Chapter 13

1. Chapter 13 Measuring and Evaluating Financial Performance PowerPoint Authors: Brandy Mackintosh Lindsay Heiser

2. Learning Objective 13-1 Describe the purpose and uses of horizontal, vertical, and ratio analyses.

3. Horizontal, Vertical, and Ratio Analyses Horizontal (trend) analyses are conducted to help financial statement users recognize important financial changes that unfold over time. 12/31/12 12/31/13 Gross Profit in 2012 Gross Profit in 2013 Δ in Gross Profit $ and/or % from 2012 Trend Analysis Vertical analyses focus on important relationships between items on the same financial statement. 2013 Amount Percent Sales Cost of Goods Sold Gross Profit $200,000 100% 150,000 75% $ 50,000 25%

4. Horizontal, Vertical, and Ratio Analyses ReceivableTurnover Ratio Net Sales Revenue Average Net Receivables Ratio analyses are conducted to understand relationships among various items reported in one or more of the financial statements. = It is essential to understand that no analysis is complete unless it leads to an interpretation that helps financial statement users understand and evaluate a company’s financial results

5. Learning Objective 13-2 Use horizontal (trend) analysis to recognize financial changes that unfold over time.

6. Horizontal (Trend) Computations Trend analyses are usually calculated in terms of year-to-year dollar and percentage changes. Let’s look at an example

7. Horizontal (Trend) Computations $48,815 – $47,220 $47,220 × 100 Calculate the change in dollars for Net Sales Revenue between 2010 and 2009. Now let’s look at the remainder of the trend analysis of the Income Statement. Can you calculate the dollar and percentage change for Cost of Sales? Now let’s calculate the percentage change in Net Sales Revenue between 2009 and 2008.

8. Learning Objective 13-3 Use vertical (common size) analysis to understand important relationships within financial statements.

9. Vertical (Common Size) Computations Vertical, or common size, analysis focuses on important relationships within financial statements. Income Statement Balance Sheet Sales = 100% Total Assets = 100% Cost of Sales Net Sales Revenue × 100

10. Learning Objective 13-4 Calculate financial ratios to assess profitability, liquidity, and solvency.

11. Ratio Computations Ratio analysis compares the amounts for one or more line items to the amounts for other line items in the same year. Ratios are classified into three categories . . . Profitability ratios examine a company’s ability to generate income. Solvency ratios examine a company’sability to payinterest and repaydebt when due. Liquidity ratios help us determine if acompany has sufficientcurrent assets to repayliabilities when due.

12. Common Profitability Ratios

13. Common Liquidity Ratios

14. Common Solvency Ratios

15. Learning Objective 13-5 Interpret the results of financial analyses.

16. Lowe’s began relying more on debt and less equity financing. Long-term liabilities increased 28.7 percent and stockholders’ equity decreased by 5%. Lowe’s assets grew only by 2.1% in fiscal 2010. Interpreting Horizontal and Vertical Analyses

17. Interpreting Horizontal and Vertical Analyses Cost of sales and operating expenses are the most important determinants of the company’s profitability. The increase in Net Income in fiscal 2010 is explained by the increase in Net Sales Revenue and the decreases in Cost of Sales and Operating Expenses as a percentage of sales.

18. Interpreting Horizontal and Vertical Analyses Lowe’s has experienced a small decrease in its percentage of Cost of Sales in relation to Sales Revenue from fiscal 2009 to 2010. Decreasing cost of sales means higher Gross Profit. Lowe’s did a better job of controlling its Operating Expenses between 2009 and 2010.

19. Ratio Calculations

20. Ratio Calculations

21. Profitability Ratios Net Profit Margin – The slowly improving economy helped boost Lowe’s profits in 2010 as shown by the increase in Net Profit Margin. Gross Profit Percentage – Lowe’s gross profit percentage indicates how much profit was made on each dollar of sales after deducting the Cost of Goods Sold.

22. Profitability Ratios Asset Turnover Ratio – indicates the amount of sales revenue generated for each dollar invested in assets during the period. Fixed Asset Turnover – indicates how much revenue the company generates in sales for each dollar invested in fixed assets, Home Depot 2010 fixed asset turnover ratio was 2.69

23. Profitability Ratios Return on Equity (ROE) – Compares the amount of net income to average stockholders’ equity. ROE reports the net amount earned during the period as a percentage of each dollar contributed by stockholders and retained in the business. Earnings Per Share (EPS) – Shows the amount of earnings generated for each share of outstanding common stock.

24. Profitability Ratios Price /Earnings (P/E) Ratio – Shows the relationship between EPS and the market price of one share of the company’s stock.

25. Liquidity Ratios Let’s change our attention to an examination of liquidity ratios. The analyses in this section focus on the company’s ability to survive in the short term, by converting assets to cash that can be used to pay current liabilities as they come due. ReceivableTurnover Ratio Net Sales Revenue Average Net Receivables = Receivable Turnover Ratio – Most retail home improvement companies have low levels of accounts receivable relative to sales revenue because they collect the majority of their sales immediately in cash.

26. Liquidity Ratios Inventory Turnover Ratio – The inventory turnover ratio indicates how frequently inventory is bought and sold. The “days to sell” indicates the average number of days needed to sell each purchase of inventory. Home Depot sells its inventory in an average of 85 days in 2010. Current Ratio – The current ratio measures the company’s ability to pay its current liabilities

27. Liquidity Ratios Quick Ratio – The quick ratio is a much more stringent test of short-term liquidity than is the current ratio. Lowe’s quick ratio increased slightly in 2010, just as its current ratio did. Referred to as “quick assets.” Let’s examine some Solvency Ratios Solvency ratios focus on a company’s ability to survive over the long term, that is, its ability to repay debt at maturity and pay interest prior to that time.

28. Solvency Ratios Debt to Assets Ratio – indicates the proportion of total assets that creditors finance. In 2010, The Home Depot had a debt-to-assets ratio of 53 percent. Times Interest Earned – indicates how many times the company’s interest expense was covered by its operating results.

29. Learning Objective 13-6 Describe how analyses depend on key accounting decisions and concepts.

30. Underlying Accounting Decisions and Concepts Accounting Decisions Difference in Strategies,e.g. type of financing. Difference in Operations,e.g. quality of items sold. Difference in Accounting Methods, e.g. FIFO vs. LIFO.

31. Accounting Concepts Companies may elect to use any acceptable generally accepted accounting principle (GAAP) as long as they apply the principle consistently.

32. Conceptual Framework for Financial Accounting and Reporting

33. Factors Contributing to Going-Concern Problems Factors that commonly contribute to going-concern problems are listed below.

34. Chapter 13Supplement 13A Nonrecurring and Other Special Items

35. Nonrecurring Items Extraordinary Items Very few events qualify as extraordinary items. Cumulative Effect of Changes in Accounting Methods Direct adjustment to Retained Earnings rather than income reporting.   Discontinued Operations For discontinued component two items are reported: Operating income prior to the date of disposal. Gain or loss on sale or disposal of net assets.  

36. Nonrecurring Items NONRECURING ITEM Discontinued Operations.

37. Other Special Items Comprehensive Income includes: Gains or losses from certain foreign currency exchange rate changes. Gains or losses resulting from the change in value of certain types of investments. Excludedfrom net income because they are likely to disappear before they are ever realized.

38. Chapter 13Supplement 13B Reviewing and Contrasting IFRS and GAAP

39. Overview At a basic level both IFRS and GAAP are concerned with accounting rules that describe when an item should be recognized in the accounting system, how that item should be classified (asset , liability, equity, expense, or revenue), and the amount at which each item should be measured. Yes No Report fixed assets at fair value. IFRS GAAP

40. Chapter 13Solved Exercises M13-1, M13-2, M13-6, E13-1, E13-3, E13-4, E13-10, E13-13

41. M13-1 Calculations for Horizontal Analyses Using the following income statements, perform the calculations needed for horizontal analyses. Round percentages to one decimal place.

