1. Analysis of Investing Activities
Chapter F12
Analysis of Investing Activities
Electronic Presentation by Douglas Cloud Pepperdine University

2. Once you have completed this chapter, you should be able to:
Objectives
1. Explain why investing decisions are important to a company and how they can affect its profits.
2. Explain how operating leverage affects a company’s risk and profits.
3. Use financial statements to evaluate investing activities for various companies.
Once you have completed this chapter, you should be able to:
Continued

3. Objectives
4. Explain how investing activities affect company value, and use accounting information to measure value-increasing activities.
5. Identify ways in which a company can use its assets to improve effectiveness and efficiency.
6. Explain why accounting information about long-term assets is useful for creditors.

4. Objective 1
Explain why investing decisions are important to a company and how they can affect its profits.

5. The Production Process for Mom’s Cookie Company
Exhibit 1
The Production Process for Mom’s Cookie Company

6. Investing Decisions and Profit
Obviously, we need equipment.

7. Investing Decisions and Profit
Can’t we just buy what we need?

8. Investing Decisions and Profit
We have to decide how much of each type of equipment we need. We can start small and add equipment as demand increases.

9. Investing Decisions and Profit
Perhaps the biggest decision we have to make is how much automation we want in the production process.

10. Investing Decisions and Profit
As an alternative, we can purchase more sophisticated equipment. Exhibit 2 shows this alternative.

11. An Alternative Production Process for Mom’s Cookie Company
Exhibit 2
An Alternative Production Process for Mom’s Cookie Company

12. Investing Decisions and Profit
Thus, our basic choice is manual or automated equipment. If we select manual equipment, we can start with less investment and add equipment as demand increase, but we will have the capacity we expect to need.

13. Investing Decisions and Profit
Also, we will be able to produce a higher quality product because the automated process is more reliable.

14. Investing Decisions and Profit
What effect do the choices have on our expected profits if we anticipate sales of $3,000,000?

15. (in thousands) Manual Automated
Sales of $3.0 Million
(in thousands) Manual Automated
Assets:
Current assets $1,000 $1,000
Plant assets 3, ,000
Total assets $4,500 $5,000
Sales $3,000 $3,000
Cost of ingredients (800) (800)
Depreciation (250) (300)
Wages and benefits (780) (700)
Other operating expenses (1,000) (1,000)
Operating income
Interest expense (170) (170)
Pretax income
Income taxes (9)
Net income $ $

16. Investing Decisions and Profit
In the second year of operations we anticipate sales of $3.6 million. What would be our projected net income if our expectations are correct?

17. Investing Decisions and Profit
If we select manual equipment, we will have to purchase an additional $250,000 of equipment to meet the higher demand.

18. (in thousands) Manual Automated
Sales of $3.6 Million
(in thousands) Manual Automated
Assets:
Current assets $1,200 $1,440
Plant assets 3, ,000
Total assets $4,950 $5,440
Sales $3,600 $3,600
Cost of ingredients (960) (960)
Depreciation (275) (300)
Wages and benefits (936) (700)
Other operating expenses (1,000) (1,000)
Operating income
Interest expense (170) (170)
Pretax income
Income taxes (78) (141)
Net income $ $ 329
Depreciation for manual increases due to additional equipment required costing $250,000

19. Objective 2
Explain how operating leverage affects a company’s risk and profits.

20. Investment Decisions and Risk
What would happen to net income if sales are only $2.8 the first year?

21. (in thousands) Manual Automated
Sales of $2.8 Million
(in thousands) Manual Automated
Assets:
Current assets $ $ 900
Plant assets 3, ,000
Total assets $4,300 $4,900
Sales $2,800 $2,800
Cost of ingredients (747) (747)
Depreciation (233) (300)
Wages and benefits (728) (700)
Other operating expenses (1,000) (1,000)
Operating income 92 53
Interest expense (170) (170)
Pretax income (78) (117)
Income taxes
Net income $ (55) $ (82)

22. A Comparison of the Effects of Investment Decisions on Profits of Mom’s Cookie Company
Exhibit 6

23. Investing Decisions and Risk
Fixed costs are costs that do not increase in proportion to increases in sales.

24. Investing Decisions and Risk
Variable costs are costs that do increase in proportion to increases in sales.

25. Investing Decisions and Risk
The use of fixed costs to increase net income as sales increase is known as operating leverage.

