Financial analysis of company s activity Management accounting

Financial analysis of company’s activity

Management accounting It measures and reports financial and nonfinancial information that helps managers make decisions to fulfill the goals of an organization

Financial Accounting Its focus is on reporting to external parties. It measures and records business transactions. It provides financial statements based on generally accepted accounting principles.

Financial Accounting Vs Managerial Accounting Managerial Purpose Primary Users Focus Financial Help managers Communicate make decisions financial position Internal managers External Stakeholders Future oriented Past oriented Rules Cost-benefit GAAP Time Span Varies Annual/Quarter

Key Themes in Management Decision Making Customer Focus Value Chain and Supply Chain Analysis Key Success Factors: Cost and Efficiency, Time, Quality, Innovation Continuous Improvement and Benchmarking

Key Themes in Management Decision Making Customer Focus – continuous process of investing sufficient (but not excessive) resources in customer satisfaction (profitable customers are attracted and retained) n Value Chain and Supply Chain Analysis: 1) treatment of each business functions as an essential and valued contributor; 2) integration and coordination of all business functions’ efforts in addition to develop the capabilities of each individual business function. n Supply Chain – describes the flow of goods, services and information from cradle to grave, regardless of whether those activities occur in the same organization or other organizations. n

Key Themes in Management Decision Making n Key Success Factors (operational factors that directly affect the economic viability of the organization): Cost – organizations are under continuous pressure to reduce costs Quality – customers are expecting higher levels of quality Time – organizations are under pressure to complete activities faster and to meet promised delivery dates more reliably Innovation – nowadays is heightened recognition that a continuing flow of innovative products or services is a prerequisite to the ongoing success of most organizations n Continuous improvements by competitors creates a neverending search for higher levels of performance within many organizations

Value Chain Refers to the sequence of business functions in which usefulness is added to the products or services of an organization (as the usefulness of the product or service is increased, so is its value to the customer)

Value Chain R&D Design Production Management Accounting Marketing Distribution Service

Learning objectives Definition of cost n Cost Object n Cost Classifications: Ø Direct/Indirect costs Ø Business function Ø Product/Period costs Ø Variable/Fixed costs n

Cost “Resource sacrificed or forgone to achieve a specific objective” “Sacrificed” refers to a resource that is consumed “Forgone” refers to giving up an opportunity to use a resource Cost is usually measured as the monetary amount that must be paid to acquire goods or services

Cost could be computed and referred to: Total amount (total cost of raw material): “Total cost” n Average amount per unit (cost of raw material per unit): “Unit cost” n Unit cost: Total costs / number of units

Cost Object Examples of Cost Objects at Procter & Gamble Cost Object Illustration Product Crest Tartar Control: Original Flavor toothpaste product Service Telephone hotline providing information and assistance to users of Pampers Diapers products Project R&D project on alternative scent-free formulations of Tide detergent products Customer Safeway, the retailer, which purchases a broad range of Procter & Gamble products Brand category Vidal Sassoon range of hairstyle products Activity Development and updating Web site on the Internet or setting up machines for production Department Environmental, Health and Safety Department

Direct and Indirect Costs Direct costs – costs related to the particular cost object and that can directly traced to it Example: the cost of cans or bottles of Coca Cola n Indirect costs – costs related to the particular cost object but that can’t be traced to it directly Example: the salaries of supervisors who oversee the production of the many soft drink products at Coca Cola plant n n Indirect manufacturing costs – “overhead costs”

Direct and Indirect Costs Type of cost Cost Assignment Cost Object Direct Costs Example: Paper on which Sports Illustrated magazine is printed Cost Tracing Example: Sports Illustrated magazine Indirect Costs Example: Lease cost for Time Warner building housing the editors of Sports Illustrated, Time, People and other magazines Cost Allocation

Business expenses Start-up expenses: n business registration fees n business licensing and permits n starting inventory n rent deposits n down payments on property n down payments on equipment

Business expenses Operating expenses: n salaries (yours and staff salaries) n telecommunications n raw materials n storage n distribution n promotion n loan payments n office supplies n maintenance

