Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. PowerPoint...

Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited.

PowerPoint Presentation by PowerPoint Presentation by

Thomas MThomas MccKaig, Ryerson UniversityKaig, Ryerson University

Managing Managing Financial Financial PerformancePerformance

1313

13-2Chapter 13 Copyright © 2003 by Nelson, a division of Thomson Canada Limited.

Looking AheadLooking Ahead

After studying this chapter, you should be able to:

1. Describe the purpose and content of financial statements.

2. Identify the basic requirements for an accounting system.

3. Explain two alternative accounting options.

4. Describe the purpose of and procedures related to internal control.

5. Evaluate a firm’s operating liquidity.

6. Assess a firm’s profitability.

7. Measure a firm’s use of debt or equity financing.

8. Evaluate the rate of return earned on the owner’s investment.


Looking AheadLooking Ahead

After studying this chapter, you should be able to:

9. Describe the working capital cycle of a small business.

10. Identify the important issues in managing a firm’s cash flows.

11. Explain the key issues in managing accounts receivable, inventory, and accounts payable.


Understanding Financial StatementsUnderstanding Financial Statements

• Financial Statements (Accounting Statements)Reports of a firm’s financial performance and

resources, including an income statement and a balance sheet• Helps determine a start-up’s financial requirements

• Assesses the financial implications of a business plan


Understanding Financial StatementsUnderstanding Financial Statements

• Income StatementA report showing the profit or loss from a firm’s operations

over a given period of time. “How profitable is the business?”

• SalesSales –– ExpensesExpenses = = ProfitsProfits Revenue from product or service sales Costs of producing product or service Operating expenses (marketing, selling, general and administrative

expenses, and depreciation) Financing costs (interest paid) Tax payments


Some Accounting TermsSome Accounting Terms

• Cost of Goods Sold (COGS) - the cost of producing or acquiring goods or services to be sold by a firm.

• Operating expenses - consisting of both selling and marketing expenses and administrative expanses.

• Operating income - earnings before interest and taxes• Gross profit - sales less the COGS• Financing costs – the amount of interest owed to lenders

on borrowed money• Net income available to owners (net income) – income

that may be distributed to owners or re-invested in the company


Operating Activities

Sales Revenue

=

= =

Operating Income

Earnings Before Taxes Net Income Availableto Owners

Cost of producing or acquiring product or service(cost of goods sold)

Gross profit

Marketing and selling expenses, general and administrative expenses and depreciation(operating expenses)

,

–

=

–

Financing Activities

Operating Income

Interest expense on debt (financing costs)

–

Taxes

Earnings Before Taxes

Income taxes–

The Income Statement: An OverviewThe Income Statement: An Overview


Income Statement for Bates & Associates Leasing Company for the Year Ending December 31, 2002

Income Statement for Bates & Associates Leasing Company for the Year Ending December 31, 2002

Sales revenue $830,000Cost of goods sold _550,000Gross profit $290,000Operating expenses:

Marketing expenses $90,000General and administrative expenses 72,000Depreciation _28,000

Total operating expenses $190,000Operating income $100,000Interest expense __20,000Earnings before taxes $ 80,000Income tax (25%) 20,000Net income $ 60,000Dividends paid $_15,000Change in retained earnings $ 45,000

Fig. 13 -1


The Balance SheetThe Balance Sheet

• Balance SheetA report showing a firm’s assets, liabilities, and

owners’ equity at a specific point in timeOutstanding debt + Owner’s equity = Total assets


The Balance Sheet: Types of AssetsThe Balance Sheet: Types of Assets

• Current assets (working capital)Assets that can be converted to cash within the firm’s

operating cycle—cash, accounts receivable, and inventories.

• Fixed AssetsRelatively permanent resources intended for the use of the

firm.Net fixed assets =

gross fixed assets – accumulated depreciation

• Other Assets Intangible assets (patents, copyrights, goodwill)


The Balance Sheet: Types of FinancingThe Balance Sheet: Types of Financing

• Debt CapitalFinancing provided by a creditor

• Short-term (current) Debt• Accounts payable• Accrued expenses• Short-term notes

• Long-Term DebtLoans and mortgages from

banks and other lenders with maturities greater than one year

…continued


The Balance Sheet:Types of FinancingThe Balance Sheet:Types of Financing

• Owners’ Equity CapitalMoney that the owners invest in the businessOwners are “residual owners” of the firm

• Creditors have first claim on the assets of the firm.

