CENTURY 21 ACCOUNTING © Thomson/South-Western

LESSON 17-2LESSON 17-2

Calculating Earnings Performance and Efficiency Analysis

CENTURY 21 ACCOUNTING © Thomson/South-Western

EARNINGS PERFORMANCE ANALYSISEARNINGS PERFORMANCE ANALYSIS

The amount & consistency of earnings are important measures of a business’s success.

Managers, owners, & creditors are interested in an analysis of earnings performance

Five earnings performance ratios: Rate earned on average total assets Rate earned on average stockholders equity Rate earned on net sales Earnings per share Price-earnings ratio

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LESSON 17-2

CENTURY 21 ACCOUNTING © Thomson/South-Western

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LESSON 17-2

page 503

RATE EARNED ON AVERAGE RATE EARNED ON AVERAGE TOTAL ASSETSTOTAL ASSETS

December 31Total Assets

January 1Total Assets

Average Total Assets

+ =÷ 2

($1,759,700.00 + = $1,913,700.00$2,067,700.00) ÷ 2

• The rate found by dividing net income after federal income tax by average total assets is known as the rate earned on average total assets

• To find average total assets add the beginning assets and the ending assets and divide by 2

Current Year Prior Year

January 1 Total Assets $1,759,700.00 $1,437,600.00

December 31 Total Assets 2,067,700.00 1,759,700.00

Average Total Assets 1,913,700.00 1,598,650.00

CENTURY 21 ACCOUNTING © Thomson/South-Western

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LESSON 17-2

CALCULATING THE RATE EARNED ON CALCULATING THE RATE EARNED ON AVERAGE TOTAL ASSETSAVERAGE TOTAL ASSETS page 504

Current Year Prior Year

Net Income after Federal Income Tax $ 222,300.00 $ 128,400.00

Average Total Assets 1,913,700.00 1,598,650.00

Rate Earned on Average Total Assets 11.6% 8.0%

Average Total Assets

Net Income after Federal Income Tax

Rate Earned on Average Total Assets

÷ =

$222,300.00 ÷ = 11.6%$1,913,700.00

• The rate found by dividing net income after federal income tax by average total assets is known as the rate earned on average total assets• Shows how well a business is using its assets to earn net income

CENTURY 21 ACCOUNTING © Thomson/South-Western

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LESSON 17-2

CALCULATING THE RATE EARNED ON CALCULATING THE RATE EARNED ON AVERAGE TOTAL ASSETSAVERAGE TOTAL ASSETS page 504

Current Year Prior Year

Net Income after Federal Income Tax $ 222,300.00 $ 128,400.00

Average Total Assets 1,913,700.00 1,598,650.00

Rate Earned on Average Total Assets 11.6% 8.0%

• An 11.6% rate earned on average total assets means that for each $1 of assets, the business earned 11.6 cents in the current year.

• The company will compare this rate to rates of return on alternative investments (bonds, etc.)• Goal is to earn a rate of return that is at least as high as other

types of investments.• If the average investment sources available to this company are

earning 10% then the rate earned on total assets is satisfactory

CENTURY 21 ACCOUNTING © Thomson/South-Western

RATE OF RETURN ON AVERAGE RATE OF RETURN ON AVERAGE STOCKHOLDER’S EQUITYSTOCKHOLDER’S EQUITY

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LESSON 17-2

Investors compare the rate earned on stockholders’ equity for several businesses to determine the best investment

If a business’s rate earned on stockholders’ equity increases significantly and is at or above industry comparisons then the rate is considered satisfactory

CENTURY 21 ACCOUNTING © Thomson/South-Western

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LESSON 17-2

RATE OF RETURN EARNED ON RATE OF RETURN EARNED ON AVERAGE STOCKHOLDERS’ EQUITYAVERAGE STOCKHOLDERS’ EQUITY

Average Total Stockholders’

Equity

Net Income after Federal Income Tax

Rate Earned on Average

Stockholders’ Equity

÷ =

$222,300.00 ÷ = 23.4%$950,450.00

December 31Stockholders’

Equity

January 1Stockholders’

Equity

Average Total Stockholders’

Equity+ =÷ 2

($849,300.00 + = $950,450.00$1,051,600.00) ÷ 2

page 505

Calculate average stockholders’ equity (Jan. 1 total stockholders’ equity is the same as the total stockholders’ equity on the prior year’s Dec. 31 balance sheet)

Divide net income after federal income taxes by average total stockholders’ equity to determine the rate earned on average total assets.

CENTURY 21 ACCOUNTING © Thomson/South-Western

RATE EARNED ON NET SALESRATE EARNED ON NET SALES

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LESSON 17-2

• A business that carefully controls costs should earn a consistent rate on net sales from year to year.

• The rate found by dividing net income after federal income tax by net sales is called the rate earned on net sales

• When determining what is normal businesses that are similar are compared.• If the rate on net sales is lower than the industry standard it is

considered unsatisfactory• If the rate is unsatisfactory the business must increase sales or

reduce costs to maintain an acceptable rate

CENTURY 21 ACCOUNTING © Thomson/South-Western

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LESSON 17-2

page 506RATE EARNED ON NET SALESRATE EARNED ON NET SALES

Net Income after Federal Income Tax

÷ Net Sales =Rate Earnedon Net Sales

÷ $4,767,200.00 = 4.7%$222,300.00

The component percentage for net income after federal income tax is the same percentage as the rate earned on net sales

CENTURY 21 ACCOUNTING © Thomson/South-Western

EARNINGS PER SHAREEARNINGS PER SHARE

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LESSON 17-2

The amount of net income earned on one share of common stock during a fiscal period is known as earnings per share

Stockholders & management frequently use earnings per share as a measure of success As earnings per share increase, more people become

interested in buying stock and stock prices go up Increases in earnings per share signal stockholders

that the company is continuing to increase the net income earned for each share.

