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14–1
Chapter 14
Financial Performance Measurement
14–2Copyright © Cengage Learning. All rights reserved.
Starbucks Corporation
From 2005 to 2007, earnings per share increased 43% and net revenues increased 48%
The company ended the fiscal 2007 year with $281 million in total cash and cash equivalents
As you study this chapter, consider what other financial performance measures would be important to investors?
© Royalty Free/ Getty Images
14–3Copyright © Cengage Learning. All rights reserved.
LO1 Financial Performance Measurement
Shows important relationships in the financial statements and relates them to important financial objectives; also called financial statement analysis
Internal External
Top managers
Mid-level managers
Employees
Creditors
Investors
Customers
Users of Financial Information
14–4Copyright © Cengage Learning. All rights reserved.
Management: Financial Objectives and Related Performance Objectives
Able to increase stockholders’ wealthMarket strength
Generate sufficient cash
Cash flow adequacy
Able to survive for many yearsLong-term solvency
Earn a satisfactory net incomeProfitability
Ability to pay bills when dueLiquidity
14–5Copyright © Cengage Learning. All rights reserved.
External Users
Use financial performance measurement to:
past performance present position Assess future earnings
potential and riskAssess future debt
paying ability
© Royalty Free/ Corbis
14–6Copyright © Cengage Learning. 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 profitabilityHigher risk
Investors demand higher expected returns for high risk investments
Creditors demand higher interest rates from high risk companies
14–7Copyright © Cengage Learning. All rights reserved.
Standards of Comparison
When analyzing financial statements, decision makers often use these measures to determine whether the results are favorable or unfavorable:
Rule-of-thumb measures
Past performance
Industry norms
14–8Copyright © Cengage Learning. All rights reserved.
Rule-of-Thumb Measures
General standards that financial analysts or lenders might apply to key ratios
WARNING!
USE WITH CAUTION
May not apply to all companies/industries
measures may simply suggest a need for further investigation
For example
A current ratio (current assets divided by current liabilities) of 2:1 is acceptable.
14–9Copyright © Cengage Learning. All rights reserved.
Past Performance
An improvement over rule-of-thumb measures
basis for judging whether the measure or ratio is improving or deteriorating
helpful in showing possible future trendsPast performance may not be a useful
indicator of adequacy for the future
Comparison of financial measures or ratios of the same company over a period of time
14–10Copyright © Cengage Learning. All rights reserved.
Industry Norms
Limitations: Companies may not be
strictly comparable Diversified companies are
difficult to compare different accounting
procedures often makes companies difficult to compare
Shows how a company compares with other companies in the same industry
Wal-Mart Target
Return on assets
7.8% 6.1%
Profit margin
3.1% 3.4%
Return on equity
19.3% 18.5%
14–11Copyright © Cengage Learning. 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
14–12Copyright © Cengage Learning. All rights reserved.
Executive Compensation
compensation committee on the board determines the company’s top executives compensation and reports to the SEC.
Components of compensation:Annual base salaryIncentive bonusesStock option awards
Starbuck’s CEO received a base salary of $1,190,000, an incentive bonus of an
equal amount, and a stock option award of 550,000 shares of common stock.
© Royalty Free/ Corbis
14–13Copyright © Cengage Learning. All rights reserved.
Discussion: Ethics on the Job
Explain the following statement: As long as chief financial officers and other corporate managers' salaries, bonuses, or promotions are linked to earnings, the temptation to manage earnings will remain a problem.
A manager whose bonus or salary is tied to corporate performance stands to benefit personally if he or she boosts earnings, even if artificially so. This places an ethical dilemma before the officers of a corporation.
14–14Copyright © Cengage Learning. All rights reserved.
Stop & Review
Q. What performance objective is tied to the financial objective of liquidity?
A. The ability to pay bills when due and to meet unexpected needs for cash
14–15Copyright © Cengage Learning. All rights reserved.
Stop & Review
Q. Why would you expect the investment risk to be lower for a well-established, stable company?
A. Able to review prior performance and trends and predict future profitability with greater assurance than a newer company
14–16Copyright © Cengage Learning. All rights reserved.
Stop & Review
Q. What three measures of comparison are often used to determine whether financial results are favorable or unfavorable?
A. Rule-of-thumb measures; past performance; industry norms
14–17Copyright © Cengage Learning. All rights reserved.
LO2 Horizontal Analysis
AmountYear Base
Change ofAmount Change Percentage
Computes changes from the previous year to the current year divided by the previous year
14–18Copyright © Cengage Learning. All rights reserved.
