Chapter 23 Evaluating Financial Performance1
23Evaluating Financial Performance
— / CHAPTER 23 LECTURE NOTES1 / Identify the basic requirements for an accounting system.
PPT 23-1
Chapter 23
Evaluating Financial Performance
PPT 23-2
Looking Ahead
PPT 23-3/TM 23-3
Accounting Activities
in Small Firms
PPT 23-4/TM 23-4
The Record-Keeping System
PPT 23-5
Small Business
Accounting Resources /
- Accounting activities in small firms
- Basic requirements for accounting systems—Identify the major goal of an accounting system (to provide an accurate and thorough picture of operating results, compare data from current and former years, offer required financial statements, facilitate tax function, reveal employee misbehavior and errors).
- The record-keeping system
Accounts payable records
Inventory records
Payroll records
Cash records
Fixed assets records
Other accounting records
- Computer software packages
- Outside accounting services (e.g., consultants and mobile bookkeepers)
2 / Explain two alternative accounting options.
PPT 23-6/TM 23-6
Alternative Accounting Options /
- Alternative accounting options
PPT 23-7/TM 23-7
Accounting Method
Alternatives /
- Cash versus accrual accounting
- The cash method is easier to use but does not provide as accurate a matching of revenue and expenses.
- The accrual method involves more record-keeping but provides a more realistic measure of profitability.
- Single-entry versus double-entry systems
- The single-entry system is still occasionally used in very small firms.
- The single-entry system is basically a checkbook system.
- The double-entry system provides a self-balancing mechanism.
3 / Describe the purpose of and procedure related to internal control.
PPT 23-8
Internal Accounting Controls
[Acetate 23-8] /
- Internal accounting controls
- Internal control is a system of checks and balances that protects assets and ensures the accuracy of financial statements.
- Review the examples of internal control from the chapter.
4 / Evaluate a firm’s liquidity.
PPT 23-9
Evaluating Financial Performance
PPT 23-10/TM 23-10, 11/TM 23-11, 12/TM 23-12
Financial Ratios for Retail Computer and Software Stores
[Acetate 23-10,11,12]
PPT 23-13/TM 23-13, 14/TM 23-14, 15/TM 23-15, 16/TM 23-16, 17/TM 23-17
Can You Pay Your Bills?
[Acetate 23-13,14,15,16,17] /
- Evaluating the firm’s financial performance
- This section presents a framework for interpreting financial statements.
- Methods of interpretation vary, depending on the interpreter.
- Discuss the issues involved when interpreting a firm’s financial performance.
- Financial ratios permit comparisons with other firms.
- Can you pay your bills?
- Discuss the term liquidity.
- Discuss how the following ratios are calculated and their importance:current ratio, account receivables turnover, and inventory turnover
5 / Assess a firm’s operating profitability.
PPT 23-18
Return on Invested
Capital: An Overview
[Acetate 23-18]
PPT 23-19/TM 23-19, 20/TM 23-20,21/TM 23-21,22/TM 23-22
Are You making a Good Return on Your Assets?
PPT 23-23/TM 23-23
Turnover Ratios /
- Are you making a good return on your assets?
- Discuss how calculating return on assets can help in financial decision making.
- Explain the components of a firm’s return on assets (operating profit margin, total asset turnover).
- Fixed asset turnover
6 / Measure a firm’s use of debt or equity financing.
PPT 23-24, 25
How Much Debt Are You Using? /
- How much debt are you using?
- Discuss the alternative ways in which firms can be financed (debt vs. equity, etc.) and financial leverage.
- What is the significance of the debt ratio?
- Times interest earned ratio is commonly used in examining a firm’s debt position.
7 / Evaluate the rate of return earned on the owners’ investment.
PPT 23-26/TM 23-26, 27, 28, 29
Are You Getting a Good Rate of Return on Your Investment? /
- Are you getting a good rate of return on your investment?
- Discuss the concept of return on equity and its use
- Return on assets – interest rate
- Discuss the role the firm’s debt ratio has on return on equity
- Discuss the financial ratios in exhibit 23-5
- Comparability between firms
— / SOURCES OF AUDIO, VIDEO, AND OTHER INSTRUCTIONAL MATERIALS
PSI Research/Oasis Press, 300 North Valley Drive, Grants Pass, OR 97526, sells a workbook entitled The Business Owner’s Guide to Accounting and Bookkeeping ($19.95), which provides step-by-step explanations of the basics of accounting, including a discussion of ratio analysis. Contact the company at (800) 228-2275.
