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Chapter 13

Measuring and Evaluating


Financial Performance

PowerPoint Authors:
Brandy Mackintosh
Lindsay Heiser

McGraw-Hill/Irwin Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objective 13-1

Describe the purpose and


uses of horizontal, vertical,
and ratio analyses.

13-2
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

in Gross Profit $
Trend Analysis
and/or % from 2012
Vertical analyses focus on important relationships between items on the
same financial statement.
2013
Amount Percent
Sales $200,000 100%
Cost of Goods Sold 150,000 75%
Gross Profit $ 50,000 25%
13-3
Horizontal, Vertical, and Ratio
Analyses
Ratio analyses are conducted to understand relationships among
various items reported in one or more of the financial statements.

Receivable
Net Sales Revenue
Turnover =
Average Net Receivables
Ratio

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 companys financial results

13-4
Learning Objective 13-2

Use horizontal (trend) analysis


to recognize financial changes
that unfold over time.

13-5
Horizontal (Trend) Computations
Trend analyses are usually calculated in terms of
year-to-year dollar and percentage changes.

Lets look at an example

13-6
Horizontal (Trend) Computations
$48,815 $47,220
100
$47,220

Now
Now lets
lets calculate
calculate the
the percentage
percentage
Calculate
Now
Canlets
Calculate
NowCan you
lets look
the
you calculate
look
the change
at the
calculate
change
at the remainder
the
in dollars
dollar
remainder
the
in dollars and
for
of
of the
dollarbetween
and
for Net
the
Net
change
change in
in Net
Net Sales
Sales Revenue
Revenue between
Sales
trend
percentage
Sales
trend analysis
Revenue
percentage
analysis
Revenue change
of
ofbetween
the
change Income
for
between
the Income
for Cost
2010
Cost
2010 Statement.
of
ofand
Sales?
2009.
Statement.
and
Sales?
2009.
2009 and 2008.
2009 and 2008.
13-7
Learning Objective 13-3

Use vertical (common size)


analysis to understand
important relationships within
financial statements.

13-8
Vertical (Common Size) Computations
Vertical,
Vertical, or
or common
common size,
size, analysis
analysis focuses
focuses on
on
important
important relationships
relationships within
within financial
financial statements.
statements.
Income Statement Sales = 100%
Balance Sheet Total Assets = 100%

Cost of Sales
100
Net Sales Revenue

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Learning Objective 13-4

Calculate financial ratios to


assess profitability,
liquidity, and solvency.

13-10
Ratio Computations
Ratio
Ratio analysis
analysis compares
compares the
the amounts
amounts for
for one
one or
or more
more line
line
items
items to
to the
the amounts
amounts for
for other
other line
line items
items in
in the
the same
same year.
year.

Ratios are classified into three categories . . .

Solvency
Solvency ratios
ratios
Profitability
Profitability ratios
ratios examine
examine aa companys
companys
examine
examine aa companys
companys ability
ability to
to pay
pay
ability
ability to
to generate
generate interest
interest and
and repay
repay
income.
income. debt
debt when
when due.
due.

Liquidity
Liquidity ratios
ratios
help
help us
us determine
determine ifif aa
company
company has has sufficient
sufficient
current
current assets
assets to
to repay
repay
liabilities
liabilities when
when due.
due.

13-11
Common Profitability Ratios

13-12
Common Liquidity Ratios

13-13
Common Solvency Ratios

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Learning Objective 13-5

Interpret the results of


financial analyses.

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

13-16
Interpreting Horizontal and Vertical
Cost of sales and operating expenses
Analyses are the most important determinants of
the companys 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.

13-17
Interpreting Horizontal and Vertical
Analyses Lowes has experienced a small
decrease in its percentage of Cost of
Lowes did a better job of
Sales in relation to Sales Revenue from
controlling its Operating
fiscal 2009 to 2010. Decreasing cost of
Expenses between 2009
sales means higher Gross Profit.
and 2010.

13-18
Ratio
Calculations

13-19
Ratio Calculations

13-20
Profitability Ratios
Net Profit Margin The slowly improving economy helped boost
Lowes profits in 2010 as shown by the increase in Net Profit
Margin.

Gross Profit Percentage Lowes gross profit percentage indicates


how much profit was made on each dollar of sales after deducting
the Cost of Goods Sold.

13-21
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
Home Depot
Depot 2010
2010 fixed
fixed asset
asset turnover
turnover ratio
ratio was
was 2.69
2.69

13-22
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.

13-23
Profitability Ratios
Price /Earnings (P/E) Ratio Shows the relationship between EPS
and the market price of one share of the companys stock.

