13
Measuring Chapter and Evaluating Financial Performance
McGraw-Hill/Irwin
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objective 1
Describe the purposes and uses of trend and ratio analyses.
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Trend and Ratio Analyses
Trend analyses are conducted to help financial statement users recognize important financial changes that unfold over time. Ratio analyses, on the other hand, are conducted to understand relationships among various items reported in the financial statements.
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Learning Objectives 2 & 3
LO 2 Calculate financial trends and ratios. LO3 Interpret the results of trend and ratio analyses.
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Calculating Trends
Horizontal Analyses
Time-Series Analyses
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Calculating Trends
Calculating Change in Dollar Amounts
Dollar Change = Current Year Figure Base Year Figure
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Calculating Trends
Calculating Change as a Percentage
Percentage Change = Dollar Change Base Year Figure
100%
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Horizontal Analysis
The following slides illustrate a trend analysis for Matrix, Inc. for the years ended December 31, 2006 and 2005. We will begin with the asset section of the company's comparative balance sheets.
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Horizontal Analysis
Matrix, Inc. Comparative Balance Sheet December 31 Assets Current assets: Cash Accounts receivable, net Inventory Prepaid expenses Total current assets Property and equipment Land Building and equipment, net Total property and equipment Total assets 2006 $ 12,000 60,000 80,000 3,000 155,000 2005 $ 23,500 40,000 100,000 1,200 164,700 40,000 85,000 125,000 $ 289,700 Increase (Decrease) Amount % $ (11,500) 20,000 (20,000) 1,800 (9,700) 35,000 35,000 25,300 -48.9% 50.0% -20.0% 150.0% -5.9% 0.0% 41.2% 28.0% 8.7%
40,000 120,000 160,000 $ 315,000
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Horizontal Analysis
Matrix, Inc. Comparative Balance Sheet December 31 Assets 2006 2005 Current assets: Cash $ 12,000 $ 23,500 $ (11,500) -48.9% Accounts receivable, net 60,000 40,000 20,000 50.0% Inventory 80,000 100,000 (20,000) -20.0% Prepaid expenses 3,000 1,200 1,800 150.0% Total current assets 164,700 (9,700) -5.9% $12,000155,000 $23,500 = $(11,500) Property and equipment Land 40,000 40,000 0.0% Building and equipment, net 120,000 85,000 35,000 41.2% ($11,500 $23,500) 100% = 48.9% Total property and equipment 160,000 125,000 35,000 28.0% Total assets $ 315,000 $ 289,700 25,300 8.7% Increase (Decrease) Amount %
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Horizontal Analysis
Matrix, Inc. Comparative Balance Sheet December 31 Assets Current assets: Cash Accounts receivable, net Inventory Prepaid expenses Total current assets Property and equipment Land Building and equipment, net Total property and equipment Total assets 2006 $ 12,000 60,000 80,000 3,000 155,000 2005 $ 23,500 40,000 100,000 1,200 164,700 40,000 85,000 125,000 $ 289,700 Increase (Decrease) Amount % $ (11,500) 20,000 (20,000) 1,800 (9,700) 35,000 35,000 25,300 -48.9% 50.0% -20.0% 150.0% -5.9% 0.0% 41.2% 28.0% 8.7%
40,000 120,000 160,000 $ 315,000
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Horizontal Analysis
We could do this for the liabilities & stockholders' equity, but now let's look at the income statement accounts.
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Horizontal Analysis
Matrix, Inc. Comparative Income Statements For the Years Ended December 31 Increase (Decrease) 2006 2005 Amount % Sales $520,000 $480,000 $ 40,000 8.3% Cost of goods sold 360,000 315,000 45,000 14.3% Gross margin 160,000 165,000 (5,000) -3.0% Operating expenses 128,600 126,000 2,600 2.1% Net operating income 31,400 39,000 (7,600) -19.5% Interest expense 6,400 7,000 (600) -8.6% Net income before taxes 25,000 32,000 (7,000) -21.9% Income taxes (30%) 7,500 9,600 (2,100) -21.9% $17,500 $22,400 Net income $ (4,900) -21.9%
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Horizontal Analysis
Matrix, Inc. Comparative Income Sales increased by 8.3% yet Statements For the Years Ended December 31 net income decreased by 21.9%. Increase (Decrease) Can you determine what happened? 2006 2005 Amount % Sales $520,000 $480,000 $ 40,000 8.3% Cost of goods sold 360,000 315,000 45,000 14.3% Gross margin 160,000 165,000 (5,000) -3.0% Operating expenses 128,600 126,000 2,600 2.1% Net operating income 31,400 39,000 (7,600) -19.5% Interest expense 6,400 7,000 (600) -8.6% Net income before taxes 25,000 32,000 (7,000) -21.9% Income taxes (30%) 7,500 9,600 (2,100) -21.9% $17,500 $22,400 Net income $ (4,900) -21.9%
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Calculating Ratios
1. Profitability relates to performance in the current
period. The focus is on the company's ability to generate income during the period.
