Year 12 Accounting

1. Year 12 Accounting Chapter 18 Evaluating Profitability

2. ANALYSIS AND INTERPRETATION OF PROFITABILITY This chapter concentrates on analysing and interpreting the information contained in the reports in order to provide advice to help the owner make more informed decisions. Analysing involves examining the reports in great detail to identify changes or differences in performance. Interpreting involves examining the relationships between the items in the reports in order to explain the cause and effect of those changes or differences. Once the causes and effects of changes or differences in performance are understood, a course of action can be recommended to the owner to assist decision making.

3. Analysis • Any analysis of business performance must be include an assessment of: • Profitability: the ability of the business to earn profit, measured by comparing its profit against a base like sales, assets or owner’s equity • Liquidity: the ability of the business to meet its debts as they fall due. • Clearly, business survival depends on having both satisfactory profitability and satisfactory liquidity: a profitable business will still fail if it cannot pay its debts. • This chapter concentrates on an assessment of profitability, while liquidity is addressed in Chapter 19. In the process, the firm’s efficiency – the way it uses its assets – will also be assessed.

4. Assessing profitability

5. Capacity or ability to earn profit • At its most elemental, a firm’s ability to earn profit is dependent on its ability to: • earn revenue • control expenses. • An analysis of the IncomeStatement a logical starting point. However, there are many factors which may affect a firm’s ability to earn revenue and control its expenses, and the significance of these factors must be considered when assessing profitability. • The size of the business (in terms of the assets it controls), the size of the investment by the owner and the level of sales are all significant in determining how much profit a business is able to earn. • If the profit was expressed per dollar of assets, a comparison of the ability of each firm to earn profit if they had the same asset base would be possible, showing which was more profitable.

6. TOOLS FOR ASSESSING PROFITABILITY

7. Clear View Windows Where changes over a number of periods form a pattern, this is known as a trend. See Clear View Windows (summarised) Income Statements on p. 429. In order to aid the Understandability of the accounting information, trends may be presented as line or bar graphs. This makes them easier to understand for users who have little or no accounting knowledge. Figure 18.1 shows a line graph showing Sales Revenue, Gross Profit and Net Profit for 2014 to 2016.

8. Horizontal Analysis In the previous example, both Sales and COGS increased, but the fact that Gross Profit actually decreased in 2016 indicates that COGS increased by more. We can reach this conclusion intuitively, but preparing a horizontal analysis will show the numerical proof. A horizontal analysis calculates the change in items from one period to the next, expressing the change in both dollar and percentage terms so that the relative size of the changes can be assessed. Using the information above, the horizontal analysis of the IncomeStatement would appear as is shown in Figure 18.2.

9. Horizontal Analysis The percentage difference is calculated by dividing the difference (in dollar terms) by the previous year’s figure (e.g. Sales: 12 000/100 000 ✕ 100 = 12%). The horizontal analysis shows that although sales has increased by 12% in 2015, Cost of Goods Sold has actually increased by 17.4% (a larger increase), and this has led to Net Profit only increasing by 5.7%.

10. Variances Trends highlight changes in revenues and expenses from one period to the next, but they don’t allow the owner to assess whether they have met the firm’s goals for that period. This assessment is performed using a variance report, which highlights the difference between actual and budgeted figures, so that problem areas can be identified and addressed (see Chapter 17). In this sense, these reports are invaluable tools for assessing profitability because they draw attention to areas in which performance has been below expectation.

11. Benchmarks • In terms of profit and profitability, it is impossible to say whether a result is satisfactory without reference to a benchmark of some sort. A benchmark is an acceptable standard against which the firm’s actual performance can be assessed. There is no set level of profitability that is considered to be satisfactory, but a firm may compare its actual profit performance against: • Performance in previous periods • Budgeted performance for the current year • Performance of other similar firms (industry average)

12. Profitability Indicators • Sometimes known as ‘profitability ratios’ (even though most are actually presented as percentages), these indicators express an element of profit in relation to some other aspect of business performance. • This course considers the following indicators: • Return on Owner’s Investment (ROI) • Return on Assets (ROA) • Asset Turnover (ATO) • Net Profit Margin(NPM) • Gross Profit Margin(GPM)

13. RETURN ON OWNER’S INVESTMENT (ROI) From an investor’s point of view, the main measure of profitability is Return on Owner’s Investment (ROI), which measures the return (profit) generated for the owner on the capital they have invested. Specifically, it shows the profit earned per dollar invested by the owner, and will be useful in helping to decide between alternative investments.

14. Average Owners Equity Given that the Net Profit figure is earned over a period, but owner’s equity is measured at a particular point in time, ‘Average owner’s equity’ is used in the calculation of Return on Owner’s Investment so that any increases or decreases in capital over the year are accounted for, and is calculated as:

15. Carl’s Clothing See Carl’s Clothing vs. Anna’s Attire example p. 432. Note there is no set level at which Return on Owner’s Investment would be considered satisfactory. However, the Return on Owner’s Investment must be comparable with the interest rate on a term deposit, the rent earned on property, the dividend earned on shares, or simply the return earned by similar businesses. In fact, given the risk the owner takes by investing, and the long hours many owners work, he or she may require a Return on Owner’s Investment that is above these alternative investments.

