Copyright © Cengage Learning. All rights reserved. Chapter 14 Financial Performance Measurement.

Copyright © Cengage Learning. All rights reserved.

Chapter 14

Financial Performance Measurement

Copyright © Cengage Learning. All rights reserved. 14-2

Foundations of Financial Performance Measurement

• Objective 1– Describe the objectives, standards of comparison, sources

of information, and compensation issues in measuring financial performance.


Financial Performance Measurement

Shows how important items in a company’s financial statements relate to the company’s financial

objectives; also called financial statement analysis

Internal External

Top managers

Mid managers

Employees who own stock in the company

Creditors

Investors

Customers who have cooperative agreements with the company

Users of Financial Information


Management’s Objectives

Able to increase shareholders’ wealthMarket strength

Generate sufficient cash through operating, investing, financing activities

Cash flow adequacy

Able to survive for several yearsLong-term solvency

Earn a satisfactory net incomeProfitability

Able to pay bills when due and meet needs for cash

Liquidity


External Users

• Creditors– Make loans in the form of trade accounts, notes, or bonds

• Investors– Buy capital stock, from which they hope to receive

dividends and an increase in value

• Both groups face risks– Goal is to achieve a return that makes up for the risk


Past Performance and Current Position

• Past performance– Good indicator of future performance

• Look at trends of past sales, expenses, net income, cash flow, and return on investment

• Current position– What assets the business owns

– What liabilities the business must pay

– Cash position

– Debt to equity

– Levels of inventories and receivables


Standards of Comparison

• Decision makers must judge whether the relationships they have found are favorable or unfavorable

• Three commonly used standards of comparison:1. Rule-of-thumb measures

2. Past performance of the company

3. Industry norms


Rule-of-Thumb Measures

• General standards, used by financial analysts, investors, and lenders, for key financial ratios

• Found in Dun & Bradstreet’s Industry Norms and Key Business Ratios– Current debt to tangible net worth

– Inventory to net working capital

• Must be used with great care


Past Performance The comparison of financial measures or ratios of the

same company over a period of time• An improvement over use of rule-of-thumb

measures• Provides a basis for judging whether the measure or

ratio is improving or deteriorating• It may also be helpful in showing possible future

trends– Trends reverse at times, so projections must be made

with care

• Past performance may not be a useful indicator of adequacy for the future


Industry Norms

Tell how the company compares with the average performance of other companies in the same

industry

• Industry norms probably offer the best available standards for judging current performance as long as they are used with care


Limitations of Industry Norms

1. Companies in the same industry may not be strictly comparable.

2. When analyzing consolidated financial statements for diversified companies, there may be no comparable companies.

– A partial solution is that diversified companies must report revenues, income from operations, and identifiable assets for each of their operating segments

3. Companies in the same industry with similar operations may use different acceptable accounting procedures.


Reports Published by the Corporation

• The annual report of a publicly held corporation is an important source of financial information.

• The main parts of an annual report– Management's analysis of the past year's operations

– The financial statements

– The notes to the statements, including the principal accounting procedures used by the company

– The auditors' report

– Financial highlights for a five- or a ten-year period

• Most publicly held companies also publish interim financial statements, usually each quarter.


SEC Reports

• Publicly held corporations must file annual reports, quarterly reports, and current reports with the Securities and Exchange Commission (SEC).– Annual report (Form 10-K)

• Contains more information than the published annual report

– Quarterly report (Form 10-Q) • Presents important facts about interim financial

performance

– Current report (Form 8-K)• Presents important changes that may affect a company’s

financial position, such as the sale or purchase of a division


Executive CompensationA public corporation’s board must establish a compensation committee to determine how the company’s top executives

will be compensated and report the details of compensation to the SEC.

Components of compensation:Annual baseIncentive bonusesStock option awards

Starbuck’s CEO received a base salary of $1,190,000, an incentive bonus of an

equal amount, and a stock option award of 550,000 shares of common stock.


Tools and Techniques of Financial Analysis

• Objective 2– Apply horizontal analysis, trend analysis, vertical

analysis, and ratio analysis to financial statements.


