Accounting Information for

Decision Making
Part (1)
 Theoretical Basis

At least two theories can be used to

explain the need for, and the bases of
using accounting information:
– The Agency Theory
– The Stakeholders Theory
 The Agency Theory
In an agency relationship, a principal hires
an agent to perform one or more tasks on
his/her behalf.
It is expected that the agent should act in
the best interest of the principal.
Due to possible conflict of interest, the
principal needs information about the
performance of the agent and to help
him/her in making decisions.
 Agency Problems (1)
1. Moral Hazard:
In the absence of motivation, an individual
will tend to spend less effort (work
aversion).
A compensation system is needed to
motivate individuals to exert more efforts
to achieve the desired goals.
 Agency Problems (2)
2. Observability:
– It is often difficult, if not impossible, to observe
the behavior of an agent.
– A management control system should include
some form of monitoring mechanism to insure
that the agent acts in the interest of the
principal.
– Evaluation apprehension Theory.
 Agency Problems (3)
3. Information Asymmetry and Adverse Selection:
– An agent usually knows more information than the
principal.
– This results in
Difficulty of performance evaluation.
Adverse Selection.
– The Concept of Information Inductance:
When an individual reports information that he/she perceives
that it might be used to evaluate his/her performance, he/she
will have the motive to either improve his/her performance to
meet the required level of performance, or to alter the
description of performance to avoid negative evaluation.
 Agency Theory implications in
Accounting
The firm can be viewed as a set of agency
contracts.
– Contract between the owners (principal) and
the managers (agents).
– Contracts between superiors (principal) and
subordinates (agents).
Owner-Manager Agency Relationship

Auditor Financial
Owner Report

Designs a
Delegates Authority Compensation
Of Making Decisions
System Results

Management Decisions
Takes Decisions Executed by
Management Subordinates
Superior-Subordinate Agency Relationship

Superior

Internal
Designs a Design a Reports
Delegates Authority Management Monetoring
Of Making Decisions Control System
System

Subordinate Results
Subordinate Takes Actions
 Stakeholders Theory
The basis for stakeholder theory is that companies are
so large and their impact on society so pervasive that
they should discharge accountability to many more
sectors of society than solely their shareholders.

Stakeholder theory may be the necessary outcome of

agency theory given that there is a business case in
considering the needs of stakeholders through improved
customer perception, employee motivation, supplier
stability, shareholder conscience ‫لضمير‬77‫ا‬investment.

Agency theory is a narrow form of stakeholders theory

Stakeholder theory
 Corporate governance
Corporate governance is a broad term used to refer to
the processes, policies, regulations, and customs by
which a corporation is directed, administered, and
controlled.
Corporate governance specifies the responsibilities and
rights of the various stakeholders in the organization.
In a narrow sense, corporate governance articulates the
relationship of the company to its immediate
stakeholders (e.g., employees, stockholders).
In a broader sense, it articulates the relationship of the
organization to society.
The concept of corporate governance is one of the core
areas of economic sociology.
Does Agency Theory Explain the Nature of Corporate
Governance?
From a sociological perspective, there are several reasons
why agency theory does not adequately explain the nature
of corporate governance.
– One of these is the fact that the relationship between principals
and agents and the assumption that ownership of a corporation is
dispersed does not take into account the fact that the stakeholders
within an organization are frequently diverse (e.g., families,
institutional investors, banks) and that each of these groups act as
socially constructed interests.
– Another difficulty with agency theory from a sociological point of
view is that it focuses on bilateral contracts between principals and
agents while largely ignoring the importance of interdependencies
with other stakeholders in the organization.
Does Agency Theory Explain the Nature of Corporate
Governance?

– A third problem with agency theory from the perspective

of sociology is that the complexity of an organization
can only be understood if it is examined in a wider
context than from the narrow perspective of
shareholders' rights.
– To overcome these perceived shortcomings,
sociologists also examine social and organizational
relations.

– This has led to the use of INTEGRATING REPORTS.

Financial Reports as a Source of Information

Financial reports contain the firm’s

financial statements, notes to financial
statements, and other voluntary
disclosures by the management.
They are considered the main source of
financial information to the external users.
Financial statements are also a source of
financial information for the management.
 Requirements for Producing Reliable
Financial Information
Financial Statements should be prepared
in accordance to the generally accepted
accounting principles (GAAP).
There should be an effective internal
control system.
Financial statements should be audited by
an independent external auditor.
Generally Accepted Accounting Principles
(GAAP)

Major Sources of GAAP in Egypt:

