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ACCT 652 week 11 1

ACCT 652 Accounting�

Ratio analysis, comparative statements, Seal Best, Cost

volume profit analysisDr. Michael Kinsman

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Ratio analysis

•  When you go to the doctor, the doctor takes your blood pressure and checks certain other vital signs to check your physical health.

•  We are going to check the “money pressure” and certain other vital signs of companies to check their fiscal health.

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What are we looking for?

•  Like the doctor, we are looking for unexplained difference.

•  Explainable differences may be just fine–our management may simply be managing differently or there is another difference.

•  Unexplained difference gives us a list of potential problems.

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Your book versus the ratios here

•  Your book supplies you many fine ratio definitions. Ignore them.

•  Ignore them not because there is anything wrong with them, but because finance, where this stuff is really going to be used, has its own set of parallel ratios.

•  There is no sense in learning them twice.

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In the real world

•  When you do ratios in the real world, you will want to do those ratios for which you have comparisons. Those are generally listed in the front of your “comparisons” book.

•  We will talk later about sources for comparison ratios.

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Liquidity RatiosThe liquidity ratios tell us about a firm’s solvency in the near term

Acid-Test ratio (or Quick ratio)

Current ratio

Current Assets - Inventories Current Liabilities = Acid-Test

Ratio

Current Assets Current Liabilities = Current

Ratio

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Asset management ratios

•  Inventory turnover ratio Inventory turnover = Sales/Year end inventories

•  Days’ Sales Outstanding (Average Collection Period)

Days’ Accounts Receivable Sales = Outstanding Net Sales

* 365

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Asset management ratios

•  Fixed asset turnover ratio

•  Total asset turnover ratio

Fixed asset turnover ratio

= Sales

Net fixed assets

Total asset turnover ratio

= Sales

Total assets

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Another asset management ratio

•  Days’ Stock on Hand Days’ Ending Inventory Stock = on Hand Cost of Goods Sold

* 365

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Long-Term Risk and Capital Structure

•  Debt Ratio

•  Times Interest Earned

Total Liabilities = Total Assets

Debt Ratio

Times Income Before Interest and Taxes Interest = Earned Interest Expense

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Profitability Ratios

•  Profit Margin on sales

•  Return on total assets

Profit margin on sales

Net Income Revenues =

Return on Total Assets

Net Income Total assets =

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Profitability Ratios

•  Return on Common EquityReturn on Common Equity

Net Income - Preferred Dividends Common Equity =

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Market value ratios

•  Price Earnings Ratio

•  Dividend yield ratio

•  Market to book ratio

Price/Earnings Ratio

Market Price Per Share Earnings Per Share =

Dividend Yield

Annual Dividends Per Share Market Price Per Share =

Market/Book Ratio

Market Price Per Share Book Value Per Share =

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Common-Size Comparative Statements

•  Common-size comparative statements use percentages to express the relationship of individual components to a total.

•  Net sales is usually expressed as 100% on the income statement.

•  Total assets is usually expressed as 100% on the balance sheet.

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Standards of ComparisonCompare ratios and turnovers with. . .

Subjective standards acquired from past experiences.

Ratios and turnovers of competing companies in the same industry.

Published ratios and turnovers.

Standards or average ratios and turnovers for the industry.

Rule-of-thumb standards.

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Seal BestPrepare the ratios for Seal Best, and prepare any additional analysis that will help you (and the class) understand what is happening in this situation.

If you were an investor in Seal Best, what changes would you make to make the company “better.” Be specific, both with the changes, the timing of them, and how you would execute them.

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Seal Best RatiosSeal Best, Inc.Ratios Ind. 1972 1973 1974

Quick (times) 1.0 2.1 1.0 0.6Current (times) 2.7 4.2 2.6 1.8Inventory turnover (times/year) 7.0 8.7 5.4 3.5Average collection period (days) 32.0 33.0 36.0 49.0Fixed asset turnover (times) 13.0 11.6 10.7 12.4Total asset turnover (times) 2.6 3.2 2.6 1.9Debt ratio (percent) 50.0 23.0 33.0 48.0Return on total assets (percent) 9.0 12.1 6.5 2.8Return on net worth (percent) 18.0 15.7 9.7 5.4Profit margin on sales (percent) 3.5 3.8 2.6 1.4

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Percentage Income StatementSeal BestPercentage Income Statement(Also called Common Sized Income Statement)

Net sales 2,210.0 100.00 2,295.0 100.00 2,380.0 100.00Cost of goods sold 1,768.0 80.00 1,836.0 80.00 1,904.0 80.00

Gross profit 442.0 20.00 459.0 20.00 476.0 20.00

Administrative and selling expense 170.0 7.69 187.0 8.15 204.0 8.57Depreciation 68.0 3.08 85.0 3.70 102.0 4.29Miscellaneous expense 34.0 1.54 71.4 3.11 102.0 4.29

Total operating expense 272.0 12.31 343.4 14.96 408.0 17.14Net income before taxes 170.0 7.69 115.6 5.04 68.0 2.86

