6.5 Financial Analysis and Interpretation

6.5 Financial Analysis and Interpretation: Asset Turnover

Obj. 5

Asset turnover, sometimes called the ratio of sales to assets, measures how effectively a business is using its assets to generate sales. A high ratio indicates an effective use of assets.

The asset turnover is computed as follows:

Asset Turnover=SalesAverage Total Assets

To illustrate, the following data (in millions) were taken from recent annual reports of Dollar Tree, Inc.:

The asset turnover for each year is as follows:

Dollar Tree’s asset turnover declined from 2.84 in Year 1 to 2.71 in Year 2. Thus, Dollar Tree’s utilization of its assets to generate sales declined slightly in Year 2.

Using the asset turnover for comparisons to competitors and with industry averages could also be beneficial in interpreting Dollar Tree’s use of its assets. For example, the following data (in millions) were taken from recent annual reports of Dollar General Corporation:

Dollar General’s asset turnover for Year 2 is as follows:

Comparing Dollar General’s Year 2 asset turnover of 1.71 to Dollar Tree’s Year 2 ratio of 2.71 implies that Dollar Tree is using its assets more efficiently than is Dollar General.

Example Exercise 6-8

Asset Turnover

Obj. 5

Financial statement data for the years ending December 31, 2019 and 2018, for Gilbert Company follow:

Follow My Example 6-8

1. Determine the asset turnover for 2019 and 2018.

Answer

1. Does the change in the asset turnover from 2018 to 2019 indicate a favorable or an unfavorable trend?

Answer

The change from 1.25 to 1.50 indicates a favorable trend in using assets to generate sales.

Practice Exercises: PE 6-8A, PE 6-8B

6-1Nature of Merchandising Businesses

Obj. 1

The activities of a service business differ from those of a merchandising business. These differences are reflected in the operating cycles of a service and merchandising business as well as in their financial statements.

6-1aOperating Cycle

The operating cycle is the process by which a company spends cash, generates revenues, and receives cash either at the time the revenues are generated or later by collecting an account receivable. The operating cycle of a service and merchandising business differs in that a merchandising business must purchase merchandise for sale to customers. The operating cycle for a merchandise business is shown in Exhibit 1.

Exhibit 1The Operating Cycle for a Merchandising Business

The time in days to complete an operating cycle differs significantly among merchandise businesses. Grocery stores normally have short operating cycles because of the nature of their merchandise. For example, many grocery items, such as milk, must be sold within their expiration dates of a week or two. In contrast, jewelry stores often carry expensive items that are displayed months before being sold to customers.

6-1bFinancial Statements

The differences between service and merchandising businesses are also reflected in their financial statements. For example, these differences are illustrated in the following condensed income statements:

Link to Dollar Tree

In a recent income statement, Dollar Tree reported the following (in billions):

On its balance sheet, it reported merchandise inventory of \$1.0 billion.

The revenue activities of a service business involve providing services to customers. On the income statement for a service business, the revenues from services are reported as fees earned. The operating expenses incurred in providing the services are subtracted from the fees earned to arrive at operating income.

In contrast, the revenue activities of a merchandising business involve the buying and selling of merchandise. A merchandising business first purchases merchandise to sell to its customers. When this merchandise is sold, the revenue is reported as sales, and its cost is recognized as an expense. This expense is called the cost of merchandise sold. The cost of merchandise sold is subtracted from sales to arrive at gross profit. This amount is called gross profit because it is the profit before deducting operating expenses.

Merchandise on hand (not sold) at the end of an accounting period is called merchandise inventory. Merchandise inventory is reported as a current asset on the balance sheet.

Business Connection

Comcast versus Lowe’s

Comcast Corporation is a service business that offers cable communications, broadcast television (NBC television), filmed entertainment (Universal Pictures), and theme parks (Universal Parks) to its customers. Lowe’s Companies is a large home improvement retailer. The differences in the operations of a service and merchandising business are illustrated in their recent income statements, as follows:

As a merchandising company, Lowe’s subtracts cost of merchandise sold from sales to disclose gross profit. As a service company, Comcast shows neither cost of merchandise sold nor a gross profit line. Rather, service expenses are subtracted from revenue straight to operating income.

Example Exercise 6-1

Gross Profit

Obj. 1

1. During the current year, merchandise is sold for \$250,000 cash and for \$975,000 on account. The cost of the merchandise sold is \$735,000. What is the amount of the gross profit?

Follow My Example 6-1

Answer

The gross profit is .

Practice Exercises: PE 6-1A, PE 6-1B

6-2Merchandising Transactions

Obj. 2

This section illustrates merchandise transactions for NetSolutions after it becomes a retailer of computer hardware and software. During 2018, Chris Clark implemented the second phase of NetSolutions’ business plan. In doing so, Chris notified clients that beginning July 1, 2019, NetSolutions would no longer offer consulting services. Instead, it would become a merchandising business.

NetSolutions’ business strategy is to offer personalized service to individuals and small businesses that are upgrading or purchasing new computer systems. NetSolutions’ personal service includes a no-obligation, on-site assessment of the customer’s computer needs. By providing personalized service and follow-up, Chris believes that NetSolutions can compete effectively against such retailers as Best BuyOffice Depot, and Dell.