— / Answers to end-of-chapterdiscussion questions
- Explain the accounting concept that income is realized when earned, whether or not it has been received in cash.
p. 508An accounting convention is a generally accepted practice. This one is important because it makes possible a more accurate picture of current-period profits than if the firm recorded profits only when income and expenses had been received and paid, respectively, in cash.
- Should entrepreneurs have an outside specialist set up an accounting system for their startup or do it themselves? Why?
p. 507The rather technical character of a good accounting system suggests that the small business entrepreneur should utilize the services of a public accountant to design the system. The CPA will know the proper system objectives and will make sure the system is consistent with accepted accounting principles and practices so that data and transactions will always be treated consistently.
- What are the primary types of records required in a sound accounting system?
p. 506The major types of accounting records are accounts receivable records, accounts payable records, inventory records, payroll records, cash records, fixed-asset records, and miscellaneous records such as the insurance register and records of leaseholds.
- What are the major advantages of a double-entry accounting system over a single-entry system?
p. 508A double-entry system of accounting has a built-in, self-balancing characteristic not present in a single-entry system. Also, a double-entry system records transactions in such a way as to provide a natural flow into finished financial statements.
- What is liquidity? Differentiate between the two approaches given in this chapter to measure liquidity.
p. 511-512Liquidity is the ability to meet maturing debt obligations. The two methods of measuring liquidity are a static approach and a flow approach. The static approach compares the amount of liquid assets to the amount of short-term debt at a point in time. The flow approach measures how quickly the firm is converting liquid assets into cash.
- Explain the following ratios:
p. 514 – 515a.Operating profit margin
p. 516b.Total asset turnover
p. 518c.Times interest earned
To understand a ratio, we must be aware of its components.
- Operating profit margin = Operating profits Sales
This ratio reveals whether the operating profits (operating income) are sufficient relative to the sales being generated. This ratio is driven by five variables related to management’s performance:
- The number of units of products sold
- The average selling price for each product unit
- The cost of manufacturing or acquiring the firm’s product
- The ability to control general and administrative expenses
- The ability to control expenses in marketing and distributing the firm’s product
- Total asset turnover = Sales Total assets
Total asset turnover is a function of how efficiently management is using the firm’s assets to generate sales—namely, how accounts receivable, inventories, and fixed assets are handled. Thus, it measures how well management is managing the firm’s balance sheet.
- Times interest earned = Operating income Interest expense
The times interest earned ratio measures a firm’s ability to cover interest expenses. It is affected by the level of operating income generated by the company, the amount of debt used, and the interest rates charged by creditors on the debt.
- What is the relationship among these ratios: operating income return on investment, operating profit margin, and total asset turnover?
p. 514Operating income return on investment is a product of the operating profit margin and total asset turnover.
- What would be the difference between using operating profit and using net income when calculating a firm’s return on investment?
p. 514,518Operating profit is income before paying interest and taxes, whereas net income is income after interest and taxes. When we look at operating profits, we are only considering the impact of operating decisions. When we look at net income, we are including the effects of how the firm is financed along with the operating dimensions of the firm.
- What is financial leverage? When should it be used and when should it be avoided? Why?
p. 517Financial leverage is the effect of debt on financial statements, particularly the income statement. Leverage is good when the operating income return on investment is greater than the firm’s interest rate. Leverage is bad when the investment does not earn at least the interest rate the firm has to pay. The problem is that a business owner never knows which will occur until after the fact.
- What determines a firm’s return on equity?
p. 518A firm’s return on equity is affected by (a)the difference between the operating income return on investment and the interest rate and (b)the amount of debt relative to the firm’s total assets.
— /COMMENTS ON CHAPTER “YOU MAKE THE CALL” SITUATIONS
Situation 1
- Why doesn’t Dalton have cash for personal needs? (As part of your analysis, measure cash flows as discussed in Chapter 10.)
Dalton’s equation to determine cash flows (profits plus depreciation), although correct once in a while, can be very misleading. The company’s cash flow can be more accurately determined as follows:
Firm's Cash Flows:Operating income / $19,000
Depreciation / 5,000
Earnings before interest, taxes and depreciation / $24,000
Cash taxes / 8,000
After-tax cash flows from operations / $16,000
Change in net working capital:
Change in current assets / $10,000
Change in non-interest bearing short-term debt / 3,000
Change in net working capital / $7,000
Investment in fixed assets / ($5,000)
Decrease in other assets / 2,000
Firm's cash flows / $6,000
Financing Cash Flows:
Interest / $3,000
Dividends / 3,000
Financing cash flows / $6,000
- Evaluate the Baugh Company’s financial performance, given the financial ratios for the industry.
