Memorial University of Newfoundland Financial Accounting: Tools for Business Decision-Making Fourth Canadian Edition Prepared by: Peggy Coady Memorial University of Newfoundland & Catherine Seguin University of Toronto Chapter 14

Performance Measurement Chapter 14 Performance Measurement

Sustainable Earnings Likely level of future cash flows is generated by earnings Sustainable earnings is net earnings adjusted for irregular items Discontinued operations Chapter 14

Discontinued Operations Disposal, or availability for sale, of an identifiable operating segment Operating segment Separate business unit with its own financial elements (e.g., revenues, expenses, and cash flows) distinguishable from the rest of the company. Chapter 14

Discontinued Operations Statement of earnings: Earnings (loss) from operations Gain (loss) on disposal of the segment Both components are reported net of applicable taxes in a section entitled Discontinued Operations, which follows Earnings from Continuing Operations Chapter 14

Discontinued Operations Balance sheet Assets (net of liabilities) held for sale segregated and reported at lower of carrying amount and fair value No further depreciation taken Chapter 14

Change in Accounting Principle When the principle used in the current year is different from the one used in the preceding year Voluntary: Permitted, when new principle results in more reliable and relevant presentation Mandatory: Required by standard setters Chapter 14

Change in Accounting Principle Reporting effects Cumulative effect of change reported as adjustment to opening retained earnings in statement of shareholders’ equity New principle used to report current results Prior period statements restated Effects of change detailed in notes Chapter 14

Discussion Question Discuss the adoption of international financial reporting standards (IFRS) as a change in accounting policy. Discussion points: Mandatory change Restatement of opening balances to comply with new standards Note some exemptions permitted where benefit does not exceed cost. Prospective application allowed in those cases. Chapter 14

Comparative Analysis Three types of comparisons: Intracompany basis Intercompany basis Industry averages Chapter 14

Comparative Analysis Three tools: Horizontal analysis Percentage of base-period amount Percentage change for the period Vertical analysis Ratio analysis Chapter 14

Analysis-period amount % of base-period amount Horizontal Analysis Analysis-period amount Base-period amount % of base-period amount 127% 121% 119% 112% 100% ANY COMPANY INC. Assumed Net Sales (in thousands) 2009 2008 2007 2006 2005 $ 6,562.8 $ 6,295.4 $ 6,190.6 $ 5,786.6 $ 5,181.4 Chapter 14

$ amount of change for period Horizontal Analysis $ amount of change for period Base-period amount % change for period Note that the base-period amount changes each year. That is, it is 2005 for the purposes of calculating the change between 2006 and 2005. It becomes 2006 for the purposes of calculating the change between 2007 and 2006; and so on. 4.2% 1.7% 7.0% 11.7% n/a ANY COMPANY INC. Assumed Net Sales (in thousands) 2009 2008 2007 2006 2005 $ 6,562.8 $ 6,295.4 $ 6,190.6 $ 5,786.6 $ 5,181.4 Chapter 14

Vertical Analysis Expresses each item in a financial statement as a percent of a base amount (total assets or net sales) ANY COMPANY, INC. Condensed Balance Sheets December 31 (in thousands) 2009 2008 Assets Amount Percent Current assets Property, plant, and equipment Other assets Total assets $1,496.5 2,888.8 666.2 $5,051.5 29.6% 57.2% 13.2% 100.0% $1,467.7 2,733.3 636.6 $4,837.6 30.1% 56.9% 13.0% Chapter 14

Ratio Analysis Liquidity Ratios: Measure short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash Solvency Ratios: Measure the ability of the company to survive over a long period of time Profitability Ratios: Measure the earnings or operating success of a company for a given period of time Chapter 14

Liquidity Ratios Working capital Current ratio Inventory turnover Days in inventory Receivables turnover Average collection period Cash current debt coverage Chapter 14

Working Capital Measures short-term debt paying ability Working Capital = Current Assets – Current Liabilities Higher is better Chapter 14

Current Ratio Measures short-term debt paying ability Current Ratio = Current Assets Current Liabilities Higher is normally (but not always) better. Be cautious about influences of slow moving inventory and receivables on this ratio Chapter 14

