1. Financial Performance Measurement
Chapter 14
Financial Performance Measurement
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2. Foundations of Financial Performance Measurement
Objective 1
Describe the objectives, standards of comparison, sources of information, and compensation issues in measuring financial performance.
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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
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
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4. 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
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5. 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
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6. 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
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7. 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
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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
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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
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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
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11. 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.
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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.
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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
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14. 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
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15. Tools and Techniques of Financial Analysis
Objective 2
Apply horizontal analysis, trend analysis, vertical analysis, and ratio analysis to financial statements.
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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
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17. 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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18. Starbucks Horizontal Analysis
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19. 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
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20. Trend Analysis for Starbucks
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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
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22. 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
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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.
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24. Comprehensive Illustration of Ratio Analysis
Objective 3
Apply ratio analysis to financial statements in a comprehensive evaluation of a company’s financial performance.
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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 Hand
Payables Turnover
Days’ Payable
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26. Evaluating Liquidity (cont’d)
Current ratio
Measures short-term debt-paying ability
• Quick ratio
– Also measures short-term debt-paying ability
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27. 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
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28. Evaluating Liquidity (cont’d)
Inventory turnover
– Measures relative size of inventory
Days’ inventory on hand
Measures average days taken to sell inventory
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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 Turnover
Return on Assets
Return on Equity
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30. 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
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31. Evaluating Profitability (cont’d)
Return on assets
– Measures overall earning power
Return on equity
Measures profitability of stockholders’ investments
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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
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33. 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
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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 sales
Cash flows to assets
Free cash flow
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35. 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
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36. Evaluating the Adequacy of Cash Flows (cont’d)
Cash flow to assets
– Measures ability of assets to generate operating cash flows
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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
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38. 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
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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.
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40. 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
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