When using ratios, we must remember what makes up each number we derive and that differences between ratios only suggest areas for us to study; they are not answers in themselves.
The Baugh Company’s liquidity is poor according to all the measures. Its current ratio and acid-test ratio are below the norm, and accounts receivable and inventories are both slow in converting to cash.
The firm’s ability to generate operating income on its assets is above average (18.8%, versus the industry norm of 16%). This advantage is due to a superior operating profit margin, which means that the company is better at managing its income statement (refer to the five “drivers” of operating profit margin). However, the firm could do better if it could improve its management of its assets—see the asset turnover ratios. The company uses less debt financing than the industry average, which means that its financial risk is less than that of other firms. Baugh’s return on equity is below average because it uses less debt than other firms, in spite of its higher operating income return on investment. However, that means the firm is less risky.
Situation 2
- Using financial ratios, compare the firm’s financial performance for 2004 and 2005.
The ratios for the respective years are as follows:
2004 / 2005Current ratio / 0.84 / 0.60
Quick ratio / 0.82 / 0.59
Accounts receivable turnover / 7.09 / 8.98
Inventory turnover / 230.54 / 309.77
Operating income return on investment / 19.0% / 10.8%
Operating profit margin / 12.9% / 8.0%
Total assets turnover / 1.48 / 1.35
Fixed assets turnover / 2.44 / 2.12
Debt ratio / 0.68 / 0.72
Times interest earned / 2.49 / 1.54
Return on equity / 49.5% / 9.9%
Based on the above ratios, we see that Cherokee's liquidity declined modestly, but the real news is the firm's sharp fall in profitability. The operating income return on investment fell from 19 percent to less than 11 percent, which was mostly due to a decline in the operating profit margin. This change, along with a much smaller unusual gain in 2005 than in 2004, resulted in the large decrease in the return on equity.
- What do you think might have happened from 2004 to 2005?
When we look at the income statement, we see that operating expenses increased more between the two years than did sales. Almost every expense item increased significantly. However, the increase in depreciation was caused by a decision to use a shorter life in depreciating off fixed assets. The big problem that occurred was the large telephone companies going after Cherokee by instigating "call around." For example, AT&T started "1-800-CALL ATT," which allowed the caller to go around Cherokee and charge the call to AT&T. In essence, callers were using Cherokee's phones but AT&T was getting the revenue from the call.
Situation 3
- Compute the firm's accounts receivable turnover. Do you think that this ratio is relevant for this business? Why or Why not?
Since we do not know how much of the sales are credit sales, we cannot calculate an accounts receivable turnover that is accurate. Some businesses extend credit for most of their sales, but in the restaurant business, little is sold on credit, thus an accounts receivable turnover is essentially meaningless.
- What is the firm's operating income return on investment? Without the benefit of an industry norm for comparison, do you think that this is a good return on investment?
The firm’s operating income return on investment (operating income total assets) is 11.3 percent (49,500 tenge 437,900 tenge = 11.3%). While we do not have an industry norm, an 11 percent return on the assets is not particularly high, especially for a business that would be relatively risky.
- What is the firm's return on equity? How does debt financing affect this return?
The firm’s return on equity, net income common equity, is 8.3 percent (34,650 tenge 481,400 tenge = 8.3%). This is relatively low by most standards. The firm has little debt; thus, the return on equity is not being magnified through financial leverage. Then, when you account for income taxes, not much is left for the owner.
— /Answers to exploring the web exercises
For each chapter, the instructor’s manual will include a short summary of suggested results students will have after completing the various Web exercises. Because the Web is a constantly changing medium, the answers may vary, and the links may change as well. Thus, answers are only suggested, and the URL for resources, where required, is provided.
Exercise 1
Note: The American Express website has changed. To access the Interactive Tools, choose Small Business and follow the link to Access Information. Here, choose Interactive Tools to find the article entitled “Manage Your Receivables and Collectibles.”
- According to the article, 27% of 90-day past due accounts, 44% of six-months past due accounts, and 75% of year-old past due accounts will never be collected.