– Accounting Standards issued by the Ministry of Trade
and Industry.
Major Sources of GAAP in United States
– Securities and Exchange Commission (SEC)
– American Institute of Certified Public Accountants
(AICPA)
– Financial Accounting Standards Board (FASB)
Major Sources of GAAP in other countries:
– International Accounting Standards Board (IASB).
 What is Internal Control?
“A process effected by an entity’s board of
directors, management and other personnel,
designed to provide reasonable assurance
regarding the achievements of objectives in the
following categories:
Effectiveness & efficiency of operations.
Reliability of financial reporting.
Compliance with applicable laws and
regulations.”
 Purposes of Internal Control
Internal Controls are to be an integral part of any
organization's financial and business policies and
procedures.
Internal controls consists of all the measures taken by
the organization for the purpose of;
1. protecting its resources against waste, fraud, and inefficiency;
2. ensuring accuracy and reliability in accounting and operating
data;
3. securing compliance with the policies of the organization; and
4. evaluating the level of performance in all organizational units
of the organization.
Internal controls are simply good business practices.
Elements of Internal Control
 Components of a Control Activity
Personnel
 Personnel need to be competent and trustworthy, with clearly
established lines of authority and responsibility documented
in written job descriptions and procedures manuals.
 Organizational charts provide a visual presentation of lines of
authority and periodic updates of job descriptions ensures
that employees are aware of the duties they are expected to
perform.
Authorization Procedures
 We need to include a thorough review of supporting
information to verify the propriety ‫ستقامة‬4‫ ا‬and validity of
transactions.
 Approval authority is to be commensurate‫ئ‬4‫متكاف‬with the nature
and significance of the transactions and in compliance with
organization’s policy.
 Components of a Control Activity
Segregation ‫لفصل‬44‫ا‬of Duties
 It reduces the likelihood of errors and irregularities.
An individual is not to have responsibility for more than one
of the three transaction components: authorization,
custody‫دة‬4‫عه‬, and record keeping.
When the work of one employee is checked by another, and
when the responsibility for custody for assets is separate
from the responsibility for maintaining the records relating to
those assets, there is appropriate segregation of duties.
This helps detect errors in a timely manner and deter
improper activities; and at the same time, it should be
devised to prompt operational efficiency and allow for
effective communications.
Physical Restrictions‫لكمبيوتر‬44‫اسوورد ا‬44‫زيب‬
 These are the most important type of protective measures for
safeguarding organization’s assets, processes and data.
Components of a Control Activity
Documentation and Record Retention
 It is to provide reasonable assurance that all
information and transactions of value are
accurately recorded and retained.
 Records are to be maintained and controlled in
accordance with the established retention period
and properly disposed 4‫دم‬4‫ع‬44‫ت‬of in accordance with
established procedures.
Monitoring Operations
 It is essential to verify that controls are operating
properly.
 Reconciliations, confirmations, and exception
reports can provide this type of information.
Balancing Risk and Control

Internal controls should be proactive, value-added, cost-

effective, and address exposure to risk
Excessive Risks Excessive Controls
Loss of Assets Increased
bureaucracy
Poor business
decisions Reduced productivity
Noncompliance Increased complexity
Increased Increased cycle time
regulations Increase of no-value
Public scandals activities
Limitations of Internal Control
Judgement.
Breakdowns.
Management override.‫لصالحيات‬44‫ ا‬4‫م‬4‫ستخدا‬4‫وء ا‬44‫س‬
Collusion. ‫طؤ‬4‫وا‬44‫ت‬
Costs Versus Benefits.
 Assignment 1

Do HBS Case:
“Société Générale (A):
The Jérôme Kerviel Affair“
Financial Reports: How to;
Read

Understan
d

Analyze

Use
 Objectives of Financial Reporting

Provide information useful in making business and

economic decisions
Information is comprehensible7‫وم‬7‫ مفه‬to those having a
reasonable understanding of business and economic
activities
Helps users to assess future cash flows
Primary focus is earnings and its components
Information is provided about economic resources and
the claims against those resources
A Hierarchy of Accounting Information Qualities
Elements of Financial Statements

Assets
– Economic resources (probable future economic
benefits) obtained or controlled as a result of past
business transactions
Liabilities
– Obligations to transfer assets or provide services in
the future; the result of past business transactions
Equity
– The owner’s residual interest in the assets after
deducting liabilities
Elements of Financial Statements (Cont’d)

Investments by owners (like retained earnings)

– Increases in equity due to transfers of value for the
purpose of obtaining or increasing ownership
Distribution to owners
– Decrease in equity resulting from transfer of asset,
rendering of service, or incurrence of liabilities by the
entity to owners
Comprehensive income
– The change in equity during a period due to non-
owner transactions, events, and circumstances
like: Unrealized gain
Elements of Financial Statements (Cont’d)

Revenues
– Inflows and other enhancements of assets or reductions of
liabilities from delivering or providing goods or services related
to the central operations
Expenses
– Outflows or consumption of assets from delivering or providing
goods or services related to the central operations
Gains
– Increases in equity from peripheral transactions(Also referred
to as peripheral activities. A company's activities outside of
its main activities of buying/producing and selling) of the
entity
Losses
– Decreases in equity from peripheral transactions of the entity
 Recognition and Measurement
To be recognized, an item should be
– One of the defined elements
– Measurable with sufficient reliability
– Based on information that is
Relevant
Reliable
Measurement attributes
– Historical cost/proceeds
– Current cost
– Current market value
– Net realizable (settlement) value (due to transactions)
– Present (discounted) value of future cash flows
 Recognition and Measurement

A full set of financial statements for a period should show

– Financial position at the end of the period
– Earnings (net income)
– Comprehensive income
– Cash flows during the period
– Investments by and distributions to owners during the period
Traditional Assumptions and Concepts
of the Accounting Model
Business Entity Matching(‫لمصروفات‬77‫مقابلة ا‬
Going Concern ‫ت‬7‫اليرادا‬77‫ا‬777‫))ب‬
(Continuity) Consistency
Time Period Full Disclosure
Monetary Unit Materiality
Historical Cost Industry Practices
Conservatism Transaction Approach
Realization(according to Cash Basis
transaction) Accrual Basis
 The Basic Financial Statements