Owners’Owners’EquityEquity ==

Owners’Owners’investmentinvestment ––

Owners’ cashOwners’ cashwithdrawalswithdrawals

CumulativeCumulativeprofitsprofits++

Owners’Owners’EquityEquity ==

Owners’Owners’investmentinvestment ++

Earnings retained Earnings retained within Businesswithin Business


Balance Sheets for Bates & Associates Leasing Company for December 31, 2001 and 2002


Assets Current assets:

Cash $ 38,000 $ 43,000 $ 5,000Accounts receivable 70,000 78,000 8,000

Inventories 175,000 210,000 35,000

Total current assets $295,000 $345,000 $ 50,000

Fixed assets:Gross plant and equipment $760,000 $890,000 $ 78,000Accumulated depreciation ( 355,000) ( 383,000) ( 28,000)Net plant and equipment $405,000 $4550,000 $ 50,000Land 70,000 0

Total fixed assets $475,000 $525,000 $ 50,000

TOTAL ASSETS $800,000 $920,000 $120,000

Changes

20022001

70,000

Fig. 13-2a

Prepaid Expenses 12,000 2,00014,000

Goodwill and patents 30,000 20,000 50,000




Debt (Liabilities) and EquityCurrent liabilities:

Accounts payable $ 61,000 $ 76,000 $ 15,000

Income tax payable 12,000 15,000 3,000

Accrued wages and salaries 4,000 5,000 1,000

Interest payable 2,000 4,000 2,000

Total current liabilities $ 79,000 $100,000 $ 21,000

Long-term notes payable 146,000 200,000 54,000

TOTAL LIABILITIES $225,000 $300,000 $ 75,000

Changes

20022001

Common Shares 300,000 300,000 0

Retained Earnings 275,000 320,000 45,000

Total shareholders’ equity $575,000 $620,000 $45,000

TOTAL DEBT AND EQUITY $800,000 $920,000 $120,000

Fig. 13-2b


The Fit of the Income Statement and the Balance Sheet

The Fit of the Income Statement and the Balance Sheet

Income statement reports the profits from

January 1, 2002 through December 31, 2002

2002 Balance Sheet Reports a firm's financial position at end of 2002

January 1 December 31

2001 Balance Sheet Reports a firm's financial position at beginning of 2002 (end of 2001)

Figure 13-3


Cash Flow Measurement: Key TermsCash Flow Measurement: Key Terms

• Statement of Cash Flows A financial report that shows changes

in a firm’s cash position over a given period of time.

• Accrual-Basis Accounting A method of accounting that matches

revenues when they are earned against the expenses associated with those revenues.


Accounting Activities in Small FirmsAccounting Activities in Small Firms

• Basic Requirements for Accounting SystemsProvide an accurate picture of operating results.Permit a quick comparison of current data with prior

years’ operations.Furnish financial statements for use by management,

bankers, and prospective creditors.Facilitate prompt filing of reports and tax returns to

regulatory and tax-collecting agencies.Reveal employee fraud, waste, and record-keeping errors.


The Record-Keeping SystemThe Record-Keeping System

• Major Types of Internal Accounting RecordsAccounts receivable recordsAccounts payable recordsInventory recordsPayroll recordsCash recordsFixed asset recordsOther accounting records


Small Business Accounting ResourcesSmall Business Accounting Resources

• Computer Accounting Software PackagesChequebook functionsAutomatic financial statements preparationCash budget trackingSubsidiary journal accounts preparation

• Outside Accounting ServicesConvenienceCompetenceCost


Alternative Accounting OptionsAlternative Accounting Options

• Cash Versus Accrual AccountingCash method

• Revenues and expenses are recognized only when payments are received or expenses are paid.