16. Changes in Return on Owner’s Investment See Filmore Doors example. Reducing Owner’s equity will lead to higher Gearing, and this is one way of increasing the return to the owner without actually increasing profit. With higher Gearing, the owner still receives all the profit, but the business is using someone else’s funds to buy the asset to earn that profit. However, higher Gearing means a higher risk that the business will be unable to repay its debts and meet the interest payments. Therefore, the owner must judge carefully so that Gearing is high enough to maximise the Return on Owner’s Investment, without sending the business into difficulties in relation to its debt burden. (Gearing is not being examined, but it has been explained here because of its effect on ROI.)

17. Return on Assets Whereas Return on Owner’s Investment assesses profitability from an investor’s point of view, Return on Assets (ROA) measures profitability from a manager’s point of view. Return on Assets measures how effectively the firm has used its assets to earn profit. Specifically, it measures Net Profit per dollar of assets controlled.

18. Return on Assets Formula Just as the formula for Return on Owner’s Investment used Average owner’s equity, Return on Assets uses Average Total Assets. However, if Total Assets has not changed significantly over the period, or an average cannot be calculated, Total Assets at the end of the period may be used. See Barry’s Books example.

19. Comparisons The Return on Owner’s Investment will always be higher than the Return on Assets. This is because owner’s equity will always be lower than total assets, which in turn is due to its borrowings – its liabilities. Only in a firm that has no liabilities (which is extremely unlikely) will the Return on Owner’s Investment be the same as the Return on Assets. It is important to keep in mind the figures that are used in its formula: on the top line, the profit the business has earned, and on the bottom, the assets it controls. If assets increase, and Net Profit increases by a smaller proportion, then the Return on Assets will fall, indicating deteriorating profitability. On the other hand, if Net Profit increases by more than assets, the Return on Assets will rise indicating improved profitability.

20. Changes An improvement in the Return on Assets may be the result of an improved ability to earn revenue, or better expense control (or both). A deterioration in the Return on Assets would, of course, be caused by the opposite. Either way, the Return on Assets will depend heavily on the firm’s ability to earn revenue and control its expenses, so this is the next phase in our analysis of profitability.

21. EARNING REVENUE: ASSET TURNOVER (ATO) Technically, Asset Turnover (ATO) is an efficiency indicator: it measures how efficiently the firm has used it assets to generate revenue. But as earning revenue is one of the keys to earning profit, Asset Turnover will have a direct and significant effect on profitability. Specifically, this indicator measures the number of times in a period the value of assets is earned as sales revenue: the higher the Asset Turnover, the more capable the firm is of using its assets to earn revenue.

22. Pino’s Plants In 2015, the business earned 1.2 times the value of its assets as revenue, and this has risen to 1.35 times in 2016. This confirms that Pino’s Plants Nursery has earned more revenue in 2015 not only because it has more assets, but because it has used those assets more productively. An increase in Asset Turnover (meaning an increased ability to earn sales revenue) should mean an increase in the Return on Assets (and increased Net Profit). However, this is not always the case. Where the Asset Turnover and the Return on Assets move in different directions, or to differing degrees, it indicates a change in expense control.

23. Controlling Expenses Expenses should not be looked on as necessarily ‘bad’, because they assist in the earning of revenue. However, this does not mean the firm should be happy to see more and more of its sales revenue being consumed by expenses. After all, every dollar that is consumed by expenses means one dollar less Net Profit. Expense control refers to the firm’s ability to manage its expenses so that they either decrease, or increase no faster than sales revenue.

24. Controlling Expenses • Provided expenses do not increase more than sales, we can consider this to be evidence of satisfactory expense control. Should they actually increase by less than sales, we would consider this to be evidence of improved expense control. • If expense control improves, then profitability should also improve. Thus, we will evaluate expense control by analysing three indicators that calculate the percentage of each dollar of sales that is retained as profit: • Net Profit Margin • Gross Profit Margin • In assessing these indicators, we will use the benchmarks established earlier in this chapter, namely: • performance in previous periods • budgeted performance • performance of similar firms.

25. NET PROFIT MARGIN It is vital that once a sale is made, the business retains as much of that revenue as profit as is possible. The Net Profit Margin(NPM) measures the percentage of sales revenue that is retained as Net Profit. Put another way, it measures how much of each dollar of sales revenue remains as Net Profit after expenses are deducted.

26. Net Profit Margin Due to differences in sales revenue, comparing Net Profit between businesses and between periods can be difficult; it is difficult to isolate how much of the difference is due to expense control, and how much is simply due to different sales revenue. Because this indicator expresses Net Profit per dollar of sales, it can identify changes in profit independent of changes in sales revenue. See Misha’s Shoe Barn example.

27. Return on Assets • The earlier discussion of Return on Assets highlighted that the ability of a firm to use its assets to earn profit depends on both its ability to earn revenue, and its ability to control its expenses. We now have an indicator that measures each of these factors: • Asset Turnover measures the ability of the firm to use its assets to earn revenue • Net Profit Marginmeasures the ability of the firm to control its expenses and retain sales revenue as Net Profit. • Thus, Return on Assets depends on both the Asset Turnover and the Net Profit Margin.

28. Gross Profit Margin If Gross Profit is used, we are able to assess expense control specifically as it relates to stock and Cost of Goods Sold. Thus, the Gross Profit Margin(GPM) measures the percentage of sales revenue that is retained as Gross Profit. The Gross Profit Margincan be used to assess the average mark-up on all goods sold during a particular period.

29. Gross Profit Margin See Misha’s Shoe Barn p 442. Note a higher Gross Profit Marginmeans a higher average mark-up – on average, a bigger gap between selling and cost prices.

30. VERTICAL ANALYSIS OF THE INCOME STATEMENT When we calculated the Net Profit Margin & Gross Profit Margin, we divided the appropriate profit figure by sales revenue. This allowed us to evaluate expense control by assessing what had happened to each dollar of sales revenue. This same approach can be applied to every item in the IncomeStatement in what is known as a vertical analysis.

31. Misha’s The vertical analysis for Misha’s Shoe Barn is shown in Figure 18.9 p. 444. By comparing the vertical analysis from one year to the next, we can see changes not just in expense amounts (as would be shown in a horizontal analysis), but changes in expenses as a percentage of sales. That is, it shows what each revenue and expense would be if sales had been constant. Given that not all business owners are accountants, presenting a vertical analysis in a pie chart (or a graph) is one way of ensuring Understandability in the accounting reports.

32. NON-FINANCIAL INFORMATION Non-financial information is a fairly broad term covering basically any information that is not expressed in dollars and cents, or reliant on dollars and cents for its calculation. It refers to information which cannot be found in the financial statements. The types of non-financial information that could be useful to the owner of a small business are impossible to quantify, but examples follow….

33. NON-FINANCIAL INFORMATION • The firm’s relationship with its customers: • customer satisfaction surveys • number of repeat sales • number of sales returns • number of customer complaints • number of sales enquiries/catalogue requests • degree of brand recognition (based on market research). • The suitability of stock: • customer satisfaction surveys • number of repeat sales • number of sales returns • number of customer complaints • number of sales enquiries/catalogue requests • degree of brand recognition (based on market research).

34. NON-FINANCIAL INFORMATION • The firm’s relationship with its employees: • Appraising their performance is an important part of assessing the firm’s performance. This could be done by structured performance appraisals. • The degree of employee satisfaction and workplace harmony on the other hand could be assessed by the number of days lost due to sick leave/industrial action, or the staff turnover/average length of employment. • The state of the economy: • Even the most profitable business will struggle to survive in a shrinking economy, so the state of the economy must be factored in to any evaluation of profitability. Specifically, the owner may wish to consider interest rates, the unemployment rate, and the number of competitors it faces, all of which will affect the firm’s ability to generate sales. The level of inflation will also be relevant when assessing the firm’s ability to control its expenses.

35. STRATEGIES TO IMPROVE PROFITABILITY • If profitability is a function of the firm’s ability to earn revenue and control its expenses, then strategies to improve profitability should concentrate on two areas. • Earning revenue: In order to improve its ability to earn revenue, a business could change: • Selling prices could be decreased to generate more sales volume, or increased to generate greater revenue per sale. • Advertising could be increased, or targeted more accurately at prospective customers. • Stock mix Only those products that are in demand should be kept on hand: slow moving lines should be removed, and replaced with those that sell. • Non-current assets More, and more efficient non-current assets will be enable the firm to earn more revenue. This may be better equipment, display fittings, delivery vehicles or in extreme cases, a new location. • Customer service Internal procedures – like paperwork – could be made more customer friendly; staff training could improve employees’ service/product knowledge; extra services (such as deliveries, wrapping, internet/phone access, product advice) could be offered.

36. STRATEGIES TO IMPROVE PROFITABILITY • Controlling expenses. In order to improve its ability to control expenses, a business could change: • Management of stock An alternative supplier may be able to provide cheaper and/or better quality stock, while different ordering procedures could reduce storage costs and stock losses, or generate price discounts (see Chapter 19 for a detailed discussion of stock management principles.) • Management of staff Different rostering systems, appropriate incentives, and extra training may improve staff productivity and performance. • Management of NCAs Assets that are inefficient, under-utilised or unreliable are ultimately expensive, and should be replaced or removed.

37. You! Read Summary. Do some end of chapter exercises. Stop yapping! Read Chapter 19 Where Are We Headed.