2. Liquidity relates to the company's short-term
survival. The focus is on the company's ability to use current assets to repay liabilities as they become due.
3. Solvency relates to the company's long-run
survival. The focus is on the company's ability to repay lenders when debt matures.
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Tests of Profitability
Net profit margin Gross profit percentage Asset turnover Fixed asset turnover Return on equity (ROE) Earnings per share (EPS) Quality of income Price/earnings ratio
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We will use the financial statement of Western Gear to perform our ratio analysis. The financial statements are shown on the next screen.
Western Gear, Inc. Balance Sheets December 31 2006 Assets Current assets: Cash Accounts receivable, net Inventory Prepaid expenses Total current assets Property and equipment: Land Buildings and equipment, net Total property and equipment Total assets 2005
$
30,000 20,000 12,000 3,000 65,000
$
20,000 17,000 10,000 2,000 49,000
165,000 116,390 281,390 $ 346,390
123,000 128,000 251,000 $ 300,000
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Western Gear, Inc. Balance Sheets December 31 2006 Liabilities and Stockholders' Equity Current liabilities: Accounts payable Notes payable, short-term Total current liabilities Long-term liabilities: Notes payable, long-term Total liabilities Stockholders' equity: Common stock, $1 par value Additional paid-in capital Total paid-in capital Retained earnings Total stockholders' equity 2005
$ 39,000 $ 40,000 3,000 2,000 42,000 42,000 70,000 112,000 27,400 158,100 185,500 48,890 234,390 78,000 120,000 17,000 113,000 130,000 50,000 180,000
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Total liabilities and stockholders' equity $ 346,390 $ 300,000
Western Gear, Inc. Income Statements For the Years Ended December 31
Sales Cost of goods sold Gross profit Operating expenses Net operating income Interest expense Net income before taxes Less income taxes (30%) Net income
2006 $ 494,000 140,000 354,000 270,000 84,000 7,300 76,700 23,010 $ 53,690
2005 $ 450,000 127,000 323,000 249,000 74,000 8,000 66,000 19,800 $ 46,200
Cash provided by operating activities is $65,000.
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Profitability Ratios
Net Profit Margin
Net Profit Net Income = Margin Net Sales Revenue Net Profit $53,690 = = 10.87% Margin $494,000
This ratio describes a company's ability to earn a net income from sales.
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Profitability Ratios
Gross Profit Profit Percentage
Gross Net Sales - Cost of Goods Sold = Percentage Net Sales Gross Profit $494,000 - $140,000 = = 71.66% Percentage $494,000
This ratio describes the profit, as a percent of sales, before operating expenses.
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Profitability Ratios
Asset Turnover
Asset = Turnover Net Sales Revenue Average Total Assets
($346,390 + $300,000) 2
Asset $494,000 = = 1.53 times Turnover $323,195 This ratio measures the efficiency of assets in producing sales.
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Profitability Ratios
Fixed Asset Turnover
Net Asset Net Sales Revenue = Turnover Average Net Fixed Assets
($281,390 + $251,000) 2
Net Asset $494,000 = = 1.86 times Turnover $266,195 This ratio indicates how much the company generates in sales for each dollar invested in fixed assets.
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Profitability Ratios
Return on Equity (ROE)
Net Income ROE = Average Stockholders' Equity
($234,390 + $180,000) 2
$53,690 ROE = = 25.91% $207,195
Shows the net amount earned this period as a percentage of each dollar contributed by stockholders, plus retained earnings.
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Profitability Ratios
Earnings Per Share (EPS)
Number of common shares outstanding January 1, 2006 December 31, 2006
Western Gear, Inc. 2006
Net Income 17,000 27,400 EPS = Average Number of December 31 market price per share $ 20.00 Cash taxes paid $ 17,500 Common Shares
Cash interest paid $ 7,000
$53,690 EPS = = $2.42 (17,000 + 27,400) 2 This ratio shows the net income for each common share outstanding.
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Profitability Ratios
Quality of Income
Quality of Net Cash From Operations = Income Net Income Quality of $65,000 = = 1.21 Income $53,690 This ratio compares net income with cash flows from operating activities.
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Profitability Ratios
Price/Earnings Ratio
Price/Earnings = Ratio Stock Price Earnings per Share
Quality of $20.00 = Income $2.42
= 8.26
This ratio is an indication of what investors are willing to pay for a share of stock in the company.