Statement of Financial Position (Balance Sheet)

Income Statement
Statement of Cash Flows
Statement of Change in Owners’ Equity
They should be accompanied by:
– Notes to the Financial Statements
 Balance Sheet
“Statement of Financial Position”

Assets = Liabilities + Stockholders'

Equity
Dated as of a specific date
Format
– Account
– Report
Please refer to the Adidas Statement of Financial
Position in the handout. Try to read it and relate the
items to each other. What do you observe?
The Five Boxes of the Balance Sheet
Some Preliminary Observations when Reading a
Balance Sheet Before Any In-depth Analysis
Observe the breakdown of assets on the assets side.
Observe the breakdown of the liabilities.
Observe any physical expansion
Observe the overall year-end cash balance
Observe the relationship between current assets and current
liabilities
Observe the relationship between liabilities and owners’ equity
(degree of leverage)
Consider the limitations of the balance sheet:
– Use of monetary unit assumption and the additivity problem.
– Use of different measurement and valuation bases
– Use of human judgment
Keep these limitations in mind when you analyze the financial
statements and use accounting information for decision making.
Balance Sheet Presentation Issues

Financial analysis is complicated by

– Many assets recorded at cost rather than fair
(replacement) value
– Varying valuation methods
Within a firm from item to item
Within an industry from company to company
– Not all items of value are listed as assets
– Certain contingent liabilities may be excluded
 The Income Statement
Dated for a period of time
– For the Year Ended...
Multiple-step format
– Gross profit
– Operating income
– Income before taxes
– Net income
Single-step format
– Total of all revenues and gains
– Less the total of all expenses and losses
 INCOME STATEMENT

Usefulness
 Evaluate past performance.

 Predict future performance.

 Help assess the risk or uncertainty of

achieving future cash flows.

LO 1
 INCOME STATEMENT

Limitations
 Companies omit items that cannot be
measured reliably.

 Income numbers are affected by the

accounting methods employed.

 Income measurement involves

judgment.

LO 1
 The Income Statement Format

Multiple-Step Single Step

Multiple-Step Company Single-Step Company
Income Statement Income Statement
For the Year Ended December 31, 20XX For the Year Ended December 31, 20XX

Sales $426,426
Sales $ 426,426
Cost of Goods Sold 190,831 Interest Income 1,293
Gross Profit 235,595 Other Income 6,371
Operating Expenses:
434,090
General & Administrative $ 116,902
Costs and Expenses:
Advertising 126,120
Uncollectible Accounts 687 243,709
Cost of Goods Sold $ 190,831
General & Administrative 116,902
Operating (Loss) Income (8,114)
Interest (Income) Expense (1,293)
Advertising 126,120
Other (Revenue)Expense (net) (6,371) (7,664) Uncollectible Accounts 687 434,540
(Loss) Income Before Taxes (450) (Loss) Income Before Taxes (450)
Income Taxes (Benefit) (666) Income Taxes (Benefit) (666)
Net Income $ 216 Net Income $ 216
Basic Elements of the Income Statement

Net Sales (Revenues)

Cost of Goods Sold (Cost of Sales)
Other Operating Revenue
Operating Expenses
Other Income or Expense
Some Preliminary Observations when Reading an
Income Statement Before Any In-depth Analysis

Observe sales pattern (last 3 years)

Observe profit pattern (last 3 years)
Try to relate all expenses to net revenues (last 3
years)
Compare the operating income number to the
cash flows from operations (to assess earnings quality)
 Reporting Within the Income Statement

What Do The Numbers Mean? Different Income Concepts

Users and
preparers look at
more than just
the bottom line
income number,
which supports
the IFRS
requirement to
provide subtotals
within the income
statement.
 Special Income Statement Items

Unusual or Infrequent Items Disclosed

Separately
– Included with normal recurring revenues and
expenses
– If material(High Value), disclosed separately, before
income taxes
– Relate to operations
– Treatment for analysis
Primary analysis: include
Supplementary analysis: exclude
Special Income Statement Items (Cnt’d.)

Equity in Earnings of Nonconsolidated

Subsidiaries
– The investor’s proportional share of the investee’s net income
– Does not represent cash flow to the investor
Cash dividends received represent cash flow
– Analysis issues:
Investor’s net income includes revenue of other entity
May distort ratios
Presented before tax; tax consequences typically immaterial
Special Income Statement Items (Cnt’d.)

Income Taxes Related to Operations

– Includes both paid and deferred taxes
Discontinued Operations
– Reported net of income tax
– Analysis issues:
Inadequate disclosure of associated assets
Lack of historical profit and loss information on the
discontinued operations
Special Income Statement Items (Cnt’d.)