Accrual method• Revenue and expenses are reported when they are

incurred, regardless of when they are received or paid.


Accounting Method AlternativesAccounting Method Alternatives

• Single-Entry Versus Double-Entry SystemsSingle-entry system

• A chequebook system of accounting reflecting only receipts and disbursements.

Double-entry system• A self-balancing accounting

system that uses journals and ledgers.


Internal Accounting ControlsInternal Accounting Controls

• Internal ControlA system of checks and balances that safeguards assets

and enhances the accuracy and reliability of financial statements.

Types of internal controls• Identifying transactions requiring owner authorization• Ensuring cheques issued have supporting documentation• Limiting access to accounting records and computers• Sending bank statements directly to the owner• Safeguarding blank cheques• Requiring employees to take vacations• Controlling access to computer facilities


Assessment of Financial PerformanceAssessment of Financial Performance

• Can a Firm Meet Its Financial Commitments? Does the firm have the capacity to meet its short-term (one year or

less) financial commitments?• Is the liquidity of the firm’s assets sufficient?

Is the firm producing adequate operating profits on its assets? How is the firm financing its assets? Are the owners (shareholders) receiving an acceptable return on their

equity?

• Financial Ratios Restatements of selected income statement and balance sheet date in

relative terms


Financial Ratios for Retail Computer Stores (Industry Code No. 5731)

Financial Ratios for Retail Computer Stores (Industry Code No. 5731)

FIRM SIZE BY TOTAL ASSETS

$250,000 to $1 Million

$1 Million Plus

Current ratio 1.5 1.2

Quick ratio .8 .6

Accounts receivable tur nover 31.4 26.2

Inventory turnover 12.3 10.7

Operating income ROI 3.6% 4.8%

Operating profit margin 0.7 0.8

Fixed asset turnover 47.0 38.2

Total asset turnover 4.3 3.8

Debt/equity 2.57 2.3

Return on equity (before tax) 18.1% 13.9% Source: Adapted from D&B Industry Norms & Key Business Rations published by Dun & Bradstreet, 2002. Table 13-1


Measuring Liquidity: Approach IMeasuring Liquidity: Approach I

• Current RatioComparing cash and near-cash current assets against

the debt (current liabilities) coming due and payable within one year.

3.45 $100,000

$345,000 ratioCurrent

Industry norm for current ratio = 1.5

sliabilitieCurrent

assetsCurrent ratioCurrent

…continued


Measuring Liquidity: Approach IMeasuring Liquidity: Approach I

• Acid-test ratio (quick ratio) A measure of a company’s liquidity that excludes inventories.

Industry norm for acid-test ratio = 0.8

liabilitiesCurrent

Inventories - assetsCurrent ratio Acid-test

1.35 $100,000

$210,000 - $345,000 ratio Acid-test


Measuring Liquidity: Approach IIMeasuring Liquidity: Approach II

• Average Collection PeriodThe average time it takes a firm to collect its accounts

receivable.

salescredit Daily

receivable Accounts period collection Average

days 34.30 365 $830,000

$78,000 period collection Average

Industry norm for average collection period = 31.4 days

…continued


Measuring Liquidity: Approach IIMeasuring Liquidity: Approach II

• Inventory turnoverThe number of times inventories “roll over” during the

year.

Inventory

sold goods ofCost turnover Inventory

2.57 $210,00

$540,000 turnover Inventory

Industry norm for inventory turnover = 4.00


Calculate Return on Investment (ROI)Calculate Return on Investment (ROI)

• A measure of operating profits relative to total assets

Industry norm for OIROI: 3.6%

assets Total

Sales X

Sales

profits Operating

Operating incomereturn on investment

(OIROI)

AssetsTotal

income Operating


0.1087 or 10.87% 000 $920,

$100,000



Return on Invested Capital:

An Overview

Return on Invested Capital:

An Overview

Capital investedby the

firm's creditorsand

equity investors(owners)

Firm'stotal assets

Profits andcash flows

Rate of returnon total capital

becomes

CreditorsEquity

investorsOperating income

Total assets

Return oncreditor's

capital

Return onequitycapital

Interest ratecharged on debt

Net incomeCommon equity

compute

equalsShared by

compute compute

equalsequals

Figure 13-4


Measuring Return on Investment (ROI)Measuring Return on Investment (ROI)

• Operating Profit MarginThe ratio of operating profits to sales, showing how well

a firm manages its income statement.