13-24
Liquidity Ratios
Lets change our attention to an examination of liquidity
ratios. The analyses in this section focus on the
companys ability to survive in the short term, by
converting assets to cash that can be used to pay current
liabilities as they come due.
Receivable
Receivable Turnover
Turnover Ratio
Ratio Most
Most retail
retail home
home improvement
improvement
companies
companies have
have low
low levels
levels of
of accounts
accounts receivable
receivable relative
relative to
to sales
sales
revenue
revenue because
because they
they collect
collect the
the majority
majority of
of their
their sales
sales
immediately
immediately inin cash.
cash.

Receivable
Net Sales Revenue
Turnover =
Average Net Receivables
Ratio

13-25
Liquidity Ratios
Inventory
Inventory Turnover
Turnover Ratio
Ratio The
The inventory
inventory turnover
turnover ratio
ratio indicates
indicates how
how
frequently
frequently inventory
inventory is
is bought
bought and
and sold.
sold. The
The days
days to
to sell
sell indicates
indicates the
the
average
average number
number ofof days
days needed
needed toto sell
sell each
each purchase
purchase ofof inventory.
inventory.
Home Depot sells its inventory in an average of 85 days in 2010.

Current
Current Ratio
Ratio The
The current
current ratio
ratio measures
measures the the companys
companys ability
ability to
to
pay
pay its
its current
current liabilities
liabilities

13-26
Liquidity Ratios
Quick
Quick Ratio
Ratio The
The quick
quick ratio
ratio is
is aa much
much more
more stringent
stringent test
test of
of
short-term
short-term liquidity
liquidity than
than isis the
the current
current ratio.
ratio. Lowes
Lowes quick
quick ratio
ratio
increased
increased slightly
slightly in
in 2010,
2010, just
just as
as its
its current
current ratio
ratio did.
did.

Referred to as quick assets.

Lets examine some Solvency Ratios


Solvency ratios focus on a companys ability to survive over the long
term, that is, its ability to repay debt at maturity and pay interest prior to
that time.

13-27
Solvency Ratios
Debt
Debt to
to Assets
Assets Ratio
Ratio indicates
indicates the
the proportion
proportion of
of total
total assets
assets that
that
creditors
creditors finance.
finance.

In 2010, The Home Depot had a debt-to-assets ratio of 53 percent.

Times
Times Interest
Interest Earned
Earned indicates
indicates how
how many
many times
times the
the companys
companys
interest
interest expense
expense was
was covered
covered by
by its
its operating
operating results.
results.

13-28
Learning Objective 13-6

Describe how analyses


depend on key accounting
decisions and concepts.

13-29
Underlying Accounting Decisions
and Concepts
Accounting Decisions

Difference in Strategies, Difference in Operations,


e.g. type of financing. e.g. quality of items sold.

Difference in Accounting
Methods, e.g. FIFO vs. LIFO.

13-30
Accounting Concepts
Companies may elect to use any acceptable generally
accepted accounting principle (GAAP) as long as they
apply the principle consistently.

13-31
Conceptual Framework for Financial
Accounting and Reporting

13-32
Factors Contributing to Going-Concern
Problems
Factors that commonly contribute to
going-concern problems are listed below.

13-33
Chapter 13
Supplement 13A

Nonrecurring and Other Special


Items

McGraw-Hill/Irwin Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
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:
1. Operating income prior to the date of disposal.
2. Gain or loss on sale or disposal of net assets.

13-35
Nonrecurring Items
NONRECURING ITEM
Discontinued Operations.

13-36
Other Special Items
Comprehensive Income includes:
1. Gains or losses from certain foreign currency
exchange rate changes.
2. Gains or losses resulting from the change in value
of certain types of investments.

Excluded from net income


because they are likely to
disappear before they are
ever realized.

13-37
Chapter 13
Supplement 13B

Reviewing and
Contrasting IFRS and
GAAP

McGraw-Hill/Irwin Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Overview
At a basic level both IFRS and GAAP are concerned with
accounting rules that describe
1) when an item should be recognized in the accounting
system,
2) how that item should be classified (asset , liability, equity,
expense, or revenue), and
3) the amount at which each item should be measured.

Yes Report fixed assets at No


IFRS fair value.
GAAP

13-39
Chapter 13
Solved Exercises

M13-1, M13-2, M13-6, E13-1, E13-


3, E13-4, E13-10, E13-13

McGraw-Hill/Irwin Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
M13-1 Calculations for Horizontal Analyses
Using the following income statements, perform the calculations
needed for horizontal analyses. Round percentages to one decimal
place.

13-41
M13-1 Calculations for Horizontal Analyses

($100,000 $75,000)
100 = 33.3%
$75,000

13-42
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 = 21.0%
$100,000
13-43
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
100 = 40.0%
$250,000

13-44
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). Lets 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?

13-45
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 Chevrons 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.
13-46
E13-1 Preparing and Interpreting a Schedule for Horizontal
and Vertical Analyses

Req. 2

As a percent of total revenues, Chevrons 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.

13-47
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. Lets 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
Tycoons 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?