- Students will take a quiz to determine which areas need improvement. Answers will vary
- The ten steps to effective collections are the following:
- Customer satisfaction phone call
- First overdue notice
- Second overdue notice
- First collection phone call
- First collection letter
- Second collection phone call
- Second collection letter
- Third collection phone call
- Final collection letter
- Turn over to collection agency
- Student answers will vary as they choose the collection laws they were not aware of. For example, threatening to use a collection agency but not actually doing so is illegal.
- Seven tips for avoiding overdue accounts are the following:
- Don’t grant credit
- Accept major credit cards
- Require deposits
- Offer terms
- Get a signed agreement
- Check credit
- Create a billing/overdue notification system
Exercise 2
- To create a cash flow budget, take the following steps. (Note: Once the budget has been created, you must give it to others who will ensure that the goals are achieved.)
- Outline expected collections from budgeted monthly invoicing
- Add in when you expect to collect existing accounts receivable
- Identify other expected cash receipts
- Start looking at expenses and cash disbursements
- Review accounts payable balance at end of fiscal year and identify when the items will be paid
- Do not include non-cash expenses
- The priorities for paying obligations are these:
- Payroll and sales taxes
- Income and other taxes
- Utilities
- Wages
- Key suppliers
- Debtors (unless the company will go bankrupt, in which case, pay these before key suppliers if these debts are personally guaranteed)
- The key questions to determine if the company is at risk are the following:
- Are there problems with your strategy?
- Is the way the company is being run leaving it vulnerable? (This one involves cash flow.)
- Are any key relationships frayed? (This may be a cash flow problem.)
- Are there new competitive threats on the horizon to which your company hasn’t responded?
- Is your marketplace changing? If so, are you able to adapt?
— / SUGGESTED SOLUTION TO CASE 23:
ARTHO, INC.
- Evaluate the two respective firms in terms of their financial performance over time (2001-2005) as it relates to (1) liquidity, (2) operating profitability, (3) financing the assets, and (4) the shareholders’ (common equity) return on investment. (A computer spreadsheet is extremely helpful here. In fact, the financial statements for these two companies are available on the text web site at and using these would save some time in doing the assignment.)
The financial ratios for Artho, Inc., and the comparison company are given below:
Artho, Inc.2001 / 2002 / 2003 / 2004 / 2005
Current ratio / 2.75 / 3.14 / 2.96 / 3.63 / 3.27
Quick ratio / 1.62 / 1.61 / 1.68 / 2.06 / 2.01
Accounts receivable turnover / 6.96 / 6.32 / 5.13 / 5.51 / 5.89
Inventory turnover / 4.14 / 2.91 / 3.10 / 3.28 / 3.37
Operating income return on investment / 20.6% / 26.3% / 24.2% / 20.3% / 12.4%
Operating profit margin / 9.5% / 13.5% / 13.2% / 11.2% / 7.7%
Gross profit margin / 38.2% / 41.3% / 41.2% / 40.7% / 39.4%
Total asset turnover / 2.16 / 1.95 / 1.83 / 1.81 / 1.62
Fixed asset turnover / 22.81 / 24.91 / 22.32 / 16.01 / 15.44
Debt ratio / 37.6% / 33.7% / 35.2% / 32.3% / 36.5%
Times interest earned / 13.85 / 15.60 / 25.59 / 15.12 / 6.36
Return on equity / 20.2% / 24.5% / 23.7% / 18.5% / 10.9%
Comparison Company
2001 / 2002 / 2003 / 2004 / 2005
Current ratio / 3.29 / 3.47 / 3.19 / 2.11 / 1.71
Quick ratio / 2.18 / 2.20 / 2.16 / 1.46 / 1.13
Accounts receivable turnover / 5.72 / 5.90 / 5.40 / 4.53 / 4.45
Inventory turnover / 4.35 / 3.94 / 3.65 / 4.45 / 3.73
Operating income return on investment / 29.5% / 28.4% / 20.1% / 21.5% / 19.9%
Operating profit margin / 16.2% / 15.8% / 13.3% / 14.1% / 13.5%
Gross profit margin / 39.9% / 40.7% / 40.9% / 41.2% / 42.0%
Total asset turnover / 1.82 / 1.80 / 1.51 / 1.52 / 1.48
Fixed asset turnover / 9.86 / 10.43 / 9.35 / 8.60 / 8.04
Debt ratio / 28.9% / 25.4% / 26.7% / 33.1% / 40.6%
Times interest earned / 17.65 / 23.45 / 32.60 / 28.13 / 20.64
Return on equity / 25.8% / 24.1% / 17.6% / 20.4% / 21.0%
Interpretation of the financial ratios across time: