14-1 Analysis of Operating Activities Electronic Presentation by Douglas Cloud Pepperdine University Chapter F14

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Analysis of Analysis of Operating Operating ActivitiesActivities

Analysis of Analysis of Operating Operating ActivitiesActivities

Electronic Presentation by Douglas Cloud

Pepperdine University

Electronic Presentation by Douglas Cloud

Pepperdine University

Chapter Chapter F14F14

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1. Explain the relationship between product pricing and sales volume in creating revenues and profits.

2. Explain how operating strategy affects a company’s return on assets.

3. Define cost leadership and product differentiation and explain how companies use their strategies to create profits.

ObjectivesObjectivesObjectivesObjectives

Once you have Once you have completed this chapter, completed this chapter, you should be able to:you should be able to:

Once you have Once you have completed this chapter, completed this chapter, you should be able to:you should be able to:

ContinuedContinuedContinuedContinued

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4. Evaluate operating performance by using accrual and cash flow measures.

5. Examine the return on equity and explain how operating, investing, and financing activities are interconnected.

6. Describe the primary components of an accounting system and how they are useful for understanding business activities.

ObjectivesObjectivesObjectivesObjectives

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11ObjectiveObjectiveObjectiveObjective

Explain the relationship between product pricing and sales volume in creating revenues and profits.

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Operating DecisionsOperating DecisionsOperating DecisionsOperating Decisions

Net income = revenues – expenses

Return on assets

= total assets net income

OR

Return on assets

sales net income revenues

sales total assets= x

revenues

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Exhibit 1Exhibit 1Exhibit 1Exhibit 1 Summary of Expected Assets and Expected Operating Results for Mom’s Cookie Company

(in thousands)(in thousands) Assets Initial Investment Operating Results Year 1 Year 2Assets Initial Investment Operating Results Year 1 Year 2

Current assets $1,000 Sales revenues $3,000 $3,600Plant assets 4,000 Cost of ingredients (800) (960)Total assets $5,000 Depreciation (300) (300)

Wages and benefits (700) (700)Other operating exp. (1,000) (1,000)Operating income 200 640Interest expense (20) (20)Pretax income 180 620Income taxes (54) (186)Net income $ 126 $ 434

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22Explain how operating strategy affects a company’s return on assets.

ObjectiveObjectiveObjectiveObjective

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Developing an Developing an Operating StrategyOperating Strategy


Profit margin =Net income

Sales revenue

Profit margin is a measure of a company’s ability to

create profit from its sales.

Profit margin is a measure of a company’s ability to

create profit from its sales.

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Asset turnover =Sales revenue

Total assets

Asset turnover is a measure of of a company’s ability to generate sales

from its investment in assets.

Asset turnover is a measure of of a company’s ability to generate sales

from its investment in assets.

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Return on assets =

Return on assets is the profit margin multiplied

by the asset turnover.

Return on assets is the profit margin multiplied

by the asset turnover.

Profit margin x Asset turnover

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If return on assets is low, a company must sell a lot of its

products to earn a reasonable profit.

If return on assets is low, a company must sell a lot of its

products to earn a reasonable profit.

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Expected Profit Margin for Expected Profit Margin for Mom’s Cookie CompanyMom’s Cookie Company


$126,000

$3,000,000= 4.2%

Year 1Year 1

Sales revenueProfit

Margin Net income

=

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Sales revenueProfit

Margin Net income

=

Year 2Year 2

$434,000

$3,600,000= 12.06%=

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Expected Asset Turnover for Expected Asset Turnover for Mom’s Cookie CompanyMom’s Cookie Company


Year 1Year 1

Total assetsAsset

TurnoverSales revenue

=

$3,000,000

$5,000,000= 0.60=

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Year 2Year 2

Total assetsAsset

TurnoverSales revenue

=

$3,600,000

$5,000,000= 0.72=

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Year 1Year 1

$126,000

$5,000,000= 2.52%=

Total assetsReturn on

assets Net income

=

Expected Return on Assets Expected Return on Assets for Mom’s Cookie Companyfor Mom’s Cookie CompanyExpected Return on Assets Expected Return on Assets

for Mom’s Cookie Companyfor Mom’s Cookie Company

or 4.2% x 0.60 = 2.52%

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Expected Return on Assets Expected Return on Assets for Mom’s Cookie Companyfor Mom’s Cookie CompanyExpected Return on Assets Expected Return on Assets

for Mom’s Cookie Companyfor Mom’s Cookie Company

or 12.06% x 0.72 = 8.68%

Year 2Year 2

Total assetsReturn on

assets Net income

=

$434,000

$5,000,000= 8.68%=

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33Define cost leadership and product differentiation, and explain how companies use these strategies to create profits.


