Chapter 14 Financial Performance Measurement Skyline College Lecture Notes.

Chapter 14

Financial Performance Measurement

Skyline College

Lecture Notes

Copyright © Houghton Mifflin Company. All rights reserved. 14–2

Financial Performance Measurement

Shows important relationships in the financial statements and relates them to important financial objectives; also called financial statement analysis

Internal External

Top managers

Mid-level managers

Employees who own stock in the company

Creditors

Investors

Customers who have agreements with the company

Users of Financial Information


Management: Financial Objectives and Related Performance Objectives

Able to increase stockholders’ wealthMarket strength

Generate sufficient cash through operating, investing, and financing activities

Cash flow adequacy

Able to survive for many yearsLong-term solvency

Earn a satisfactory net incomeProfitability

Able to pay bills when due and meet unexpected needs for cash

Liquidity


External Users

Use financial performance measurement to:

Judge past and present position

Assess future earnings potential and risk

Assess future debt paying ability


Assessment of Risk

• Well-established, stable company

Can predict future profitability with higher level of confidence

Lower risk

• Newly established, small company

Difficult to predict future profitability

Higher risk

Investors demand higher expected returns for high risk investments

Creditors demand higher interest rates from high risk companies


Standards of Comparison

When analyzing financial statements, decision makers often use these three common methods to determine whether the results are favorable or unfavorable:

Rule-of-thumb measures There is no proof that apply to all companies Must be used with caution

Past performance Provides a basis for judging whether the measure or ratio chnging It may also be helpful in showing possible future trends Past

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

Industry norms or averages


Industry Norms

Limitations: Companies in the same

industry may not be strictly comparable

Diversified companies are difficult to compare

Use of different accounting procedures often makes companies difficult to compare

Shows how a company compares with other companies in the same industry

Wal-Mart Target

Return on assets

7.8% 6.1%

Profit margin

3.1% 3.4%

Return on equity

19.3% 18.5%


Sources of Financial Information

Reports published by the corporation

Annual report, interim financial statements

Reports filed with the SEC

Form 10-K (annual); Form 10-Q (quarterly)

Business periodicals and credit and investment advisory services

The Wall Street Journal, Forbes, Barron’s


Executive Compensation

A 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 base salaryIncentive 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.


Discussion: Ethics on the Job

Explain the following statement: As long as chief financial officers and other corporate managers' salaries, bonuses, or promotions are linked to earnings, the temptation to manage earnings will remain a problem.

A manager whose bonus or salary is tied to corporate performance stands to benefit personally if he or she boosts earnings, even if artificially so. This places an ethical dilemma before the officers of a corporation.


Horizontal Analysis

AmountYear Base

Change ofAmount 100 Change Percentage

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


Starbucks’ Horizontal Analysis

(Dollar amounts in thousands) 2004 2003 Amount Percentage

Net revenues 5,294,247$ 4,075,522$ 1,218,725$ 29.9Cost of sales, including occupancy costs 2,198,654 1,685,928 512,726 30.4Gross margin 3,095,593$ 2,389,594$ 705,999$ 29.5Operating expenses: Store operating expenses 1,790,168$ 1,379,574$ 410,594$ 29.8 Other operating expenses 171,648 141,346 30,302 21.4 Deprec. and amortization expenses 280,024 237,807 42,217 17.8 General and adminstrative expenses 304,293 244,550 59,743 24.4 Total operating expenses 2,546,133$ 2,003,277$ 542,856$ 27.1Operating income 549,460$ 386,317$ 163,143$ 42.2Other income, net 74,797 50,018 24,779 49.5Income before income taxes 624,257$ 436,335$ 187,922$ 43.1Provision for income taxes 232,482 167,989 64,493 38.4Net income 391,775$ 268,346$ 123,429$ 46.0

Increase (Decrease)

Starbucks CorporationConsolidated Income Statements

For the Years Ended October 3, 2004, and September 28, 2003


Trend Analysis

Calculation of percentage changes for several successive years

2004 2003 2002 2001 2000

Dollar values(In thousands)Net revenues $5,294,247 $4,075,522 $3,288,908 $2,648,980 $2,177,614Operating income 549,460 386,317 282,893 252,479 191,952

Trend analysis(In percentages)Net revenues 243.1 187.2 151.0 121.6 100.0Operating income 286.2 201.3 147.4 131.5 100.0

Starbucks CorporationNet Revenues and Operating Income

Trend Analysis

AmountYear Base

AmountYear Index 100 Index Uses an index

number


Vertical Analysis

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

On the balance sheet, set total assets or total liabilities and stockholders’ equity to 100%.

