Evaluating and Managing Financial Performance: Powerpoint Presentation by Ian Anderson, Algonquin College

13
Evaluating and
Managing Financial
Performance
PowerPoint Presentation by
Ian Anderson, Algonquin College
Chapter 13 Copyright 2010 by Nelson Education Ltd.

Looking Ahead
After studying this chapter, you should be able to:

1. Describe the purpose and content of financial
statements.
2. Identify the basic requirements for an accounting
system.
3. Explain two alternative accounting options.
4. Describe the purpose of and procedures related to
internal control.
5. Evaluate a firms operating liquidity. continued
Chapter 13 Copyright 2010 by Nelson Education Ltd. 13-2

Looking Ahead
6. Assess a firms profitability.
7. Measure a firms use of debt or equity financing.
8. Evaluate the rate of return earned on the owners
investment.
9. Describe the working capital cycle of a small
business.
10. Identify the important issues in managing a
firms cash flows.
11. Explain the key issues in managing accounts
receivable, inventory, and accounts payable.
Understanding Financial Statements
Financial Statements (Accounting Statements)

Reports of a firms financial performance and
resources, including an income statement, a
balance sheet and a cash flow
Helps determine a start-ups financial requirements
Assesses the financial implications
of a business plan

Income Statement
Income Statement
A report showing the profit or loss from a firms
operations over a given period of time.
How profitable is the business?
Sales Expenses = Profits
Revenue from product or service sales
Costs of producing product or service
Operating expenses (marketing, selling, general and administrative
expenses, and depreciation)
Financing costs (interest paid)
Tax payments
Some Accounting Terms
Cost of Goods Sold (COGS) - the cost of producing or

acquiring goods or services to be sold by a firm.
Operating expenses - consisting of both selling and
marketing expenses and administrative expanses.
Operating income - earnings before interest and taxes
Gross profit - sales less the COGS
Financing costs the amount of interest owed to
lenders on borrowed money
Net income available to owners (net income) income
that may be distributed to owners or re-invested in the
company
The Income Statement: An Overview
Operating Activities Financing Activities Taxes

Sales Revenue Operating Income Earnings Before Taxes
Interest expense
Cost of producing or on debt Income taxes
acquiring product or
(financing costs)
service
(cost of goods sold)
= Gross profit
= =
Marketing and selling
expenses, general and
administrative Earnings Before Taxes Net Income Available
,expenses and
to Owners
depreciation
(operating expenses)
Operating Income

Income Statement for Computer World Ltd.
for the Year Ending December 31, 2008
Chapter 13 Copyright 2010 by Nelson Education Ltd. Exhibit 13 -1 13-8

The Balance Sheet
Balance Sheet
Report showing a firms assets, liabilities (debt),
and owners equity at a specific point in time
Outstanding debt + Owners equity = Total assets
Snapshot of a businesss
financial position at a specific
point in time

The Balance Sheet:
Types of Assets
Current assets (working capital)
Assets that can be converted to cash within the firms
operating cyclecash, accounts receivable, and
inventories.
Fixed Assets
Relatively permanent resources intended for the use of
the firm.
Net fixed assets =
gross fixed assets accumulated depreciation
Other Assets
Intangible assets (patents, copyrights, goodwill)
The Balance Sheet:
Types of Financing
Debt Capital
Financing provided by a creditor
Short-term (current) Debt
Accounts payable
Accrued expenses
Short-term notes
Long-Term Debt
Loans and mortgages from
banks and other lenders with
maturities greater than one year
continued
The Balance Sheet:
Types of Financing
Owners Equity Capital
Money that the owners invest in the business
Owners are residual owners of the firm
Creditors have first claim on the assets of the firm.
Owners Owners Cumulative Owners cash

Equity = investment + profits withdrawals
Owners Owners Earnings retained

Equity = investment
+ within the firm
Balance Sheets for Computer World Ltd. for
December 31, 2007 and 2008
Exhibit 13-2
Balance Sheets for Computer World Ltd. for
December 31, 2007 and 2008
Exhibit 13-2
The Fit of the Income Statement
and the Balance Sheet
Exhibit 13-3
Cash Flow Measurement: Key Terms
Statement of Cash Flows

A financial report that shows
changes in a firms cash position
over a given period of time.
Accrual-Basis Accounting
A method of accounting that
matches revenues when they are
earned against the expenses
associated with those revenues.
Basic Requirements for
Accounting Systems
Provide an accurate picture of operating results.