Starbucks’ Horizontal Analysis
(Dollar amounts in thousands) 2007 2006 Amount Percentage
Net revenues 9,411,497$ 7,786,942$ 1,624,555$ 20.9Cost of sales, including occupancy costs 3,999,124 3,178,791 820,333 25.8Gross margin 5,412,373$ 4,608,151$ 804,222$ 17.5Operating expenses: Store operating expenses 3,215,889$ 2,687,815$ 528,074$ 19.6 Other operating expenses 294,136 253,724 40,412 15.9 Deprec. and amortization expenses 467,160 387,211 79,949 20.6 General and adminstrative expenses 489,249 479,386 9,863 2.1 Total operating expenses 4,466,434$ 3,808,136$ 658,298$ 17.3Operating income 945,939$ 800,015$ 145,924$ 18.2Other income, net 110,425 106,228 4,197 4Income before income taxes 1,056,364$ 906,243$ 150,121$ 16.6Provision for income taxes 383,726 324,770 58,956 18.2Net income 672,638$ 581,473$ 91,165$ 15.7
Increase (Decrease)
Starbucks CorporationConsolidated Income Statements
For the Years Ended September 30, 2007, and October 1, 2006
14–19Copyright © Cengage Learning. All rights reserved.
Trend Analysis
Calculation of changes for several years
2007 2006 2005 2004 2003
Dollar values(In thousands)Net revenues $9,411,497 $7,786,942 $6,369,300 $5,294,247 $4,075,522Operating income 945,939 800,015 703,870 549,460 386,317
Trend analysis(In percentages)Net revenues 230.9 191.1 156.3 129.9 100.0Operating income 244.9 207.1 182.2 142.2 100.0
Starbucks CorporationNet Revenues and Operating Income
Trend Analysis
AmountYear Base
AmountYear Index Index Uses an index
number
14–20Copyright © Cengage Learning. All rights reserved.
Vertical Analysisor Common-Size Statement
how the 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 statement, expressed entirely in percentages,
14–21Copyright © Cengage Learning. All rights reserved.
Starbucks Common-Size Income Statement
2007* 2006*
Net revenues 100.0 % 100.0 %Cost of sales, including occupancy costs 42.5 40.8Gross margin 57.5 % 59.2 %Operating expenses: Store operating expenses 34.2 % 34.5 % Other operating expenses 3.1 3.3 Depreciation and amortization expenses 5.0 5.0 General and administrative expenses 5.2 6.2 Total operating expenses 47.5 % 48.9 %Operating income 10.1 % 10.3 %Other income, net 1.2 1.4Income before income taxes 11.2 % 11.6 %Provision for income taxes 4.1 4.2Net income 7.1 % 7.2 %
*Percentages don't always add up due to rounding.
Starbucks CorporationCommon-Size Income Statements
For the Years Ended September 30, 2007 and October 1, 2006All other figures are expressed in relation to net
revenues
Cost of sales including
occupancy costs is 42.5% of net
revenues; depreciation and
amortization expenses is 5.0% of net revenues
14–22Copyright © Cengage Learning. 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 sales to net income 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
14–23Copyright © Cengage Learning. All rights reserved.
Stop & Review
Q. If you were asked to perform a vertical analysis of an income statement, which figure would you set to 100 percent?
A. Net sales or net revenues
14–24Copyright © Cengage Learning. All rights reserved.
Stop & Review
Q. What is the difference between trend analysis and horizontal analysis?
A. Horizontal analysis compares two years while trend analysis compares several consecutive years.
14–25Copyright © Cengage Learning. All rights reserved.
Stop & Review
Q. The CEO of Roundtable Industries would like to know how the company’s sales and expenses have changed since the last year. Which type of analysis would be most useful?
A. Horizontal analysis of the income statement
14–26Copyright © Cengage Learning. All rights reserved.
LO3 Illustration of Ratio Analysis Evaluating Liquidity
Selected liquidity ratios for Starbucks:2006
Current Assets $1,696,487Current Liabilities $2,155,566
Current Ratio
2007
0.8 times= = 0.8 times=
2006Net Sales $9,411,497
Average A/R ($287,925 + $224,271) ÷ 2Receivable Turnover
2007
37.5 times= = 36.7 times=
2006Cost of Goods Sold $3,999,124Average Inventory ($691,658 + $636,222) ÷ 2
Inventory Turnover
2007
5.4 times= = 6.0 times=
Starbuck’s management of receivables declined while inventory improved from 2003 to 2004.
The company has insufficient current assets to cover current liabilities.
14–27Copyright © Cengage Learning. All rights reserved.
Evaluating Profitability
2006Net Income $672,638Net Sales $9,411,497
Profit Margin
2007
7.2%= = 7.1%=
Selected profitability ratios for Starbucks:
2006Net Income $672,638
Average Stockholders' Equity $2,256,312Return on Equity
2007
26.1%= = 29.8%=
Starbucks is doing a slightly worse job of managing its costs per dollar of sales in 2007.
From 2006 to 2007 return on assets weakened but return on equity improved.
2006Net Income $672,638
Average Total Assets $4,886,410Return on Assets
2007
14.2%= = 13.8%=
14–28Copyright © Cengage Learning. All rights reserved.
Evaluating Long-Term Solvency
Solvency ratio for Starbucks:2006
Total Liabilities $3,059,761Stockholders' Equity $2,284,117
Debt-to-Equity Ratio
2007
1.0 times= = 1.3 times=
Long-term solvency means that a company is expected to survive for many years.
Increased debt may mean it is becoming too heavily leveraged and can result in bankruptcy
shows the amount of assets provided by creditors in relation to the amount provided by stockholders.
The ratio increased from 2003 to 2004 – indicating an increased reliance on debt financing.