Sales

profits Operating marginprofit Operating

12.05% $830,000

000 $100, margin profit Operating

Industry norm for operating profit margin: 0.7%…continued



• Total Asset TurnoverA ratio of sales to total assets, showing the efficiency

with which the firm’s assets are used to generate sales.

Industry norm for total asset turnover = 3.82

assets Total

Sales over asset turn Total

0.90 $920,000

$830,000 over asset turn Total

…continued



• Operating Income Return on Investment

Operating incomereturn on investment =

Operatingprofit margin X

Total assetturnover

.1205 x 0.90Operating income

return on investment = = 10.85%

Industry norm for OIROI = 2.67%


Turnover RatiosTurnover Ratios

10.64 $78,000

$830,000

receivable Accounts

salesCredit

Accountsreceivableturnover

4.00 $210,000

$540,000

Inventory

sold goods ofCost Inventory

turnover

1.58 $252,000

$830,000

assets Fixed

Sales Fixed asset turnover

IndustryNorm

10.43

4.00

2.50


How is the Firm Financing Its AssetsHow is the Firm Financing Its Assets

• Financial Leverage The use of debt in financing a firm’s assets

• Debt-Equity Ratio The ratio of total debt to total assets

AssetsTotal

debt Total ratioDebt

33.0% or 0.33, $920,000

$300,000 ratioDebt

Industry norm for debt ratio = 40.0% …continued


How is the Firm Financing Its AssetsHow is the Firm Financing Its Assets

• Times Interest Earned RatioThe ratio of operating income to interest charges

ExpenseInterest

income Operating earnedinterest Times

5.00 $20,000

$100,000 earnedinterest Times

Industry norm for time interest earned = 4.00


Return on InvestmentReturn on Investment

• Return on equityThe rate of return that owners earn on their investment.

Equity Common

incomeNet equity on Return

9.7% or 0.097, $620,000

$60,000 equity on Return

Industry norm for return on equity = 12.5%


Working-CapitalWorking-Capital

• Working Capital ManagementThe management of current assets and current

liabilities

• Net Working CapitalThe sum of a firm’s current assets (cash,

accounts receivable, and inventories) less current liabilities (short-term notes, accounts payable, and accruals).


The Working-Capital CycleThe Working-Capital Cycle

1. Purchase or produce inventory for sale, which increases accounts payable.

2. a. Sell inventory for cash.b. Sell inventory for credit (accounts receivable).

3. Pay the accounts payable (decreases cash and accounts payable).

4. Collect the accounts receivable (decreases accounts payable and increases cash).

5. Begin cycle again


The Working Capital Cycle

Illustrated

The Working Capital Cycle

Illustrated

Increasesaccounts payable

Increases inventory

Decreases inventory

2afor cash

3bPay

operatingexpensesand taxes

1Purchase

or produceinventory

2Sell the

inventory

2bon credit

Increasesaccountsreceivable

Decreasesaccountspayable

Decreasesaccountsreceivable

3aPay

accountspayable

4Collect

accountsreceivable

5Begin cycle

againCash

decreasesdecreases increasesincreases

Figure 13-6


Working-Capital Time LineWorking-Capital Time Line

Source: Adapted from Terry W. Maness and John T. Zeitlow, Short-Term Financial Management (New York: Dryden Press/Harcourt Brace, 1998), p. 4.

Cash conversion Cash conversion period—period—the time required to the time required to convert paid-for convert paid-for inventories and inventories and accounts receivable accounts receivable into cash.into cash.

