of the company’s financing, implying that it was the company’s main source of financing. The debt-to-assets ratio increased from 2012 to 2013 as a result of issuing new bonds and repurchasing common stock. Part II The Home Depot, which had a debt-to-assets ratio of 69 percent in 2013, relies even more on debt financing. Part III Times Interest Earned indicates how many times the company’s interest expense was covered by its operating results. This ratio is calculated using accrual-based interest expense and net income before interest and income taxes. Lowe’s ratio of 8.7 indicates the company is generating more than enough profit to cover its interest expense. A times interest earned ratio above 1.0 indicates that net income (before the costs of financing and taxes) is sufficient to cover the company’s interest expense.

Describe how analyses depend on key accounting decisions and concepts.
Learning Objective 13-6 Describe how analyses depend on key accounting decisions and concepts. Learning objective 13-6 is to describe how analyses depend on key accounting decisions and concepts.

Underlying Accounting Decisions and Concepts
Difference in Strategies, e.g., type of financing. Difference in Operations, e.g., quality of items sold. Difference in Accounting Methods, e.g., FIFO vs. LIFO. In any analysis you prepare it is essential that you understand the underlying accounting decisions and concepts. When comparing two companies we must understand each company’s strategy. One company may have decided to increase revenue by expanding into new locations, while the other company may attempt to increase revenue by upgrading its existing locations and spending more resources to understand customer needs. We also need to understand the differences in operation between the two companies. One company may elect to be the low cost provider in its market while the other company may concentrate on upscale products and heavy customer assistance. Finally, we must be aware of any differences in the accounting methods employed by the two companies. For example, one company may elect to use accelerated depreciation method for financial accounting and reporting while the other company uses straight-line depreciation. The choices made in these three areas will impact the values we produce from our analysis.

Accounting Concepts Companies may elect to use any acceptable generally accepted accounting principle (GAAP) as long as they apply the principle consistently. Companies may elect to use any acceptable generally accepted accounting principle (GAAP) as long as they apply the principle consistently. This table shows the differences in inventory and depreciation principles for Lowe’s, The Home Depot, and Builder’s FirstSource, all companies in the home improvement industry. Notice how much more quickly Builder’s FirstSource depreciated its equipment when compared to Lowe’s and The Home Depot.

Conceptual Framework for Financial Accounting and Reporting
The concepts that you have already studied in prior chapters are highlighted in red. The appropriate chapter reference is shown. The primary objective of financial accounting and reporting is to provide useful financial information for external users to use in making decisions about the company. To be useful, this information must be relevant and faithfully represent the underlying business. We will discuss some of the concepts previously omitted. The going concern concept is an assumption that underlies accounting rules. It is the belief that the business will be capable of continuing its operations long enough to realize its recorded assets and meet its obligations in the normal course of business. If a company runs into severe financial difficulty (such as bankruptcy), this assumption may no longer be appropriate and we will be faced with a going concern problem. Simply put, the principle of full disclosure is that financial reports should present all information that is needed to properly interpret the results of the company’s business activities.

Factors Contributing to Going-Concern Problems
Factors that commonly contribute to going-concern problems are listed below. If ever a company encounters a going-concern problem, it may need to adjust the amount and classification of items in its financial statements, which would be explained in the financial statement notes and to which the auditor’s report would draw attention. Financial and other types of analyses often call to our attention a potential going-concern issue.

Nonrecurring and Other Special Items
Chapter 13 Supplement 13A Nonrecurring and Other Special Items Chapter 13, Supplement 13A: Nonrecurring and Other Special Items.

Learning Objective 13-S1 Describe how nonrecurring and other comprehensive income items are reported. Learning objective 13-S1 is to describe how nonrecurring and other comprehensive income items are reported.

  Nonrecurring Items Extraordinary Items
Very few events qualify as extraordinary items.  Cumulative Effect of Changes in Accounting Methods Direct adjustment to Retained Earnings rather than income reporting.  Part I The definition of extraordinary has become so restricted that few events—not even BP ’s $20 billion of losses that arose from its April 2010 oil spill in the Gulf of Mexico—qualify as extraordinary. Part II The cumulative effect of an accounting change is reported as a direct adjustment to the beginning balance in Retained Earnings rather than as part of the income statement in the period when the change is made. Part III Discontinued operations result from abandoning or selling a major business component. Because an abandoned or sold business unit will not affect financial results in future years, its results for the current year are reported on a separate line of the income statement immediately after Income Tax Expense. In the year of disposal, any gain or loss of the discontinued unit will be in the reporting company’s income statement as well as the operating income from the beginning of the year until the date of disposal. Discontinued Operations For discontinued component two items are reported: Operating income prior to the date of disposal. Gain or loss on sale or disposal of net assets. 

Discontinued Operations.
Nonrecurring Items NONRECURRING ITEM Discontinued Operations. Here is an example of the reporting of nonrecurring items. In our example, we are reporting earnings from discontinued operations. Because discontinued operations will not affect financial results in future years, its results for the current year are reported on a separate line of the income statement following Income Tax Expense. This discontinued operations line includes any gain or loss on disposal of the discontinued operation as well as any operating income generated before its disposal. Because this appears below the Income Tax Expense line, any related tax effects are netted against (included with) the gains or losses on discontinued operations.

Other Special Items Comprehensive Income includes:
Gains or losses from certain foreign currency exchange rate changes. Gains or losses resulting from the change in value of certain types of investments. Excluded from net income because they are likely to disappear before they are ever realized. Items included in comprehensive income are excluded from net income and reported in the equity section of the balance sheet. The main reason for excluding these gains and losses from net income is that the changes in value that created them may well disappear before they are ever realized (when the company sells the related assets or liabilities).

Reviewing and Contrasting IFRS and GAAP
Chapter 13 Supplement 13B Reviewing and Contrasting IFRS and GAAP Chapter 13, Supplement 13B: Reviewing and Contrasting IFRS and GAAP .

Describe significant differences between GAAP and IFRS.
Learning Objective 13-S2 Describe significant differences between GAAP and IFRS. Learning objective 13-S2 is to describe significant differences between GAAP and IFRS.

Report fixed assets at fair value.
Overview At a basic level both IFRS and GAAP are concerned with accounting rules that describe when an item should be recognized in the accounting system, how that item should be classified (asset , liability, equity, expense, or revenue), and the amount at which each item should be measured. Part I At a basic level both IFRS and GAAP are concerned with accounting rules that describe (1) when an item should be recognized in the accounting system, (2) how that item should be classified (asset, liability, equity, revenue, or expense), and (3) the amount at which each item should be measured. Both systems require that items be recorded only after an exchange between the company and another party. Initially, these items are recorded at the value they enter the company. Part II There are differences between IFRS and GAAP. For example, IFRS requires or allows companies to report items using values that differ from those required or allowed by GAAP. For example, IFRS permits companies to report fixed assets at fair values. Report fixed assets at fair value. IFRS Yes GAAP No

End of Chapter 13 End of Chapter 13.

Measuring and Evaluating Financial Performance

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