Extraordinary Items
– Unusual and infrequent
– Reported net of income tax
– Analysis issues:
Exclude from primary analysis
Include for supplementary analysis

Please refer to the Adidas Group Income

Statements. What do you observe based
on the above discussion?
 Reconciliation of Retained Earnings
Reported as part of the Statement of Stockholders’
Equity or combined with the Income Statement

Beginning of year balance of retained earnings

+ Prior period adjustments (net of tax)
± Cumulative effect of a change in accounting principles
(net of tax)
= Beginning balance as adjusted
+ Net income
– Dividends
= End-of-year balance of retained earnings
 Retained Earnings

The accumulated undistributed earnings of the

corporation reported on the balance sheet
Appropriated (Reserves)
– Restricted by law, contract, or management decision
– Not available for dividends
Unappropriated
– Available for dividends
– Does not represent cash or any other asset
 Comprehensive Income

Net income
+The period’s change in accumulated other comprehensive income
= Comprehensive income

 Foreign currency translation adjustments

 Unrealized holding gains and losses on available-for-sale
marketable securities
 Changes to stockholders’ equity resulting from additional
minimum pension liability adjustments
 Unrealized gains and losses from derivative instruments
 Comprehensive Income –
Separate Statement
XYZ Corporation
Statement of Comprehensive Income
For the Year Ended December 31, 20XX

Net income $ 34,000

Other comprehensive income
Available-for-sale security adjustment, net of tax 5,500
Minimum pension liability adjustment, net of tax 3,500
Foreign currency transaction adjustment, net of tax (5,000)
Total other comprehensive income 4,000
Comprehensive income $ 38,000
 Comprehensive Income –
Combined with Income Statement
XYZ Corporation
Statement of Income and Comprehensive Income
For the Year Ended December 31, 20XX

Sales $ 230,000
Cost of goods sold 140,000
Gross profit 370,000
Operating expenses 40,000
Operating income 330,000
Other income 4,000

Income before income taxes 326,000

Income taxes 20,000
Net income 306,000
Other comprehensive income
Available-for-sale security adjustment, net of tax 5,500
Minimum pension liability adjustment, net of tax 3,500
Foreign currency transaction adjustment, net of tax (5,000)
Other comprehensive income 4,000
Comprehensive income $ 310,000

Earnings per share (for net income only) $ 2.80

 Statement of Cash Flows

Importance:
For Internal users
– Determine dividend policy
– Evaluate cash generated by operations
– Review investing and financing policy
For External users
– Assess firm’s ability to increase dividends(Investors)
– Assess firm’s ability to pay debt from
operations(Creditors)
– Assess firm’s relationship of cash from operations to
total cash
 Statement Structure
Cash flows from operations
+ Cash flows from investing activities
+ Cash flows from financing activities
= Change in cash
+ Beginning cash balance
= Ending cash balance
Supplemental disclosure: non-cash financing and
investing activities

Please refer to the Adidas Group statement of

cash flows. What do you observe?
 Operating Activities
The cash effects of transactions and other events
that enter into the determination of net income:

Cash inflows from Cash outflows for

Sale of goods or Payments for
services acquisitions of inventory
Returns on loans Payments to employees
(interest) Payments for taxes
Return on equity Payments for interest
securities (dividends) Payments for other
expenses
 Investing Activities
Lending money and collecting on those loans and
acquiring and selling investments and productive
long-term assets:

Cash inflows from Cash outflows for

Receipts for loans
collected
Sales of debt or equity
securities
Sales of plant, property,
and equipment
Loans to other entities
Investment in debt or
equity securities
Purchase of plant,
property, and equipment
 Financing Activities
Borrowing and repaying long-term loans; issuing
equity securities; payment of dividends to
shareholders:

Cash inflows from Cash outflows for

Sale of equity securities
Sale of bonds,
mortgages, notes, and
other short- and long-
term borrowings
Payment of dividends
Reacquisition of capital
stock
Payment of amounts
borrowed
CONTENT AND FORMAT
Cash Inflows and Outflows

LO 5
 Cash Flows from Operations
Cash flows from operations:
Cash received from customers $ 370,000
Cash paid to suppliers and employees (310,000)
Interest received 10,000 Direct
Interest paid (net of amount capitalized) (4,000)
Income taxes paid (15,000)
Net cash provided by operations 51,000

Cash flows from operations:

