Dying businesses stay alive by cannibalizing their assets to fund their unprofitable operations. Pan American Airlines, once the largest airline in the world, withered in 1991 when it sold its coveted European routes to its competitors to raise cash. Pan Am died in 1992.
Did the company borrow heavily or has the company gone to investors to fund its operational or investing activities? The financing activities section tells that important story. In Bob’s case he borrowed from the bank and invested his own money.
Whatever the sources and uses of cash, the statement of cash flows tells a great deal about a business’s health. To many financial analysts, it is the most important statement of all.
ACCOUNTING’S BIG PICTURE
A knowledgeable person can always get back to the fundamental equation of accounting to make sense of any jumble of numbers making up any of the financial statements of a company: Assets = Liabilities + Owners’ Equity.
With the statement of cash flows it was demonstrated that the changes during the year in the cash balance had to result from changes in assets, liabilities, and owners’ equity. The assets and liabilities changes came from the balance sheet. The owners’ equity changes were the result of changes in net income, provided in detail by the income statement. The three basic financial statements are inextricably tied together.
The fundamental accounting equation, the balance sheet, and each of the many journal entries made during the year always balance. That fundamental property allows for changes in any piece of the accounting puzzle to be explained by changes in the other parts. By grasping this basic concept of the interrelationships of the financial statements, you have learned the essence of accounting. Congratulations!
READING THE FINANCIAL STATEMENTS USING RATIOS
With an understanding of how accountants create their financial statements, let me add some tools to interpret them: ratios. Absolute numbers in a financial statement in and of themselves often are of limited significance. The real information can be found in an analysis of the relationship of one number to another or of one company to another in the same industry—using ratios. In the grocery game, profits are usually low in relation to sales, so grocers must sell in large volume to make any real profit. A jewelry store survives on slower-paced sales but higher profits per item. That is why ratios are used to compare performances among companies within an industry and against a company’s own historical performance.
There are four major categories of ratios:
Liquidity measures: How much is on hand that can be converted to cash to pay the bills?
Capitalization measures: Is a company heavily burdened with debt? Are its investors financing the company? How is the company funding itself?
Activity measures: How actively are the firm’s assets being deployed? (MBAs deploy assets, rather than just use them.)
Profitability measures: How profitable is a company in relation to the assets and the sales that made its profits possible?
There are literally hundreds of possible ratios, but most have their origin in eight basic ratios from the four categories listed above. Using Bob’s financial statements, I have calculated these eight ratios for his operation and have placed them below each of the ratio explanations.
LIQUIDITY RATIOS
1. Current Ratio = Current Assets / Current Liabilities
Can the company pay its bills comfortably? A ratio greater than 1 shows liquidity. It shows that there is leeway in the current assets available to pay for current liabilities.
CAPITALIZATION RATIOS
2. Financial Leverage = (Total Liabilities + Owners’ Equity) / OE
When a company assumes a larger proportion of debt than the amount invested by its owners, it is said to be leveraged. In a profitable company, by using a higher level of debt, the return is much higher because a smaller amount appears in the denominator of the ratio. The “same” amount of earnings is divided by a smaller equity base. Ratios of greater than 2 show an extensive use of debt. I will explain leverage more fully when discussing the profitability ratios.
3. Long-Term Debt to Capital = Long-Term Debt / (Liabilities + OE)
Because debt payments are fixed obligations that must be paid while dividends to investors are not, the level of debt is an important measure of a company’s riskiness. A ratio of greater than 50 percent shows a high level of debt. Depending on the timing and stability of a firm’s cash flows, 50 percent could be considered risky. Stable electric utilities have predictable sales and cash flows; therefore, ratios over 50 percent are commonplace. Investment analysts on Wall Street consider those debt levels conservative.
ACTIVITY RATIOS
4. Assets Turnover per Period = Sales / Total Assets
This ratio tells the reader how actively the firm uses all of its assets. The firm that can generate more sales with a given set of assets is said to have managed its assets efficiently. Ratios are industry-specific. Thirty-six is a high turnover of assets for most industries, but for an antique shop a turnover of three may be considered high. One-of-a-kind antiques sit waiting for the right collector to come along. In the grocery trade 36.6 turns per year is normal because the shelf inventory of a supermarket is sold about every week. The produce, milk, and toilet paper inventory turn over several times a week, while the exotic spices take much longer to sell.
5. Inventory Turns per Period = Cost of Goods Sold / Average Inventory Held During the Period
(A simple way to calculate “average inventory” is by adding the beginning and ending inventory balances, then dividing by two.)
6. Days Sales in Inventory = Ending Inventory / (Cost of Goods Sold / 365)
These two activity ratios show how actively a company’s inventory is being deployed. Is inventory sitting around collecting dust or is it being sold as soon as it hits the shelf? In a high-turnover business, like the grocery trade, there are many turns of inventory during a year and only a few days of inventory on hand. Most grocery items are perishable and purchased frequently.