Permit a quick comparison of current data with
prior years operations.
Furnish financial statements for use by
management, bankers, and prospective creditors.
Facilitate prompt filing of reports and tax returns
to regulatory and tax-collecting agencies.
Reveal employee fraud, waste, and record-
keeping errors.
The Record-Keeping System
Major Types of Internal Accounting Records

Accounts receivable records
Accounts payable records
Inventory records
Payroll records
Cash records
Fixed asset records
Other accounting records

Computer Software Packages
Chequebook functions
Automatic financial statements preparation
Cash budget tracking
Subsidiary journal accounts preparation
Outside Accounting Services
Convenience
Competence
Cost

Alternative Accounting Options
Cash Versus Accrual Accounting

Cash method
Revenues and expenses are recognized only when
payments are received or expenses are paid.
Accrual method
Revenue and expenses are reported when they are
incurred, regardless of when they are received or paid.

Accounting Method Alternatives
Single-Entry Versus Double-Entry Systems

Single-entry system
A chequebook system of
accounting reflecting only
receipts and disbursements.
Double-entry system
A self-balancing accounting
system that uses journals
and ledgers.

Internal Accounting Controls
Internal Control
A system of checks and balances that safeguards assets
and enhances the accuracy and reliability of financial
statements.
Types of internal controls
Identifying transactions requiring owner authorization
Ensuring cheques issued have supporting documentation
Limiting access to accounting records and computers
Sending bank statements directly to the owner
Safeguarding blank cheques
Requiring employees to take vacations
Controlling access to computer facilities

Assessment of Financial Performance
Methods to Interpret Financial Statements

Liquidity - does the firm have the capacity to meet its short-term
(one year or less) financial commitments?
Profitability - is the firm producing adequate operating profits on its
assets?
Stability - how is the firm financing its assets?
Return - are the owners (shareholders) receiving an acceptable
return on their equity?
Financial Ratios
Restatements of selected income statement and balance sheet date in
relative terms

Financial Ratios for
Retail Electronics and Appliance Stores
(Industry SIC Code 5731 and NAICS Code 443)
Exhibit 13-4
Measures of Liquidity
Current Ratio
Comparing cash and near-cash current assets against
the debt (current liabilities) coming due and payable
within one year.
Current assets
Current ratio
Current liabilities
$345,000
Current ratio 3.45
$100,000
Industry norm for 2008 current ratio = 1.6 continued

Acid-test ratio (quick ratio)

A measure of a companys liquidity that excludes
inventories.
Current assets - Inventories
Acid-test ratio
Current liabilities
$345,000 - $210,000
Acid-test ratio 1.35
$100,000
Industry norm for 2007 acid-test ratio = 0.7

Average Collection Period

The average time it takes a firm to collect its accounts
receivable.
Accounts receivable
Average collection period
Daily credit sales
$78,000
Average collection period 365 34.30 days
$830,000
Industry norm for average collection period = 16 days
continued
Inventory turnover
The number of times inventories roll over during the
year.
Cost of goods sold
Inventory turnover
Inventory
$540,000
Inventory turnover 2.57
$210,00
Industry norm for inventory turnover = 3.77 times