Net earnings $ 40,000
Provision for depreciation 6,000
Provision for allowance for doubtful accounts 1,000
Deferred income taxes 1,000
Loss on property, plant, and equipment disposals 2,000
Indirect Changes in operating assets and liabilities:
Receivables increase (2,000)
Inventories increase (4,000)
Accounts payable increase 5,000
Accrued income taxes increase 2,000
Net cash provided by operations $51,000
Statement of Cash Flows – Direct Method
O P E R A TING A CTIV ITIE S
Cas h rec eived from c us tom ers $ 370,000
Cas h paid to s uppliers and em ploy ees (310,000)
Interes t rec eived 10,000
Interes t paid (4,000)
Inc om e tax es paid (15,000)
Net c as h provided (us ed) by operating ac tivities 51,000
IN V E S TIN G A C TIV ITIE S
Capital ex penditures (30,000)
P roc eeds from property , plant, and equipm ent dis pos als 6,000
Net c as h provided (us ed) by operating ac tivities (24,000)
F INA NC IN G A CTIV ITIE S
Net proc eeds from repay m ent of c om m erc ial paper (4,000)
P roc eeds from is s uanc e of long-term debt 6,000
Dividends paid (5,000)
Net c as h provided (us ed) by financ ing ac tivities (3,000)
Inc reas e in Cas h 24,000
B eginning c as h balanc e 8,000
E nding c as h balanc e $ 32,000
Statement of Cash Flows – Indirect Method
O P E R A T IN G A C T IV IT IE S
N e t e a r n in g s $ 4 0 ,0 0 0
P r o v is io n fo r d e p r e c ia tio n 6 ,0 0 0
P r o v is io n fo r a llo w a n c e fo r d o u b tfu l a c c o u n ts 1 ,0 0 0
D e fe r r e d in c o m e ta x e s 1 ,0 0 0
L o s s o n p r o p e r ty , p la n t, a n d e q u ip m e n t d is p o s a ls 2 ,0 0 0
C h a n g e s in o p e r a tin g a s s e ts a n d lia b ilitie s :
R e c e iv a b le s in c r e a s e (2 ,0 0 0 )
In v e n to rie s in c r e a s e (4 ,0 0 0 )
A c c o u n ts p a y a b le in c r e a s e 5 ,0 0 0
A c c r u e d in c o m e ta x e s in c r e a s e 2 ,0 0 0
N e t c a s h p r o v id e d (u s e d ) b y o p e r a tin g a c tiv itie s 5 1 ,0 0 0
IN V E S T IN G A C T IV IT IE S
C a p ita l e x p e n d itu r e s (3 0 ,0 0 0 )
P r o c e e d s fr o m p ro p e rty , p la n t, a n d e q u ip m e n t d is p o s a ls 6 ,0 0 0
N e t c a s h p r o v id e d (u s e d ) b y o p e r a tin g a c tiv itie s (2 4 ,0 0 0 )
F IN A N C IN G A C T IV IT IE S
N e t p r o c e e d s fro m r e p a y m e n t o f c o m m e r c ia l p a p e r (4 ,0 0 0 )
P r o c e e d s fr o m is s u a n c e o f lo n g -te r m d e b t 6 ,0 0 0
D iv id e n d s p a id (5 ,0 0 0 )
N e t c a s h p r o v id e d (u s e d ) b y fin a n c in g a c tiv itie s (3 ,0 0 0 )
In c r e a s e in C a s h 2 4 ,0 0 0
B e g in n in g c a s h b a la n c e 8 ,0 0 0
E n d in g c a s h b a la n c e $ 3 2 ,0 0 0
 Basics of Analysis
Liquidity
– Measures a firm’s ability to meet its current obligations
Leverage (borrowing capacity)
– Measures the degree of protection for long-term creditors
Profitability
– Measures the earning ability of a firm
Investor-focused
– Measures the return on equity and the price/earnings ratio
Cash flow
– Indicates liquidity, borrowing capacity, and profitability

Interpreted in comparison with

– Prior ratios
– Competitor ratios
– Industry ratios
– Predetermined standards
 Common-Size Analysis
The use of percentages is usually preferable to
the use of absolute amounts
Vertical analysis
– All amounts of a year expressed as a
percentage of a base amount (e.g., net sales
revenue, total assets)
Horizontal analysis
– Amounts for comparative years are expressed
as a percentage of the base year amount
Let’s review a
very simple XYZ Incorporated Vertical Analysis
example of   2017 2018 2019
vertical Sales $25,000,000 $27,500,000 $35,000,000
analysis: COGS $12,500,000 $14,000,000 $19,000,000

GROSS PROFIT $12,500,000 $13,500,000 $16,000,000

       

Salaries $4,500,000 $4,800,000 $6,000,000

Marketing $1,100,000 $1,100,000 $1,900,000

Rent $2,000,000 $2,000,000 $2,000,000

Utilities $300,000 $300,000 $300,000

Misc. Expenses $500,000 $750,000 $680,000

TOTAL
$8,400,000 $8,950,000 $10,880,000
EXPENSES

       

NET INCOME $4,100,000 $4,550,000 $5,120,000

 If we convert
these values to XYZ Incorporated Vertical Analysis
percentages, our   2017 2018 2019
new chart looks Sales 100% 100% 100%
like this: COGS 50% 51% 54%

GROSS PROFIT 50% 49% 46%

       

Salaries 18% 17.5% 17.2%

Marketing 4.4% 4% 5.5%

Rent 8% 7.3% 5.8%

Utilities 1.2% 1% .9%

Misc. Expenses 2% 2.7% 1.9%

TOTAL EXPENSES 33.6% 32.6% 31.3%

       

NET INCOME 16.4% 16.4% 14.7%

If we convert these
values to
percentages, Using XYZ Incorporated Vertical Analysis
Horizontal
  2017 2018 2019
Analysis our new
chart looks like this: Sales 100% 110% 140%

COGS 100% 112% 152%

GROSS PROFIT 100% 108% 128%

       

Salaries 100% 107% 133%

Marketing 100% 100% 173%

Rent 100% 100% 100%

Utilities 100% 100% 100%

Misc. Expenses 100% 150% 136%

TOTAL EXPENSES 100% 107% 130%

       

NET INCOME 100% 111% 125%

 Comparisons: Trend Analysis

A study of the financial history of a firm

Longitudinal ratio comparison
– Falling
– Rising
– Relatively constant
Highlight
– Effective management
– Evidence of problems
 The Users of Financial Statements
Investors
– Analysis of past and present information to
project the future prospects of the entity
Creditors
– Short-term: focus is on current resources
– Long-term: consider the future prospects of
the firm
Management
– Analyze information from the perspective of
both investors and creditors
 Liquidity Analysis
To measure the ability of the firm to meet its
short-term debts when they become due.
Examine current assets and current liabilities.
Pay special attention to Cash, Receivables, and
Inventory.
Examine the operating cycle.
Operating
Cycle

