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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
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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
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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
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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
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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
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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
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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%
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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
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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%
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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 
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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%
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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
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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%
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22–27