26. Objective 3
Use financial statements to evaluate investing activities for various companies.

27. Identifying Investing Activities
As a first step in our analysis, we want to identify the companies’ long-term assets and the changes in these assets resulting from investing activities.

28. Selected Financial Statement Information for Krispy Kreme and Starbucks
Exhibit 7
Plant and equipment accounts for most of the long-term assets of both companies.

29. Krispy Kreme’s total assets grew by 63%.
Selected Financial Statement Information for Krispy Kreme and Starbucks
Exhibit 7
Krispy Kreme’s total assets grew by 63%.

30. Starbucks’ total assets grew by 24%.
Selected Financial Statement Information for Krispy Kreme and Starbucks
Exhibit 7
Starbucks’ total assets grew by 24%.

31. Krispy Kreme’s plant and equipment grew by 29%.
Selected Financial Statement Information for Krispy Kreme and Starbucks
Exhibit 7
Krispy Kreme’s plant and equipment grew by 29%.

32. Starbucks’ plant and equipment grew by 22%.
Selected Financial Statement Information for Krispy Kreme and Starbucks
Exhibit 7
Starbucks’ plant and equipment grew by 22%.

33. Selected Financial Statement Information for Krispy Kreme and Starbucks
Exhibit 7
Exhibit 7
Krispy Kreme’s revenue grew by 37%.
Krispy Kreme’s revenue grew by 37%.

34. Selected Financial Statement Information for Krispy Kreme and Starbucks
Exhibit 7
Exhibit 7
Starbucks’ revenue grew by 22%.
Krispy Kreme’s revenue grew by 37%.

35. Objective 4
Explain how investing activities affect company value, and use accounting information to measure value-increasing activities.

36. The Importance of Asset Growth
Growth in assets is important to the value of a company and the wealth of its stockholders.

37. Selected Financial Statement Information for Krispy Kreme and Starbucks
Exhibit 7
Exhibit 7
Krispy Kreme’s net income increased 147%.
Krispy Kreme’s revenue grew by 37%.

38. Selected Financial Statement Information for Krispy Kreme and Starbucks
Exhibit 7
Exhibit 7
Starbucks’ net income increased 92%.
Krispy Kreme’s revenue grew by 37%.

39. The Importance of Asset Growth
Starbucks opened 1,208 new stores during 2001 and Krispy Kreme opened 26 new stores during 2001.

40. Measuring the Effects of Growth
A common measure of outcome of a company’s investment decisions is return on assets (ROA).
Return on Assets =
Net Income
Total Assets

41. Measuring the Effects of Growth
2001
Net Income
Total Assets
Return on Assets =
$14,725
$171,493
Krispy Kreme =
= 8.6%
$181,210
$1,851,039
Starbucks =
= 9.8%

42. Measuring the Effects of Growth
Asset turnover is the ratio of revenues to total assets. It is a measure of the ability of a company to use its assets to sell its products.
Revenues
Total Assets
Asset Turnover =

43. Measuring the Effects of Growth
A company with a high asset turnover is more effective in using its assets than one with a low asset turnover.

44. Measuring the Effects of Growth
Profit margin (or return on sales) is the ratio of net income to sales. It is a measure of the ability of a company to produce profits from it sales.
Net Income
Revenues
Profit Margin =

45. Measuring the Effects of Growth
A company with a high profit margin is more efficient in controlling costs than one with a low profit margin.