OrderPlaced

InventoryReceived

Cash Paymentfor Inventory

Sale

Cash Collectionof Receivables

Days in InventoryDays in Accounts Receivable

Days in Accounts Payable Cash Conversion Period

a b c d e

Figure 13-7


Order

Placed

Inventory

Received

Cash Payment for Inventory

SaleCash Collection

of Receivables

Days in InventoryDays in Accounts Receivable

Days in Accounts Payable Cash Conversion Period

Pokey, Inc.

Oct. 15 Nov. 30Aug. 31 Aug. 15 Sept. 30

Working Capital Time Linefor Pokey, Inc.

Working Capital Time Linefor Pokey, Inc.

Figure 13-8a


Working Capital Time Linefor Quick-turn Company

Working Capital Time Linefor Quick-turn Company

OrderPlaced

InventoryReceived

Cash Payment for Inventory

SaleCash Collectionof Receivables

Days in Inventory Days in Accounts Receivable

Days in Accounts Payable

Quick-turn Company

Aug. 31 Aug. 15 Sept. 30 Oct. 31

Figure 13-8b


Pokey, Inc.’s Beginning Balance SheetPokey, Inc.’s Beginning Balance Sheet

JulyCash 400Accounts receivable 0Inventory 0Fixed assets 600Accumulated depreciation 0TOTAL ASSETS 1,000

Accounts payable 0Accrued operating expenses 0Income tax payable 0Long-term debt 300Common debt 700Retained earnings 0TOTAL DEBT AND EQUITY 1,000


Pokey, Inc.’s Monthly Balance SheetsPokey, Inc.’s Monthly Balance Sheets

July Aug. Sept.Cash 400 400 (100)Accounts receivable 0 0 0Inventory 0 500 500Fixed assets 600 600 600Accumulated depreciation 0 0 0TOTAL ASSETS 1,000 1,500 1,000

Accounts payable 0 500 0Accrued operating expenses 0 0 0Income tax payable 0 0 0Long-term debt 300 300 300Common debt 700 700 700Retained earnings 0 0 0TOTAL DEBT AND EQUITY 1,000 1,500 1,000

Changes: August to September

–500

–500

…continued



July Aug. Sept. Oct.Cash 400 400 (100) (100)Accounts receivable 0 0 0 900Inventory 0 500 500 0Fixed assets 600 600 600 600Accumulated depreciation 0 0 0 (50)TOTAL ASSETS 1,000 1,500 1,000 1,350

Accounts payable 0 500 0 0Accrued operating expenses 0 0 0 250Income tax payable 0 0 0 25Long-term debt 300 300 300 300Common debt 700 700 700 700Retained earnings 0 0 0 75TOTAL DEBT AND EQUITY 1,000 1,500 1,000 1,350

Changes: September to

October

+900–500

–50

+250+25

+75

…continued



Changes: October to November

+650–900

–250

July Aug. Sept. Oct. Nov.Cash 400 400 (100) (100) 550Accounts receivable 0 0 0 900 0Inventory 0 500 500 0 0Fixed assets 600 600 600 600 600Accumulated depreciation 0 0 0 (50) (50)TOTAL ASSETS 1,000 1,500 1,000 1,350 1,100

Accounts payable 0 500 0 0 0Accrued operating expenses 0 0 0 250 0Income tax payable 0 0 0 25 25Long-term debt 300 300 300 300 300Common debt 700 700 700 700 700Retained earnings 0 0 0 75 75TOTAL DEBT AND EQUITY 1,000 1,500 1,000 1,350 1,100


Changes in Pokey’s Balance SheetChanges in Pokey’s Balance Sheet

Change in the Balance Sheet Effect on Income Statement

Increase accounts receivable of $900 Sales $ 900

Decrease inventories of $500 Cost of goods sold $ 500

Increase in accrued operating Operating expenses $ 250

expenses of $250

Increase accumulated depreciation of $50Depreciation expense $ 50

Increase accrued taxes of $25 Tax expense $ 25


Pokey’s November Income StatementPokey’s November Income Statement

Sales revenue 900Cost of goods sold 500Gross Profit 400Operating expenses:

Cash 250Depreciation 50

Total operating expenses 300Operating income 100

Income tax (25%) 25Net income 75


Managing Cash FlowsManaging Cash Flows

• The Nature of Cash FlowsThe flow of actual cash through a firm.

