1. Evaluating Financial Performance
Part 6 Understanding the Numbers

2. Looking Ahead After studying this chapter, you should be able to:
Identify the basic requirements for an accounting system.
Explain two alternative accounting options.
Describe the purpose of and procedures related to internal control.
Evaluate a firm’s ability to pay its bills as they come due.
Assess a firm’s overall profitability on its asset base.
Measure a firm’s use of debt and equity financing.
Evaluate the rate of return earned on the owners’ investment.
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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
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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
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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
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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.
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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
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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
Identifying transactions requiring owner authorization
Ensuring checks issued have supporting documentation
Limiting access to accounting records and computers
Sending bank statements directly to the owner
Safeguarding blank checks
Requiring employees to take vacations
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9. Evaluating Financial Performance
Can a Firm Meet Its Financial Commitments?
Can you pay your bills when they come due?
Are you making a good return on your assets?
How much debt are your using, and what are the implications for the firm’s future?
Are you getting a good return on your investments?
Financial Ratios
Restatements of selected income statement and balance sheet data in relative terms
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10. Financial Ratios for Retail Computer and Software Stores, 2003
*Based on cost of goods sold.
†Not reported in the RMA data, but computed by multiplying the operating profit margin times the total asset turnover.
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.
Source: Adapted from RMA 2003–2004 Annual Statement Studies, published by Robert Morris Associates, Philadelphia, Pa. Copyright Robert Morris Associates, 2004.
Exhibit 23.1
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11. Income Statement for Petri & Associates Leasing Company for the Year Ending December 31, 2005
Exhibit 23.2
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12. Balance Sheet for Petri & Associates Leasing Company for December 31, 2005
Exhibit 23.3
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13. Can You Pay Your Bills? 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
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14. Can You Pay Your Bills? (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
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15. Can You Pay Your Bills? (cont’d.)
Inventory Turnover
The number of times inventories “roll over” during the year
Industry norm for inventory turnover = 4.00
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16. Can You Pay Your Bills? (cont’d.)
Acid-Test Ratio (Quick Ratio)
A measure of a company’s liquidity that excludes inventories
liabilities
Current
Inventories -
assets
ratio
Acid-test =
1.30
$100,000
$220,000 -
$350,000
ratio =
Acid-test
Industry norm for acid-test ratio = 1.25
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17. Can You Pay Your Bills? (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
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18. Return on Invested Capital: An Overview
Capital invested
by the
firm's creditors
and
equity investors
(owners)
Firm's
total assets
Profits and
cash flows
Rate of return
on total capital
becomes
Creditors
Equity
investors
Operating income
Total assets
Return on
creditor's
capital
equity
Interest rate
charged on debt
Net income
Common equity
compute
equals
Shared by
Return on Invested Capital: An Overview
Exhibit 23.4
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19. Are You Making a Good Return on Your Assets?
A measure of operating profits relative to total assets
Industry norm for OIROI: 13.20%
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20. Are You Making a Good Return on Your 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%
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21. Are You Making a Good Return on Your 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
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22. Are You Making a Good Return on Your Assets? (cont’d.)
Operating Income Return on Assets
Operating profit margin
Total asset turnover =
Return on Assets X = =
.1176 x 0.92
10.82%
Industry ROA = 11.0% x 1.2 = 13.20%
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23. Accounts receivable turnover
Turnover Ratios
Industry Norm
Accounts receivable turnover
10.43
Inventory turnover
4.00
Fixed asset turnover
2.50
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24. How Much Debt Are You 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%
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25. How Much Debt Are You Using?
Times Interest Earned Ratio
The ratio of operating income to interest charges
Industry norm for time interest earned = 4.00
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26. Are You Getting a Good Rate of Return on Your Investment?
Return on equity
The rate of return that owners earn on their investment
Industry norm for return on equity = 12.5%
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27. Financial Ratio Analysis for Petri & Associates Leasing Company
Exhibit 23.5
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28. Financial Ratio Analysis for Petri & Associates Leasing Company
Exhibit 23.5 (cont’d)
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29. Financial Ratio Analysis for Petri & Associates Leasing Company
Exhibit 23.5 (cont’d)
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30. 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
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