Taxes (50%) 85.0 3.85 57.8 2.52 34.0 1.43

Net income 85.0 3.85 57.8 2.52 34.0 1.43

1972 1973 1974

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Data for Cash Flow StatementSeal BestBalance sheet (used as data)

1972 1973 1974 1972-1973 1973-1974

Cash 51,000 23,800 17,000 (27,200) (6,800)Accounts receivable 204,000 231,200 323,000 27,200 91,800Inventory 255,000 425,000 688,500 170,000 263,500Property (net) 190,400 214,200 192,100 23,800 (22,100)

Notes payable bank 85,000 238,000 85,000 153,000Accounts payable 81,600 129,200 255,000 47,600 125,800Accrued expenses 40,800 47,600 64,600 6,800 17,000Long term debt 37,400 34,000 30,600 (3,400) (3,400)Net worth 540,600 598,400 632,400 57,800 34,000

Difference

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Cash Flow Statement–OperatingFrom operations:

From customersSales 2,295,000 2,380,000Minus accounts receivable change (27,200) (91,800)Net from customers 2,267,800 2,288,200

To suppliersMinus cost of goods sold (1,836,000) (1,904,000)Minus change in inventory (170,000) (263,500)Plus accounts payable change 47,600 125,800Minus operating expense (187,000) (204,000)Minus miscellaneous expense (71,400) (102,000)Minus provision for taxes (57,800) (34,000)Plus change in accrued expense 6,800 17,000Net to suppliers (2,267,800) (2,364,700)

Net from operations 0 (76,500)

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Cash Flow Statement–Investing and Financing Activities

From investingInvestment to replace depreciation (85,000) (102,000)Minus change in property (23,800) 22,100Net from investing (108,800) (79,900)

From financingNotes payable, bank 85,000 153,000Long term debt (3,400) (3,400)Net from financing 81,600 149,600

Change in cash (27,200) (6,800)Beginning cash 51,000 23,800Ending cash 23,800 17,000

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Statement of Cash Flows: Reconciliation of Net Income to

Cash Flows from OperationsReconciliation of net income to cash flow from operations

Net income 57,800 34,000Add back depreciation 85,000 102,000Change in accounts receivable (27,200) (91,800)Change in inventory (170,000) (263,500)Change in accounts payable 47,600 125,800Accrued expenses 6,800 17,000

Net cash flow from operations 0 (76,500)

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Importance of�Cost-Volume-Profit Analysis

CVP analysis aids in understanding the relationship between an organization’s costs, revenue, volume, and income.

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Questions Addressed by�Cost-Volume-Profit Analysis

CVP analysis is used to answer questions �such as: How much must I sell to earn my desired income? How will income be affected�if I reduce selling prices to�increase sales volume? How will income be affected�if I change the sales mix�of my products?

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Why include CVP–I’ve got a computer!

•  You might wonder why you should learn CVP when you have a computer to do pro-forma estimates of income under various circumstances.– Good point. The reason to learn this is not to

learn formulas, which are just shortcut pro-forma statements, but instead to learn about fixed, variable, and semi-variable costs that may be useful in doing your pro-formas.

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Fixed Costs

•  Fixed costs are costs that do not vary over a wide range of the activity–you can make many local phone calls without paying more for your phone.

•  If you have fixed costs, your cost per unit declines as you spread those costs over more units.

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Cost Behavior Unit Fixed Costs

Number of Local Calls

Monthly Basic

Telephone Charge

per Local Call

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Cost Behavior�Variable Costs

•  Total variable costs change in direct proportion to changes in activity.

•  Unit variable costs remain constant over wide ranges of activity.

•  Example: long distance telephone charges Total cost will increase as �a function of minutes talked. Cost per minute remains �unchanged.

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Cost Behavior Total Variable Costs

Long Distance Minutes

Total Long

Distance Charge

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Cost Behavior�Total Cost

Fixed Portion

Variable Portion

Activity

Cos

t

Total costs = Fixed costs + Variable costs

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Cost Behavior�Step-Variable Costs

•  Total cost remains constant within a narrow range of activity and then jumps to a new higher cost for the next higher range of activity.

•  Example: The supervisor’s salary is $30,000 for a process that produces 10,000 units. When volume increases beyond 10,000 units, a second process is added with a second supervisor, increasing total salaries to $60,000.

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Cost Behavior�Step-Variable Costs

Supe

rvis

ory

Sala

ries

Thou

sand

s of

Dol

lars

0 10 20 Activity in Thousands

0

30

60

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Cost Behavior Patterns �Semivariable Costs

Costs that increase when activity increases, but in a nonlinear manner

Activity

Tota

l Cos

t

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•  Mixed costs contain a fixed portion that is incurred even when facility is unused, and a variable portion that increases with usage.