Tools and Techniques of Financial Analysis

The tools of financial performance evaluation are intended to show relationships and changes– Few numbers are very significant when looked at

individually

– It is the relationship between various numbers or their change from one period to another that is important

• Horizontal analysis • Trend analysis • Vertical analysis • Ratio Analysis


AmountYear Base

Change ofAmount 100 Change Percentage

Horizontal Analysis

Computes changes from the previous year to the current year in both dollar amounts and percentages

• The base year is the first year considered


Starbucks Horizontal Analysis

(Dollar amounts in thousands) 2007 2006 Amount Percentage

Net revenues $9,411,497 $7,786,942 $1,624,555 20.9Cost of sales, including occupancy costs 3,999,124 3,178,791 820,333 25.8Gross margin $5,412,373 $4,608,151 $804,222 17.5Operating expenses Store operating expenses 3,215,889 2,687,815 528,074 19.6 Other operating expenses 294,136 253,724 40,412 15.9 Deprec. and amortization expenses 467,160 387,211 79,949 20.6 General and adminstrative expenses 489,249 479,386 9,863 2.1 Total operating expenses $4,466,434 $3,808,136 $658,298 17.3Operating income 945,939 800,015 145,924 18.2Other income, net 110,425 106,228 4,197 4Income before taxes $1,056,364 $906,243 $150,121 16.6Provision for income taxes 383,726 324,770 58,956 18.2Income before cumulative change $672,638 $581,473 $91,165 15.7Cumulative effect of FIN47 (net of tax) -- $17,214 -$17,214 -100Net income $672,638 $564,259 $108,379 19.2

Increase (Decrease)


AmountYear Base

Change ofAmount 100 Index

Trend Analysis

A type of horizontal analysis in which percentage changes are calculated for several successive years

instead of for just two years

• Important because it may point to basic changes in the nature of a business

• Uses an index number to show changes in related items over a period of time


Trend Analysis for Starbucks

2007 2006 2005 2004 2003

Dollar values(In thousands)Net revenues $9,411,497 $7,786,942 $6,369,300 $5,294,247 $4,075,522Operating income 945,939 800,015 703,870 549,460 386,317

Trend analysis(In percentages)Net revenues 230.9 191.1 156.3 129.9 100.0Operating income 244.9 207.1 182.2 142.2 100.0

Starbucks CorporationNet Revenues and Operating Income

Trend Analysis


Vertical Analysis

Shows how the different components of a financial statement relate to a total figure in the statement

• The total figure in the statement set to equal to 100%– Each component’s percentage of that total is computed

• Also called a common-size statement• Useful for comparing

– The importance of specific components in the operation of a business

– Changes in the components from one year to the next


Starbucks Common-Size Income Statement

2007 2006

Net revenues 100.0 % 100.0 %Cost of sales including occupancy costs 42.5 40.8Gross margin 57.5 % 59.2 %Operating expenses:Store operating expenses 34.2 % 34.5 %Other operating expenses 3.1 3.3Depreciation and amortization expenses 5.0 5.0General and administrative expenses 5.2 6.2Total operating expenses 47.5 % 48.9 %Operating income 10.1 % 10.3 %Other income, net 1.2 1.4Earnings before income taxes 11.2 % 11.6 %Provision for income taxes 4.1 4.2Income before cumulative change 7.1 7.5 %Cumulative effect of FIN47, net of taxes --- 0.2Net earnings 7.1 % 7.2 %

All other figures are expressed in relation to net

revenues

Cost of sales are 42.5% of net

revenues; Depreciation is

5.0% of net sales


Ratio Analysis

A technique of evaluation that identifies key relationships between components of the

financial statements• Useful in

– Evaluating a company’s financial position and operations

– Making comparisons with results in previous years or with other companies

• The primary purpose of ratios is to point out areas needing further investigation.


Comprehensive Illustration of Ratio Analysis

• Objective 3– Apply ratio analysis to financial statements in a

comprehensive evaluation of a company’s financial performance.


Evaluating Liquidity

• Liquidity is a company's ability to pay bills when they are due and to meet unexpected needs for cash

• All ratios that relate to liquidity involve working capital or some part of it

Current Ratio Quick Ratio Receivable Turnover Days’ Sales Uncollected

Inventory Turnover Days’ Inventory on HandPayables TurnoverDays’ Payable


sLiabilitieCurrent

sReceivable Securities Marketable Cash RatioQuick

sLiabilitieCurrent

AssetsCurrent RatioCurrent

Evaluating Liquidity (cont’d)

• Current ratio– Measures short-term debt-paying ability

• Quick ratio– Also measures short-term debt-paying ability


Receivable Accounts Average

SalesNet Turnover Receivable

Turnover Receivable

Year ain Days ed UncollectSales Days'


• Days’ sales uncollected– Measures average days taken to collect receivables

• Receivable turnover– Measures relative size of receivables and effectiveness

of credit policies


Inventory Average

Sold Goods ofCost Turnover Inventory

TurnoverInventory

Year ain Days Handon Inventory Days'


• Days’ inventory on hand– Measures average days taken to sell inventory

• Inventory turnover– Measures relative size of inventory


Evaluating Profitability

• Profitability reflects a company's ability to earn a satisfactory income

• A company's profitability is closely linked to its liquidity because earnings ultimately produce cash flow

Profit Margin Asset TurnoverReturn on Assets Return on Equity


SalesNet

IncomeNet Margin Profit

Assets Total Average

SalesNet Turnover Asset

Evaluating Profitability (cont’d)

• Asset turnover– Measures how efficiently assets are used to produce sales

• Profit margin– Measures net income produced by each sales dollar


Equity rs'Stockholde Average

IncomeNet Equity on Return


IncomeNet Assetson Return

Evaluating Profitability (cont’d)

• Return on equity– Measures profitability of stockholders’ investments

• Return on assets– Measures overall earning power


Evaluating Long-Term Solvency

• Refers to a company's ability to survive for many years

• The aim of long-term solvency analysis is to detect early signs that a company is headed for financial difficulty– Declining profitability and liquidity ratios

– Unfavorable debt to equity ratio

– Unfavorable interest coverage ratio


ExpenseInterest

ExpenseInterest Taxes Income Before Income Ratio CoverageInterest

Evaluating Long-Term Solvency (cont’d)

• Interest coverage ratio– Measure of creditors’ protection from default on interest

payments

• Debt to equity ratio– Measure of capital structure and leverage by showing the

amount of a company’s assets provided by creditors in relation to the amount provided by stockholders

Equity rs'Stockholde

sLiabilitie Total Equity Debt to


Evaluating the Adequacy of Cash Flows

• Cash flow measures are closely related to the objectives of liquidity and long-term solvency– Because cash flows are needed to pay debts when they

are due

Cash flow yield Cash flows to salesCash flows to assetsFree cash flow


IncomeNet

Activities Operating from FlowsCash Net Yield FlowCash

SalesNet

Activities Operating from FlowsCash Net Sales toFlowsCash

Evaluating Cash Flow Adequacy (cont’d)

• Cash flows to sales– Measures ability of sales to generate operating cash flows

• Cash flow yield– Measures overall ability to generate operating cash

flows in relation to net income



Activities Operating from FlowsCash Net Assets toFlowsCash

Evaluating the Adequacy of Cash Flows (cont’d)

• Cash flow to assets– Measures ability of assets to generate operating cash

flows


Evaluating Market Strength

• Market price– Price at which a company’s stock is bought and sold

– Represents what investors as a whole think of the company at a point in time

– Provides information about how investors view the potential return and risk connected with owning the company's stock

– Is not very informative unless related to earnings by considering the price/earnings ratio and the dividends yield


Shareper Earnings

Shareper PriceMarket Ratio ingsPrice/Earn

Shareper PriceMarket

Shareper Dividends Yield Dividends

Evaluating Market Strength (cont’d)

• Dividends yield– Measures a stock’s current return to an investor in the

form of dividends

• Price/earnings ratio– Measures investor confidence in a company


Stop & Review

Q. What is the difference between liquidity and solvency?

A. Liquidity is a firm’s ability to meet its current obligations, whereas solvency is a firm’s ability to meet all its maturing obligations as they come due, without losing the ability to continue operations.


Chapter Review

1. Describe the objectives, standards of comparison, sources of information, and compensation issues in measuring financial performance.

2. Apply horizontal analysis, trend analysis, vertical analysis, and ratio analysis to financial statements.

3. Apply ratio analysis to financial statements in a comprehensive evaluation of a company’s financial performance.

4. Textbook definition of free cash flow is different from the definition that we use in finance

Copyright © Cengage Learning. All rights reserved. Chapter 14 Financial Performance Measurement.

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