Calculate Return on Investment (ROI)
A measure of operating profits relative to total assets
Operating income
Operating profits Sales
return on investment X
(OIROI) Sales Total assets
Operating income Operating income

return on investment Total Assets
Operating income $100,000

return on investment 0.1087 or 10.87%
$920, 000
Industry norm for OIROI: 3.0%

Return on
Invested Capital:
An Overview
Exhibit 13-5
Measuring Return on Investment
(ROI)
Operating Profit Margin
The ratio of operating profits to sales, showing how well
a firm manages its income statement.
Operating profits
Operating profit margin
Sales
$100, 000
Operating profit margin 12.05%
$830,000
Industry norm for operating profit margin: 1.8%

continued
(ROI)
Total Asset Turnover
A ratio of sales to total assets, showing the efficiency
with which the firms assets are used to generate sales.
Sales
Total asset turn over
Total assets
$830,000
Total asset turn over 0.90
$920,000
Industry norm for total asset turnover = 3.7

continued
(ROI)
Operating Income Return on Investment
Operating income Operating Total asset

return on investment = profit margin X turnover
Operating income
return on investment = .1205 x 0.90 = 10.85%
Industry norm for OIROI = 1.33%

Turnover Ratios
Industry
Accounts Norm
Credit sales $830,000
receivable 10.64 17.0
Accounts receivable $78,000
turnover
Inventory Cost of goods sold $540,000

2.57 3.77
turnover Inventory $210,000
Sales $830,000
Fixed asset turnover 1.58 3.7
Fixed assets $525,000

How is the Firm Financing Its Assets
Financial Leverage
The use of debt in financing a firms assets
Debt-Equity Ratio
The ratio of total debt to total assets
Total debt
Debt ratio
Total Assets
$300,000
Debt ratio 0.33, or 33.0%
$920,000
Industry norm for debt ratio = 42% continued
How is the Firm Financing Its Assets
Times Interest Earned Ratio

The ratio of operating income to interest charges
Operating income
Times interest earned
Interest Expense
$100,000
Times interest earned 5.0
$20,000
Industry norm for time interest earned = 2.9

Return on Investment
Return on equity
The rate of return that owners earn on their investment.
Net income
Return on equity
Common Equity
$80,000
Return on equity 26.7%
$300,000
Industry norm for return on equity = 0.4%

Working-Capital
Working Capital Management

The management of current assets and current
liabilities
Net Working Capital
The sum of a firms current assets (cash,
accounts receivable, and inventories) less current
liabilities (short-term notes, accounts payable,
and accruals).

1
Increases Purchase
or produce Increases inventory
accounts payable
inventory
The Working-
Capital Cycle 2
Sell the Decreases inventory
Illustrated inventory
Increases
2a 2b accounts
for cash on credit receivable
3a 3b
Decreases Pay Pay
accounts accounts operating
payable payable expenses
and taxes
4
Collect Decreases
accounts accounts
receivable receivable
decreases increases increases decreases

5
Cash Begin cycle
again
Exhibit 13-8
Working-Capital Time Line
Order Inventory Cash Collection

Placed Received Sale of Receivables
Days in Inventory
Days in Accounts Receivable
a b c d e
Days in Accounts Payable
Cash Conversion Period
Cash Payment
for Inventory
Cash conversion
period
the time required to
convert paid-for
inventories and
accounts receivable
into cash.
Exhibit 13-9
Working Capital Time Line
for Pokey, Inc.
Pokey, Inc.
Days in Inventory
Days in Accounts Receivable
Aug. 15 Aug. 31 Sept. 30 Oct. 15 Nov. 30

Cash Conversion Period
Cash Payment for Inventory
Exhibit 13-10
Working Capital Time Line
for Quick-turn Company
Quick-turn Company
Days in Inventory Days in Accounts Receivable
Aug. 15 Aug. 31 Sept. 30 Oct. 31
Cash Payment for Inventory
Exhibit 13-10
Pokey, Inc.s Beginning Balance Sheet
July
Cash 400
Accounts receivable 0
Inventory 0
Fixed assets 600
Accumulated depreciation 0
TOTAL ASSETS 1,000
Accounts payable 0
Accrued operating expenses 0
Income tax payable 0
Long-term debt 300
Common debt 700
Retained earnings 0
TOTAL DEBT AND EQUITY 1,000

Pokey, Inc.s Monthly Balance Sheets
Changes: August
July Aug. Sept. to September
Cash 400 400 (100) 500
Accounts receivable 0 0 0
Inventory 0 500 500
Fixed assets 600 600 600
Accumulated depreciation 0 0 0
TOTAL ASSETS 1,000 1,500 1,000
Accounts payable 0 500 0 500

