Financial Accounting:: Tools For Business Decision-Making

Financial Accounting:1
Tools for Business DecisionMaking Fifth Canadian Edition
Prepared By: Debbie Musil Kwantlen Polytechnic University
Copyright John Wiley & Sons Canada, Ltd.
CHAPTER
14
14
1.
C H APT ER
Performance Measurement
Study Objectives
Understand the concept of sustainable income and indicate how irregular items are presented.
2.
3. 4. 5. 6. 7.
2
Explain and apply horizontal analysis.

Explain and apply vertical analysis. Identify and calculate ratios that are used to analyze liquidity. Identify and calculate ratios that are used to analyze solvency. Identify and calculate ratios that are used to analyze profitability. Understand the limitations of financial analysis.
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14
Sustainable Income
1
The level of profit that is likely to be attainable in the future Differs from actual profit due to irregular revenues, expenses, gains and losses that are included in profit Two common types of irregular items:
Discontinued operations Changes in accounting policy
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14
Discontinued Operations
1
Disposal, or availability for sale, of a component of an entity
Separate major line of business or major geographical area of operations that has been disposed of or is for sale Must be clearly distinguishable operationally and financially
CHAPTER
14
Discontinued Operations: Statement of Financial Position 1

Assets and liabilities are reported separately Valued and reported at lower of carrying amount and fair value, less any expected costs of disposition
Reported as non-current assets or liabilities
CHAPTER
14
Discontinued Operations: Income Statement
Segregated from continuing operations and reported separately on the income statement
Shown immediately following profit/loss from continuing operations
Consists of two parts:

Profit (loss) from discontinued operations
Gain (loss) on disposal of the segment

Both components are reported net of applicable taxes
6
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14
Change in Accounting Policy

1
Occurs when the policy used in the current year is different from the one used in the preceding year
Voluntary change: Allowed when new policy results in more reliable and relevant presentation Mandatory: Required by standard setters
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14
Change in Accounting Policy: Effect on Reporting 1

Cumulative effect of change to prior years is reported as adjustment to opening retained earnings
In statement of changes in equity (IFRS)
In statement of retained earnings (ASPE)
New policy used to report results of current year
Prior period statements restated

Effects of change detailed in notes
8
CHAPTER
14
Discussion Question
1
Discuss the adoption of international financial reporting standards (IFRS) as a change in accounting policy.
CHAPTER
14
Comparative Analysis
1
Three types of comparisons:
Intracompany basis comparisons within a company
Intercompany basis comparisons between one or more competitor companies Industry averages
10
CHAPTER
14
Comparative Analysis: Three Tools

Horizontal analysis (trend analysis)
A technique to determine the change over time

Percentage of base-period amount Percentage change for the period
Vertical analysis (common size analysis)

Ratio analysis
11
CHAPTER
14
Horizontal Analysis
Illustration 14-5
ANY COMPANY INC. Assumed Net Sales (in thousands)

2012 2011 2010 2009 2008
$ 6,051.0 $ 3,657.6 $ 8,989.2 $ 4,764.0 $ 3,376.8 179.2%

12
108.3%
266.2%
141.1%
100%
CHAPTER
14
Horizontal Analysis (Continued)

Illustration 14-6
ANY COMPANY INC. Assumed Net Sales (in thousands) 2012

65.4%
13
2011
(59.3)%
2010
88.7%
2009
41.1%
2008
n/a
CHAPTER
$ 6,051.0 $ 3,657.6 $ 8,989.2 $ 4,764.0 $ 3,376.8
14
Vertical Analysis
Expresses each item in a financial statement as a percent of a base amount (total assets or net sales) Illustration 14-9
14
CHAPTER
14
Vertical Analysis (Continued)

