ACCOUNTING FINANCIAL PRELIM 1
BUSINESS OPERATIONS Owner Managers: founders of the business who also function as managers Lender: or creditor, lends money to an entity in hopes of gaining on interest payments Investors: invest in a company, in hopes of earning gains in one of two ways: 1. Dividends: a portion of what the company earns in the form of cash payments 2. Capital Gains: selling the stock at a higher price than bought THE ACCOUNTING SYSTEM: collects + reports financial info to decision makers Managerial Accounting: developing detailed plans and continuous performance reports for internal decision makersmanagers Financial Accounting: periodic financial statements and related disclosures, prepared for external decision makers investors, creditors, suppliers, customers
THE FOUR BASIC FINANCIAL STATEMENTS: summarize financial activities of the business,
can be prepared at any point in time (end of the year, quarter, month)
INCOME STATEMENT RETAINED EARNINGS BALANCE SHEET CASH FLOWS
THE BALANCE SHEET: reports the financial position of an accounting entity at a particular point in time, a snapshot Assets: economic resources owned by the entity as a result of past transactions, listed by their ease conversion to cash (their liquidity) o Current Assets: resources that will be used or turned into cash within 1 year, inventory will always be a current asset no matter what Accounts receivable, Cash, Supplies, Prepaid Expenses, Other Current Assets o Long Term Assets: resources owned by a company to be used over 3 years Long-Term Investments, Property and Equipment, Long Term Notes Receivable Intangible Assets: have no physical existence yet have a long life: patents, trademarks, copyrights, franchises that are used in a way similar to the depreciation of tangible assets They are reported net of accumulated amortization on the balance sheet Liabilities: debts or obligations from past transactions, listed by maturity o Current Liabilities: those obligations needing to be paid within 1 year Accounts Payable, accrued expense o Long Term Liabilities: Unearned Franchise Fees, Long-Term Notes Payable, Other Long-Term Liabilities Stockholders Equity: financing provided by owners of the business and earnings o Contributed Capital: the investment of cash and other assets in the business by the owners, shown in two accounts: Common Stock: when a corporation issues capital stock, the amount received is recorded in part as common stock
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Number of Shares X Par Value per Share o Each share of common stock usually has a low par value (the legal amount per share established by the board of directors) printed on the face of the certificate Additional Paid-in Capital/Contributed Capital in Excess of Par: the excess above par o Retained Earnings: company earnings (profits) that are not distributed to the owners as dividends and are instead reinvested in the business Assets = Liabilities + Stockholders Equity THE INCOME STATEMENT: reports the accountants primary measure of performance of a business: revenues less expenses during the accounting period Revenues: increases in assets or settlements of liabilities from ongoing operations / increase in net sales (A-L) o Reported whether the entity has received payment for the goods or not o Retail stores such as Wal-Mart or McDonalds usually receive cash at time of sale, however Maxidrive often receives promises to pay (receivables) Examples: provision of services, sale of goods, rental of property, commissary sales, franchise fees Expenses: the amount of assets used to generate revenues during the period o Examples: cost of goods sold, cost of sales (supplies + rental expenses), salaries and benefits, general / administrative expense (Insurance + Utilities Expenses), research + development expense, interest expense Other Revenues + Expenses: peripheral activities affecting the income statement that are not central to ongoing operations o Examples: Papa Johns purchases stocks w/ excess cash + earns capital gains, report under Investment Revenue in Other Revenues/Expenses Income Tax Expense: last item on income statement, calculated as a percentage of the difference b/w revenues and expenses Net Income: also called net earnings or the bottom line is the excess of total revenues over total expenses o Net Loss = Expenses > Revenues o Breakeven = Expenses = Revenues Earnings Per Share: used to evaluate operating performance and profitability o Earnings Per Share = Net Income / # of Shares Outstanding Revenues Expenses = Net Income THE STATEMENT OF RETAINED EARNINGS: reports the way that net income and the distribution of dividends affects the companys financial position during the accounting period represents the relationship between the income statement and the balance sheet Net Income: increases the balance of retained earnings Dividends: decrease the balance of retained earnings Beginning Retained Earnings + Net Income Dividends = Ending Retained Earnings Statement of Stockholders Equity: 2
Beginning Balance Stock Issuance Net Income Dividends Ending Balance
PAPA JOHNS INC. Contributed Retained Capital Earnings $1,000 $158,000 $2,000 $7,241 (3,000) $3,000 $162,241
