Chapter 26 - Managerial Accounting Foundation of Financial...

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Unformatted text preview: Managerial Accounting Foundation of Financial Performance Measurement Chapter 26 I. Financial Performance Evaluation by Internal and External Users: Both creditors and investors want to maximize their returns and minimize risks. The Creditor (they make loans in the form of trade accounts, notes and bonds with the expectation to receive interest on the notes and bonds payable) they face the risk that the debtor will fail to pay back the loan. Investors (they buy stock) they hope to have increase stock equity and dividend payments. Both creditors and investors face great risks, in general, the greater the risk the greater the return. To average the returns and the risks creditors and investors put their funds into a portfolio. Portfolio is a group of loans or investments. The portfolio is designed to average both the returns and the risks. Creditors and Investors use financial statements to: 1. Judge past performance and current position 2. Judge future potential and the risk connected with that potential ASSESSMENT OF PAST PERFORMANCE AND CURRENT POSITION: Past performance is an indication of future performance. Creditors and Investors look at past sales, expenses, net income, cash flow, and return on investment as possible indicators of future performance. ASSESMENT OF FUTURE POTENTIAL AND RELATED RISKS: Information about the past and present is useful on to the extent that it bears on decisions about the future. The risk of an investment depends on the certainty with which investors can predict the company’s future profitability. The risk of loan depends on the certainty with which creditors can predict the company’s liquidity. Standards for Financial Performance Evaluation Commonly used financial evaluations: 1. Rule-of-Thumb Measures: These can be industry standards, such as credit rating published by the firm of Dun and Bradstreet, or Industry norms such as using a current ratio of 2:1 etc. Rule-of-Thumb measures just gives an idea. Great care must be exercise utilizing these measures. Sometimes these are used to confirm a firm is within certain standard. 2. Past Performance of the Company. Calculation of a company’s financial measures or ratios over a period of time. Comparing rations will allow the analyst to prepare a trend analysis and help them find if ratios are improving or deteriorating. Industry Norms: Comparing the organizations’ performance with industry norms. There are some limitation, however, these are: 3. Chapter 26 Needles 2008 1 Author: Anna Rovira Beavers 8/6/07 a) b) c) Two companies that seem to be in the same industry may not be strictly comparable. Most large companies operate in more than one industry. Similar companies in the same industry may operate used different methods for valuing inventory, depreciation, etc. II. Source of Information: 1. Reports Published by the company Management’s analysis of past year’s operations Financial statements Notes to financial statements Auditors’ report Summary of operations for a five-year period S E C Re p o rt s Publicly held corporations must file annual reports, quarterly reports, and current reports with the Securities and Exchange Commission (SEC). Reports that a company must submit to the SEC. A n n u a l F o rm 1 0 -K Quarterly – or interim 10-K Special events for 8-K. Example will be an important change to the accounting performance that will affect future performance. 2. BUSINESS PERIODICALS AND CREDIT AND INVESTMENT ADVISORY SERVICES III. Tools and Techniques of Financial Performance Evaluation: Horizontal Analysis: General Accepted Principles requires the presentations of comparative financial statements that give financial information for the current year and the previous year. Horizontal analysis begins with the computation of changes form the previous year to the current year in both dollar amounts and percentages. The percentages change must be computed to relate the size of the change to the size of the dollar amounts involves. Trend Analysis: Calculation of percentage changes is calculated for several successive years instead of for two years. Trend analysis has a long-term view, very important to point out the significant changes of a company over time. Vertical Analysis: To show relationship of the different parts to a total in a single statement. I n c l a s s : S E -3 , S E 4 , S E -5 , S E 6 , S E 7 Chapter 26 Needles 2008 2 Author: Anna Rovira Beavers 8/6/07 IV. Comprehensive Illustration of Ratio Analysis: Objective of the ratio: a. Liquidity b. Profitability c. Long-term solvency d. Market strength Ratio Current Ratio Calculation Current Assets / Current Liabilities Objective Measure the short term debt paying ability Quick Ratio Current Assets (Only cash + Marketable Securities + Receivables / Current Liabilities (excludes inventories and prepaid expenses) Net Sales / Average Accounts Receivable Cost of Good Sold / Average Inventory Net Income / Net Sales Measure the short term debt paying ability The lower the ratio the greatest ability a company has to pay its debt. Measures the size of accounts receivable and the effectiveness of credit policies. Measures relative size of inventory Measure of Net Income produced by each dollar of revenue Measure how efficiently assets are used to produced sales Measures overall earning power or profitability Measures of the profitability of stockholder investment Measure of capital structure land leverage Measures of investment confidence in a company. Receivables Turnover Inventory Turnover Profit Margin Asset Turnover Return on Assets Net Sales / Average Total Sales Net Income / Average Net Sales Net Income/ Average Stockholders Equity Total Liabilities / Stockholders Equity Market price per share/ Earning per share Return on Equity Debt to Equity Ratio Price Earning Ratio Chapter 28 Homework: E8, E9, P1, Chapter 26 Needles 2008 3 Author: Anna Rovira Beavers 8/6/07 ...
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