chapter 14 analysis of operating activities how do operations create value for our business?

Chapter 14 Analysis of Operating Activities

How do operations create value for our business?

Analysis of Operating Activities

• Operating Decisions– Determine how to price products– Determine how to create a return on assets that

will satisfy stockholders– Determine how to generate as much revenue

as possible from the products– Determine how to create value for its

customers– Determine how to compete with other

producers


• Developing an Operating Strategy– Profit margin is a measure of a company’s ability to

create profit from its sales.– Asset turnover is a measure of of a company’s ability

to generate sales from its investment in assets.– Return on assets is the profit margin multiplied by the

asset turnover.

If return on assets is low, a company must sell a lot of its products to earn a reasonable

profit.

Developing an Operating Strategy

Profit margin =Net income

Sales revenue

Asset turnover =Sales revenue

Total assets

Return on assets = Profit margin x Asset turnover


• Interpretation of Operating Activities– Asset Turnover and Profit Margin are

not the same for all companies.

– For Highly profitable firms• Asset Turnover is high for some• Profit Margin is high for others


• Business Strategy– The difference in profit margin and asset

turnover is generated by the different strategies companies use.

– Two primary strategies are• Companies that keep their prices low to generate high sales

volume use a cost leadership strategy.• High profit margin companies use a product differentiation

strategy.

– Cost leadership and Product differentiation are two ends of a competitive spectrum.

Exhibit 5Exhibit 5Exhibit 5Exhibit 5 Cost Leadership and Product Differentiation as Alternative Operating Strategies

Operating Strategy Profit Margin Asset TurnoverOperating Strategy Profit Margin Asset Turnover Cost Leadership Low High

Product Differentiation High Low

Analysis of Operating Activities• Business Strategy

– Product Differentiation Strategy• They compete by offering products with special

features or qualities that customers are willing to buy.• They emphasize service quality and often use

elaborate selling facilities.• Advertising emphasizes the high quality or special

features of their products and how these products are better than products offered by competitors.

• They attempt to build brand loyalty.• Research & Development is critical for these

companies.

Analysis of Operating Activities• Business Strategy

– Cost Leadership Strategy• They compete by keeping their prices low and

generating high sales volume. • They keep their expenses low so they can earn a

profit.• They typically buy and sell in high volume.• They offer few specialized customer services.• They do not have elaborate sales facilities.• Advertising often emphasizes low prices and

convenience.• They do not invest in research and development.

Analysis of Operating Activities• Comparing Accrual and Cash Flow

Measures of Operating Performance– If a company does not convert its profits into

cash, the profits are a misleading performance indicator.

– The ratio of operating cash flow to total assets is useful for comparing the operating cash flows of different companies.


Inventory turnover is the ratio of cost of good sold to inventory. It measures the success of a

company in converting its investment in inventory into sales.

$150,414,000

$12,031,000 12.50 =

Krispy Kreme—2001

$1,175,787,000

$221,253,000 5.31 =

Starbucks—2001

Inventory turnover = Cost of goods sold

Inventories


A ratio related to inventory turnover is day’s sales in inventory, the ratio of inventory to average daily cost of goods sold.

Day’s sales in inventory

Inventory

Cost of good sold ÷ 365

$12,031,000

$412,093 29.19 =

Krispy Krme—2001

$150,414,000$150,414,000÷ 365÷ 365


A ratio related to inventory turnover is day’s sales in inventory, the ratio of inventory to average daily cost of goods sold.

Day’s sales in inventory

Inventory

Cost of good sold ÷ 365

$1,175,789,000$1,175,789,000÷ 365÷ 365

$221,253,000

$3,221,334 68.68 =

Starbucks—2001


Accounts receivable turnover measures the success of a company’s ability to convert revenues into cash.

Sales revenueAccounts receivable

=Accounts receivable

turnover


Gross profit margin measures efficiency in the production or

purchase of goods for sale.

Gross profitSales revenue

=Gross profit margin


Operating profit margin is an indicator of a company’s efficiency in controlling

operating costs other than product costs.

Operating incomeSales revenue

=Operating profit

margin


Another ratio to measure financial risk is times interest earned.

Operating incomeInterest expense

=Times interest

earned

Net income

Equity

Net income

Equity

Linking Operating and Investing Activities with Linking Operating and Investing Activities with Financing ActivitiesFinancing Activities

Linking Operating and Investing Activities with Linking Operating and Investing Activities with Financing ActivitiesFinancing Activities

Return on Equity

Return on Equity

Profit Margin

Profit Margin

Financial Leverage

Financial Leverage

Asset Turnover

Asset Turnover= x x

Sales Revenues

Total Assets

Sales Revenues

Total Assets

Net income

Sales Revenues

Net income

Sales Revenues

Total Assets

Equity

Total Assets

Equity

= x x

The Big PictureThe Big PictureThe Big PictureThe Big Picture

A business is a transformation process in which—

(1) financial resources are obtained through financing activities,

(2) financial resources are used to acquire other resources through investing activities, and

(3) resources are used to produce and sell goods and services through operating activities.

The Accounting CycleThe Accounting CycleThe Accounting CycleThe Accounting Cycle

1. Examining business activities2. Recording transactions3. Updating account balances4. Making end-of-period adjustments5. Preparing financial statements6. Closing revenue and expense accounts

Steps in the accounting cycle include:

chapter 14 analysis of operating activities how do operations create value for our business?

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