Stockholders Equity $159,000 $2,000 $7,241 (3,000) $165,241
THE STATEMENT OF CASH FLOWS: reports a companys inflow and out flow of cold hard cash during a specific period of time Cash Flows from Operating Activities: flows directly related to earning income o Cash Collected from Customers / Franchises/ Investments (interest/divid.) o Cash paid to suppliers / Employees o Cash paid for Interest on Debt / Income Taxes Cash Flows from Investing Activities: cash flows related to the acquisition or sale of productive (long-term) assets o Purchasing Manufacturing Equipment / Investments / Assets for Cash o Selling Assets or Investments for Cash o Lending cash to others / Receiving principal payments on loans to others o Purchase Patent (Intangible) Cash Flows from Financing Activities: cash flows from owners or creditors o Bank borrowings o Dividends Paid to Investors o Repaying the Principal on Bank Borrowings o Issuing Stocks / Repurchasing Stocks Net Income will NOT equal Net Change in Cash with Accrual Accounting! +/- Cash Flows from Operating +/- Cash Flows from Investing +/- Cash Flows from Financing = Formula Net Change in Cash
Revenues Expenses = Net Income Beg. Retained Earnings + Net Income Dividends = Retained Earnings Assets (Cash etc) = Liabilities + Stockholders Equity (Cont. Cap + R.E) in Cash = Operating + Investing + Financing Activities
OVERVIEW!
Statement
Income Statement Statement of Retained Earnings Balance Sheet Statement of Cash Flows
Notes: provide supplemental info a/b the financial condition of a company 1. Note #1: describes the accounting rules applied in the companys statements 2. Note # 2: provides additional detail about a line on the financial statements 3
3. Note #3: provides additional financial disclosures a/b items not listed on the statements themselves ACCOUNTING ETHICS Generally Accepted Accounting Principles (GAAP): the measurement rules used to develop the information in financial statements The Securities and Exchange Commission (SEC): created after the stock market crash of 1929 by the Securities Exchange Act of 1934 The SEC is given broad power to determine the rules for financial statements that publicly traded companies must provide to stockholders The Financial Accounting Standards Board (FASB): the private sector body given the responsibility to work out the detailed rules that become the GAAP Report of Management/Management Certification: a formal statement in the annual report stating that management is responsible for the validity of financial statements Management takes 3 important steps to maintain integrity: 1. System of Controls: They maintain a system of controls over both the records and the assets of the company 2. External Auditors: they hire outside independent auditors (CPAs) to verify the fairness of the financial statements in an audit report Audit Reports: state the CPAs opinion of the fairness of the financial statements + the evidence to support that opinion 3. Board of Directors: They form a committee of the board of directors to oversee the integrity of these to other safeguards Public Company Accounting Oversight Board: sets standards for tests and professional approaches for auditors of public companies to use in examining transactions Ethics, Reputation, and Legal Liability: the American Institute of CPAs requires that all members adhere to a professional code of ethics and standards, failure to comply results in serious implications Malpractice repercussions are enormous incentive for auditors to be honest
BUSINESS TRANSACTIONS & WHAT TO RECORD ON FINANCIAL STATEMENTS
Transaction: events recorded as part of the accounting process, there are 2 kinds: 1. External Events: the exchange of assets + liabilities between a business and one or more parties 2. Internal Events: events that are not exchanges between the business and other parties yet still have a direct + measurable effect on the entity: losses due to fires A Contract is usually NOT considered a transaction, it involves only the exchange of promises Accounts: the standardized format which organizations use to accumulate the dollar effect of transactions one ach financial statement item Chart of Accounts: used to facilitate the recording of transactions Some Hints To Remember: 1. Accounts w/ Receivable in the title ASSET ACCOUNT 2. Accounts w/ Payable in the title LIABILITY ACCOUNT 3. Prepaid Expense Accounts ASSET ACCOUNT 4