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Liquidity Ratios
Receivables turnover Days to collect Inventory turnover Days to sell Current ratio
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Liquidity Ratios Receivables Turnover
Receivables = Turnover Net Sales Revenue Average Net Receivables
($17,000 + $20,000) 2
Receivables $494,000 = = 26.70 times Turnover $18,500 This ratio tells us how many times receivables are collected each period.
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Liquidity Ratios
Days to Collect
Days to Collect Days to Collect
=
365 Receivable Turnover
365 = 26.70
= 13.67 days
This ratio tells us how quickly the company is able to collect its receivables.
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Liquidity Ratios Inventory Turnover
Inventory Cost of Goods Sold = Turnover Average Inventory
($12,000 + $10,000) 2
Inventory $140,000 = = 12.73 times Turnover $11,000 This ratio tells us how many times a company's inventory was sold and replaced during the year.
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Liquidity Ratios
Days to Sell
Days to Sell Days to Sell 365 = Inventory Turnover 365 = 12.73 = 28.67 days
This ratio tells us how long it takes the company to sell its inventory.
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Liquidity Ratios
Current Ratio
Current = Ratio Current Assets Current Liabilities
This ratio measures the short-term debt-paying ability of the company.
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Current $65,000 = = 1.55:1 Ratio $42,000
Solvency Ratios
Debt-to-assets Times interest earned Cash coverage Capital acquisitions ratio
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Solvency Ratios
Debt-to-Assets
Total Liabilities Debt to = Total Assets Assets Debt to $112,000 = = 32.33% Assets $346,390
This ratio indicates the proportion of total assets that are financed by creditors.
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Solvency Ratios
Times Interest Earned
Times Interest Earned
=
Net Income + Interest Expense + Income Tax Expense Interest Expense
Times Interest $53,690 + $7,300 + $23,010 = 11.51 times = Earned $7,300
This is the most common measure of the ability of a firm's operations to provide protection to the long-term creditor.
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Solvency Ratios
Cash Coverage Ratio
Cash = Coverage Net Cash from Operations + Interest Paid + Income Taxes Paid Interest Paid
Cash $65,000 + $7,000 + $17,500 = = 12.79 times Coverage $7,000
This ratio is similar to times interest earned but measure cash from operations rather than net income.
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Solvency Ratios
Capital Acquisitions Ratio
Net Cash from Operations Capital = Cash Paid for PPE Acquisitions
$281,390 - $251,000
$65,000 Capital = = 2.14 $30,390 Acquisitions This ratio relates cash flows from operating activities to cash paid for property, plant, and equipment.
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Learning Objective 4
Describe how trend and ratio analyses depend on key accounting decisions and concepts.
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Accounting Decisions and Concepts
Maintain consistency among accounting standards. Resolve new accounting problems. Provide user benefits.
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The Conceptual Framework
Objectives of Financial Reporting
Qualitative Characteristics of Accounting Information
Elements of Financial Statements
Recognition and Measurement Criteria
Environment assumptions Implementation principles Implementation constraints
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Conceptual Framework Objectives To provide information: Useful for decisions. That helps predict cash flows. About economic resources, claims to resources, and changes in resources and claims.
Exhibit 13-7
Qualitative Characteristics
Elements
Recognition and Measurement Concepts
Constraints
Financial Statements
Continued
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Objectives
Qualitative Characteristics
Understandability Primary Relevance Reliability Secondary Comparability Consistency
Elements
Assets Liabilities Equity Investments by Owners Distributions to owners Revenues Expenses Gains Losses Comprehensive Income
Recognition and Measurement Concepts
Assumptions Economic entity Going concern Periodicity Monetary unit Principles Historical cost Realization Matching Full Disclosure
Financial Statements Constraints
Cost effectiveness Materiality Conservatism Balance sheet Income statement Statement of cash flows Statement of shareholders' equity Related disclosures
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Qualitative Characteristics Understandability
Decision Usefulness
Relevance
Reliability
Predictive Value
Feedback Value
Timeliness
Verifiability
Neutrality
Representational Faithfulness
Comparability
Consistency
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Accounting Constraints
Conservatism
Cost Effectiveness
Materiality
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Chapter 13 Supplement
Nonrecurring and Other Special Items
McGraw-Hill/Irwin
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
Nonrecurring Items
Nonrecurring items include the impact of discontinued operations and extraordinary items.
Reported Net of Taxes
Reported After Income from Operations
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Other Special Items
Comprehensive Income
Gains and losses that are excluded from income are included in "comprehensive" income. The balance in comprehensive income appears in the stockholders' equity section of the balance sheet.
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End of Chapter 13
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