Business function R&D costs n Production costs (raw materials, direct labour) n Selling costs (provisions to vendors, advertising, promotion …) n Distribution costs (transport, contracts with distributors …) n General and administrative costs (electricity, telephone, rents, plant’ cleaning, office’ heating …) n

Business function n Manufacturing costs: ü Production n Non-Manufacturing ü R&D ü Marketing ü Customer Service costs:

Product and period costs Product costs – all costs of a product that are considered as assets in the balance sheet (inventory) when they are incurred and that become cost of goods sold when the product is sold n Period costs – all costs in the income statement other than cost of goods sold; they are treated as expenses of the accounting period whatever the volume of production/sales is n

Which costs become product costs? GAAP version GAAP requires “Full costing” for external reporting purposes. As a result indirect production costs must be allocated to goods produced n Cost Behaviour version It depends on what the company is trying to achieve by means of financial analysis (strategic analysis, operating analysis, evaluation of inventory) n

Variable and Fixed costs Variable cost – cost that changes the total in proportion to changes in the related level of total activity or volume n Fixed cost – cost that remains unchanged in total for a given period despite the wide changes in the related level of total activity or volume n Total costs: variable costs + fixed costs

Cost Behaviour Do not assume that individual costs are inherently variable or fixed: a particular cost item could be variable with respect to one level of activity and fixed respect to another Example: annual registration and licence costs for a fleet of planes owned by an airline company n Variable cost with respect to the number of planes owned n Fixed cost with respect to the miles flown by that plane during the year n

Direct-Indirect, Fixed-Variable costs Assignment of Costs to Cost Object Cost - Behabiour Pattern Direct Costs Variable Costs Cost object: BMW X 5 s produced Example: Tires used in assembly of automobile Fixed Costs Cost object: BMW X 5 s produced Example: Salary of supervisor on BMW X 5 assembly line Indirect Costs Cost object: BMW X 5 s produced Example: Power costs at Spartanburg plant. Power usage is metered only to the plant where multiple products are assembled Cost object: BMW X 5 s produced Example: Annual lease costs at Spartanburg plant. Lease is for whole plant where multiple products are produced

Budget n Ø Ø Ø Ø n Ø Ø Operating budget: Sales budget Production budget Direct materials budget Direct labor budget Factory overhead budget Selling and administrative expense budget Pro forma income statement Financial budget: Cash budget Pro forma balance sheet

Financial statements n n Balance sheet: also referred to as statement of financial position or condition, reports on a company's assets, liabilities, and net equity as of a given point in time. Income statement: also referred to as Profit and Loss statement (or a "P&L"), reports on a company's income, expenses, and profits over a period of time. Statement of retained earnings: explains the changes in a company's retained earnings over the reporting period. Statement of cash flows: reports on a company's cash flow activities, particularly its operating, investing and financing activities.

Financial ratio or accounting ratio n n n Liquidity ratios measure the availability of cash to pay debt. Activity ratios measure how quickly a firm converts non-cash assets to cash assets. Debt ratios measure the firm's ability to repay longterm debt. Profitability ratios measure the firm's use of its assets and control of its expenses to generate an acceptable rate of return. Market ratios measure investor response to owning a company's stock and also the cost of issuing stock.

Profitability ratios measure the firm's use of its assets and control of its expenses to generate an acceptable rate of return. n n n Gross margin, Gross profit margin or Gross Profit Rate Operating margin, Operating Income Margin, Operating profit margin or Return on sales (ROS) Profit margin, net margin or net profit margin Return on equity (ROE) Return on investment (ROI ratio or ) Return on assets (ROA) Return on assets Du Pont (ROA Du Pont) Return on net assets (RONA) Return on capital (ROC) Risk adjusted return on capital (RAROC) Return on capital employed (ROCE) Cash flow return on investment (CFROI) Efficiency ratio

