1. 14-1 PowerPoint Presentation by Douglas Cloud Professor Emeritus of Accounting Pepperdine University © Copyright 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star Logo, and South-Western are trademarks used herein under license. Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc. F13 14 Analysis of Operating Activities Financial Accounting A Bridge to Decision Making Ingram and Albright 6 th edition

2. 14-2ObjectivesObjectives Once you have completed this chapter, you should be able to—

3. 14-3 1.Explain the relationship between product pricing and sales volume in creating revenues and profits. ObjectivesObjectives ContinuedContinued 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.

4. 14-4 4.Evaluate operating performance by using accrual and cash flow measures. ObjectivesObjectives 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.

5. 14-51 ObjectiveObjective Explain the relationship between product pricing and sales volume in creating revenues and profits.

6. 14-6 Operating Decisions Net income = revenues – expenses Return on assets net income operating revenues operating revenues total assets = x total assets Return on assets net income = OR

7. 14-7 Exhibit 1 Summary of Expected Assets and Expected Operating Results for Favorite 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$3,000$,3600 Plant assets 4,000Cost of ingredients(800)(960) Total assets$5,000Depreciation(300)(300) Wages and benefits(700)(700) Other operating exp.(1,000)(1,000) Operating income200640 Interest expense (20) (20) Pretax income180620 Income taxes (54) (186) Net income$ 126$ 434

8. 14-8 2 2 Explain how operating strategy affects a company’s return on assets. ObjectiveObjective

9. 14-9 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.

10. 14-10 Developing an Operating Strategy Asset turnover = Sales revenue Total assets Asset turnover is a measure of a company’s ability to generate sales from its investment in assets.

11. 14-11 Developing an Operating Strategy Return on assets is a combination of profit margin and asset turnover. Return on assets = Profit margin x Asset turnover

12. 14-12 Developing an Operating Strategy If return on assets is low, a company must sell a lot of its products to earn a reasonable profit.

13. 14-13 Developing an Operating Strategy Favorite Cookie Company’s primary challenge in the first couple of years is to get the product into the hands of customers. Once customers are sold on the product’s value, then the company can consider higher prices.

14. 14-14 Expected Return on Assets for Favorite Cooking Company in Year 2 (Based on Exhibit 3) Profit margin = Net income Sales revenue = $434,000 $3,600,000 = 12.06%

15. 14-15 Expected Return on Assets for Favorite Cooking Company in Year 2 (Based on Exhibit 3) = $3,600,000 $5,000,000 = 0.720 Asset turnover = Sales revenue Total assets

16. 14-16 Expected Return on Assets for Favorite Cooking Company in Year 2 (Based on Exhibit 3) Return on assets = Profit margin x Asset turnover = 12.06% x 0.720 = 8.68%

17. 14-17 3 3 Define cost leadership and product differentiation, and explain how companies use these strategies to create profits. ObjectiveObjective

18. 14-18 Exhibit 4 Profit Margin, Asset Turnover, and Return on Assets for Microsoft and Proctor & Gamble Microsoft Proctor & Gamble 2004 2003 2004 2003 Microsoft Proctor & Gamble 2004 2003 2004 2003 (in millions) Net income$ 8,168$ 7,531$ 6,481$ 5,186 Total revenues36,83532,18751,40743,377 Total assets92,38981,73257,04843,706 Asset turnover0.3990.3940.9010.992 Profit margin22.223.412.612.0 Return on assets8.89.211.411.9 %% %% %% %%

19. 14-19 Cost Leadership and Product Differentiation Strategies Companies that keep their prices low to generate high sales volume use a cost leadership strategy.

20. 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.

21. 14-21 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

22. 14-22 Cost Leadership and Product Differentiation Strategies Cost leadership and product differentiation are two ends of a competitive spectrum.

23. 14-23 Cost Leadership and Product Differentiation Strategies Cost leadership and product differentiation are two ends of a competitive spectrum. Microsoft falls closer toward the product differentiation end than does Proctor & Gamble.