On the income statement, set net sales to 100%.

The resulting statement, expressed entirely in percentages, is called a common-size statement.


Starbucks Common-Size Income Statement

2004* 2003*

Net revenues 100.0 % 100.0 %Cost of sales, including occupancy costs 41.5 41.4Gross margin 58.5 % 58.6 %Operating expenses: Store operating expenses 33.8 % 33.9 % Other operating expenses 3.2 3.5 Depreciation and amortization expenses 5.3 5.8 General and administrative expenses 5.7 6.0 Total operating expenses 48.1 % 49.2 %Operating income 10.4 % 9.5 %Other income, net 1.4 1.2Income before income taxes 11.8 % 10.7 %Provision for income taxes 4.4 4.1Net income 7.4 % 6.6 %

*Percentages don't always add up due to rounding.

Starbucks CorporationCommon-Size Income Statements

For the Years Ended October 3, 2004, and September 28, 2003All other figures are expressed in relation to net

revenues

Cost of sales including

occupancy costs is 41.5% of net

revenues; Depreciation and amortization is

5.3% of net sales


Ratio Analysis

Identifies meaningful relationships between the components of the financial statements

Ratios may be expressed in several ways:

Net income is 1/10 of sales

Net income is 10 percent of sales

The ratio of net income to sales is 10 to 1 (10:1)

Sales are 10 times net income

For every dollar of sales, the company has an average net income of 10 cents


Evaluating Liquidity

Selected liquidity ratios for Starbucks:2003

Current Assets $1,368,485Current Liabilities $782,980

Current Ratio

2004

1.5 times= = 1.7 times=

2003Net Sales $5,294,247

Average A/R ($140,226 + $114,448) ÷ 2Receivable Turnover

2004


2003Cost of Goods Sold $2,198,654Average Inventory ($422,663 + $342,944) ÷ 2

Inventory Turnover

2004


Starbuck’s management of receivables and inventory improved from 2003 to 2004.

The company has sufficient current assets to cover current liabilities.


Evaluating Profitability

2003Net Income $391,775Net Sales $5,294,247

Profit Margin

2004

6.6%= = 7.4%=

Selected profitability ratios for Starbucks:

2003Net Income $391,775

Average Stockholders' Equity $2,284,591Return on Equity

2004

14.1%= = 17.1%=

Starbucks is doing a better job of managing its costs per dollar of sales in 2004.

Both return on assets and return on equity improved from 2003 to 2004.

2003Net Income $391,775

Average Total Assets $3,028,957Return on Assets

2004

10.9%= = 12.9%=


Evaluating Long-Term Solvency

Solvency ratio for Starbucks:2003

Total Liabilities $841,413Stockholders' Equity $2,486,755

Debt-to-Equity Ratio

2004


Long-term solvency means that a company is expected to survive for many years.

Increasing amounts of debt may mean that it is becoming too heavily leveraged and can result in bankruptcy

This ratio shows the amount of Starbucks’ assets provided by creditors in relation to the amount provided by stockholders. The ratio is stable from 2003 to 2004 – a positive indicator.


Evaluating Cash Flow Adequacy

2003Net Cash Flows from Operating Activities $793,848

Net Income $391,775Cash Flow

2004


2003Net Cash Flows from Operating Activities $793,848

Net Sales $5,294,247Cash Flows

to Sales

2004

13.9%= = 15.0%=

Selected cash flow adequacy ratios for Starbucks:

The cash flow yield decreased, revealing that net income increased faster than net cash flows provided by operating activities.

The cash-generating ability of sales increased from 2003 to 2004.


Evaluating Market Strength

Market price indicates how investors view the potential risk and return of owning the stock.

Ratios that combine market price with earnings or dividends help measure investors’ confidence in a company.

Starbucks' 2003Market Price per Share $45.23

Earnings per Share $0.99Price/Earnings

Ratio

2004


Chapter 14 Financial Performance Measurement Skyline College Lecture Notes.

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