Profitability ratios Gross margin, Gross profit margin or Gross Profit Rate can be defined as the amount of contribution to the business enterprise, after paying for direct-fixed and direct-variable unit costs, required to coverheads (fixed commitments) and provide a buffer for unknown items. It expresses the relationship between gross profit and sales revenue. n Gross margin, Gross profit margin or Gross Profit Rate = (Revenue - Cost of sales) / Revenue = (Net sales - Cost of goods sold) / Net sales = Operating earnings / Net sales

Profitability ratios Operating margin, Operating Income Margin, Operating profit margin or Return on sales (ROS) is the ratio of operating income (operating profit in the UK) divided by net sales, usually presented in percent. Earnings before interest and taxes (EBIT) is a measure of a firm's profitability that excludes interest and income tax expenses n Operating margin, Operating Income Margin, Operating profit margin or Return on sales (ROS) = Operating income / Net sales Note: Operating income is the difference between operating revenues and operating expenses, but it is also sometimes used as a synonym for EBIT and operating profit. This is true if the firm has no non-operating income. (Earnings before interst and taxes / Sales) EBIT = Operating Revenue – Operating Expenses (OPEX) + Non-operating Income Operating Income = Operating Revenue – Operating Expenses Operating income is the difference between operating revenues and operating expenses, but it is also sometimes used as a synonym for EBIT and operating profit. This is true if the firm has no non-operating income.

Profitability ratios n n n Profit margin, Net Margin, Net profit margin or Net Profit Ratio all refer to a measure of profitability. Profit margin, net margin or net profit margin = Net income / Sales = Net profits after taxes / Sales Net income is equal to the income that a firm has after subtracting costs and expenses from the total revenue. Net income can be distributed among holders of common stock as a dividend or held by the firm as retained earnings. Net income is an accounting term; in some countries (such as the UK) profit is the usual term. Often, the term income is substituted for net income, yet this is not preferred due to the possible ambiguity. Return on Equity (ROE, Return on average common equity, return on net worth) measures the rate of return on the ownership interest (shareholders equity) of the common stock owners. ROE is viewed as one of the most important financial ratios. It measures a firm's efficiency at generating profits from every dollar of net assets (assets minus liabilities), and shows how well a company uses investment dollars to generate earnings growth. ROE is equal to a fiscal year’s net income (after preferred stock dividends but before common stock dividends) divided by total equity (excluding preferred shares) Return on equity (ROE) = Net profits after taxes / Stockholders' equity or tangible net worth = Net profit / Equity Rate of return (ROR), also known as return on investment (ROI), rate of profit or sometimes just return, is the ratio of money gained or lost (realized or unrealized) on an investment relative to the amount of money invested. The amount of money gained or lost may be referred to as interst, profit / loss, gain/loss, or net income/loss. The money invested may be referred to as the asset, capital, principal or the cost basis of the investment. Return on investment (ROI ratio or ) = Net income / Total Assets

Profitability ratios The Return on Assets (ROA) percentage shows how profitable a company's assets are in generating revenue. n Return on assets (ROA) = Net Income / Total Assets are everything of value that is owned by a person or company. The Balance Sheet of a firm records the monetary value of the assets owned by the firm. The 2 major Asset Classes are Tangible Assets and Intangible Assets. Tangible Assets contain various subclasses, including Financial Assets and Fixed Assets. Financial Assets include such items as Account Receivable, Bonds, Stocks and Cash; while Fixed Assets include such items as Buildings and Equipment Intangible Assets are nonphysical resources and rights that have a value to the firm because they give the firm some kind of advantage in the Market Place. Examples of Intangible Assets are Goodwill, Copyrights, Trademarks, Patents and Computer Programs. Return on Assets Du Pont is a financial ratio that shows how the return on assets depends on both asset turnover and profit margin. The Du Pont method breaks out these two components from the return on assets ratio in order to determine the impact of each on the profitability of the company. n Return on assets Du Pont (ROA Du Pont) = (Net Income / Sales) * (Sales / Total Assets) (ROE Du Pont) =(Net Income/Sales) * (Sales/Average Assets) * (Average Assets/Average Equity) n Return on net assets (RONA) = Profit after tax / ( Fixed assets + working capital )