13-48
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 Tycoons sales volume. In fact, the sales volume also decreased,
leaving an overall decrease in sales revenues of 16.7%.

13-49
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.

13-50
E13-4 Computing Profitability Ratios
Use the information in E13-3 to complete the following requirements.
Required:
1. Compute the gross profit percentage for each year (one decimal place).
Assuming that the change for 2009 to 2010 is the beginning of a
sustained trend, is Computer Tycoon likely to earn more or less gross
profit from each dollar of sales in 2011?
2. Compute the net profit margin for each year (expressed as a percentage
with one decimal place). Given your calculations here and in
requirement 1, explain whether Computer Tycoon did a better or worse
job of controlling operating expenses in 2010 relative to 2009.
3. Computer Tycoon reported average net fixed assets of $54,200 in 2010
and $45,100 in 2009. Compute the fixed asset turnover ratios for both
years (round to two decimal places). Did the company better utilize its
investment in fixed assets to generate revenues in 2010 or 2009?
4. Computer Tycoon reported average stockholders equity of $54,000 in
2010 and $40,800 in 2009. Compute the return on equity ratios for both
years (expressed as a percentage with one decimal place). Did the
company generate greater returns for stockholders in 2010 or 2009?

13-51
E13-4 Computing Profitability Ratios

Req. 1

If these results are the beginning of a sustained trend,


then it is likely that Computer Tycoon will have lower total
revenues in 2011, and a decline in gross profit
percentage. The gross profit percentage of 40.0% means
that the company generated 40.0 cents of gross profit on
each dollar of sales in 2010, which was down almost half
of one cent from 2009. If this continues, the company
could be expected to generate even less gross profit from
each dollar of sales in 2011.
13-52
E13-4 Computing Profitability Ratios

Req. 2

Computer Tycoon did a worse job of controlling expenses (other than


the cost of goods sold) in 2010 relative to 2009 because the net profit
margin decreased 2.5% (5.0 2.5) at the same time that the gross
profit percentage decreased only 0.4% (from 40.4% to 40.0%).

13-53
E13-4 Computing Profitability Ratios

Req. 3

The company better utilized its investment in fixed assets in


2009. Its fixed asset turnover ratio fell from 2.66 in 2009 to
1.85 in 2010. The 2010 ratio means that the company
generated $1.85 of sales revenue for every dollar invested in
fixed assets.

13-54
E13-4 Computing Profitability Ratios

Req. 4

The company generated better returns for stockholders


in 2009 (14.8%) than in 2010 (4.6%).

13-55
E13-10 Inferring Financial Information from Profitability and
Liquidity Ratios
Dollar General Corporation operates approximately 9,400 general
merchandise stores that feature quality merchandise at low prices to meet
the needs of middle-, low-, and fixed-income families in
southern, eastern, and mid-western states. For the year ended January 28,
2011, the company reported average inventories of $1,643 (in millions) and
an inventory turnover of 5.39. Average total fixed assets were $1,427
(million), and the fixed asset turnover ratio was 9.13.
Required:
1. Calculate Dollar Generals gross profit percentage (expressed as a
percentage with one decimal place). What does this imply about the
amount of gross profit made from each dollar of sales? TIP: Work
backward from the fixed asset turnover and inventory turnover ratios to
compute the amounts needed for the gross profit percentage.
2. Is this an improvement from the gross profit percentage of 31.3 percent
earned during the previous year?

13-56
E13-10 Inferring Financial Information from Profitability and
Liquidity Ratios

Req. 1
We can get the net sales number from the fixed assets turnover ratio and the
cost of goods sold number from the inventory turnover ratio, as shown below.

Fixed asset turnover = Net sales Average fixed assets


9.13 = Net sales $1,427,000,000
9.13 x $1,427,000,000 = Net sales
$13,028,510,000 = Net sales

Inventory turnover = Cost of goods sold Average inventory


5.39 = Cost of goods sold $1,643,000,000
5.39 x $1,643,000,000 = Cost of goods sold
$8,855,770,000 = Cost of goods sold

So, Gross profit percentage = (Net sales Cost of goods sold) Net sales
= ($13,028,510,000 $8,855,770,000) $13,028,510,000
= 0.320 or 32.0%
13-57
E13-13 Analyzing the Impact of Selected Transactions on the
Current Ratio
The Sports Authority, Inc., is a private full-line sporting goods retailer.
Assume one of the Sports Authority stores reported current assets of
$88,000 and its current ratio was 1.75, and then completed the
following transactions:
1) paid $6,000 on accounts payable,
2) purchased a delivery truck for $10,000 cash,
3) wrote off a bad account receivable for $2,000, and
4) paid previously declared dividends in the amount of $25,000.

Required:
Compute the updated current ratio rounded to two decimal places,
after each transaction.

13-58
E13-13 Analyzing the Impact of Selected Transactions on the
Current Ratio

13-59
End of Chapter 13

13-60