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part 7 Financial Management in the Entrepreneurial Firm 22 Evaluating Financial Performance PowerPoint Presentation by Charlie Cook 12e Copyright © 2003 South-Western College Publishing. All rights reserved. Looking Ahead After studying this chapter, you should be able to: 1. Identify the basic requirements for an accounting system. 2. Explain two alternative accounting options. 3. Describe the purpose of and procedures related to internal control. 4. Evaluate a firm’s liquidity. 5. Assess a firm’s profitability. 6. Measure a firm’s use of debt or equity financing. 7. Evaluate the rate of return earned on the owner’s investment. Copyright © by South-Western College Publishing. All rights reserved. 22–2 Accounting Activities in Small Firms • Basic Requirements for Accounting Systems –Provide 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. Copyright © by South-Western College Publishing. All rights reserved. 22–3 The Record-Keeping System • Major Types of Internal Accounting Records –Accounts receivable records –Accounts payable records –Inventory records –Payroll records –Cash records –Fixed asset records –Other accounting records Copyright © by South-Western College Publishing. All rights reserved. 22–4 Small Business Accounting Resources • Computer Accounting Software Packages –Checkbook functions –Automatic financial statements preparation –Cash budget tracking –Subsidiary journal accounts preparation • Outside Accounting Services –Convenience –Competence –Cost Copyright © by South-Western College Publishing. All rights reserved. 22–5 Alternative Accounting Options • Cash Versus Accrual Accounting –Cash 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. Copyright © by South-Western College Publishing. All rights reserved. 22–6 Accounting Method Alternatives • Single-Entry Versus Double-Entry Systems –Single-entry system A checkbook system of accounting reflecting only receipts and disbursements. –Double-entry system A self-balancing accounting system that uses journals and ledgers. Copyright © by South-Western College Publishing. All rights reserved. 22–7 Internal Accounting Controls • Internal Control –A 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 checks issued have supporting documentation Limiting access to accounting records and computers Sending bank statements directly to the owner Safeguarding blank checks Requiring employees to take vacations Copyright © by South-Western College Publishing. All rights reserved. 22–8 Assessment of Financial Performance • Can a Firm Meet Its Financial Commitments? –Does the firm have the capacity to meet its shortterm (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 (stockholders) receiving an acceptable return on their equity? Copyright © by South-Western College Publishing. All rights reserved. 22–9 Financial Ratios for Retail Computer and Software Stores (Industry Code No. 5734) FIRM SIZE BY TOTAL ASSETS Less the $500,000 $500,000 to $2 Million $2 Million to $10 Million Current ratio 1.0 1.4 1.2 Quick ratio 0.7 1.0 1.0 Accounts receivable turnover 15.4 8.5 6.3 Inventory turnover 16.2 22.9 43.9 Operating income ROI -1.53% -6.08% Gross profit margin 41.2% 38.9% Operating profit margin -0.3 -1.6 2.5 Fixed asset turnover 38.3 33.9 54.6 Total asset turnover 5.1 3.8 3.5 Debt/equity 4.5 3.1 4.1 Return on equity (before tax) 8.4% 13.4% 32.7% Source: Adapted from RMA 2001–2002 Annual Statement Studies published by Robert Morris Associates, Philadelphia, Pa. Copyright Robert Morris Associates, 2001. Copyright © by South-Western College Publishing. All rights reserved. 8.75% 29.0% 22–10 Income Statement for Bates & Associates Leasing Company for the Year Ending December 31, 2002 Sales revenue Cost of goods sold Gross profit Operating expenses: Marketing expenses $90,000 General and administrative expenses 80,000 Depreciation _30,000 Total operating expenses Operating income Interest expense Earnings before taxes Income tax (25%) Net income Dividends paid Change in retained earnings $850,000 _550,000 $300,000 $200,000 $100,000 __20,000 $ 80,000 20,000 $ 60,000 $_15,000 $ 45,000 Fig. 22.1 Copyright © by South-Western College Publishing. All rights reserved. 22–11 Balance Sheets for Bates & Associates Leasing Company for December 31, 2001 and 2002 2001 2002 Changes $ 45,000 75,000 180,000 $300,000 $ 50,000 80,000 220,000 $350,000 $ 5,000 8,000 40,000 $ 50,000 $790,000 ( 360,000) $430,000 70,000 $500,000 $890,000 ( 390,000) $500,000 70,000 $570,000 $ 100,000 ( 30,000) $ 70,000 0 $ 70,000 $920,000 $120,000 Assets Current assets: Cash Accounts receivable Inventories Total current assets Fixed assets: Gross plant and equipment Accumulated depreciation Net plant and equipment Land Total fixed assets TOTAL ASSETS $800,000 Fig. 22.2a Copyright © by South-Western College Publishing. All rights reserved. 22–12 Balance Sheets for Bates & Associates Leasing Company for December 31, 2001 and 2002 (cont’d) 2001 2002 Changes Debt (Liabilities) and Equity Current liabilities: Accounts payable and accruals Short-tern notes Total current liabilities Long-term notes payable Total liabilities Common stock Retained earnings Total stockholders’ equity TOTAL DEBT AND EQUITY $ 15,000 60,000 $ 75,000 150,000 $225,000 $300,000 275,000 $575,000 $800,000 $ 20,000 80,000 $100,000 200,000 $300,000 $300,000 320,000 $620,000 $920,000 $ 5,000 20,000 $ 25,000 50,000 $ 75,000 $ 0 5,000 $ 45,000 $120,000 Fig. 22.2b Copyright © by South-Western College Publishing. All rights reserved. 