4. Accounts w/ Unearned in title LIABILITY ACCOUNT Transaction Analysis: the process of studying a transaction to determine its economic effect on the entity in terms of the accounting equation, 2 principles: Duality of Effects: every transaction affects at least 2 accounts Not all Transactions Affect Financial Statements Ex: contracts, or if Papa Johns sent an order for napkins to its supplier and they accepted the order but did not fill it The transaction would be recorded when supplies are shipped A Compound Entry: when more than 2 accounts are affected Maintaining the Accounting Balance: assets = liabilities + stockholders equity Transaction Analysis Steps: 1Identify the Accounts Affected and Classify them by Type 2Determine Direction of Effects (increase/decrease) 3Balance the Equation! (A=L+SE) 4Maintain That Debits = Credts General Journal: a formal method of transaction analysis that records external transactions in the general ledger Journal Entries & T-Accounts: highly efficient, less formal, analytical tools\ DEBIT = LEFT SIDE CREDIT = RIGHT SIDE General Journal: method for expressing effects of a transaction on accounts in a debits equal credits format, yet no balances are shown T-Accounts: method for expressing effects of a transaction for each account and determining the ending balance of each account The Expanded Transaction Analysis Model: includes Revenues and Losses 1Revenues: cash inflow that increases income + S.E Revenues have Credit Balances: to increase a revenue you credit it How to Record: an asset is increased or liability decreased 2Expenses: cash outflow that decreases net income + S.E. through Retained Earnings Expenses Have Debit Balances: to increase an expense you debit it How to Record: an asset is decreased or liability increased 3When Revenues > Expenses = Net Income 4When Expenses > Revenues = Net Loss 5All Accounts can Increase or Decrease: but Revenue and Expense accounts tend to increase throughout the period ACCRUAL ACCOUNTING: records revenues when earned, expenses when incurred 1. Revenue Principle: revenues are recorded when earned, regardless of when payment is received, 4 criteria for revenue to be recorded: a. Delivery Has Occurred/Services have Been Rendered b. Persuasive Evidence of an Arrangement for Customer Payment c. The Price is Fixed or Determinable d. Collection is Reasonably Assured 2. Matching Principle: expenses are recorded when incurred, not when paid a. Wages to Employees who Worked During the Period
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b. c. d. e.
Utilities for Electricity used During the Period Supplies used During the Period Facilities Rental used During the Period Use of Oven and Other Equipment During the Period
ADJUSTING REVENUES AND EXPENSES Trial Balance: a list of individual accounts in one column, usually in financial statement order, with their ending debit or credit balances in the next two columns Contra Accounts: an account that is an offset to, or reduction of, a primary account Property & Equipment increase when assets are purchased and decrease when assets are sold, however, the portion of the asset which is used during the period between buying and selling is reflected in a contra account Accumulated Depreciation: Property & Equipment contra account Net Book Value: the difference between the acquisition cost of an asset and its accumulated cost of depreciation Historical Cost Accumulated Depreciation Adjusting Entries: revenues and expenses are easy to measure when cash is received or paid at the same time a service is rendered, goods received, or expenses incurred, however, payment is often received after the company performs and earns revenues, so its necessary to adjust the account at the end of the period to measure all revenues and expenses of that period and provide for accruals revenue & matching principles 1Deferred Revenue: when cash is received prior to delivering a good/service Examples: Unearned Ticket Revenue, Unearned Subscription Revenue During the Period: Debit Cash (+Asset) Credit Unearned Fee Revenue (+Liability) At the End of the Period: adjusting journal entry Debit Unearned Fee Revenue (-Liability) Credit Revenue (+Revenue, +Retained Earnings, +S.E.) 2Accrued Revenue: when cash is received after delivering a good/service Examples: Interest Receivable on Loans to Others, Rent Receivable At the End of the Period: adjusting journal entry Debit Accounts Receivable (+Asset) Credit Interest Revenue (+Revenue, +Retained Earnings, +SE) Next Period: Debit Cash (+Asset) Credit Accounts Receivable (-Asset) 3Deferred Expenses: when cash is paid prior to incurring an expense Examples: Supplies, Prepaid Expenses (Rent, Advertising, Insurance), Buildings and Equipment During the Period: Debit Prepaid Insurance (+Asset) Credit Cash (-Asset) At the End of the Period: adjusting journal entry
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Debit Insurance Expense (+Expense, -SE) Credit Prepaid Insurance (-Asset) 4Accrued Expense: when cash is paid after incurring an expense Examples: Interest Payable, Wages Payable, Property Taxes Payable, Interest Expense on Debt, Wages Expense, Utilities Expense (billed but not yet paid for) At the End of the Period: adjusting journal entry Debit Wages Expense (+Expense, -SE) Credit Wages Payable (+Liability) Next Period: Debit Wages Payable (-Liability) Credit Cash (+Asset) Lending Money: two components- principal and interest Note Principal is recorded when the money was loaned Interest Revenue is earned over time Interest Rate is ALWAYS given as an annual percentage To compute interest revenue for less than a year, the # of months is divided by 12 Post-Closing Balance: Temporary Accounts: income statement items (revenues/expenses) Permanent Accounts: balance sheet items (assets, liabilities and S.E) Set up in debit equals credit format + close out temporary accounts ENTRY JOURNAL EXAMPLES 1The