• Net Cash FlowThe difference between inflow and outflows

• Net ProfitThe difference between revenue and expenses

• The Growth TrapA cash shortage resulting from rapid growth


Flow of Cash Through A BusinessFlow of Cash Through A Business

BorrowedFunds

Collection ofAccounts

Receivable

Owner'sInvestment

BorrowedFunds

Sale ofFixed Assets

Collection ofAccounts

Receivable

Payment ofExpenses

Payment forInventory

Payment ofDividends

CashSales

Purchase ofFixed Assets

…Figure 13-9


Candace Corporation: Cash Budget (July -September)Candace Corporation: Cash Budget (July -September)

May June July August September

Monthly Sales $100,000 $120,000 $130,000 $130,000 $120,000

Cash receipts

Cash sales for month (40%) $ 52,000 $ 52,000 $ 48,000

1 month after sale (30%) 36,000 39,000 39,000

2 months after sale (30%) 30,000 36,000 39,000

Step 1 Total collections $118,000 $127,000 $126,000

Purchases (80% of sales) $104,000 $104,000 $ 96,000 $ 80,000

Cash disbursements

Step 2a Payments on purchases $104,000 $104,000 $ 96,000

Rent 3,000 3,000 3,000

Wages and salaries 18,000 18,000 16,000

Step 2b Tax prepayment 1,000

Utilities (2% of sales) 2,600 2,600 2,400

Interest on long-term note 800

Step 2c Short-term interest (1% of short-term debt) 106 113

Total cash disbursements $128,600 $127,706 $118,313

Step 3 Net change in cash $ 10,600 $ 706 $ 7,687

Step 4 Beginning cash balance 5,000 5,000 5,000

Step 5 Cash balance before borrowing $ 5,600 $ 4,294 $ 12,687

Step 6 Short-term borrowing (payments) 10,600 706 7,687

Ending cash balance $ 5,000 $ 5,000 $ 5,000

Step 7 Cumulative short-term debt outstanding $ 10,600 $ 11,306 $ 3,619


Managing Accounts ReceivableManaging Accounts Receivable

• How Accounts Receivable Affect CashAccounts receivable represent the firm’s decision

to delay the inflow of cash from customers who have been extended credit.

• Life Cycle of Accounts ReceivableFirm makes credit sale to customer.Invoice is prepared and sent to customer.Customer pays firm.

…continued


Managing Accounts Receivable Managing Accounts Receivable

• Accounts Receivable FinancingFinancing speeds up immediate cash flowPledged accounts receivable

• Accounts receivable used as collateral for a loan.

Factoring• Obtaining cash by selling accounts receivable at a

discount to another firm.


Managing InventoryManaging Inventory

• Inventory is a “necessary evil.”Product supply and consumer demand don’t always match

up.

• Reducing Inventory to Free CashMonitoring current inventory

• Determine age and suitability for sale.Controlling stockpiles

• Match on-hand inventory with demand.

• Avoid personalizing the business-customer relationship.

• Avoid forward purchasing of inventory; the carrying cost for excess inventory may exceed any savings.


Managing Accounts PayableManaging Accounts Payable

• NegotiationAsks creditors for adjustments or additional time.

• TimingCreditors’ funds can supply short-term cash needs

until payment is demanded.Accounts with cash discounts for early payment

should be examined for their savings potential.“Buy now, pay later”—pay early enough to get

cash discounts and timely enough to avoid late-payment fees.


An Accounts Payable for Terms 3/10, Net 30An Accounts Payable for Terms 3/10, Net 30

Timetable (days after invoice) Settlement Costs for $20,000 Purchase

Day 1 through 10 $19,400

Day 11 through 30 $20,000

Day 31 and thereafter $20,000 + possible late penalty + deterioration in credit standing

Annualizedinterest rate

discount% Cash - 100

%discount Cash x

perioddiscount Cash - periodNet

yearin Days

3-100

3 X

10-30

365

56.4% or 0.564, 0.030928 x 18.25

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