42. M13-1 Calculations for Horizontal Analyses ($100,000 – $75,000)$75,000 × 100 = 33.3%

43. M13-2 Calculations for Vertical Analyses Refer to M13-1 . Perform the calculations needed for vertical analyses. Round percentages to one decimal place. $21,000 $100,000 × 100 = 21.0%

44. M13-6 Inferring Financial Information Using Gross Profit Percentage and Year-over-Year Comparisons A consumer products company reported a 25 percent increase in sales from 2012 to 2013. Sales in 2012 were $200,000. In 2013, the company reported Cost of Goods Sold in the amount of $150,000. What was the gross profit percentage in 2013? Round to one decimal place. Sales ($200,000 x 1.25) $250,000 100.0% Cost of Goods Sold (given) (150,000) -60.0% Gross Profit $100,000 40.0% $100,000 $250,000 × 100 = 40.0%

45. E13-1 Preparing and Interpreting a Schedule for Horizontal and Vertical Analyses The average price of a gallon of gas in 2010 jumped $0.43 (18 percent) from $2.36 in 2009 (to $2.79 in 2010). Let’s see whether these changes are reflected in the income statement of Chevron Corporation for the year ended December 31, 2010 (amounts in billions). Required: 1. Conduct a horizontal analysis by calculating the year-over-year changes in each line item, expressed in dollars and in percentages (rounded to one decimal place). How did the change in gas prices compare to the changes in Chevron Corp.’s total revenues and costs of crude oil and products? 2. Conduct a vertical analysis by expressing each line as a percentage of total revenues (round to one decimal place). Excluding income tax and other operating costs, did Chevron earn more profit per dollar of revenue in 2010 compared to 2009?

46. E13-1 Preparing and Interpreting a Schedule for Horizontal and Vertical Analyses Req. 1 The 18% increase in the average gas price was less than the 19.2% increase in total revenues and more than the 16.0% increase in cost of crude oil and products. It appears from this analysis that the increase in gas prices explains only part of Chevron’s increase in total revenues. Note that the percentage increase in total revenues was similar to the percentage increase in the cost of crude oil and products, suggesting the costs of crude oil really did increase a lot in 2010, necessitating the increase in gas prices.

47. E13-1 Preparing and Interpreting a Schedule for Horizontal and Vertical Analyses Req. 2 As a percent of total revenues, Chevron’s cost of crude oil and products was higher in 2009 (58.1%) than in 2010 (56.6%). This implies that Chevron earned more profit (excluding income tax and other operating costs) per dollar of revenues in 2010 than in 2009.

48. E13-3 Preparing and Interpreting a Schedule for Horizontal and Vertical Analyses According to the producer price index database maintained by the Bureau of Labor Statistics, the average cost of computer equipment fell 4.8 percent between 2009 and 2010. Let’s see whether these changes are reflected in the income statement of Computer Tycoon Inc. for the year ended December 31, 2010. Required: 1. Conduct a horizontal analysis by calculating the year-over-year changes in each line item, expressed in dollars and in percentages (rounded to one decimal place). How did the change in computer prices compare to the changes in Computer Tycoon’s sales revenues? 2. Conduct a vertical analysis by expressing each line as a percentage of total revenues (round to one decimal place). Excluding income tax, interest, and operating expenses, did Computer Tycoon earn more profit per dollar of sales in 2010 compared to 2009?

49. E13-3 Preparing and Interpreting a Schedule for Horizontal and Vertical Analyses Req. 1 The 4.8% decrease in the average price of computer equipment was less than the 16.7% decrease in total revenues. It appears from this analysis that the 4.8% decrease in computer prices was not offset by an increase in Computer Tycoon’s sales volume. In fact, the sales volume also decreased, leaving an overall decrease in sales revenues of 16.7%.

50. E13-3 Preparing and Interpreting a Schedule for Horizontal and Vertical Analyses Req. 2 Excluding income tax, interest, and operating expenses (i.e., looking at gross profit), we see that Computer Tycoon earned 40.0% gross profit in 2010, which is down from 40.4% in 2009. In other words, Computer Tycoon earned 0.4 cents less (40.0 – 40.4) per dollar of revenues in 2010 than in 2009.