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Exhibit 4Exhibit 4Exhibit 4Exhibit 4 Profit Margin, Asset Turnover, and Return on Assets for Krispy Kreme and Starbucks

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Cost Leadership and Product Cost Leadership and Product Differentiation StrategiesDifferentiation Strategies


Companies that keep their prices low to generate high

sales volume use a cost leadership strategy.

Companies that keep their prices low to generate high

sales volume use a cost leadership strategy.

High profit margin companies use a product differentiation strategy.

High profit margin companies use a product differentiation strategy.

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They compete by offering products with special

features or qualities that customers are willing to buy.

They compete by offering products with special

features or qualities that customers are willing to buy.

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Starbucks is closer to using product

differentiation than is Krispy Kreme.

Starbucks is closer to using product

differentiation than is Krispy Kreme.

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Exhibit 5Exhibit 5Exhibit 5Exhibit 5 Cost Leadership and Product Differentiation as Alternative Operating Strategies

Operating Strategy Profit Margin Asset TurnoverOperating Strategy Profit Margin Asset Turnover Operating Strategy Profit Margin Asset TurnoverOperating Strategy Profit Margin Asset Turnover Cost Leadership Low High

Product Differentiation High Low

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Cost leadership companies typically buy and sell in

high volume.

Cost leadership companies typically buy and sell in

high volume.

Advertising often emphasizes low prices and convenient

one-stop shopping.

Advertising often emphasizes low prices and convenient

one-stop shopping.

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44Evaluate operating performance by using accrual and cash flow measures.


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Comparing Accrual and Cash Flow Comparing Accrual and Cash Flow Measures of Operating PerformanceMeasures of Operating PerformanceComparing Accrual and Cash Flow Comparing Accrual and Cash Flow Measures of Operating PerformanceMeasures of Operating Performance

If a company does not convert its profits into cash, the profits are a misleading

performance indicator.

If a company does not convert its profits into cash, the profits are a misleading

performance indicator.

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Comparing Accrual and Cash Flow Comparing Accrual and Cash Flow Measures of Operating PerformanceMeasures of Operating PerformanceComparing Accrual and Cash Flow Comparing Accrual and Cash Flow Measures of Operating PerformanceMeasures of Operating Performance

The ratio of operating cash flow to total assets is useful for

comparing the operating cash flows of different companies.

The ratio of operating cash flow to total assets is useful for

comparing the operating cash flows of different companies.

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Exhibit 6Exhibit 6Exhibit 6Exhibit 6 A Comparison of Operating Cash Flows for Krispy Kreme and Starbucks

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Further Evaluation of Further Evaluation of Operating StrategyOperating Strategy


Inventory turnover is the ratio of cost of good

sold to inventory. It measures the success of a

company in converting its investment in

inventory into sales.

Inventory turnover is the ratio of cost of good

sold to inventory. It measures the success of a

company in converting its investment in

inventory into sales.

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Exhibit 7Exhibit 7Exhibit 7Exhibit 7 Selected Financial Statement Information and Ratios

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Inventory turnover = Cost of goods sold

Inventories

$150,414,000

$12,031,000 12.50 =

Krispy Kreme—2001Krispy Kreme—2001



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Inventory turnover = Cost of goods sold

Inventories

$1,175,787,000

$221,253,000 5.31 =

Starbucks—2001Starbucks—2001



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A ratio related to inventory turnover is day’s sales in

inventory, the ratio of inventory to average daily

cost of goods sold.

A ratio related to inventory turnover is day’s sales in

inventory, the ratio of inventory to average daily

cost of goods sold.