Board of Directors decides to issue $3,000 of dividends next month Debit: Retained Earnings (- Stockholders Equity) $3,000 Credit: Dividends Payable (+Liability) $3,000 2Papa Johns issues $2,000 of additional stock, receiving cash from investors Debit: Cash (+A) $2,000 Credit: Contributed Capital (-SE) $2,000 3Papa Johns sold $36,000 of pizza to customers for. Their commissaries also sold $30,000 in supplies to franchises, receiving $21,000 in cash and the rest on account: Debit: Cash [$36,000 + $21,000] (+A) $57,000 Accounts Receivable (+A) $9,000 Credit: Restaurant & Commissary Sales (+RE+SE) $66,000 4The cost of dough, sauce, cheese, and other ingredients for the pizza sales was $10,000 and $20,000 for the commissary sales Debit: Cost of Sales (+E,-RE,-SE) $30,000 Credit: Supplies (-A) $30,000 5Papa Johns sold new franchises for $400 cash. The company earned $100 immediately by performing services for franchises; the rest will be earned over the next several months Debit: Cash (+A) $400 7
Credit: Unearned Franchise Fees (+L) $300 Franchise Fee Revenue (+R, +RE, +SE) $100 6Papa Johns Commissaries ordered and received $29,000 in supplies paying $9,000 with cash and owing the rest on account Debit: Supplies (+A) $29,000 Credit: Cash (-A) $9,000 Accounts Payable (+L) $20,000 7You sell land with a historical expense of $1,000 for $4,000 Debit: Cash (+A) $4,000 Credit: Land (-A) $1,000 Gain on Sale of Land (+R, +RE, +SE) $3,000 8Papa Johns received $3,500 in franchise fees from weekly sales, $800 was from the December, the rest were from January sales Debit: Cash (+A) $3,500 Credit: Accounts Receivable (-A) $800 Franchise Fee Revenue (+R, +RE, +SE) $2,700 9Callaway Golf issues 1,000,000 shares of stock at $16/share with par value of $.01 Debit: Cash [16 x 1,000,000] (+A) $16,000,000 Credit: Common Stock [.01 x 1,000,000] (+SE) $10,000 Additional Paid-in Capital [16,000,000 -10,000] $15,990,000 asdf
CHAPTER 5: COMMUNICATING & INTERPRETING ACCOUNTING INFORMATION 1) Regulators: Securities & Exchange Commission: mission to protect investors and maintain the integrity of the securities markets, to maintain this mission, they supervise. The Financial Accounting Standards Board (FASB): establishes the generally accepted accounting principles (GAAP) Public Company Accounting Oversight Board (PCAOB): sets auditing standards for independent auditors (CPAs) of public companies Stock Exchanges: establishes, along with state governments, the overall corporate governance standards 2) Management: has the primary responsibility for the information in financial statements, specifically the highest officer (CEO) and highest financial officer, the chief financial officer (CFO), these two individuals must certify that: Each report filed doesnt contain false material, and fairly reports the financial condition, results of operation, and cash flow in the company There are no significant deficiencies and material weaknesses in the internal controls over financial reporting They have disclosed to the auditors any weaknesses in internal controls or any fraud involving management or other employees
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Executives who knowingly certify false financial repots are subject to a $5 million fine and 20 years in prison The accounting staff, who prepare the details of financial statements, is also held responsible for this information with smaller legal implications, with instead their profession on the line Board of Directors (Audit Committee): responsible for ensuring that processes are in place for maintaining the integrity of the companys accounting, financial statement preparation, and financial reporting Composed of nonmanagement (independent) directors w/ financial knowledge Responsible for hiring the companys independent auditors + meeting separately with the auditors to discuss managements compliance with financial reporting standards Auditors: the SEC requires publicly traded companies to have their statements and control systems over the financial reporting process audited by an independent registered public accounting firm (independent auditor) following auditing standards established by the PCAOB Unqualified/Clean Audit Opinion: the auditors statement that financial statements are fair presentations of financial condition, complying w/ GAAP In signing this document, the CPA assumes some financial responsibility Often must also be signed by private investors and lenders Information Intermediaries: Financial Analysts: receive accounting reports and gather information through conversation w/ company executives and visits to company facilities + competitors and compile findings into analysts reports Earnings Forecasts: the analyst forecast future quarterly and annual earnings per share and advises recommendations: a buy, hold, or sell Information Services: analysts get their info from services such as: Compustat (compustat.com) + Thomson Research (research.thomsonib.com) Information Services: allow investors to gather company info EDGAR (Electronic Data Gathering and Retrieval) Service: sponsored by the SEC, companies file their forms electronically w/ in 24 hours of submission Users: Institutional Users: pension funds (associated w/ unions and employees of specific companies or government agencies), mutual funds, and charitable foundations Usually hire their own analysts Control the majority of publicly traded shares of U.S. companies Private Investors: large individual investors as well as small retail investors Retail Investors usually lack the expertise to understand financial statements and therefore hire brokers to buy stock for them such as Merrill Lynch Lenders/Creditors: suppliers, banks, commercial credit companies Utilize additional financial information such as monthly statements which the company agrees to provide as part of the lending contract
