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

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.

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 Users of Financial Information Internal External Top managers Mid managers Employees who own stock in the company Creditors Investors Customers who have cooperative agreements with the company Copyright © Cengage Learning. All rights reserved.

Management’s Objectives Liquidity Able to pay bills when due and meet needs for cash Profitability Earn a satisfactory net income Long-term solvency Able to survive for several years Cash flow adequacy Generate sufficient cash through operating, investing, financing activities Market strength Able to increase shareholders’ wealth Copyright © Cengage Learning. All rights reserved.

External Users Creditors Investors Both groups face risks 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.

Past Performance and Current Position 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.

Standards of Comparison Decision makers must judge whether the relationships they have found are favorable or unfavorable Three commonly used standards of comparison: Rule-of-thumb measures Past performance of the company Industry norms Copyright © Cengage Learning. All rights reserved.

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.

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.

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.

Limitations of Industry Norms Companies in the same industry may not be strictly comparable. 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 Companies in the same industry with similar operations may use different acceptable accounting procedures. Copyright © Cengage Learning. All rights reserved.

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.

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.

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 Incentive bonuses Stock option awards Copyright © Cengage Learning. All rights reserved.

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.

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.

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 Copyright © Cengage Learning. All rights reserved.

Starbucks Horizontal Analysis Copyright © Cengage Learning. All rights reserved.

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.

Trend Analysis for Starbucks Copyright © Cengage Learning. All rights reserved.

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.

Starbucks Common-Size Income Statement 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.

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.

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.

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 Hand Payables Turnover Days’ Payable Copyright © Cengage Learning. All rights reserved.

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.

Evaluating Liquidity (cont’d) Receivable turnover – Measures relative size of receivables and effectiveness of credit policies Days’ sales uncollected Measures average days taken to collect receivables Copyright © Cengage Learning. All rights reserved.

Evaluating Liquidity (cont’d) Inventory turnover – Measures relative size of inventory Days’ inventory on hand Measures average days taken to sell inventory Copyright © Cengage Learning. All rights reserved.

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 Turnover Return on Assets Return on Equity Copyright © Cengage Learning. All rights reserved.

Evaluating Profitability (cont’d) Profit margin – Measures net income produced by each sales dollar Asset turnover Measures how efficiently assets are used to produce sales Copyright © Cengage Learning. All rights reserved.

Evaluating Profitability (cont’d) Return on assets – Measures overall earning power Return on equity Measures profitability of stockholders’ investments Copyright © Cengage Learning. All rights reserved.

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.

Evaluating Long-Term Solvency (cont’d) 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 Interest coverage ratio Measure of creditors’ protection from default on interest payments Copyright © Cengage Learning. All rights reserved.

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 sales Cash flows to assets Free cash flow Copyright © Cengage Learning. All rights reserved.

Evaluating Cash Flow Adequacy (cont’d) Cash flow yield – Measures overall ability to generate operating cash flows in relation to net income Cash flows to sales Measures ability of sales to generate operating cash flows Copyright © Cengage Learning. All rights reserved.

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.

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.

Evaluating Market Strength (cont’d) Price/earnings ratio – Measures investor confidence in a company Dividends yield Measures a stock’s current return to an investor in the form of dividends Copyright © Cengage Learning. All rights reserved.

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.

Chapter Review Describe the objectives, standards of comparison, sources of information, and compensation issues in measuring financial performance. Apply horizontal analysis, trend analysis, vertical analysis, and ratio analysis to financial statements. Apply ratio analysis to financial statements in a comprehensive evaluation of a company’s financial performance. Textbook definition of free cash flow is different from the definition that we use in finance Copyright © Cengage Learning. All rights reserved.