Financial Performance Measurement Skyline College Lecture Notes Chapter 14 Financial Performance Measurement Skyline College Lecture Notes

Financial Performance Measurement Shows important relationships in the financial statements and relates them to important financial objectives; also called financial statement analysis Users of Financial Information Internal External Top managers Mid-level managers Employees who own stock in the company Creditors Investors Customers who have agreements with the company Copyright © Houghton Mifflin Company. All rights reserved.

Management: Financial Objectives and Related Performance Objectives Liquidity Able to pay bills when due and meet unexpected needs for cash Profitability Earn a satisfactory net income Long-term solvency Able to survive for many years Cash flow adequacy Generate sufficient cash through operating, investing, and financing activities Market strength Able to increase stockholders’ wealth Copyright © Houghton Mifflin Company. All rights reserved.

External Users Use financial performance measurement to: Judge past and present position Assess future earnings potential and risk Assess future debt paying ability Copyright © Houghton Mifflin Company. All rights reserved.

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 Copyright © Houghton Mifflin Company. All rights reserved.

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 Copyright © Houghton Mifflin Company. All rights reserved.

Shows how a company compares with other companies in the same industry Industry Norms Shows how a company compares with other companies in the same industry 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 Wal-Mart Target Return on assets 7.8% 6.1% Profit margin 3.1% 3.4% Return on equity 19.3% 18.5% Copyright © Houghton Mifflin Company. All rights reserved.

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 Copyright © Houghton Mifflin Company. All rights reserved.

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. 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. Components of compensation: Annual base salary Incentive bonuses Stock option awards Copyright © Houghton Mifflin Company. All rights reserved.

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. Copyright © Houghton Mifflin Company. All rights reserved.

Horizontal Analysis Computes changes from the previous year to the current year in both dollar amounts and percentages Copyright © Houghton Mifflin Company. All rights reserved.

Starbucks’ Horizontal Analysis Copyright © Houghton Mifflin Company. All rights reserved.

Calculation of percentage changes for several successive years Trend Analysis Calculation of percentage changes for several successive years Uses an index number Copyright © Houghton Mifflin Company. All rights reserved.

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. Copyright © Houghton Mifflin Company. All rights reserved.

Starbucks Common-Size Income Statement All 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 Copyright © Houghton Mifflin Company. All rights reserved.

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 Copyright © Houghton Mifflin Company. All rights reserved.

Evaluating Liquidity Selected liquidity ratios for Starbucks: The company has sufficient current assets to cover current liabilities. Starbuck’s management of receivables and inventory improved from 2003 to 2004. Copyright © Houghton Mifflin Company. All rights reserved.

Evaluating Profitability Selected profitability ratios for Starbucks: 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. Copyright © Houghton Mifflin Company. All rights reserved.

Evaluating Long-Term Solvency Solvency ratio for Starbucks: 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. 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 Copyright © Houghton Mifflin Company. All rights reserved.

Evaluating Cash Flow Adequacy 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. Copyright © Houghton Mifflin Company. All rights reserved.

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. Copyright © Houghton Mifflin Company. All rights reserved.