Profitability ratios Return on invested capital (ROIC) is a financial measure that quantifies how well a company generates cash flow relative to the capital it has invested in its business. It is defined as Net operating profit less adjusted taxes divided by Invested Capital and is usually expressed as a percentage. In this calculation, capital invested includes all monetary capital invested: long-term debt, common and preferred shares. When the return on capital is greater than the cost of capital (usually measured as the weighted aversge cost of capital), the company is creating value; when it is less than the cost of capital, value is destroyed. n Return on capital (ROC) = (Net Operating Profit Less Adjusted Taxes) / (Invested Capital) Risk adjusted return on capital (RAROC) is a risk-based profitability measurement framework for analysing risk-adjusted financial performance and providing a consistent view of profitability across businesses. The concept was developed by Bankers Trust in the late 1970 s. Note, however, that more and more Risk Adjusted Return on Risk Adjusted Capital (RARORAC) is used as a measure, whereby the risk adjustment of Capital is based on the as outlined by the Basel Committee, currently Basel II. n Risk adjusted return on capital (RAROC) = (Expected Return)/(Economic Capital) or (Expected Return)/(Value at risk) Return on Capital Employed (ROCE) is used in finance as a measure of the returns that a company is realising from its capital employed. It is commonly used as a measure for comparing the performance between businesses and for assessing whether a business generates enough returns to pay for its cost of capital. n Return on capital employed (ROCE) = Profit After Tax (Net Profit)/ Capital Employed * 100 n Cash flow return on investment (CFROI) = Cash Flow / Market Recapitalization n Efficiency ratio = Non-Interest Income/(Net Interest

Liquidity ratios measure the availability of cash to pay debt. n Current ratio = Current assets / Current liabilities n Acid-test ratio (Quick ratio) = (Current assets – [Inventories + Prepayments]) / Current liabilities n Operation cash flow ratio = Operation cash flow / Current liabilities n

Activity ratios measure the effectiveness of the firms use of resources. n Average collection period = Accounts receivable / (Annual credit sales / 365 days) n DOL = Degree of Operating Leverage = % change in net operating income / % change in sales n DSO Ratio = Accounts receivable / Average Sales per Day Collection period (period end) n Average payment period = Accounts payable / (Annual credit purchases / 365 days) n Asset turnover = Sales / Assets n Inventory turnover ratio = Cost of goods sold / Average inventory n Receivables Turnover Ratio = Net credit sales/ Average net receivables n Inventory turnover ratio = Cost of goods sold / Average inventory n Inventory conversion ratio = Inventory conversion to cash period (days) = 365 days / Inventory turnover days Inventory n Cash Conversion Cycle = Inventory conversion period (in days) + Receivables conversion period (in days) – Payables conversion period (in days) n Inventory conversion period = (Inventory/COGS)*(No. of Days in a Year) n Receivables conversion period = (Receivables/Sales)*(No. of Days in a Year) n Payables conversion period = (Purchases/Accounts Payable) where Purchases = Ending Inventory + COGS - Beginning Inventory

Debt ratios measure the firm's ability to repay long-term debt. Debt ratios measure financial leverage. n n n Debt ratio = Total liabilities / Total assets Debt to equity ratio = (Long-term debt + Value of leases) / Stockholders' equity Long-term debt/Total asset (LD/TA) ratio = longterm debt / Total assets Times interest-earned ratio = Earnings before interest and taxes EBIT / Annual interest expense Debt service coverage ratio = Net operating income / Total debt service

Market ratios measure investor response to owning a company's stock and also the cost of issuing stock. n Payout ratio = Dividend / Earnings, or = Dividend per share / Earnings per share n Note: Earnings per share is not a ratio, it is a value in currency. Earnings per share = Expected earnings / Number of outstanding shares n P/E ratio = Price / Earnings per share n Cash flow ratio or Price/cash flow ratio = Price of stock / present value of cash flow per share n Price to book value ratio (P/B or PBV) = Price of stock / Book value per share n Price/sales ratio n PEG ratio = Price Per Earnings / Annual EPS Growth Other Market Ratios n EV/EBITDA n EV/Sales n Cost/income ratio

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