PROFITABILITY RATIOS
7. Return on Sales (ROS) = Net Income / Sales
“Return” ratios are easy to calculate and investment analysts use them frequently. They calculate the return on just about any part of the balance sheet and income statement. Another common one is the return on assets (ROA).
8. Return on Equity (ROE) = Net Income / Owners’ Equity
The mix of debt and equity can dramatically affect the ratios. If a company has a high level of debt and a small amount of equity, the return on equity (ROE) can be tremendously affected. That is called financial leverage, the term that I mentioned before in discussing capitalization ratios. To illustrate the point, Bob and his father could have decided to leave very little equity in the company in 2012. They could have taken all of the $30,000 of net income made in 2012 out of the company as dividends and borrowed for their future cash needs. If that had happened, the balance sheet would have reflected a long-term debt balance of $40,000 ($10,000 + $30,000) and only $15,000 ($45,000 − $30,000) in equity. The resulting debt to equity ratio would increase from 7 percent to 28 percent, and the return on equity would have increased from 67 percent to 200 percent ($30,000/$15,000). As shown, ratios can be greatly affected by the financial leverage used. The choice of a lower equity level can “leverage” the ROE to extremely high levels.
ROE ratio is a widely accepted yardstick to measure success. If management’s goal is to achieve a higher profitability ratio through leverage, there is a risk cost. Higher debt levels require higher interest payments that a company may not be able to service if operations do poorly. The corporate failures in the financial meltdown of 2008 of Lehman Brothers and Washington Mutual were cases in which management risked bankruptcy with high leverage and lost.
THE DU PONT CHART
Academics have a tendency to give imposing names to simple concepts. Your MBA vocabulary would not be complete without including the Du Pont Chart. The chart shows how several of the most im
portant financial statement ratios are related to one another by displaying their components.
THE DU PONT CHART
By charting the interrelationships among ratios, one can see that changes in a component of one ratio affect the other ratios. The ratios share the same inputs. For example, when Total Assets is reduced, both the Asset Turnover and Return on Assets ratios increase because Total Assets are included in the calculation of both of those ratios as a denominator. Conversely, a reduction of Total Assets (equal to total liabilities and owners’ equity) decreases Financial Leverage as it is used in that ratio’s numerator.
RATIOS ARE INDUSTRY-SPECIFIC
Profitability is, as in the case of all other ratios, industry-specific. Every industry has a profit level depending on the physical demands of the industry. Heavy manufacturers such as steel makers have a return on assets (ROA) of less than 10 percent. They have large steel mills and a great deal of factory equipment. Service businesses such as profitable headhunting firms may have ROAs over 100 percent. The only assets they need are cash, office furniture, and customer receivables. Their real asset is their staff’s talent for nursing and persuading, which cannot be quantified on the balance sheet.
Profitability also depends on the level of competition. In the grocery business, intense competition keeps the return on sales to a low 1 percent. During Bob’s first year he had a .58 percent return, which was below the industry average. Considering that it was his first year, any profit should be commended.
Any part of the financial statements can be compared to another with a ratio of some sort. Any calculator can divide one number by another. Only those ratios that can provide some insight into a business’s performance are valuable. The true value of ratios is seen when one firm’s ratios are compared to those of another in the same industry, or to that firm’s historical performance. Alternatively the “attractiveness” of various industries as business opportunities may be explored by comparing their averages. Each firm and industry has its own key operating statistics that are meaningful.
For industry-specific references on all these ratios, RMA publishes its Annual Statement Studies. This valuable reference book, available in most libraries, includes financial and operating ratios for over three hundred manufacturers, wholesalers, retailers, services, contractors, and finance companies.
MANAGERIAL ACCOUNTING
Managerial accounting, like ratio analysis, uses accounting data to manage and analyze operations. Managerial accounting focuses on operations. Instead of ratios, managerial accounting uses standards, budgets, and variances to run the business and explain operational results. The object of managerial accounting is to budget a company’s activities for a period of time, and then to explain why the actual results “varied” from the projections. In most manufacturing settings, monthly budgeting and analysis are the norm so that management can take timely action.
To establish a yardstick for measuring performance, the factory team must set standards for comparison. This requires the input from more than just the accountants. In automobile manufacturing, the production manager establishes what he or she believes should be the standard costs for materials, labor, and other expenses. Industrial engineers help by performing studies to obtain the data. Factory managers work with sales managers to budget production volumes to meet forecasted demand and also to maintain assembly line efficiency. Sales managers set standard prices and quantities for their products. Using those standards as a yardstick, managerial accountants analyze actual results to explain the variances from those budgets and standards the company’s team developed. Once completed, variance analysis highlights the source of positive or negative results for management decision making.
PRICE AND VOLUME VARIANCES
There are two basic types of variances, price and volume variances. As with financial statement ratios, they are derived from simple mathematical formulas.