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Institutional & Private Investors also became creditors when they buy a companys publicly traded bonds Cost Benefit Constraint: suppliers themselves also create financial statements to help customers evaluate their financial health and future performance Cost Benefit Constraint suggests that the benefits of creating financial statements outweigh the costs 8) Principles for Communicating Useful Information: Relevant Information: can influence a decision, allows users to assess past activities and predict future ones Reliable Information: is accurate, unbiased, and verifiable Consistent Information: similar accounting methods have been applied within a company Comparable Information: similar accounting methods have been applied across industries Material Amounts: amounts that are large enough to influence a users decision, and are therefore required on financial statements Immaterial Amounts: small amounts not significant enough to be reported The user must be aware of immaterial amounts! Conservatism: care should be taken not to overstate revenues/understate expenses 9) The Disclosure Process Press Releases: provide timely info to external users to limit the possibility of selective leakage of information Some companies follow up press releases w/ conference calls Released within between 15 + 45 days of the end of the period Then sent electronically to news services such as Dow Jones, Reuters, and Bloomberg which makes them immediately available to users Include: key financial figures, condensed financial statements, and excerpts from a typical earnings press release Stock reaction to press releases usually happens quickly When the companys actual earnings are released, the public reacts not to the amount of earnings, but to the difference b/w expected + actual earnings Unexpected Earnings: difference b/w expected + actual earnings 10) Annual Reports: Private Companies: relatively simple documents, including The Four Basic Financial Statements Related Notes Report of Independent Accountants if the statements are audited Public Companies: more complex b/c of SEC regulations Nonfinancial Section: includes letter to stockholders from CEO, descriptions of the companys mgmnt philosophy, products, successes, challenges to future Financial Section: includes the SECs minimum disclosure standards Summarized financial data for a 5 or 10 year period
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Managements discussion and analysis of financial condition, results of operations and disclosures about market risk The Four Basic financial statements Notes Report of Independent Accountants (Auditors opinion) Recent stock price information Summaries of the uaudited quarterly financial data Lists of directors and officers of the company and their addresses 11) Quarterly Reports: begins w/ short letter to shareholders, followed by a condensed income statement and condensed balance sheet, both of which are unaudited Private companies also normally provide quarterly reports for their lenders 12) SEC Reports: public companies must file periodic reports w/ the SEC Form 10-K: the annual report, present all info in the companys annual report The 10-K simply provides a more detailed description of the business including its products, product development, sales/marketing, manufacturing, competitors and lists properties owned or leased, legal proceedings and significant contracts signed Form 10-Q: quarterly reports, present all info in the companys quarterly report Form 8-K: reports disclosing material events not previously reported that is important to investors such as auditor changes, mergers, etc 13) A Closer Look at Financial Statements Items: Classified Income Statement/Consolidated Statement of Operations: Net Sales - Cost of Goods Sold Gross Profit Co - Operating Expenses m Income from Operations mo +/- Nonoperating Revenues/Expenses and nGains/Losses Income Before Income Taxes - Income Tax Expense Size Income Statements: consolidated income statements also include line items as a percentage of net sales Nonoperating (Other) Items: income, expenses, gains, and losses that do not relate to the companys primary operations added or subtracted from income from operations to obtain Income Before Income Taxes/ Pretax Earnings Interest Income/Interest Expense, Gains and Losses on the Sale of Fixed Assets & Investments Nonrecurring Items: three nonrecurring items Discontinued Operations: the loss or gain from when a major component of a business is sold/abandoned Extraordinary Items: gains or losses incurred that are both unusual and infrequent in occurrence