24. 14-24 Partial Exercise 14-9 Click the button to skip this exercise. If you experience trouble making the button work, type 27 and press “Enter.” The numbers below are from the 2004 annual reports of two major airlines. Southwest Airlines Delta Air Lines 2004 2003 2004 2003 Southwest Airlines Delta Air Lines 2004 2003 2004 2003 (in millions) Sales$6,530$5,937$15,002$14,087 Net income (loss)313442(5,198)(773) Total assets11,3379,87821,80125,939 ContinuedContinued

25. 14-25 Partial Exercise 14-9 Southwest Airlines Delta Air Lines 2004 2003 2004 2003 Southwest Airlines Delta Air Lines 2004 2003 2004 2003 (in millions) Sales$6,530$5,937$15,002$14,087 Net income (loss)313442(5,198)(773) Total assets11,3379,87821,80125,939 Calculate return on assets, asset turnover, and profit margin. Which airline appears to be more successful? Press “Enter” or left click the mouse for solution.

26. 14-26 Partial Exercise 14-9 Southwest Airlines Delta Air Lines 2004 2003 2004 2003 Southwest Airlines Delta Air Lines 2004 2003 2004 2003 (in millions) Profit margin 4.79%7.44%–34.65%–5.49% Asset turnover0.576 0.6010.6880.543 Return on assets2.76%4.47%–23.84%–2.98% The airlines have similar asset turnover ratios. Southwest has positive profit margins, while Delta’s profit margins are negative. Thus, our ratio analysis suggests Southwest is doing a better job of controlling costs.

27. 14-27 4 4 Evaluate operating performance by using accrual and cash flow measures. ObjectiveObjective

28. 14-28 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. It is a measure of cash flow generated during a period through the use of assets to produce and sell goods and services.

29. 14-29 Exhibit 6 A Comparison of Operating Cash Flows for Microsoft and Proctor & Gamble. Microsoft Proctor & Gamble 2004 2003 2004 2003 Microsoft Proctor & Gamble 2004 2003 2004 2003 (in millions) Net income$8,168$7,531$6,481$5,186 Depreciation and amortization1,1861,3931,7331,703 Other adjustments5,2726,8731,1481,811 Net cash from operations14.62615.7979.3628.700 Operating cash flows to total assets15.8%19.3%16.4%19.9%

30. 14-30 Further Evaluation of Operating Strategy Inventory turnover is the ratio of cost of goods sold to inventory. It measures the success of a company in converting its investment in inventory into sales.

31. 14-31 Inventory turnover = Cost of goods sold Inventories $6,716,000,000 $640,000,000 10.5 = Microsoft—2004 Further Evaluation of Operating Strategy

32. 14-32 Inventory turnover = Cost of goods sold Inventories $25,076,000,000 $4,400,000,000 5.7 = Proctor & Gamble—2004 Further Evaluation of Operating Strategy

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

34. 14-34 Further Evaluation of Operating Strategy Microsoft—2004 Days’ sales in inventory Inventories Cost of good sold ÷ 365 $640,000,000 $18,400,000 34.8 = = $6,716,000,000 ÷ 365

35. 14-35 Further Evaluation of Operating Strategy Proctor & Gamble—2004 Days’ sales in inventory Inventories Cost of good sold ÷ 365 $4,400,000,000 $68,701,000 64.0 = = $25,076,000,000 ÷ 365

36. 14-36 Accounts receivable turnover measures the success of a company’s ability to convert revenues into cash. Further Evaluation of Operating Strategy

37. 14-37 $36,835,000,000 $5,890,000,000 6.3 = Further Evaluation of Operating Strategy Sales revenue Receivables = Accounts receivable turnover Microsoft—2004

38. 14-38 $51,407,000,000 $4,062,000,000 12.7 = Further Evaluation of Operating Strategy Sales revenue Receivables = Accounts receivable turnover Proctor & Gamble—2004

39. 14-39 Further Evaluation of Operating Strategy A ratio related to accounts receivable turnover is average collection period, the ratio of accounts receivable to average daily sales.

40. 14-40 Further Evaluation of Operating Strategy $5,890,000,000 $100,917,800 58.4 days = Receivables Sales revenue ÷ 365 = Average Collection Period Microsoft—2004 $36,835,000,000 ÷ 365

41. 14-41 Further Evaluation of Operating Strategy $4,062,000,000 $140,841,000 28.8 days = Receivables Sales revenue ÷ 365 = Average Collection Period Proctor & Gamble—2004 $51,407,000,000 ÷ 365

42. 14-42 Further Evaluation of Operating Strategy The fixed asset turnover measures the effectiveness of a company in using its investment in fixed assets to create sales.