Accrued operating expenses 0 0 0
Income tax payable 0 0 0
Long-term debt 300 300 300
Common debt 700 700 700
Retained earnings 0 0 0
TOTAL DEBT AND EQUITY 1,000 1,500 1,000
continued

Changes:
September to
July Aug. Sept. Oct. October
Cash 400 400 (100) (100)
Accounts receivable 0 0 0 900 +900
Inventory 0 500 500 0 500
Fixed assets 600 600 600 600
Accumulated depreciation 0 0 0 (50) 50
TOTAL ASSETS 1,000 1,500 1,000 1,350
Accounts payable 0 500 0 0

Accrued operating expenses 0 0 0 250 +250
Income tax payable 0 0 0 25 +25
Long-term debt 300 300 300 300
Common debt 700 700 700 700
Retained earnings 0 0 0 75 +75
TOTAL DEBT AND EQUITY 1,000 1,500 1,000 1,350
continued

Changes:
October to
November
July Aug. Sept. Oct. Nov.
Cash 400 400 (100) (100) 550 +650
Accounts receivable 0 0 0 900 0 900
Inventory 0 500 500 0 0
Fixed assets 600 600 600 600 600
Accumulated depreciation 0 0 0 (50) (50)
TOTAL ASSETS 1,000 1,500 1,000 1,350 1,100
Accounts payable 0 500 0 0 0

Accrued operating expenses 0 0 0 250 0 250
Income tax payable 0 0 0 25 25
Long-term debt 300 300 300 300 300
Common debt 700 700 700 700 700
Retained earnings 0 0 0 75 75
TOTAL DEBT AND EQUITY 1,000 1,500 1,000 1,350 1,100

Changes in Pokeys Balance Sheet
Change in the Balance Sheet Effect on Income Statement

Increase accounts receivable of $900 Sales $ 900
Decrease inventories of $500 Cost of goods sold $ 500
Increase in accrued operating Operating expenses $ 250
expenses of $250
Increase accumulated depreciation of $50 Depreciation expense $ 50
Increase accrued taxes of $25 Tax expense $ 25

Pokeys November Income Statement
Sales revenue 900

Cost of goods sold 500
Gross Profit 400
Operating expenses:
Cash 250
Depreciation 50
Total operating expenses 300
Operating income 100
Income tax (25%) 25
Net income 75

Managing Cash Flows
The Nature of Cash Flows

The flow of actual cash through a firm.
Net Cash Flow
The difference between inflow and outflows
Net Profit
The difference between revenue and expenses
The Growth Trap
A cash shortage resulting from rapid growth
Flow of Cash Through A Business
Owner's Borrowed Sale of

Investment Borrowed
Funds Fixed Assets
Funds
Collection
Collection of
of
Cash Accounts
Sales Accounts
Receivable
Receivable
Purchase of Payment of
Fixed Assets Expenses
Payment of Payment for

Dividends Inventory
Exhibit 13-11

Candace
Corporation:
Cash Budget
(July -
September)

Managing Accounts Receivable
How Accounts Receivable Affect Cash

Accounts receivable represent the firms decision
to delay the inflow of cash from customers who
have been extended credit.
Life Cycle of Accounts Receivable
Firm makes credit sale to customer.
Invoice is prepared and sent to customer.
Customer pays firm.
continued
Managing Accounts Receivable
Accounts Receivable Financing

Financing speeds up immediate cash flow
Pledged accounts receivable
Accounts receivable used as collateral for a loan.
Factoring
Obtaining cash by selling accounts receivable at a
discount to another firm.

