McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 13Measuring and EvaluatingFinancial Performance

PowerPoint Authors:Brandy MackintoshLindsay Heiser

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Learning Objective 13-1

Describe the purpose and uses of horizontal, vertical,

and ratio analyses.

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Horizontal, Vertical, and Ratio Analyses

Horizontal (trend) analyses are conducted to help financial statement users recognize important financial changes that unfold over time.

Gross Profit in 2012

Δ in Gross Profit $ and/or % from 2012

12/31/12 12/31/13

Gross Profit in 2013

Trend Analysis

Vertical analyses focus on important relationships between items on the same financial statement.

SalesCost of Goods SoldGross Profit

$200,000 100% 150,000 75%$ 50,000 25%

Amount Percent2013

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Horizontal, Vertical, and Ratio Analyses

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

ReceivableTurnoverRatio

=Net Sales Revenue

Average Net Receivables

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Learning Objective 13-2

Use horizontal (trend) analysis to recognize financial changes

that unfold over time.

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Horizontal (Trend) ComputationsTrend analyses are usually calculated in terms of

year-to-year dollar and percentage changes.

Let’s look at an example

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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.

Horizontal (Trend) Computations

Calculate the change in dollars for Net Sales Revenue between 2010 and 2009.

$48,815 – $47,220$47,220

× 100

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Learning Objective 13-3

Use vertical (common size) analysis to understand

important relationships within financial statements.

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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 SalesNet Sales Revenue × 100

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Learning Objective 13-4

Calculate financial ratios to assess profitability,

liquidity, and solvency.

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Ratio ComputationsRatio 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 ratiosexamine a company’s

ability to generate income.

Liquidity ratios help us determine if a

company has sufficientcurrent assets to repay

liabilities when due.

Solvency ratios examine a company’s

ability to payinterest and repay

debt when due.

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Common Profitability Ratios

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Common Liquidity Ratios

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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

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.

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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.

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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.

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RatioCalculations

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Ratio Calculations

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Profitability RatiosNet 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.

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Profitability RatiosAsset 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

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Profitability RatiosReturn 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.

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Profitability Ratios

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

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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.

ReceivableTurnoverRatio

=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.

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Liquidity RatiosInventory 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

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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 RatiosSolvency 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.

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Solvency RatiosDebt 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.

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Learning Objective 13-6

Describe how analyses depend on key accounting decisions and concepts.

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Underlying Accounting Decisions and Concepts

Accounting Decisions

Difference in Strategies,e.g. type of financing.

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

Difference in Operations,e.g. quality of items sold.

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Accounting Concepts

Companies may elect to use any acceptable generally accepted accounting principle (GAAP) as long as they

apply the principle consistently.

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Conceptual Framework for Financial Accounting and Reporting

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Factors Contributing to Going-Concern Problems

Factors that commonly contribute to going-concern problems are listed below.

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 13Supplement 13A

Nonrecurring and Other Special Items

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Nonrecurring Items

Extraordinary ItemsVery few events qualify as

extraordinary items.Cumulative Effect of Changes in

Accounting MethodsDirect adjustment to Retained Earnings rather

than income reporting.

Discontinued OperationsFor 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.

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Nonrecurring ItemsNONRECURING ITEMDiscontinued Operations.

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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.

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 13Supplement 13B

Reviewing and Contrasting IFRS and GAAP

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OverviewAt 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), and3) the amount at which each item should be measured.

Report fixed assets at fair value.

IFRS YesGAAPNo

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 13Solved Exercises

M13-1, M13-2, M13-6, E13-1, E13-3, E13-4, E13-10, E13-13

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

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M13-1 Calculations for Horizontal Analyses

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

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M13-2 Calculations for Vertical AnalysesRefer to M13-1 . Perform the calculations needed for vertical analyses. Round percentages to one decimal place.

$21,000$100,000

× 100 = 21.0%

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M13-6 Inferring Financial Information Using Gross Profit Percentage and Year-over-Year ComparisonsA 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.

$100,000$250,000

× 100 = 40.0%

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%

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E13-1 Preparing and Interpreting a Schedule for Horizontaland Vertical AnalysesThe 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?

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E13-1 Preparing and Interpreting a Schedule for Horizontaland Vertical Analyses

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.

Req. 1

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E13-1 Preparing and Interpreting a Schedule for Horizontaland Vertical Analyses

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.

Req. 2

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E13-3 Preparing and Interpreting a Schedule for Horizontal and Vertical AnalysesAccording 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?

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E13-3 Preparing and Interpreting a Schedule for Horizontal and Vertical Analyses

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%.

Req. 1

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E13-3 Preparing and Interpreting a Schedule for Horizontal and Vertical Analyses

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.

Req. 2

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E13-4 Computing Profitability RatiosUse 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?

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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.

Gross Profit Percentage = Net Sales Revenue - Cost of Goods Sold

Net Sales Revenue

2009 = $120,000 - $71,500

= 0.404 or 40.4% $120,000

2010 = $100,000 - $60,000

= 0.40 or 40.0% $100,000

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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%).

Net Profit Margin = Net Income

Total Revenue

2009 = $6,025

= 0.050

or 5.0% $120,000

2010 = $2,500

= 0.025

or 2.5% $100,000

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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.

Fixed Asset Turnover = Total Revenue

Average Net Fixed Assets

2009 = $120,000

= 2.66 $45,100

2010 = $100,000

= 1.85 $54,200

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E13-4 Computing Profitability Ratios

Req. 4

The company generated better returns for stockholders in 2009 (14.8%) than in 2010 (4.6%).

Return on Equity (ROE) = Net Income

Average Stockholders' Equity

2009 = $6,025

= 0.148 or 14.8% $40,800

2010 = $2,500

= 0.046 or

4.6% $54,000

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E13-10 Inferring Financial Information from Profitability and Liquidity RatiosDollar 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 insouthern, 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 General’s 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?

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E13-10 Inferring Financial Information from Profitability and Liquidity Ratios

Req. 1

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%

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

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E13-13 Analyzing the Impact of Selected Transactions on theCurrent RatioThe 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.

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Current Assets

(CA)

Current Liabilities

(CL)

Current Ratio

(CA ÷ CL) Start $88,000 ($88,000 ÷ 1.75) $50,286 1.75

Transaction (1) Cash –6,000 Accts. pay. –6,000 Subtotal 82,000 44,286 1.85 Transaction (2) Cash –10,000 Subtotal 72,000 44,286 1.63 Transaction (3) No

impact*

Subtotal 72,000 44,286 1.63 Transaction (4) Cash –25,000 Dividends pay. –25,000 Subtotal $ 47,000 $19,286 2.44

E13-13 Analyzing the Impact of Selected Transactions on theCurrent Ratio

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End of Chapter 13