43. 14-43 Further Evaluation of Operating Strategy $36,835,000,000 $2,326,000,000 15.8 = Sales revenue Plant assets = Fixed asset turnover Microsoft—2004

44. 14-44 Further Evaluation of Operating Strategy $51,407,000,000 $14,108,000,000 3.6 = Sales revenue Plant assets = Fixed asset turnover Proctor & Gamble—2004

45. 14-45 Gross profit margin measures efficiency in the production or purchase of goods for sale. Further Evaluation of Operating Strategy

46. 14-46 Further Evaluation of Operating Strategy Gross profit Sales revenue $30,119,000,000 $36,835,000,000 81.8% = = Gross profit margin Microsoft—2004

47. 14-47 Further Evaluation of Operating Strategy Gross profit Sales revenue $26,331,000,000 $51,407,000,000 51.2% = = Gross profit margin Proctor & Gamble—2004

48. 14-48 Operating profit margin is an indicator of a company’s efficiency in controlling operating costs other than product costs. Further Evaluation of Operating Strategy

49. 14-49 Further Evaluation of Operating Strategy Operating income Sales revenue $27,801,000,000 $36,835,000,000 75.5% = = Operating profit margin Microsoft—2004

50. 14-50 Further Evaluation of Operating Strategy Operating income Sales revenue $9,827,000,000 $51,407,000,000 19.1% = = Operating profit margin Proctor & Gamble—2004

51. 14-51 Exercise 14-14 Click the button to skip this exercise. If you experience trouble making the button work, type 55 and press “Enter.” Using the income statement for Crystal Corporation on the next slide, calculate three ratios that indicate the efficiency and interpret the results for Crystal Corporation. ContinuedContinued

52. 14-52 Exercise 14-14 Sales revenue$50,000 Less: Cost of goods sold 25,000 Gross profit$25,000 Other operating expenses: Advertising$3,000 Utilities3,500 Wages 2,500 9,000 Operating income$16,000 Less: Income taxes 5,600 Net income$10,400 Crystal Corporation Income Statement For the Year Ending December 31, 2007 Press “Enter” or left click the mouse for solution.

53. 14-53 Exercise 14-14 Gross profit margin= Gross profit ÷ Sales revenue = $25,000 ÷ $50,000 = 50%ContinuedContinued Operating profit margin = Operating income ÷ Sales revenue = $16,000 ÷ $50,000 = 32%

54. 14-54 Exercise 14-14 For every dollar of sales revenue that Crystal Corporation earns, it realizes $0.50 in gross profit, which includes $0.32 of operating profit, which in turn includes $0.21 in net income. Profit margin= Net income ÷ Sales revenue = $10,400 ÷ $50,000 = 20.8%

55. 14-55 5 5 Examine return on equity and explain how operating, investing, and financing activities are interconnected. ObjectiveObjective

56. 14-56 Net income Equity Net income Equity Linking Operating and Investing Activities with Financing Activities Return on Equity Profit Margin Financial Leverage Asset Turnover = xx Net income Sales Revenues Net income Sales Revenues Total Assets Sales Revenues Total Assets Equity Total Assets Equity = xx

57. 14-57 Linking Operating and Investing Activities with Financing Activities Another ratio to measure financial risk is times interest earned. Microsoft had no interest expense in 2004, so times interest earned cannot be calculated.

58. 14-58 Linking Operating and Investing Activities with Financing Activities $9,827,000,000 $629,000,000 15.6 = Operating income Interest expense = Times interest earned Proctor & Gamble—2004

59. 14-59 6 6 Describe the primary components of an accounting system and how they are useful for understanding business activities. ObjectiveObjective

60. 14-60 Exhibit 8 Accounting and Business Decisions Transformation ProcessActivities Investing FinancingOperating Accounting SystemInformation Investing FinancingOperating Decision MakersDecisions Investing FinancingOperating

61. 14-61 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.

62. 14-62 Exhibit 9 The Accounting Information System

63. 14-63 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:

64. 14-64 Exhibit 10 Using Accounting Information to Make Decisions About Company Value

65. 14-65 T HE E ND C HAPTER 14

66. 14-66