Managing Inventory
Inventory is a necessary evil.
Product supply and consumer demand dont always match
up.
Reducing Inventory to Free Cash
Monitoring current inventory
Determine age and suitability for sale.
Controlling stockpiles
Match on-hand inventory with demand.
Avoid personalizing the business-customer relationship.
Avoid forward purchasing of inventory; the carrying cost
for excess inventory may exceed any savings.
Managing Accounts Payable
Negotiation
Asks creditors for adjustments or additional time.
Timing
Creditors funds can supply short-term cash needs
until payment is demanded.
Accounts with cash discounts for early payment
should be examined for their savings potential.
Buy now, pay laterpay early enough to get
cash discounts and timely enough to avoid late-
payment fees.
An Accounts Payable for Terms 3/10, Net 30
Timetable
(days after invoice) Settlement Costs for $20,000 Purchase
Day 1 through 10 $19,400
Day 11 through 30 $20,000
Day 31 and thereafter $20,000 + possible late penalty + deterioration
in credit standing
Annualized Days in year Cash discount %

interest rate x
Net period - Cash discount period 100 - Cash discount%
365 3
X
30 - 10 100 - 3
18.25 x 0.030928 0.564, or 56.4%

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13

Chapter 13 Copyright 2010 by Nelson Education Ltd.

After studying this chapter, you should be able to:

Chapter 13 Copyright 2010 by Nelson Education Ltd. 13-2

Financial Statements (Accounting Statements)

Chapter 13 Copyright 2010 by Nelson Education Ltd. 13-4

Cost of Goods Sold (COGS) - the cost of producing or

Operating Activities Financing Activities Taxes

Chapter 13 Copyright 2010 by Nelson Education Ltd. 13-7

Chapter 13 Copyright 2010 by Nelson Education Ltd. Exhibit 13 -1 13-8

Chapter 13 Copyright 2010 by Nelson Education Ltd. 13-9

Owners Owners Cumulative Owners cash

Owners Owners Earnings retained

Statement of Cash Flows

Provide an accurate picture of operating results.

Major Types of Internal Accounting Records

Chapter 13 Copyright 2010 by Nelson Education Ltd. 13-18

Chapter 13 Copyright 2010 by Nelson Education Ltd. 13-19

Cash Versus Accrual Accounting

Chapter 13 Copyright 2010 by Nelson Education Ltd. 13-20

Single-Entry Versus Double-Entry Systems

Chapter 13 Copyright 2010 by Nelson Education Ltd. 13-21

Chapter 13 Copyright 2010 by Nelson Education Ltd. 13-22

Methods to Interpret Financial Statements

Chapter 13 Copyright 2010 by Nelson Education Ltd. 13-23

Industry norm for 2008 current ratio = 1.6 continued

Acid-test ratio (quick ratio)

Industry norm for 2007 acid-test ratio = 0.7

Chapter 13 Copyright 2010 by Nelson Education Ltd. 13-26

Average Collection Period

Industry norm for average collection period = 16 days

Industry norm for inventory turnover = 3.77 times

Chapter 13 Copyright 2010 by Nelson Education Ltd. 13-28

A measure of operating profits relative to total assets

Operating income Operating income

Operating income $100,000

Industry norm for OIROI: 3.0%

Industry norm for operating profit margin: 1.8%

Industry norm for total asset turnover = 3.7

Operating income Operating Total asset

Industry norm for OIROI = 1.33%

Chapter 13 Copyright 2010 by Nelson Education Ltd. 13-33

Inventory Cost of goods sold $540,000

Chapter 13 Copyright 2010 by Nelson Education Ltd. 13-34

Times Interest Earned Ratio

Industry norm for time interest earned = 2.9

Industry norm for return on equity = 0.4%

Chapter 13 Copyright 2010 by Nelson Education Ltd. 13-37

Working Capital Management

Chapter 13 Copyright 2010 by Nelson Education Ltd. 13-38

decreases increases increases decreases

Order Inventory Cash Collection

Aug. 15 Aug. 31 Sept. 30 Oct. 15 Nov. 30

Days in Accounts Payable

Cash Payment for Inventory

Days in Inventory Days in Accounts Receivable

Aug. 15 Aug. 31 Sept. 30 Oct. 31

Days in Accounts Payable

Cash Payment for Inventory

Chapter 13 Copyright 2010 by Nelson Education Ltd. 13-43

Accounts payable 0 500 0 500

Chapter 13 Copyright 2010 by Nelson Education Ltd. 13-44

Accounts payable 0 500 0 0