The time period

between the
acquisition of
goods and the final
cash realization
from sales.
 Days’ Sales in Receivables
Gross Receivables
 Net Sales 
 
 365 
 Should mirror the company’s credit terms
 Reading reflects end-of-year status of
receivables
 Use of the natural business year (lower sales at
year-end) can understate result
 Compare
 Firm data for several years
 Other industry firms and industry averages
 Days’ Sales in Receivables (Cont’d)

Causes for overstatement

– Sales volume expands materially late in the year
– Receivables are uncollectible and should have been written off
– The company seasonally dates invoices
– A large portion of receivables are on the installment basis
Causes for understatement
– Sales volume decreases materially late in the year
– A material amount of sales are on a cash basis
– The company has a factoring arrangement in which a material
amount of the receivables is sold to an outside party
 Accounts Receivable Turnover

Net Sales
Average Gross Receivables

 Indicates the liquidity of receivables

 Determining average gross receivables
End of year and beginning of year base points
for average mask seasonal fluctuations
Internal analysis: use monthly or weekly
amounts
External analysis: use quarterly data
Accounts Receivable Turnover in Days

Average Gross Receivables

 Net Sales 
 
 365 

 Similar to Number of Days’ Sales in

Receivables except average
receivables are used
 Should reflect firm’s credit and
collection policies
 Liquidity of Inventory

Number of days’ sales in inventory

Inventory turnover in times per year
Inventory turnover in days
 Days’ Sales in Inventory

Ending Inventory
 Cost of Goods Sold 
 
 365 

 Indicates the length of time needed to sell all

inventory on hand
 Use of a natural business year (low ending
inventory at the end of year)
 Understates number of day’s sale in
inventory
 Overstates liquidity of inventory
 Implications of extremes
 High: excessive inventory for sales activity
 Low: inventory shortage and lost sales
 Inventory Turnover

Cost of Goods Sold

Average Inventory

 Indicates the liquidity of inventory

 Determining average inventory
End of year and beginning of year base
points for average mask seasonal
fluctuations
Internal analysis: use monthly or weekly
amounts
External analysis: use quarterly data
Inventory Turnover Inventory Turnover
in Days per Year

Average Inventory 365

 Cost of Goods Sold  Inventory Turnover
  in Days
 365 
 Current Assets: Operating Cycle

The time period between acquisition of goods

and the final cash realization from sales

Accounts Reciveable Inventory

Operating Cycle = Turnover + Turnover
in Days in Days

Subject to potential understatement from

understatement of turnover measures
 Working Capital
Current Assets
– Current Liabilities
= Working Capital

Subject to understatement if certain assets

are understated.
Longitudinal comparison appropriate.
Inter-firm comparison is of no value.
 Acid-Test (Quick)
Current Ratio Ratios

Current Assets Current Assets - Inventory

Current Liabilities Current Liabilities

 Cash Equivalents 
 + Marketable Securities 
 + Net Receivables 
 
Current Liabilities
 Current Ratio

Determines short-term debt-paying ability

Focus is on the relationship between current assets and
current liabilities
– Inter-firm comparison is possible and meaningful
Traditional benchmark: 2.00
– Decreased current ratio indicates lower liquidity
– Industry averages provide contextual benchmark
Considerations
– Quality of inventory and receivables
– Inventory cost flow assumptions (LIFO, FIFO)
 Acid-Test (Quick) Ratio
Measures the immediate liquidity of the firm
Relates the most liquid assets to current liabilities
– Exclude inventory
– More conservative variation: Also exclude other
current assets that do not represent current cash flow
Traditional benchmark: 1.00
– Industry averages provide contextual benchmark
Consideration
– Quality of receivables
 Cash Ratio

Cash Equivalents + Marketable Securities

Current Liabilities

Extremely conservative
Unrealistic for a firm to have sufficient
cash and securities to cover all its current
liabilities
Appropriate context
• Firms with naturally slow-moving
inventory and receivables
• Firms that are highly speculative
 Sales to Working Capital

Sales
Average Working Capital
 Measures the turnover of working capital per
year
 Compare with
• Historical data
• Industry competitors
• Industry averages
 Assessment
• Low: potentially unprofitable use of working capital
(Low generation of sales)
• High: potential undercapitalization(Low short term
assets needed to generate sales or high short-term
debts)
 Solvency Analysis
Times Interest Earned:
Recurring Earnings, Excluding Interest
Expense, Tax Expense, Equity Earnings,
and Minority Earnings
Interest Expense, Including Capitalized Interest

 Indicates long-term debt-paying ability

 Consider only recurring income
 Exclude discontinued operations
 Exclude extraordinary items
 Comparisons
 3 to 5 years of historical data
 Lowest value is the primary
indicator of interest coverage
 Industry competitors and averages
 Solvency Analysis (Cont’d)
Fixed Charge Coverage:
Recurring Earnings, Excluding Interest
Expense, Tax Expense, Equity Earnings,
and Minority Earnings
+ Interest Portion of Rentals
Interest Expense, Including Capitalized Interest
+ Interest Portion of Rentals

