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Tools for Business Decision-Making

Fifth Canadian Edition

Financial Accounting:

Prepared By:Debbie Musil

Kwantlen Polytechnic University

Copyright John Wiley & Sons Canada, Ltd.1 14

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Performance Measurement

Study Objectives

1. Understand the concept of sustainable income and indicate how irregular items are presented.

2. Explain and apply horizontal analysis.

3. Explain and apply vertical analysis.

4. Identify and calculate ratios that are used to analyze liquidity.

5. Identify and calculate ratios that are used to analyze solvency.

6. Identify and calculate ratios that are used to analyze profitability.

7. Understand the limitations of financial analysis.

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1Sustainable Income

• The level of profit that is likely to be attainable in the future

• Differs from actual profit due to irregular revenues, expenses, gains and losses that are included in profit

• Two common types of irregular items:– Discontinued operations– Changes in accounting policy


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1Discontinued Operations

• Disposal, or availability for sale, of a component of an entity

– Separate major line of business or major geographical area of operations that has been disposed of or is for sale

– Must be clearly distinguishable operationally and financially


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Discontinued Operations:Statement of Financial Position

• Assets and liabilities are reported separately

• Valued and reported at lower of carrying amount and fair value, less any expected costs of disposition

– Reported as non-current assets or liabilities


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Discontinued Operations:Income Statement

• Segregated from continuing operations and reported separately on the income statement

– Shown immediately following profit/loss from continuing operations

• Consists of two parts:

– Profit (loss) from discontinued operations

– Gain (loss) on disposal of the segment

– Both components are reported net of applicable taxes


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1Change in Accounting Policy

• Occurs when the policy used in the current year is different from the one used in the preceding year

– Voluntary change: Allowed when new policy results in more reliable and relevant presentation

– Mandatory: Required by standard setters


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Change in Accounting Policy:Effect on Reporting

• Cumulative effect of change to prior years is reported as adjustment to opening retained earnings

– In statement of changes in equity (IFRS)

– In statement of retained earnings (ASPE)

• New policy used to report results of current year

• Prior period statements restated

• Effects of change detailed in notes


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1Discussion Question

Discuss the adoption of international financial reporting standards (IFRS) as a change in accounting policy.


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1Comparative Analysis

• Three types of comparisons:

– Intracompany basis – comparisons within a company

– Intercompany basis – comparisons between one or more competitor companies

– Industry averages


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Comparative Analysis:Three Tools

• Horizontal analysis (trend analysis)

– A technique to determine the change over time

• Percentage of base-period amount

• Percentage change for the period

• Vertical analysis (common size analysis)

• Ratio analysis


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Horizontal Analysis

Copyright John Wiley & Sons Canada, Ltd.12

Illustration 14-5

ANY COMPANY INC.Assumed Net Sales (in thousands)

2012 2011 2010 2009 2008

$ 6,051.0 $ 3,657.6 $ 8,989.2 $ 4,764.0 $ 3,376.8

179.2% 108.3% 266.2% 141.1% 100%

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Horizontal Analysis (Continued)


ANY COMPANY INC.Assumed Net Sales (in thousands)

2012 2011 2010 2009 2008

$ 6,051.0 $ 3,657.6 $ 8,989.2 $ 4,764.0 $ 3,376.8

65.4% (59.3)% 88.7% 41.1% n/a

Illustration 14-6

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Vertical Analysis


Expresses each item in a financial statement as a percent of a base amount (total assets or net sales)

Illustration 14-9

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Vertical Analysis (Continued)


ANY COMPANY INC.Condensed Statement of Financial Position

December 31 (in thousands)

2012 2011

Assets Amount Percent Amount Percent

Current Assets $ 2,139.9 20.3% $ 2,271.7 25.1%

Property, Plant, and Equipment 8,062.7 76.3% 6,413.3 70.9%

Other Assets 363.1 3.4% 359.9 4.0%

Total Assets $ 10,565.7 100% $ 9,044.9 100%

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Identify some situations when a horizontal or vertical percentage cannot be calculated or is not meaningful.