14–29Copyright © Cengage Learning. All rights reserved.
Evaluating Cash Flow Adequacy
2006Net Cash Flows from Operating Activities $1,331,221
Net Income $672,638Cash Flow
2007
2.0 times= = 2.0 times=
2006Net Cash Flows from Operating Activities $1,331,221
Net Sales $9,411,497Cash Flows
to Sales
2007
14.5%= = 14.1%=
Selected cash flow adequacy ratios for Starbucks:
The cash flow yield was stable from 2006 to 2007.
The cash-generating ability of sales decreased from 2006 to 2007.
14–30Copyright © Cengage Learning. All rights reserved.
Evaluating Market Strength
Market price indicates how investors view the potential risk and return associated with owning the stock.
Ratios that combine market price with earnings or dividends help measure investors’ confidence in a company.
Starbucks' 2006Market Price per Share $27.08
Earnings per Share $0.90Price/Earnings
Ratio
2007
45.6 times= = 30.1 times=
© Royalty Free/ Corbis
14–31Copyright © Cengage Learning. All rights reserved.
Internet Research: Starbucks
Locate an investors guide or stock analysis website and find a current analysis of Starbucks’ stock (SBUX). Is the company considered a “buy,” “hold,” or “sell” stock? What discussion is provided that supports this opinion?
14–32Copyright © Cengage Learning. All rights reserved.
Performance Evaluation at Harley Davidson
View this video to learn more about how companies like Harley
Davidson evaluate their progress and
performance.
14–33Copyright © Cengage Learning. All rights reserved.
Stop & Review
Q. Why might some investors find liquidity a more immediate goal than profitability?
A. Some investors may feel that without sufficient cash to pay for debts, the company will not survive long enough to be profitable
14–34Copyright © Cengage Learning. All rights reserved.
Stop & Review
Q. What types of ratios help investors determine liquidity?
A. Current, quick, receivable turnover, days’ sales uncollected, inventory turnover, days’ inventory on hand, payables turnover, days’ payable
14–35Copyright © Cengage Learning. All rights reserved.
Chapter Review Problem
The balance sheet and income statement for Tray Companies are presented on the following screens. As a prospective investor, review the statements and analyze the company’s performance as required in the next five steps.
Required: 1. Perform a vertical analysis of the income statement. 2. How well is the company prepared to cover its current liabilities? 3. What is the company’s profit margin? How well does it compare to the
industry norm of 9 percent? 4. Cash flows from operating activities were $563,535. What was the cash
flow yield? 5. What is the return on assets? Total assets at the beginning of the year were
$3,095,440.
14–36Copyright © Cengage Learning. All rights reserved.
Chapter Review Problem
Net revenues 1,435,339.00$ Cost of sales 765,339.00 Gross margin 670,000.00$ Operating expenses Store operating expenses 174,930.00 Other operating expenses 121,861.00 Deprec. and amortization expenses 59,539.00 General and adminstrative expenses 85,334.00 Total operating expenses 441,664.00$ Operating income 228,336.00 Other income, net 34,797.00 Income before income taxes 263,133.00$ Provision for income taxes 52,626.60 Net income 210,506.40$
Tray CompaniesIncome Statement
For the Year Ended December 31, 20x6
14–37Copyright © Cengage Learning. All rights reserved.
Chapter Review Problem (cont’d)
AssetsCurrent assets 654,833$ Property, plant, and equipment, net 1,353,659 Long-term investments 935,353 Other assets 65,343 Goodwill 93,335 Other intangible assets 45,338 Total assets 3,147,861$
Liabilities and Stockholders’ EquityCurrent liabilities 353,987$ Deferred income taxes 34,985 Long-term debt and other obligations 1,183,533 Stockholders’ equity 1,575,356 Total liabilities and stockholders' equity 3,147,861$
Balance SheetDecember 31, 20x6
Tray Companies
14–38Copyright © Cengage Learning. All rights reserved.
Chapter Review Problem (Solution)
Net revenues $1,435,339 100.0%Cost of sales 765,339 53.3Gross margin $670,000 46.7%Operating expenses Store operating expenses $174,930 12.2% Other operating expenses 121,861 8.5 Deprec. and amortization expenses 59,539 4.1 General and adminstrative expenses 85,334 5.9 Total operating expenses $441,664 30.8%Operating income $228,336 15.9%Other income, net 34,797 2.4Income before income taxes $263,133 18.3%Provision for income taxes 52,627 3.7Net income $210,506 14.7%
Tray Companies Income Statement
For the Year Ended December 31, 20x6
1.
14–39Copyright © Cengage Learning. All rights reserved.
Chapter Review Problem (cont’d)
2. Current Assets $654,833Current Liabilities $353,987
Current
Ratio= = 1.8 times=
3. Net Income $210,506Net Sales $1,435,339
Profit
Margin= = 14.7%=
This company is performing better than the industry norm of 9 percent.
4. Net Cash Flows from Oper. Activities $563,535Net Income $210,506
Cash Flow Yield
= = 2.7 times=
5. Net Income $210,506Average Total Assets $3,121,651
Return on Assets
= = 6.7%=