46. Measuring the Effects of Growth
Once profit margin and asset turnover have been calculated, return on assets can be determined by finding the product of the two.
ROA = Asset Turnover x Profit Margin

47. Asset Turnover and Profit Margin for Krispy Kreme and Starbucks
Exhibit 7
Exhibit 8
Krispy Kreme
Starbucks
Asset Turnover and Profit Margin for Krispy Kreme and Starbucks
Asset Turnover
Profit Margin 4.90% 2.70% 6.84% 4.34%
Return on Assets 8.59% 5.67% 9.79% 6.34%
Krispy Kreme was able to generate $1.75 of sales for every $1 invested in assets.
Starbucks was able to generate $1.43 of sales for every $1 invested in assets.

48. Asset Turnover and Profit Margin for Krispy Kreme and Starbucks
Exhibit 7
Exhibit 8
Krispy Kreme
Starbucks
Asset Turnover and Profit Margin for Krispy Kreme and Starbucks
Asset Turnover
Profit Margin 4.90% 2.70% 6.84% 4.34%
Return on Assets 8.59% 5.67% 9.79% 6.34%
Krispy Kreme was able to generate $0.049 of net income for every $1 of sales.
Starbucks was able to generate over $0.068 of net income for every $1 of sales.

49. Objective 5
Identify ways in which a company can use its assets to improve effectiveness and efficiency.

50. The Effect of Investment on Effectiveness and Efficiency
Effectiveness increases when the dollar amount of sales increases more rapidly than the dollar amount of additional investment.

51. The Effect of Investment on Effectiveness and Efficiency
Efficiency increases when a company is able to earn greater profit for each additional dollar of product it sells.

52. The Effect of Investment on Effectiveness and Efficiency
Average cost of goods sold for its product is 60% of sales, and income taxes are 30% of pretax income. In 2004, the store sold $3.0 million of goods.
Mom’s Cookie Company invests $5 million in assets. It pays employees $700,000. Utilities and other costs amount to $300,000 per year.
Sales $3,000,000
Cost of goods sold (60%) (1,800,000)
Other operating expenses (1,000,000)
Pretax income 200,000
Income tax (60,000)
Net income $ 140,000

53. The Effect of Investment on Effectiveness and Efficiency
By changing some of its product line, the company can increase sales to $3.3 million without any additional asset investment or increasing expenses.
Sales $3,300,000
Cost of goods sold (60%) (1,980,000)
Other operating expenses (1,000,000)
Pretax income 320,000
Income tax (96,000)
Net income $ 224,000

54. The Effect of a Sales Increase on Return on Assets
Exhibit 7
Exhibit 9
Asset Turnover and Profit Margin for Krispy Kreme and Starbucks
After
Before
Sales Revenues (in millions) $3.0 $3.3
Asset Turnover
Profit Margin 4.67% 6.79%
Return on Assets 2.80% 4.48%

55. The Effect of Investment on Effectiveness and Efficiency
If sales decrease for any length of time, a company must find ways to reduce its investment so that it can eliminate unnecessary costs.

56. Objective 6
Explain why accounting information about long-term assets is useful for creditors.

57. Investing Activities and Creditor Decisions
Companies often borrow money to acquire long-term assets. Accordingly, the ability of a company to repay creditors and…

58. Investing Activities and Creditor Decisions
…to pay interest usually is connected to its ability to use it long-term assets to generate profits and cash flows.

59. Investing Activities and Creditor Decisions
Accounting measurement rules require companies to write down their assets if the market values of the assets decrease below their book value.

60. Investing Activities and Creditor Decisions
A company owns a building that it purchased for $1 million. Accumulated depreciation on the building at the end of 2004 was $600,000 (book value = $400,000). At that time, the company determined that the market value of the building was $250,000. The company recognizes a loss by writing down the asset by $150,000 ($400,000 – $250,000).

61. Investing Activities and Creditor Decisions
This measurement rule is known as lower of cost or market and is intended to protect investors, particularly creditors, by ensuring that assets are not overstated.

62. CHAPTER F12
THE END