Accounting 4: Measuring Performance

What are profitability ratios?

Financial ratios that measure how efficiently a company generates profit from its revenues, assets, or equity.

What's important to know about the comparison of profitability ratios?

They need to be meaningful and makes sense so comparing them across time or cross-sectional or even from one time of the year to the other time of the year like Christmas.

Where the 4 main profitability ratios?

• Return on total assets (ROTA)

• Return on sales (ROS)

• Return on equity (ROE)

• Asset turnover

What is return on total assets (ROTA) and what is it formula?

It measures how well management uses all assets to generate an opening surplus and provide provides a benchmark against which operations can be measured

EBIT / total assets %

What are the issues related to return on total assets (ROTA?

• Firms deal with many products and ROTA is general

• ROTA differs across industries

• ROTA depends on how assets are valued in the balance sheet

How should ROTA be interpreted?

As how much is generated from each dollar invested

How should ROTA be compared?

Within the industry

What does a high ROTA represent?

it's good, so it shows a competitive advantage

How should ROTA be used?

to be useful in decision-making, it should be broken down into its components:

ROTA = ROS x asset turnover

What is return on sales (ROS) and what is its formula?

it shows the profit of sales (per dollar) as a percentage

EBIT / total sales %

What is asset turnover and what is its formula?

How effectively accompany uses its assets to make sales

total sales / total assets

What is usually more looked at asset turnover or ROS?

ROS since profit margins may still have high asset turnover (high sale volume like supermarkets)

What are liquidity ratios?

short and long-term solvency: the ability to pay all current liabilities

What is the cash-flow cycle?

cash (non-operative outflow like taxes) → accounts payable → inventory → accounts receivable → cash (non-operative inflow like long term loans)

between cash → inventory we have labor

between inventory → accounts receivable we have profit depreciation

What are the 6 main liquidity ratios?

• Current ratio

• Quick ratio

• Working capital days

• Deptor days (Days Sales Outstanding)

• Inventory days (Days Inventory Outstading)

• Creditor days (Days Payable Outstanding)

What is the current ratio formula and what does the value represent?

(depends on the industry)

current assets / current liabilities

when > 1: the firm has enough near cash assets to cover immediate future payments

What is the quick ratio formula and what does the value represent?

(current assets - inventory) / current liabilities

We excluded inventory because it is hard to make them become quick cash

1 = very high

0.8 = good

Which ratio is widely used to assess liquidity levels?

the quick ratio

How is the quick ratio compared?

it is compared to the industry benchmark

What does a short working capital days mean?

that the firm is effective.

The finance account receivable and inventory for short period

What does the cash conversion cycle tell us and what is its formula?

how many days a company needs to finance its working capital. (how long to wait between paying the supplier and receiving money)

(inventory days + receivable days) - accounts payable days

What is Days Sales Outstanding (DSO) and it's formula?

It's the collection period. So how long on average customers take to pay?

(Accounts receivable / sales) x 365

What is Days Inventory Outstanding (DIO) and it's formula?

how many days on average an item stays in inventory?

(inventory / sales) x 365

What is Days Payable Outstanding (DPO) and it's formula?

How many days on average the company takes to pay suppliers?

(accounts payable / sales) x 365

What is the difference between financial strength, liquidity, and profitability ratios?

• Financial Strength Ratios: Measure a company’s long-term financial stability and ability to repay its debts.

• Liquidity Ratios: Measure a company’s ability to pay its short-term obligations (debts due soon).

• Profitability Ratios: Measure how efficiently a company generates profits from its sales, assets, or equity.

What are financial strength ratios?

measures of a company's ability to meet interest and principal payments in the long run

What are the two types of capital associated with financial strength ratios?

Capital structure:

• Risk capital (equity)

• Loan capital (bank, and corporate debt)

What are the 2 financial strength ratios?

• Interest cover ratio

• Debt to equity ratio

What is the interest cover ratio and what is it formula?

it is how many times operating income (EBIT, profit) can cover interest expenses

EBIT / interest

What are the factors that determine the interest cover ratio?