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1Ratio Analysis

• Liquidity Ratios: Measure short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash

• Solvency Ratios: Measure the ability of the company to survive over a long period of time

• Profitability Ratios: Measure the earnings or operating success of a company for a given period of time


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1Liquidity Ratios

• Working capital

• Current ratio

• Cash current debt coverage

• Receivables turnover

• Average collection period

• Inventory turnover

• Days in inventory


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1Working Capital

• Measures short-term debt paying ability

Working Capital = Current Assets – Current Liabilities


Higher is better

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1Current Ratio

• Measures short-term debt paying ability


Current Ratio = Current Assets Current Liabilities

Higher is normally (but not always) better. Be cautious about influences of slow moving

inventory and receivables on this ratio.

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1Cash Current Debt Coverage

• Measures short-term debt-paying ability (cash basis)


Cash Current Debt Coverage =

Cash Provided (Used) by Operating

ActivitiesAverage Current

Liabilities

Higher is better

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1Receivables Turnover

• Measures liquidity of receivables


Receivables Turnover =

Net Credit SalesAverage Gross Receivables

Higher is better

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1Average Collection Period

• Measures number of days receivables are outstanding


Average Collection

Period =

365 DaysReceivables Turnover

Lower is better

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1Inventory Turnover

• Measures liquidity of inventory


Inventory

Turnover =

Cost of Goods SoldAverage Inventory

Higher is better

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1Days in Inventory

• Measures number of days inventory is on hand


Days in Inventory =365 Days

Inventory Turnover

Lower is better

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1Solvency Ratios

• Debt to total assets• Times interest earned• Cash total debt coverage• Free cash flow


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1Debt to Total Assets Ratio

• Measures % of total assets provided by creditors


Debt to Total Assets =Total Liabilities

Total Assets

Lower is better

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1Times Interest Earned

• Measures ability to meet interest payments as they come due


Times Interest Earned =

Profit + Interest Expense + Income Tax

Expense (EBIT)Interest Expense

Higher is better

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1Cash Total Debt Coverage

• Measures long-term debt-paying ability (cash basis)


Cash Total Debt Coverage =

Cash Provided (Used) by Operating Activities

Average Total Liabilities

Higher is better

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1Free Cash Flow

• Measures cash available for paying dividends or expanding operations


Net Cash Provided (Used) by Operating Activities

Net Capital Expenditures Dividends

Paid =Free Cash Flow

Higher is better

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1Profitability Ratios


• Return on common shareholders’ equity• Profit margin• Return on assets• Asset turnover• Gross profit margin• Earnings per share (EPS)• Price-earnings (P-E) ratio• Payout ratio• Dividend yield

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Return on Common Shareholders’ Equity

• Measures overall profitability of shareholders’ investment


Return on Common

Shareholders’ Equity =

Profit – Preferred Dividends

Average Common Shareholders’ Equity*

*Common shareholders’ equity = Total shareholders’ equity – Preferred shares

Higher is better

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1Return on Assets

• Measures overall profitability of assets– How much is earned on each dollar invested in

assets


Return on Assets =Profit

Average Total Assets

Higher is better

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1Profit Margin

• Measures the percentage of profit generated by each dollar of sales


Profit Margin =Profit

Net Sales

Higher is better

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1Asset Turnover

• Measures how efficiently assets are used to generate sales


Asset Turnover =Net Sales

Average Total Assets

Higher is better

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1Gross Profit Margin

• Measures margin between selling price and cost of goods sold


Gross Profit Margin =

Gross ProfitNet Sales

Higher is better

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Relationship Amongst Profitability Ratios


Illustration 14-15

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1Earnings per Share (EPS)

• Measures profit earned on each common share


Earnings Per Share =

Profit – Preferred Dividends

Weighted Average Number of Common

Shares

Not comparable between companies

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1Price-Earnings (P-E) Ratio

• Measures relationship between market price per share and earnings per share


Price-Earnings Ratio =

Share PriceEarnings Per Share

Higher indicates investors expect favourable profitability in future

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1Payout Ratio

• Measures % of profit distributed in the form of cash dividends


Payout Ratio =Cash Dividends

Profit

Higher is better for investors seeking income

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1Dividend Yield

• Measures rate of return earned from dividends during the year


Dividend Yield =Dividend per Share

Market Price per Share

Higher is better for investors seeking income

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Why are the P-E and dividend yield ratios known as market measures?


CHAPTERCHAPTER

1Limitations of Financial Analysis

• Can be impacted by– Alternative accounting principles– Professional judgement– Comprehensive income– Diversification – Inflation– Economic factors


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Comparing IFRS and ASPE

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1Copyright Notice

Copyright © 2012 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein.


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