Chapter 2. Data for Financial Decision Making

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Rosalind Byrd
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1 Chapter 2 Data for Financial Decision Making

2 Data for Financial Decision Making Introductory concepts the need for good data Financial accounting data Financial ratios Managerial accounting data Other data 2-2

3 Data for Financial Decision Making Introductory concepts the need for good data Financial accounting data Financial ratios Managerial accounting data Other data 2-3

4 The Need for Good Data Good judgments require good data Theory precedes data Economic-finance theory teaches us to look at financial data cash flow, profitability, liquidity, leverage, resource use Modern management theory teaches us to look at customer satisfaction and process performance 2-4

5 Data for Financial Decision Making Introductory concepts the need for good data Financial accounting data Financial ratios Managerial accounting data Other data 2-5

6 Financial Accounting Data Used to produce public financial statements Balance sheet, income statement, statement of cash flows Rules made by FASB, SEC The limitations of GAAP Two different valuation methods mixed together Monetary items cash value Nonmonetary items historical cost Alternative numbers for the same event Important information omitted 2-6

7 Financial Accounting Data The need to compare numbers Impossible to make a judgment with one number Types of comparisons: Benchmark comparison to a standard value Competitive benchmark comparison to best example Time-series comparison to previous values of the same measure, a trend over time Cross-section comparison across peer companies at a point in time 2-7

8 Data for Financial Decision Making Introductory concepts the need for good data Financial accounting data Financial ratios Managerial accounting data Other data 2-8

9 Ratios That Measure Profitability Profitability compared to sales gross profit Gross profit margin = sales EBIT Operating profit margin = sales earnings before taxes Pre - tax profit margin = sales earnings aftertaxes Net profit margin = sales contribution Contributi on margin = sales 2-9

10 Ratios That Measure Profitability Profitability compared to assets EBIT Basic earning power = average total assets earnings after taxes Return on assets (ROA) = average total assets Profitability compared to equity Return on equity (ROE) = earnings after taxes average total equity 2-10

11 Ratios That Measure Effective Use of Working Capital Working capital Refers to current assets and current liabilities Mathematically: Working capital current Measures of overall liquidity = Current ratio = Quick ratio = assets current current assets current liabilities quick assets current liabilities liabilitie s 2-11

12 Ratios That Measure Effective Use of Working Capital Measures of the effective use of accounts receivable credit sales Accounts receivable turnover = average accounts receivable average accounts receivable Collection period = 360 credit sales Measures of the effective use of inventories cost of goods sold Inventory turnover = average inventory average inventory Inventory days = 360 cost of goods sold 2-12

13 Ratios That Measure Effective Use of Working Capital Measures of the effective use of accounts payable Accounts payable turnover = The cash conversion cycle purchases average accounts payable average accounts payable Payables period = 360 purchases Cash conversion cycle = inventory days + collection payables period period 2-13

14 The Cash Conversion Cycle 2-14

15 Ratios That Measure the Use of Fixed and Total Assets A measure of the productivity of fixed assets Fixed asset turnover = sales average fixed assets A measure of the productivity of total assets Total asset turnover = sales average total assets 2-15

16 Ratios That Measure the Choice and Management of Funding Measures of the financing mix The debt ratio = The funded debt ratio = The debt/equity ratio = total liabilities total assets funded debt total assets total liabilities total equity The assets/equity ratio = total total assets equity 2-16

17 Ratios That Measure the Choice and Management of Funding Measures of the ability to service debt Times interest earned = EBIT interest Fixed charge coverage = interest + EBIT principal 1 1- t 2-17

18 Ratios That Measure the Choice and Management of Funding Measures of payments against equity Dividend payout ratio = Retention ratio = dividends earnings after taxes earnings retained earnings after taxes 2-18

19 Data for Financial Decision Making Introductory concepts the need for good data Financial accounting data Financial ratios Managerial accounting data Other data 2-19

20 Managerial Accounting Data Used for internal planning, analysis, decision making Cash flows vs. accrual accounting Cash flow real, tangible event; clearly identifiable; has immediate value Accrual numbers based on accounting conventions, depend on human-made rules We use a cash flow spreadsheet to summarize cash flows 2-20

21 Cash Flow Spreadsheet Cash Flow Spreadsheet A company is trying to organize the following cash flows: Buy a machine for $25,000 in Increase cash inflows by $15,000 in 2008, 2009, and Pay additional taxes of $8,000 in Sell the machine for $10,000 in Question: Prepare a cash flow spreadsheet to summarize this information Solution: Year 0 Year 1 Year 2 Year 3 Event Buy machine (25,000) Additional cash inflows 15,000 15,000 15,000 Additional taxes (8,000) Sell machine 10,000 Net cash flows (25,000) 15,000 7,000 25,

22 Types of Costs Total, average, marginal Total sum of the costs for all units made Average cost per unit Marginal cost of making one more unit Incremental the change from taking an action Sunk spent in the past, cannot change Opportunity a lost benefit Variable, fixed with respect to sales 2-22

23 A U-Shaped Cost Curve 2-23

24 Managerial Accounting Data Tax rates Taxes are a cash flow, therefore important in financial decision making The government requires a company pay only the taxes specified by law paying more taxes takes value from other stakeholders While the tax code is complex, the textbook uses flat rates of 34% or 35% to simplify illustrations 2-24

25 Data for Financial Decision Making Introductory concepts the need for good data Financial accounting data Financial ratios Managerial accounting data Other data 2-25

26 Other Data Economic data GNP growth, inflation, interest rates, foreign exchange rates, etc. Competitive actions, pressures within industry People data customer and employee satisfaction Process data Absolute number of failures Relative number of failures failures per opportunity to fail, six sigma goal Cycle time time for a process or process step 2-26

Appendix: Financial Definitions. Basic Accounting Reports

Appendix: Financial Definitions Several standardized methods have been created to analyze business financial data. These numbers are easily computed from the standard reported accounting data. The various