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LESSON 17-2

page 507EARNINGS PER SHAREEARNINGS PER SHARE

Net Income after Federal Income Tax

÷ =Earnings per

ShareShares of Capital Stock Outstanding

= $3.71$222,300.00 ÷ 60,000.00

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LESSON 17-2

page 508PRICE-EARNINGS RATIOPRICE-EARNINGS RATIO

Earnings per Share

Market Price per Share

Price-Earnings Ratio

÷ =

$43.50 ÷ = 11.7 times$3.71

• Investors want to buy stock in companies that will earn a reasonable return on their investment

• The relationship between the market value per share of stock and the earnings per share is known as the price-earnings ratio• Relates profitability to the amount that the investors

currently pay for the stock• Usually expressed as a ratio

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LESSON 17-2

page 508PRICE-EARNINGS RATIOPRICE-EARNINGS RATIO

Earnings per Share

Market Price per Share

Price-Earnings Ratio

÷ =

$43.50 ÷ = 11.7 times$3.71

• A comparison to last year’s price-earnings ratio indicates an increase from 9.5 to 11.7 • The change indicates that investors considered the

stock more valuable & were willing to pay more for the stock per dollar earned by the company in the current year.

• This is considered a favorable trend.

CENTURY 21 ACCOUNTING © Thomson/South-Western

EFFICIENCY ANALYSISEFFICIENCY ANALYSIS

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LESSON 17-2

• The profitability & continued growth of a business are influenced by how efficiently the business utilizes its assets

• The operating cycle of a merchandising business consists of 3 phases:• Purchase merchandise• Sell merchandise, frequently on account• Collect the accounts receivable

• The faster a business can convert accounts receivable and merchandise inventory into cash, the more efficient & profitable the business will be

CENTURY 21 ACCOUNTING © Thomson/South-Western

ACCOUNTS RECEIVABLE TURNOVER ACCOUNTS RECEIVABLE TURNOVER RATIORATIO

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LESSON 17-2

• A business accepts accounts receivable to encourage sales. However, the earnings process is not complete until the business receives cash for sales on account• An efficient company closely monitors the length of time

required to collect its receivables• The number of times the average amount of accounts

receivable is collected annually is known as the accounts receivable turnover ratio• Monitors a business’s accounts receivable collection

efficiency

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LESSON 17-2

page 509

ACCOUNTS RECEIVABLE ACCOUNTS RECEIVABLE TURNOVER RATIOTURNOVER RATIO

Average Book Value of Accounts

Receivable

Net Sales on Account

Accounts Receivable

Turnover Ratio÷ =

$4,767,200.00 ÷ = 9.1 times$521,600.00

Ending Book Value of Accounts

Receivable

Beginning Book Value of Accounts

Receivable

Average Book Value of Accounts

Receivable

+ =÷ 2

($569,200.00 + = $521,600.00$474,000.00) ÷ 2

The turnover ratio indicates accounts receivable are being collected 9.1 times per year. If the terms are n/30 then this amount should be 12 times per year

CENTURY 21 ACCOUNTING © Thomson/South-Western

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LESSON 17-2

page 510

AVERAGE NUMBER OF DAYS AVERAGE NUMBER OF DAYS FOR PAYMENTFOR PAYMENT

Accounts Receivable

Turnover RatioDays in Year

Average Number of Days for Payment

÷ =

365 ÷ = 40 days9.1

• To figure the average number of days customers are taking to pay their accounts receivable you would divide the number of days in a year by the accounts receivable turnover ratio.

• If the terms are n/30 then the 40 days would be considered unsatisfactory

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MERCHANDISE INVENTORY TURNOVER MERCHANDISE INVENTORY TURNOVER RATIORATIO

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LESSON 17-2

• A company earns income when it sells merchandise – the faster is sells the more efficient & generally more profitable the business

• The number of times the average amount of merchandise inventory is sold annually is known as the merchandise inventory turnover ratio

• An optimum merchandise inventory turnover ratio is determined by two factors:• Amount of sales• Number of days needed to replenish inventory

CENTURY 21 ACCOUNTING © Thomson/South-Western

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LESSON 17-2

page 510

MERCHANDISE INVENTORY MERCHANDISE INVENTORY TURNOVER RATIOTURNOVER RATIO

Average Merchandise

Inventory

Cost of Merchandise

Sold

Merchandise Inventory

Turnover Ratio÷ =

$2,602,800.00 ÷ = 5.4 times$485,850.00

December 31Merchandise

Inventory

January 1Merchandise

Inventory

Average Merchandise

Inventory+ =÷ 2

($423,800.00 + = $485,850.00$547,900.00) ÷ 2

• The 5.4 turnover ratio indicates that the inventory is being sold 5.4 times in a year.• The average number of days’ sales in merchandise inventory is 68 days

(365 days\5.4 turnover ratio)• If previous experience indicates an inventory turnover ratio of about 6.0 then the

turnover ratio is unsatisfactory• Would result in lost sales because some items were out of stock before new inventory

arrived.

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LESSON 17-2

page 511TERM REVIEWTERM REVIEW

rate earned on net sales