1
ANY COMPANY INC. Condensed Statement of Financial Position December 31 (in thousands) 2012 Assets Current Assets Property, Plant, and Equipment Other Assets Amount $ 2,139.9 8,062.7 363.1 Percent 20.3% 76.3% 3.4% 2011 Amount Percent $ 2,271.7 6,413.3 359.9 25.1% 70.9% 4.0%
Total Assets
15
$ 10,565.7
100%
$ 9,044.9
CHAPTER
100%
14
Discussion Question
1
Identify some situations when a horizontal or vertical percentage cannot be calculated or is not meaningful.
16
CHAPTER
14
Ratio Analysis
1
Liquidity Ratios: Measure short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash Solvency Ratios: Measure the ability of the company to survive over a long period of time Profitability Ratios: Measure the earnings or operating success of a company for a given period of time
17
CHAPTER
14
Liquidity Ratios
1
Working capital
Current ratio
Cash current debt coverage Receivables turnover Average collection period Inventory turnover
Days in inventory
18
CHAPTER
14
Working Capital
1
Measures short-term debt paying ability
Working Capital = Current Assets Current Liabilities
Higher is better
19
CHAPTER
14
Current Ratio
1
Measures short-term debt paying ability
Current Ratio = Current Assets Current Liabilities
Higher is normally (but not always) better. Be cautious about influences of slow moving inventory and receivables on this ratio.
20
CHAPTER
14
Cash Current Debt Coverage

1
Measures short-term debt-paying ability (cash basis)
Cash Provided (Used) by Operating Activities Average Current Liabilities
Cash Current = Debt Coverage
Higher is better
21
CHAPTER
14
Receivables Turnover
1
Measures liquidity of receivables
Net Credit Sales Receivables = Average Gross Receivables Turnover Higher is better
22
CHAPTER
14
Average Collection Period

1
Measures number of days receivables are outstanding
Average Collection Period
365 Days = Receivables Turnover
Lower is better
23
CHAPTER
14
Inventory Turnover
1
Measures liquidity of inventory
Inventory
Cost of Goods Sold =
Turnover
Average Inventory
Higher is better
24
CHAPTER
14
Days in Inventory
1
Measures number of days inventory is on hand
Days in Inventory
365 Days Inventory Turnover
Lower is better
25
CHAPTER
14
Solvency Ratios
1
Debt to total assets Times interest earned Cash total debt coverage Free cash flow
26
CHAPTER
14
Debt to Total Assets Ratio

1
Measures % of total assets provided by creditors
Debt to Total Assets =
Total Liabilities Total Assets
Lower is better
27
CHAPTER
14
Times Interest Earned

1
Measures ability to meet interest payments as they come due
Profit + Interest Expense + Income Tax Expense (EBIT) Interest Expense
Times Interest Earned
Higher is better
28
CHAPTER
14
Cash Total Debt Coverage

1
Measures long-term debt-paying ability (cash basis)
Cash Provided (Used) by Operating Activities Average Total Liabilities
Cash Total Debt = Coverage
Higher is better
29
CHAPTER
14
Free Cash Flow

1
Measures cash available for paying dividends or expanding operations
Net Cash Provided (Used) by Operating Activities
Net Capital Expenditures
Dividends Paid
Free Cash Flow
Higher is better
30
CHAPTER
14
Profitability Ratios
1

31
Return on common shareholders equity Profit margin Return on assets Asset turnover Gross profit margin Earnings per share (EPS) Price-earnings (P-E) ratio Payout ratio Dividend yield
CHAPTER
14
Return on Common Shareholders Equity 1

Measures overall profitability of shareholders investment
Return on Common Shareholders Equity Profit Preferred Dividends Average Common Shareholders Equity*
*Common shareholders equity = Total shareholders equity Preferred shares
Higher is better
32
CHAPTER
14
Return on Assets
1
Measures overall profitability of assets
How much is earned on each dollar invested in assets
Profit Average Total Assets
Return on Assets =
Higher is better
33
CHAPTER
14
Profit Margin
1
Measures the percentage of profit generated by each dollar of sales
Profit Margin =
Profit Net Sales
Higher is better
34
CHAPTER
14
Asset Turnover
1
Measures how efficiently assets are used to generate sales
Asset Turnover =
Net Sales Average Total Assets
Higher is better
35
CHAPTER
14
Gross Profit Margin

1
Measures margin between selling price and cost of goods sold
Gross Profit Margin
Gross Profit Net Sales
Higher is better
36
CHAPTER
14
Relationship Amongst Profitability Ratios

Illustration 14-15
37
CHAPTER
14
Earnings per Share (EPS)

