Copyright © Cengage Learning. All rights reserved. Chapter 14 Financial Performance Measurement.
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Transcript of 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.
Copyright © Cengage Learning. All rights reserved. 14-3
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
Copyright © Cengage Learning. All rights reserved. 14-4
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
Copyright © Cengage Learning. All rights reserved. 14-5
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
Copyright © Cengage Learning. All rights reserved. 14-6
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
Copyright © Cengage Learning. All rights reserved. 14-7
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
Copyright © Cengage Learning. All rights reserved. 14-8
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
Copyright © Cengage Learning. All rights reserved. 14-9
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
Copyright © Cengage Learning. All rights reserved. 14-10
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
Copyright © Cengage Learning. All rights reserved. 14-11
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.
Copyright © Cengage Learning. All rights reserved. 14-12
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.
Copyright © Cengage Learning. All rights reserved. 14-13
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
Copyright © Cengage Learning. All rights reserved. 14-14
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.
Copyright © Cengage Learning. All rights reserved. 14-15
Tools and Techniques of Financial Analysis
• Objective 2– Apply horizontal analysis, trend analysis, vertical
analysis, and ratio analysis to financial statements.
Copyright © Cengage Learning. All rights reserved. 14-16
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
Copyright © Cengage Learning. All rights reserved. 14-17
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
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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)
Copyright © Cengage Learning. All rights reserved. 14-19
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
Copyright © Cengage Learning. All rights reserved. 14-20
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
Copyright © Cengage Learning. All rights reserved. 14-21
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
Copyright © Cengage Learning. All rights reserved. 14-22
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
Copyright © Cengage Learning. All rights reserved. 14-23
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.
Copyright © Cengage Learning. All rights reserved. 14-24
Comprehensive Illustration of Ratio Analysis
• Objective 3– Apply ratio analysis to financial statements in a
comprehensive evaluation of a company’s financial performance.
Copyright © Cengage Learning. All rights reserved. 14-25
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
Copyright © Cengage Learning. All rights reserved. 14-26
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
Copyright © Cengage Learning. All rights reserved. 14-27
Receivable Accounts Average
SalesNet Turnover Receivable
Turnover Receivable
Year ain Days ed UncollectSales Days'
Evaluating Liquidity (cont’d)
• Days’ sales uncollected– Measures average days taken to collect receivables
• Receivable turnover– Measures relative size of receivables and effectiveness
of credit policies
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Inventory Average
Sold Goods ofCost Turnover Inventory
TurnoverInventory
Year ain Days Handon Inventory Days'
Evaluating Liquidity (cont’d)
• Days’ inventory on hand– Measures average days taken to sell inventory
• Inventory turnover– Measures relative size of inventory
Copyright © Cengage Learning. All rights reserved. 14-29
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
Copyright © Cengage Learning. All rights reserved. 14-30
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
Copyright © Cengage Learning. All rights reserved. 14-31
Equity rs'Stockholde Average
IncomeNet Equity on Return
Assets Total Average
IncomeNet Assetson Return
Evaluating Profitability (cont’d)
• Return on equity– Measures profitability of stockholders’ investments
• Return on assets– Measures overall earning power
Copyright © Cengage Learning. All rights reserved. 14-32
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
Copyright © Cengage Learning. All rights reserved. 14-33
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
Copyright © Cengage Learning. All rights reserved. 14-34
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
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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
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Assets Total Average
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
Copyright © Cengage Learning. All rights reserved. 14-37
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
Copyright © Cengage Learning. All rights reserved. 14-38
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
Copyright © Cengage Learning. All rights reserved. 14-39
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.
Copyright © Cengage Learning. All rights reserved. 14-40
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