• Operating profit

• Amount borrowed

• Effective rate of interest

What happens to the interest cover ratio if the amount borrowed and effective rate of interest increase?

The ratio decreases

What does a interest cover ratio 0 < x < 1 mean?

it means the firm can cover expenses, but with a small safety margin. it is questionable

What does a negative interest cover ratio mean?

that the company is already losing money before paying interest

What is capital structure?

the combination of debt and equity used to finance activities

What are the obligations related to capital structure?

paying interest and paying principal value (principle repayment)

What are the risks associated with debt?

being unable to meet payment and going into bankruptcy

If debt has its risks, why do people choose it?

Because it is usually cheaper than equity.

• Lenders expect less return than shareholders

• It is tax deductive

• It can fund growth without issuing new shares

What is the debt to equity formula and what does its values mean?

(total liabilities - owner’s funds (entire debt)) / owner's funds

Value between 1-2: good

< 1: over capitalize

> 2: executive risk in capital structure (common in capital intensive industries)

What is the formula for financial leverage or return on equity (ROE)?

ROE = ROTA + (ROTA - i) x (debt / equity)

i: interest rate on debt

What does increasing debt/equity in financial leverage do?

It increases ROE and corporate risk

means an increase in debt use

Why would increasing debt/equity be good?

it pays off in good times, because it increases ROE

Why would increasing debt/equity be bad?

in risky times it isn't smart to increase because profits are low

When operating profits are low increasing debt use decreases ROE because operating profits won’t cover interest expenses. Profits are too low and company still has to pay interest on that debt

EBIT / total assets is what? and should it be greater than, equal to, or smaller than interest rate?

EBIT/total assets = ROTA

It should be greater than interest rate

What is IKEA and how does it work?

IKEA is a private company that sells ready to assemble furniture, etc. It is controlled by the retailer IKEA group that sells to IKEA franchises

What is the organization structure of IKEA and explain each part?

Top → holding of inter IKEA group: controls core franchise range and supply

• Franchise system: owns the IKEA concept and ensures successful implementation

• Range system (Sweden): develops products, designs, products, oversees product range and communication

• Supply system: has two branches

  • Supply: sources cells, and distribute to IKEA franchises

  • Industry: the strategic manufacturer

What does each subsection of IKEA’s Balance Sheet represent?

• Fixed assets: the trademark (intangible), factories (tangible)

• Current assets: inventories, receivables

• Owner’s funds / equity: privately owned by Kamprad

• Long-term loans: loans from Interogo (they repay 500M a year)

• Current liabilities: money owed to suppliers

What is IKEA’s revenue made from?

• Sales

• Franchise fees: IKEA franchises pay 3% of net sales to IKEA group

What does IKEA’s Balance Sheet and Profit & Loss account say about the company?

IKEA is profitable liquid and financially strong, but needs improvement in asset, efficiency and working capital management.

more specifically: ROE & assets turnover decreased and asset turnover is lower compared to Walmart. DIO, DSO, DPO are bad.

What is IKEA’s business model?

A franchise network

How much is IKEA taxed at?

15% of pre-tax income

What is Financial income and expenses?

All revenues and costs arising from financial activities, mainly interest received and interest paid (loans and investments).

What's the difference between the income statement and the balance sheet?

The profit and loss statement shows what the company earned and lost while the balance sheet shows what it has and owes.

What are provisions and where would they go in the Balance Sheet?

Provisions are money set aside from lawsuits, etc. They represent future expenses. They would go under long-term liabilities

When do materials go into the P&L statement?

When they are used.

What is interesting about paying a loan?

It does not equal paying interest. A loan can be paid by:

• principal payment: the amount borrowed

• interest: the cost for borrowing

What does purchasing inventory affect?

Purchasing inventory doesn’t automatically create an expense. When the company uses the coffee in production, its cost will be recognized as an expense, according to the relevant accounting rules.

What is the accounting equation?

assets = liabilities (owns to third parties) + equity (owes to owners)

What is incorporation?

Incorporation is the legal process of forming a corporation as a separate legal entity from its owners.