Inventory Turnover Measures liquidity of inventory Inventory Turnover = Cost of Goods Sold Average Inventory Higher is better Chapter 14

Days in Inventory Measures number of days inventory is on hand = 365 Days Inventory Turnover Lower is better Chapter 14

Average Gross Receivables Receivables Turnover Measures liquidity of receivables Receivables Turnover = Net Credit Sales Average Gross Receivables Higher is better Chapter 14

Average Collection Period Measures number of days receivables are outstanding Average Collection Period = 365 Days Receivables Turnover Lower is better Chapter 14

Cash Current Debt Coverage Measures short-term debt-paying ability (cash basis) Cash Current Debt Coverage = Cash Provided (Used) by Operating Activities Average Current Liabilities Higher is better Chapter 14

Solvency Ratios Debt to total assets Free cash flow Times interest earned Cash total debt coverage Chapter 14

Debt to Total Assets Ratio Measures % of total assets provided by creditors Debt to Total Assets = Total Liabilities Total Assets Lower is better Chapter 14

Free Cash Flow Measures cash available for paying dividends or expanding operations Cash Provided (Used) by Operating Activities  Net Capital Expenditures Dividends Paid = Free Cash Flow Higher is better Chapter 14

Earnings Before Interest Expense and Income Tax Expense (EBIT) Times Interest Earned Measures ability to meet interest payments as they come due Times Interest Earned = Earnings Before Interest Expense and Income Tax Expense (EBIT) Interest Expense Higher is better Chapter 14

Cash Total Debt Coverage Measures long-term debt-paying ability (cash basis) Cash Total Debt Coverage = Cash Provided (Used) by Operating Activities Average Total Liabilities Higher is better Chapter 14

Profitability Ratios Corporate Measures Investor Measures Gross profit margin Profit margin Return on assets Asset turnover Return on common shareholders equity Investor Measures Earnings per share (EPS) Price-earnings (P-E) ratio Payout ratio Dividend yield Chapter 14

Discussion Question Why are profitability ratios are subdivided into corporate measures and investor measures? Discussion points: Both investors and creditors are interested in evaluating profitability The investor measures are used by investors to determines whether to purchase the company’s shares for income or growth. The corporate measures relate to the company’s past profitability. Chapter 14

Gross Profit Margin Measures margin between selling price and cost of goods sold Gross Profit Margin = Gross Profit Net Sales Higher is better Chapter 14

Profit Margin Measures net earnings generated by each dollar of sales Net Sales Higher is better Chapter 14

Return on Assets Measures overall profitability of assets Net Earnings Average Total Assets Higher is better Chapter 14

Asset Turnover Measures how efficiently assets are used to generate sales Asset Turnover = Net Sales Average Total Assets Higher is better Chapter 14

Return on Common Shareholders’ Equity Measures overall profitability of shareholders’ investment Return on Common Shareholders’ Equity = Net Earnings – Preferred Dividends Average Common Shareholders’ Equity* *Common shareholders’ equity = Total shareholders’ equity – Preferred shares Higher is better Chapter 14

Earnings per Share (EPS) Measures net earnings earned on each common share Earnings Per Share = Net Earnings – Preferred Dividends Weighted Average Number of Common Shares Not comparable between companies Chapter 14

Price-Earnings (P-E) Ratio Measures relationship between market price per share and earnings per share Price-Earnings Ratio = Share Price Earnings Per Share Higher indicates investors expect favourable earnings in future Chapter 14

Higher is better for investors seeking income Payout Ratio Measures % of earnings distributed in the form of cash dividends Payout Ratio = Cash Dividends Net Earnings Higher is better for investors seeking income Chapter 14

Higher is better for investors seeking income Dividend Yield Measures earnings generated by each share, based on the market price per share Dividend Yield = Dividend per Share Market Price per Share Higher is better for investors seeking income Chapter 14

Limitations of Financial Analysis Can be impacted by Alternative accounting principles Inflation Diversification Professional judgment Chapter 14

Copyright © 2009 John Wiley & Sons Canada, Ltd. All rights reserved Copyright © 2009 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein. Kimmel, Weygandt, Kieso, Trenholm Financial Accounting : Tools for Business Decision-Making, Fourth Canadian Edition © 2008 John Wiley & Sons Canada, Ltd. Chapter 14