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Cumulative Effect of Changes in Accounting Methods: presents the effects on the balance sheet of changing from one acceptable accounting method to another, the affect of that change on assets and liabilities on the balance sheet is actually reflected on the income statement If present, an additional subtotal following these accounts is presented, Income from Continuing Operations/Income from Nonrecurring Items Manufacturing Companies: report one item more than service firms Gross Profit/Gross Margin: Net Sales Cost of Goods Sold Income from Operations/Operating Income: Operating Expenses Gross Profit
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EQUATIONS: used to analyze a companys past performance to predict its future potential 1Price Earnings Ratio: measures how many times the current years earnings investors are willing to pay for a companys stock Price/Earnings Ratio = Market Price / Net Income Market (Purchase Price) = P/E Ratio x Net Income 2Financial Leverage Ratio: measures managements effectiveness at utilizing debt to increase the amount of assets the company employs to earn income for stockholders Measures: the relationship b/w total assets and the stockholders equity that finances those assets The more assets financed by debt = the the FLR The more assets financed by S.E. = the the FLR A ratio of 2 = all debt/liability high risk company A ratio of 1 = no debt/liability low risk company Lower risk company, yet not making effort expand, or enhance return to stockholders Can be Increased By: Increased Borrowing Repurchasing (decreasing) outstanding stock Financial Leverage Ratio: Avg Total Assets/Avg Stockholders Equity Average = (Beginning Balance + Ending Balance) / 2 Competition: not a good way to compare competitors?? Ratio affected greatly by business strategy 3Total Asset Turnover Ratio: managements ability to utilize assets to generate sales Measures: the sales generated per dollar of assets A High Asset Turnover Ratio = efficient management of assets A Low Asset Turnover Ratio = less efficient management of assets Can by Increased By: Increasing Sales Volume Disposing of (Decreasing) Less Productive Assets Competition: when companies occupy similar niches in an industry, managements ability to control the firms assets is vital to success Total Asset Turnover Ratio= Sales (Operating) Revenue / Avg. Total Assets Caution! The TATR can decrease seasonally, with a change in management, or with a change in company policy 4Net Profit Margin: measures the managements ability to control revenues and expenses in order to generate more profit for stockholders Measures: how much of every sales dollar generated is profit A Rising Net Profit Margin = efficient mgmt of sales/expenses A Decreasing Net Profit Margin = less efficient mgmt Can be Increased By: Increasing Sales Volume Increasing Sales Price 13
Decreasing Expenses Competition: net profit margins of competitors in the same industry reflect how each company responds to changes in competition, changes in demand for the product, and changes in managing sales volume, price, and costs Business strategies have large impacts upon net profit margins Net Profit Margin = Net Income / Net Sales (Operating Revenue) Caution! Decisions managers make to maintain, increase their net profit margin quarterly may have negative repercussions in the long run Solution: divide each line in the income statement by net sales 5Return on Equity (ROE): the most comprehensive framework through which to evaluate company performance Measures: how well management used stockholders investment during the period, measures companys overall business strategy (operating +financing) In the Long Run, firms w/ a higher ROE are expected to have higher stock prices than firms w/ lower ROE 40% = pretty high Economic Gravity: when a company with high levels of ROE are driven down over the years due to competition ROE % + Stock Price = Directly Proportional: an ROE that from one year to the next drop in stock price Return on Equity = Net Profit Margin x Asset Turnover x Financial Leverage
Caution! An increasing ROE can indicate that a company is failing to invest in research and development or modernization of plant + equipment while such a strategy will decrease expenses and thus decrease ROE in the short run, it can result in future decreases in ROE as the companys products or plant and equipment reach the end of their life cycles Solution: evaluate ROE in the context of a companys business strategy ROE Decomposition: analyzes why ROE changes from year to year by breaking it down into profit drivers : Net Profit Margin, Asset Turnover, Financial Lev. Profit Drivers + Business Strategy: two strategies: High Value/Product Differentiation: brand identity allows company to charge higher price Low Cost Strategy: relies on efficient mgmt of accounts receivable, inventory, and productive assets to produce high asset turnover
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