FINANCIAL ACCOUNTING Tools for Business Decision-Making KIMMEL  WEYGANDT  KIESO  TRENHOLM  IRVINE CHAPTER 14: Performance Measurement

SO 1: Understand the concept of sustainable income and indicate how discontinued items are presented. SO 2: Explain and apply horizontal analysis. SO 3: Explain and apply vertical analysis. SO 4: Identify and calculate ratios that are used to analyze liquidity. SO 5: Identify and calculate ratios that are used to analyze solvency. SO 6: Identify and calculate ratios that are used to analyze profitability. SO 7: Understand the limitations of financial analysis. STUDY OBJECTIVES

Sustainable Income The level of profit that is likely to be obtained in the future Differs from actual profit due to irregular revenues, expenses, gains and losses that are included in profit Most common irregular item is discontinued operations

Discontinued Operations Disposal, or availability for sale, of a component of an entity – Separate major line of business or major geographical area of operations that has been disposed of or is for sale – Must be clearly distinguishable operationally and financially

Discontinued Operations: Statement of Financial Position Assets and liabilities are reported separately Valued and reported at lower of carrying amount and fair value, less any anticipated costs of selling – Reported as current or non-current assets or liabilities

Discontinued Operations: Income Statement Segregated from continuing operations and reported separately on the income statement – Shown immediately following profit/loss from continuing operations Consists of two parts: – Profit (loss) from discontinued operations – Gain (loss) on disposal of the segment – Both components are reported net of applicable taxes

Comparative Analysis: Two Tools Horizontal analysis (trend analysis) – A technique to determine the change over time Percentage of base-period amount Percentage change for the period Vertical analysis (common size analysis) Important to review non-financial information as well – Mission, strategy, goals and objectives, management discussion and analysis

Horizontal Percentage of a Base-Period Amount

Horizontal Percentage Change for the Period

Vertical Analysis Expresses each item in a financial statement as a percent of a base amount (total assets or net sales)

Discussion Question Identify some situations when a horizontal or vertical percentage cannot be calculated or is not meaningful.

Comparative Analysis Three types of comparisons: – Intracompany basis – comparisons within a company – Intercompany basis – comparisons between one or more competitor companies – Industry averages

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

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

Working Capital Measures short-term debt paying ability Working Capital = Current Assets – Current Liabilities Current Ratio is a better indicator Higher is better

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.

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

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

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

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

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

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

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

Times Interest Earned Measures ability to meet interest payments as they come due Times Interest Earned = Profit + Interest Expense + Income Tax Expense (EBIT) Interest Expense Higher is better

Cash Total Debt Coverage Measures long-term debt-paying ability from cash provided by operations Cash Total Debt Coverage = Net Cash Provided (Used) by Operating Activities Average Total Liabilities Higher is better

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

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

Relationship Amongst Profitability Ratios

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

Profit Margin Measures the percentage of profit generated by each dollar of sales Profit Margin = Profit Net Sales Higher is better

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

Return on Assets Measures overall profitability of assets – How much is earned on each dollar invested in assets Return on Assets = Profit Average Total Assets Higher is better

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

Earnings per Share (EPS) Measures profit earned on each common share Earnings Per Share = Profit – Preferred Dividends Weighted Average Number of Common Shares Not comparable between companies

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

Payout Ratio Measures % of profit distributed in the form of cash dividends Payout Ratio = Cash Dividends Profit Higher is better for investors seeking income

Dividend Yield Measures rate of return earned from dividends during the year Dividend Yield= Dividend per Share Market Price per Share Higher is better for investors seeking income

Discussion Question Why are the P-E and dividend yield ratios known as market measures?

Limitations of Financial Analysis Can be impacted by – Alternative accounting principles – Professional judgement – Comprehensive income – Diversification – Inflation – Economic factors

Comparing IFRS and ASPE

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