•  Example: monthly electric utility charge– Fixed service fee– Variable charge per�

kilowatt hour used

Cost Behavior�Mixed Costs

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Cost Behavior�Total Cost

Fixed Portion

Variable Portion

Activity

Cos

t

Total mixed cost

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Assumptions Used in�Cost-Volume-Profit Analysis

• Unit selling price must remain constant for all units sold during the planning period.•  All costs are classified as either fixed or variable.

–  Unit variable costs must remain constant.–  Total fixed cost must remain constant over the volumes

projected for the planning period.•  These assumptions allow all CVP relationships to be

expressed as straight lines.•  Last, the level of production is the same as the level of

sales (no inventory changes).

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Working with the Assumptions

•  Working with total variable costs (aggregating costs) may result in straight lines which are combinations of other curvilinear lines.

•  Limiting the analysis to the relevant range of activity enables the CVP relationships to be expressed as straight lines.

Relevant Range The relevant range of operations is a limited range

of activity where the following cost behavior assumptions are valid:

1. Total fixed costs remain constant. 2. Unit variable costs remain unchanged.

The relevant range excludes extremely high and low levels of operating activity that

are not likely to be encountered.

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Working with the Assumptions

•  Working with total variable costs (aggregating costs) may result in straight lines that are combinations of other curvilinear lines.

•  Limiting the analysis to the relevant range of activity enables the CVP relationships to be expressed as straight lines.

•  CVP analysis yields an imprecise, starting point for analyzing complex situations.

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Identifying Cost Behavior

The objective is to classify all costs as

either fixed or variable.

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If a cost is not obviously fixed or variable, a scatter diagram of past cost behavior may be helpful.– Plot the data points on a �

graph (total cost vs. activity).– Draw a line through the �

plotted data points.

Identifying Cost Behavior�Scatter Diagrams

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Variable unit costs are represented by the slope of the estimated line of cost behavior.

Identifying Cost Behavior�Estimated Line of Cost Behavior

Activity, 1000’s of Units Produced

0 1 2 3 4

*

Tota

l Cos

t in

1000’s

of D

olla

rs

10

20

0

* * *

* *

* * *

Estimated fixed cost = 10,000

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The break-even point (expressed in units of product or dollars of sales) is the unique sales level at which a company earns neither a profit

nor incurs a loss.

Finding the Break-Even Point

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We have just seen one of the basic CVP relationships – the break-even computation.

Break-even units = Fixed costs

Sales - Variable Costs

Finding the Break-Even Point

The number of units that must be sold to break even is equal to fixed costs divided by the unit contribution margin. Unit contribution margin is unit sales price

less unit variable cost.

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The break-even formula may also be expressed in sales dollars.

Break-even dollars = Fixed costs* Selling price per unit

Sales - Variable Costs

Finding the Break-Even Point

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•  A CVP chart is a graph where the vertical axis �is dollars of costs and revenues, and the horizontal axis is number of units sold.

•  A CVP chart is prepared using these steps: Plot total fixed costs on the vertical axis.Starting at the level of fixed costs on the� vertical axis, draw the total cost line with � a slope equal to the unit variable cost.Starting at the origin, draw the sales line� with a slope equal to the unit sales price.

Drawing a CVP Chart

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Drawing a CVP Chart

Profit

Loss

Sales

Total costs

Volume in Units

Cos

ts a

nd R

even

ue

in D

olla

rs

Break-even Point

Total fixed costs

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At any point on the CVP chart the following relationship is valid:�

Profit = Sales - Fixed costs - Variable costs

Finding the Income from an Expected Level of Sales

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Your company has net income of $10,000 while selling 2,000 product units at $20 each. Variable costs are $6 per unit and fixed costs total $18,000. What is the effect on income of a 10 percent price reduction that results in a 30 percent volume increase? You plan to spend $3,000 to advertise this special sale. Should you undertake this special sale?

A CVP problem

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Using CVP concepts

•  Often, rather than using the formulas of Cost Volume Profits analysis directly, we are better served to use the concepts of CVP in a spreadsheet.

•  The spreadsheet lets us make clear assumptions about the changes we are making, as well as allowing us a cleaner, more follow-able analysis.

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Is a $200 increase worth the risk? Now, you have information to make decisions about the special sale.

Should we do the special sale?

Normal Sale DifferenceUnit sales 2,000 2,600 Unit price 20 18 Sales 40,000 46,800 6,800 Variable costs (12,000) (15,600) (3,600) Fixed costs (18,000) (21,000) (3,000) Profit 10,000 10,200 200

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Evaluating the Usefulness � of CVP Analysis

•  CVP analysis is useful for predicting the results of alternative strategies for selling prices, fixed costs, variable costs, sales volume and product sales mix.

•  However, the results of CVP may be only rough approximations because:– As in all forecasts, data in the analysis are

predictions of future conditions.– CVP analysis is based on assumptions which

may not be valid in all situations.

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Have a great week!

•  Appeals should be emailed to me (along with a copy of your full exam) as soon as possible. All grades are final as of next Thursday at 6 pm.

•  Work well with your team and let’s have a great presentation!