1
Measures profit earned on each common share
Profit Preferred Dividends Weighted Average Number of Common Shares
Earnings Per Share
Not comparable between companies

38
CHAPTER
14
Price-Earnings (P-E) Ratio

1
Measures relationship between market price per share and earnings per share
Price-Earnings Ratio
Share Price Earnings Per Share
Higher indicates investors expect favourable profitability in future

39
CHAPTER
14
Payout Ratio
1
Measures % of profit distributed in the form of cash dividends
Cash Dividends Profit
Payout Ratio =
Higher is better for investors seeking income
40
CHAPTER
14
Dividend Yield
1
Measures rate of return earned from dividends during the year
Dividend Yield
Dividend per Share Market Price per Share
Higher is better for investors seeking income
41
CHAPTER
14
Discussion Question
1
Why are the P-E and dividend yield ratios known as market measures?
42
CHAPTER
14
Limitations of Financial Analysis

1
Can be impacted by
Alternative accounting principles Professional judgement Comprehensive income Diversification Inflation Economic factors
43
CHAPTER
14
Comparing IFRS and ASPE 1
CHAPTER
14
Copyright Notice
Copyright 2012 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein.
45
CHAPTER
14

Financial Accounting:: Tools For Business Decision-Making

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Financial Accounting:1

Tools for Business DecisionMaking Fifth Canadian Edition

Prepared By: Debbie Musil Kwantlen Polytechnic University

Copyright John Wiley & Sons Canada, Ltd.

Explain and apply horizontal analysis.

Copyright John Wiley & Sons Canada, Ltd.

Copyright John Wiley & Sons Canada, Ltd.

Discontinued Operations: Statement of Financial Position 1

Copyright John Wiley & Sons Canada, Ltd.

Discontinued Operations: Income Statement

Consists of two parts:

Gain (loss) on disposal of the segment

Change in Accounting Policy

Copyright John Wiley & Sons Canada, Ltd.

Change in Accounting Policy: Effect on Reporting 1

In statement of retained earnings (ASPE)

New policy used to report results of current year

Prior period statements restated

Copyright John Wiley & Sons Canada, Ltd.

Copyright John Wiley & Sons Canada, Ltd.

Comparative Analysis: Three Tools

A technique to determine the change over time

Vertical analysis (common size analysis)

Copyright John Wiley & Sons Canada, Ltd.

ANY COMPANY INC. Assumed Net Sales (in thousands)

$ 6,051.0 $ 3,657.6 $ 8,989.2 $ 4,764.0 $ 3,376.8 179.2%

Copyright John Wiley & Sons Canada, Ltd.

Horizontal Analysis (Continued)

ANY COMPANY INC. Assumed Net Sales (in thousands) 2012

$ 6,051.0 $ 3,657.6 $ 8,989.2 $ 4,764.0 $ 3,376.8

Copyright John Wiley & Sons Canada, Ltd.

Copyright John Wiley & Sons Canada, Ltd.

Vertical Analysis (Continued)

Copyright John Wiley & Sons Canada, Ltd.

Copyright John Wiley & Sons Canada, Ltd.

Copyright John Wiley & Sons Canada, Ltd.

Copyright John Wiley & Sons Canada, Ltd.

Copyright John Wiley & Sons Canada, Ltd.

Cash Current Debt Coverage

Cash Current = Debt Coverage

Copyright John Wiley & Sons Canada, Ltd.

Copyright John Wiley & Sons Canada, Ltd.

Average Collection Period

Average Collection Period

365 Days = Receivables Turnover

Copyright John Wiley & Sons Canada, Ltd.

Cost of Goods Sold =

Copyright John Wiley & Sons Canada, Ltd.

365 Days Inventory Turnover

Copyright John Wiley & Sons Canada, Ltd.

Copyright John Wiley & Sons Canada, Ltd.

Debt to Total Assets Ratio

Debt to Total Assets =

Total Liabilities Total Assets

Copyright John Wiley & Sons Canada, Ltd.

Times Interest Earned

Times Interest Earned

Cash Total Debt Coverage

Cash Total Debt = Coverage

Copyright John Wiley & Sons Canada, Ltd.

Free Cash Flow

Net Capital Expenditures

Free Cash Flow