Sales Price Variances. The price variance tells the manager how much of the difference between budgeted sales revenue and actual sales revenues is due to changes in sales price changes.
(Actual Sales Price − Standard Sales Price) × (Actual Quantity Sold) = Sales Price Variance
Sales Volume Variances. The volume variance isolates the dollar effect of a different unit volume from what was budgeted assuming no price changes.
(Standard Sales Price) × (Actual Quantity Sold − Standard Quantity Sold) = Sales Volume Variance
Using a hypothetical example, Chrysler planned to sell 10,000 Dodge Caravan minivans in July 2012 at a price of $30,000 each for a total of $300 million in sales. In August the analyst received accounting data showing that sales were actually $580 million in July. Dodge actually sold 20,000 Caravans at an average price of $29,000 due to a $1,000 rebate program. The total variance of sales was $280 million: (20,000 × $29,000) − (10,000 × $30,000). How did that occur? Variances told the story.
The variance solely due to price, the price variance, was a negative $20 million (($29,000 − $30,000) × 20,000 units). But because 10,000 more units were sold than planned, the volume variance was positive $300 million ((20,000 − 10,000 units) × $30,000). The two variances (−$20 + $300 = +$280) equaled the total variance from the total sales budget ($580 − $300 = +$280). The variance analysis told the Chrysler executive in charge of the Caravan model that the overall increase in sales was due to a larger sales volume, rather than to a price increase. Conversely, the small negative price variance due to a rebate was more than made up for by a stronger sales volume. When you add together the price and the volume variances, they equal the “total” monthly sales variance from budget. The variance analysis enabled the Dodge executive to explain why his results hit his division’s targets.
PURCHASE PRICE, EFFICIENCY, AND VOLUME VARIANCES
Using the same two basic formulas, sales price and sales volume variances, production departments also calculate variances for management control.
Purchases and usage of production materials have purchase price variances.
Purchase Price Variance = (Standard Price − Actual Price) × (Actual Quantity Purchased or Used)
The amount of materials and labor used to produce products may also differ from the standard amount. Similar to sales volume variances, these differences are called efficiency variances. Shoe workers, for example, can be more efficient by using more leather from a hide than planned. Chemically dependent workers on the assembly line in Detroit could take more labor hours than planned to produce their cars.
Material or Labor Efficiency Variance = (Standard Use Quantity − Actual Usage Quantity) × (Standard Cost of Material or Labor)
Using the Caravan again as a hyphothetical example, the production foreman had budgeted in July that each Caravan made should use a standard 8 gallons of paint at a cost of $10 per gallon. It actually took 7 gallons at a cost of $12 per gallon for the 20,000 minivans that were produced. The accountant calculated the following variances for the Dodge executive:
Material Price Variance = ($10 − $12 price per gallon) × (20,000 units × 7 gal.) = −$280,000 negative paint price variance
This was the effect of paying more per gallon than planned. Instead of scratching his head, the Dodge executive could use this information to confront his purchasing agent and demand that he negotiate a better deal the following month.
Material Efficiency Variance = (8 gal. − 7 gal.) × (20,000 units) × $10 per gallon = $200,000 positive variance
This was the effect of using less paint than planned.
As with ratios, there are an infinite number of variances that can be cooked up to keep a department of accounting analysts busy from now until the next century. There are basically only two types of variances: price and volume variances. When you hear the words managerial accounting, think “variances.”
COST ACCOUNTING AND ACTIVITY-BASED COSTING
Cost accounting is the relatively straightforward process of determining the cost of producing goods and services. It is clo
sely associated with managerial accounting, as all its “standards” are based on the data gathered by cost accountants. With manufactured goods, direct labor and direct materials are relatively simple to allocate to the cost of a product. However, allocating overhead is much more difficult. More important, if not done properly, it may falsely determine profitability of individual products and divisions of companies. Overhead must be allocated based on the actual usage of the overhead expenses; hence, it is called activity-based costing (ABC). Overhead should be allocated based on what it takes to create and deliver the product to the customer. In the past, overhead expenses were a relatively minor component in relation to materials and labor costs, but today expenses such as telephone, billing, consultants, and computer systems are huge.
For example, if a high-revenue division of a company makes sales to a few vendors with few orders, it should be allocated less of the cost of the billing department’s cost than a lower-sales division that has many small customers ordering many times a year. If accountants allocate based on sales, not volume of transactions, the profit picture would be distorted. When a manufacturing process of a product is highly automated and that of another product is not, allocation of computer system expense based on direct labor hours would be misleading. What often happens in a company is that accountants, detached from the business, arbitrarily or mechanically allocate overhead expenses. That distorts the financial results that managers live or die by. Entire product lines and divisions can be shut down and or outsourced because of these relatively “unimportant” allocation decisions that neglect their ABC’s.
The Ten-Day MBA 4th Ed. Page 11