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Day’s sales in inventory

Inventory

Cost of good sold ÷ 365

$12,031,000

$412,093 29.19 =


=

$150,414,000$150,414,000÷ 365÷ 365

$150,414,000$150,414,000÷ 365÷ 365

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Day’s sales in inventory

Inventory

Cost of good sold ÷ 365

$221,253,000

$3,221,334 68.68 =


=

$1,175,787,000$1,175,787,000÷ 365÷ 365

$1,175,787,000$1,175,787,000÷ 365÷ 365

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Accounts receivable turnover measures the success of a company’s

ability to convert revenues into cash.

Accounts receivable turnover measures the success of a company’s

ability to convert revenues into cash.



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Sales revenueAccounts receivable

$300,715,000$19,855,000

15.15 =

=




Accounts receivable turnover

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Accounts receivable turnover

$2,648,980,000 $90,425,000

29.29 =

=




Sales revenueAccounts receivable

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Gross profit margin measures efficiency in the production or purchase of

goods for sale.

Gross profit margin measures efficiency in the production or purchase of

goods for sale.



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Gross profitSales revenue

$150,301,000$300,715,000

50.0% =

=


Gross profit margin

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Gross profitSales revenue

$1,473,193,000$2,648,980,000

55.6% =

=


Gross profit margin

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Operating profit margin is an indicator

of a company’s efficiency in controlling

operating costs other than product costs.

Operating profit margin is an indicator

of a company’s efficiency in controlling

operating costs other than product costs.



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Operating incomeSales revenue

$23,507,000$300,715,000

7.8% =

=


Operating profit margin

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=Operating profit

margin

$281,094,000$2,648,980,000

10.6% =


Operating incomeSales revenue

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55Examine return on equity and explain how operating, investing, and financing activities are interconnected.


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Net income

Equity

Net income

Equity

Linking Operating and Investing Linking Operating and Investing Activities with Financing ActivitiesActivities with Financing ActivitiesLinking Operating and Investing Linking Operating and Investing

Activities with Financing ActivitiesActivities with Financing Activities

Return on Equity

Return on Equity

Profit Margin

Profit Margin

Financial Leverage

Financial Leverage

Asset Turnover

Asset Turnover= x x

Sales Revenues

Total Assets

Sales Revenues

Total Assets

Net income

Sales Revenues

Net income

Sales Revenues

Total Assets

Equity

Total Assets

Equity

= x x

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Another ratio to measure financial risk is times

interest earned.

Another ratio to measure financial risk is times

interest earned.

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Operating incomeInterest expense

$23,507,000$607,000

38.73 =

=


Times interest earned

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$281,094,000$2,087,000

134.71* =


Times interest earned

Operating incomeInterest expense

=

*Rounded

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66Describe the primary components of an accounting system and how they are useful for understanding business activities.


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The Big PictureThe Big PictureThe Big PictureThe Big Picture

A business is a transformation process in which—

(1) financial resources are obtained through financing activities,

(2) financial resources are used to acquire other resources through investing activities, and

(3) resources are used to produce and sell goods and services through operating activities.

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Exhibit 8Exhibit 8Exhibit 8Exhibit 8 Accounting and Business Decisions

Transformation Process

ActivitiesActivitiesInvestingInvesting

FinancingFinancing OperatingOperating

Accounting System

InformationInformationInvestingInvesting


Decision Makers

DecisionsDecisionsInvestingInvesting


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Exhibit 9Exhibit 9Exhibit 9Exhibit 9 The Accounting Information System

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The Accounting CycleThe Accounting CycleThe Accounting CycleThe Accounting Cycle

1. Examining business activities2. Recording transactions3. Updating account balances4. Making end-of-period adjustments5. Preparing financial statements6. Closing revenue and expense

accounts

Steps in the accounting cycle include:

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Exhibit 10Exhibit 10Exhibit 10Exhibit 10 Using Accounting Information to Make Decisions About Company Value

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THE ENDTHE END

CCHAPTERHAPTER F14 F14

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Documents

14-1 Analysis of Operating Activities Electronic Presentation by Douglas Cloud Pepperdine University Chapter F14