Ratio trend is usually similar to trend of times-

interest-earned ratio
 Solvency Analysis (Cont’d)
Fixed Charge Coverage (cont’d)
Fixed charges include
– Interest portion of operating lease payments
General approximation: 1/3 of payments
SEC requires specific calculation using lease terms
– May also include
Depreciation, depletion, and amortization
Debt principal payments
Pension payments
Substantial preferred stock dividends
The more items included as “fixed charges,” the more
conservative the ratio
 Debt Ratio

Total Liabilities
Total Assets
 Indicates the percentage of assets financed by
creditors
 Comparisons
Industry competitors and averages
 Variations in application
• Short-term liabilities
 Not part of long-term source of funds: exclude
 Part of the total source of funds: include
• Liabilities that do not necessarily represent a commitment
to pay out funds in the future
 Debt/Equity Ratio

Total Liabilities
Shareholders' Equity

 Helps determine how well creditors

are protected in case of insolvency
 Comparisons
Industry competitors and averages
 Debt to Tangible Net Worth Ratio

Total Liabilities
Shareholders' Equity - Intangible Assets

 Determines the entity’s long-term debt

payment ability
 Indicates how well creditors are protected
in case of the firm’s insolvency
 More conservative than debt ratio or
debt/equity ratio due to exclusion of
intangibles
Other Long-Term Debt-Paying Ability Ratios

Current debt/net worth ratio

– The relationship between current liabilities and funds
contributed by shareholders
Total capitalization ratio
– Compares long-term debt to total capitalization
– Total capitalization: long-term debt, preferred stock,
and common stockholders’ equity
Fixed asset/equity ratio
– The extent to which shareholders have provided
funds in relation to fixed assets against leverage by
creditors
 Assessing Profitability

Profitability Measures:
– Exclude items of income not arising from
normal operations
Discontinued operations
Extraordinary items
 Net Profit Margin

Net Income Before Noncontrolling Interest,

Equity Income, and Nonrecurring Items
Net Sales

Also referred to as return on sales

Reflects net income dollars generated by
each dollar of sales
Potential distortion
 Net “other” income or loss (not related to
operation)
 Total Asset Turnover

Net Sales
Average Total Assets

Measures the activity of the assets and

the ability of the firm to generate sales
through the use of the assets
Potential distortion
• Investments
• Construction in progress
• Other assets that do not relate to
net sales
 Return on Assets
Net Income Before Noncontrolling Interest
and Nonrecurring Items
Average Total Assets

 Measures the ability to utilize assets to create

profits
 Average total assets
 Internal analysis: month-end amounts
 External analysis: beginning and ending
amounts
 If necessary, consistent use of end-of-year
amounts
 DuPont Return on Assets

Return on Assets = Net Profit Margin  Total Asset Turnover

Net Income Before Net Income Before

Noncontrolling Noncontrolling
Interest and Interest and
Nonrecurring Items Nonrecurring Items Net Sales
= 
Average Total Assets Net Sales Average Total Assets
 DuPont Return on Assets (cont’d)
DuPont analysis separates return on assets into
net profit margin and total asset turnover
Return on Net Profit Total Asset
Assets = Margin × Turnover
Firm A
Year 1 10% = 4.0% × 2.5
Year 2 8% = 4.0% × 2.0

FIRM B
Year 1 10% = 4.0% × 2.5
Year 2 8% = 3.2% × 2.5
Separating the ratio into the two elements allows
evaluation of the causes for the change in return
on assets
 Operating Income Margin

Operating Income
Net Sales
 Use operating income in the numerator
 Operating Asset Turnover

Net Sales
Average Operating Assets

 Measures the ability of operating

assets to generate sales dollars
 Return on Operating Assets

Operating Income
Average Operating Assets

 Measures the ability of operating assets to

generate operating income
 DuPont analysis of the return on operating
assets:
DuPont Return Operating Operating
on = Income × Asset
Operating Assets Margin Turnover
 Sales to Fixed Assets
Net Sales
Average Net Fixed Assets

 Measures the ability to make productive use of

property, plant, and equipment by generating
sales dollars
 Exclude construction in progress
 Possible distortions
 Old fixed assets
 Labor-intensive industry
 Return on Investment (ROI)
Net Income Before Noncontrolling
Interest and Nonrecurring Items
+ Interest Expense   1-Tax Rate 
Average Long-Term Liabilities + Equity 

 Measures income earned on investment and

how well the firm utilizes its asset base
 Evaluates enterprise performance
 Measures ability to reward
investors(Creditors and shareholders) and
to attract providers of future funds
 Evaluates the earnings performance without
regard to financing sources
 Return on Total Equity
Net Income Before Nonrecurring Items
- Dividends on Redeemable Preferred Stock
Average Total Equity

 Measures the return to common and preferred

stockholders
 Adjustments for redeemable preferred stock
 Deduct dividends from net income
(numerator)
 Deduct stock value from total equity
(denominator)
 Return on Common Equity
Net Income Before Nonrecurring Items
- Preferred Dividends
Average Common Equity

 Measures the return to the common stockholder

 Common equity:
Total stockholders’ equity
less preferred capital
less minority interest reported as equity
 Gross Profit Margin

