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

2. 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
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3. 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
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4. External Users Use financial performance measurement to:
Judge past and present position
Assess future earnings potential and risk
Assess future debt paying ability
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5. 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
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6. 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
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7. 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%
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8. 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
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9. 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
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10. 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.
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11. Horizontal Analysis
Computes changes from the previous year to the current year in both dollar amounts and percentages
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12. Starbucks’ Horizontal Analysis
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13. Calculation of percentage changes for several successive years
Trend Analysis
Calculation of percentage changes for several successive years
Uses an index
number
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14. 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.
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15. 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
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16. 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
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17. 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.
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18. 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.
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19. 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
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20. 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.
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21. 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.
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