22–13 Measuring Liquidity: Approach I • Current Ratio –Comparing cash and near-cash current assets against the debt (current liabilities) coming due and payable within one year. Current ratio Current assets Current liabilities $350,000 Current ratio 3.50 $100,000 Industry norm for current ratio = 2.70 Copyright © by South-Western College Publishing. All rights reserved. 22–14 Measuring Liquidity: Approach I • Acid-test ratio (quick ratio) –A measure of a company’s liquidity that excludes inventories. Acid-test ratio Current assets - Inventories Current liabilities Acid-test ratio $350,000 - $220,000 1.30 $100,000 Industry norm for acid-test ratio = 1.25 Copyright © by South-Western College Publishing. All rights reserved. 22–15 Measuring Liquidity: Approach II • Average Collection Period –The average time it takes a firm to collect its accounts receivable. Average collection period Accounts receivable Daily credit sales Average collection period $80,000 365 34.35 days $850,000 Industry norm for average collection period = 35 days Copyright © by South-Western College Publishing. All rights reserved. 22–16 Measuring Liquidity: Approach II • Account Receivable Turnover Ratio –The number of time accounts receivable “roll over” during a year. Credit sales Accounts receivable turnover Accounts receivable $850,000 Accounts receivable turnover 10.63 $80,000 Industry norm for accounts receivable turnover = 10.43 Copyright © by South-Western College Publishing. All rights reserved. 22–17 Measuring Liquidity: Approach II • Inventory turnover –The number of times inventories “roll over” during the year. Cost of goods sold Inventory turnover Inventory Inventory turnover $550,000 2.50 $220,00 Industry norm for inventory turnover = 4.00 Copyright © by South-Western College Publishing. All rights reserved. 22–18 Capital invested by the firm's creditors and equity investors (owners) Profits and cash flows Firm's total assets becomes compute Rate of return on total capital Shared by equals Creditors Equity investors compute compute Return on creditor's capital equals Return on equity capital equals Interest rate charged on debt Operating income Total assets Return on Invested Capital: An Overview Net income Common equity Fig. 22-3 Copyright © by South-Western College Publishing. All rights reserved. 22–19 Measuring Return on Investment (ROI) • A measure of operating profits relative to total assets Sales Operating income Operating profits X return on investment Sales Total assets Operating income Operating income return on investment Total Assets Operating income $100,000 10.87% return on investment $920, 000 Industry norm for OIROI: 13.20% Copyright © by South-Western College Publishing. All rights reserved. 22–20 Measuring Return on Investment (ROI) • Operating Profit Margin –The ratio of operating profits to sales, showing how well a firm manages its income statement. Operating profit margin Operating profits Sales $100, 000 Operating profit margin 11.76% $850,000 Industry norm for operating profit margin: 11.0% Copyright © by South-Western College Publishing. All rights reserved. 22–21 Measuring Return on Investment (ROI) • Total Asset Turnover –A ratio of sales to total assets, showing the efficiency with which the firm’s assets are used to generate sales. Total asset turnover Sales Total assets $850,000 Total asset turnover 0.92 $920,000 Industry norm for total asset turnover = 1.20 Copyright © by South-Western College Publishing. All rights reserved. 22–22 Measuring Return on Investment (ROI) • Operating Income Return on Investment Operating income return on investment = Operating profit margin X Operating income return on investment = .1176 x 0.92 Total asset turnover = 10.82% Industry norm for OIROI = 13.20% Copyright © by South-Western College Publishing. All rights reserved. 22–23 Turnover Ratios Accounts Credit sales $850,000 10.63 receivable Accounts receivable $80,000 turnover Inventory turnover Industry Norm 10.43 Cost of goods sold $550,000 2.50 Inventory $220,00 4.00 Sales $850,000 1.49 Fixed assets $570,000 2.50 Fixed asset turnover Copyright © by South-Western College Publishing. All rights reserved. 22–24 How 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 Total debt Debt ratio Total Assets $300,000 Debt ratio 0.33, or 33.0% $920,000 Industry norm for debt ratio = 40.0% Copyright © by South-Western College Publishing. All rights reserved. 22–25 How is the Firm Financing Its Assets • Times Interest Earned Ratio –The ratio of operating income to interest charges Operating income Times interest earned Interest Expense $100,000 Times interest earned 5.00 $20,000 Industry norm for time interest earned = 4.00 Copyright © by South-Western College Publishing. All rights reserved. 22–26 Return on Investment • Return on equity –The rate of return that owners earn on their investment. Net income Return on equity Common Equity $60,000 Return on equity 0.097, or 9.7% $620,000 Industry norm for return on equity = 12.5% Copyright © by South-Western College Publishing. All rights reserved. 22–27