Gross Profit
Net Sales
Sales Beginning Inventory
– Cost of Goods Sold + Purchases of Inventory
– Ending Inventory
= Gross Profit
 Example
The following are extracted from the financial statements of Alexandria Foods, Inc., for
2015, 2014, and 2013.
  2015    2014    2013   
Net sales $233,000  $204,000   
Cost of sales (124,000) (110,000)  
Selling and administrative expenses (95,000) (81,500)  
       
Other income:      
  Interest (3,700) (3,050)  
  Other 100  1,175   
Earnings before tax and extraordinary credit $ 10,400 $ 10,625   
Provision for income tax (4,800) (4,740)  
Earnings before extraordinary credit 5,600  5,885   
Extraordinary credit — 1,510  
  $  5,600  $  7,395   
       
Total assets $202,000  $173,000  $161,000 
Long-term debt 24,600  17,400  15,200 
Common equity 123,000  116,800  112,800 
Copyright 2011 by South-
Preferred stock
Western, a part of Cengage 4,000  4,000  4,000 
Preferred
Learning. Alldividends
rights reserved. Chapter 8, Slide #111 280  280  280 
 Example

1. Compute the following ratios for 2015 and 2014.

2. Net profit margin
3. Total asset turnover
4. Return on assets
5. Return on investment
6. Return on total equity
7. Return on common equity
8. Gross profit margin
 Example Solution
a.   2015   2014
1. Net Profit Margin =      
       
Net Income Before Non-controlling Interest      

and Nonrecurring Items $5,600   $5,885

Net Sales $233,000   $204,000
       
  = 2.40%   = 2.88%

2. Total Asset Turnover =  

  2015  2014 

       Net Sales                 $233,000                    $204,000          

Average Total Assets ($202,000 + $173,000)/2 ($173,000 + $161,000)/2

  = 1.24 times = 1.22 times

 Example

Example Solution
3. Return On Assets =  
     

Net Income Before  

 
Noncontrolling Interest
and Nonrecurring Items   $5,600    $5,885  
 

Average Total Assets $187,500 $167,000

 

  2.99% 3.52%  

4. Return On Investment =
Net Income Before Non-controlling Interest

and Nonrecurring Items

+ [(Interest Expense) ´ (1 - Tax Rate)]

Average (Long-Term Liabilities + Equity)

 Example Solution

 Net income before extraordinary item $5,600 $5,885

Interest expense 3,700 3,050
Tax rate:
 
2015 4,800 = 46.15%
$10,400
 
2014 $4,740 = 44.61%
$10,625
 

Interest expense x (1 - t) 1,992 1,689

Net income before extraordinary item + interest expense (1 - t)  
(5,600 + 1,992)[A] 7,592
(5,885 + 1,689)[A]  7,574 
 
 Example Solution
Long-term liabilities and stockholders' equity:
Beginning of year:
  Long-term debt $ 17,400 $ 15,200
Common equity 116,800 112,800
Preferred stock 4,000 4,000 
 
End of year
  Long-term debt 24,600 17,400
Common equity 123,000 116,800
Preferred stock 4,000    4,000  
Total $289,800 $270,200
Average [B] 144,900 135,100
 
Return on investment [A]/[B] 5.24% 5.61%
 Example Solution

5. Return on Equity =  

(Net income before nonrecurring Items -
Dividends on Redeemable Preferred Stock)
Average Total Equity
 Example Solution
Net income before nonrecurring items -- Dividends on 
redeemable preferred stock [A] $  5,600 $  5,885
 
Total equity:
Beginning of year:
Common equity $116,800 $112,800
Preferred stock 4,000 4,000
End of year:
Common stock 123,000 116,800
Preferred stock 4,000 4,000
Total $247,800 $237,600
  Average [B] 123,900 118,800
 
Return on total equity [A]/[B] 4.52% 4.95%
 
 Example Solution

6. Return on Common Equity = 

Net Income Before Nonrecurring Items -
Preferred Dividends
Average Common Equity
 Example Solution

Net income before nonrecurring items $ 5,600 $ 5,885

Less: Preferred dividends 280 280
Numerator [A] 5,320 5,605
 
 Total common equity:
  Beginning of year 116,800 112,800
  End of year 123,000 116,800
  Total $239,800 $229,600
 
Average [B] 119,900 114,800
 
 Return on common equity [A]/[B] 4.44% 4.88%
 Example Solution
7. a. Gross Profit Margin =
 
Net Sales [B] $233,000 $204,000
Cost of Sales -124,000 -110,000
Gross Profit [A] $109,000 $ 94,000
 
  [A]/[B] 46.78% 46.08%

 
b. Net profit margin, return on total assets, return on investment, return on total equity, and
return on common equity have declined. Total asset turnover and gross profit margin
rose slightly. The problem appears to be in selling and administrative expenses, other
income, and taxes, since gross profit margin rose. Of particular concern is the very low
return to common shareholders. It is lower than return on total equity and investment,
which indicates that preferred owners and creditors, who bear less risk, are getting a
higher return.
 
 

 
 Group Cases

Each group of three will be asked to analyze the financial

statements of one of the following companies and submit
their findings before the last class meeting:
– The company you work for
– Nike
– McDonalds
– General Motors or Toyota
– Bayer
– ExxonMobil
– Apple, Inc. or Microsoft
– Sony Electronics, Toshiba, or Samsung Electronics
Questions?