OPERATING PERFORMANCE ANALYSIS Chapter 12

CHAPTER 12 OBJECTIVES Explain the objectives for analyzing operating performance. Explain the objectives for analyzing operating performance. Describe the importance of earnings quality in operating performance analysis. Describe the importance of earnings quality in operating performance analysis. Identify characteristics of sustainable earnings. Identify characteristics of sustainable earnings.

CHAPTER 12 OBJECTIVES (CONT.) Distinguish between recurring and non- recurring earnings and explain why they produce different earnings quality. Distinguish between recurring and non- recurring earnings and explain why they produce different earnings quality. Discuss how managerial decisions affect reported income. Discuss how managerial decisions affect reported income. Present a preliminary analysis of a company or industry’s operating performance. Present a preliminary analysis of a company or industry’s operating performance.

OBJECTIVES FOR ANALYZING OPERATING PERFORMANCE Understand the various types of income and attach economic meaning to them Understand the various types of income and attach economic meaning to them Determine the sufficiency and sustainability of corporate earnings Determine the sufficiency and sustainability of corporate earnings Relate those earnings to a firm’s value and share price Relate those earnings to a firm’s value and share price

INCOME AND WEALTH Pervasive concepts Pervasive concepts Wealth is discrete; the amount of goods and services that can be consumed at a given point in time Wealth is discrete; the amount of goods and services that can be consumed at a given point in time Wealth changes: the extent to which the amount wealth increases or decreases in a reporting period Wealth changes: the extent to which the amount wealth increases or decreases in a reporting period Analytical problem: wealth and wealth creation are related to, but not the same as, cash balances and cash flows Analytical problem: wealth and wealth creation are related to, but not the same as, cash balances and cash flows

INCOME AND WEALTH (CONT.) Income theory Income theory The economic view is that income represents the amount of periodic consumption that does not alter a store of wealth The economic view is that income represents the amount of periodic consumption that does not alter a store of wealth Financial reporting bases its perspective of income on economic theory Financial reporting bases its perspective of income on economic theory The financial reporting system measures income as the difference between capital invested at the beginning of a period less net assets at the end of that period The financial reporting system measures income as the difference between capital invested at the beginning of a period less net assets at the end of that period

INCOME AND WEALTH (CONT.) Financial reporting assumes a nominal dollar concept of capital maintenance and adheres to the historical cost concept of asset valuation in measuring income Financial reporting assumes a nominal dollar concept of capital maintenance and adheres to the historical cost concept of asset valuation in measuring income The financial reporting system reports income on a transaction approach (revenue and expense activities) The financial reporting system reports income on a transaction approach (revenue and expense activities)

INCOME AND WEALTH (CONT.) Income composition (Exhibit 12-1) Income composition (Exhibit 12-1) The all-inclusive income concept reports virtually all wealth related transactions in a reporting period The all-inclusive income concept reports virtually all wealth related transactions in a reporting period These transactions are categorized as operating, non-operating, and irregular income items These transactions are categorized as operating, non-operating, and irregular income items

INCOME AND WEALTH (CONT.) Operating income represents wealth created by core business activities Operating income represents wealth created by core business activities Non-operating income results from financing transactions (e.g., interest expense) and non-core activities (e.g., loss on the disposal of fixed assets) Non-operating income results from financing transactions (e.g., interest expense) and non-core activities (e.g., loss on the disposal of fixed assets)

INCOME AND WEALTH (CONT.) Irregular items only sporadically affect income Irregular items only sporadically affect income Often involve substantially monetary amounts Often involve substantially monetary amounts Reported on a net of tax basis Reported on a net of tax basis Cover three types of gains (losses): discontinued business operations, extraordinary (unusual and infrequent) items, and changes in accounting principles Cover three types of gains (losses): discontinued business operations, extraordinary (unusual and infrequent) items, and changes in accounting principles

INCOME AND WEALTH (CONT.) Comprehensive income Comprehensive income Items that affect wealth but are not reported on the income statement (e.g., market adjustments to available-for-sale securities) Items that affect wealth but are not reported on the income statement (e.g., market adjustments to available-for-sale securities) Usually reported as a separate component of shareholders’ equity (i.e., the changes to wealth bypass the income statement) Usually reported as a separate component of shareholders’ equity (i.e., the changes to wealth bypass the income statement)

INCOME AND WEALTH (CONT.) Earnings per share (EPS) Earnings per share (EPS) Reports the amount of income earned by one share of stock Reports the amount of income earned by one share of stock Eliminates the size bias inherent in aggregate income disclosures Eliminates the size bias inherent in aggregate income disclosures Computed as (net income – preferred dividends) / weighted number of outstanding shares of common stock Computed as (net income – preferred dividends) / weighted number of outstanding shares of common stock

INCOME AND WEALTH (CONT.) Capital structure determines EPS disclosure Capital structure determines EPS disclosure A simple capital structure consists of common stock and possibly preferred shares A simple capital structure consists of common stock and possibly preferred shares A complex capital structure includes convertible securities and stock options, which would dilute EPS if they were exercised A complex capital structure includes convertible securities and stock options, which would dilute EPS if they were exercised An entity with a simple capital structure discloses a single EPS number, called basic EPS An entity with a simple capital structure discloses a single EPS number, called basic EPS An entity with a complex capital structure discloses two EPS numbers (dual disclosures), referred to as basic and diluted EPS An entity with a complex capital structure discloses two EPS numbers (dual disclosures), referred to as basic and diluted EPS

EARNINGS QUALITY An assessment as to the extent to which reported income disclosures change an entity’s underlying wealth An assessment as to the extent to which reported income disclosures change an entity’s underlying wealth All income components do not affect wealth in the same manner All income components do not affect wealth in the same manner Analysts must judge the relative worth of the various income disclosures Analysts must judge the relative worth of the various income disclosures

EARNINGS QUALITY (CONT.) Earnings sustainability Earnings sustainability An enterprise’s capacity to produce earnings on a recurring basis An enterprise’s capacity to produce earnings on a recurring basis Permanent in nature (i.e., they occur every reporting period) Permanent in nature (i.e., they occur every reporting period) Fundamental wealth increases Fundamental wealth increases Produced by central business operations Produced by central business operations Highly valued by analysts Highly valued by analysts

EARNINGS QUALITY (CONT.) Transitory earnings are not permanent Transitory earnings are not permanent Marginal wealth increases Marginal wealth increases Result from nonrecurring or intermittently recurring items Result from nonrecurring or intermittently recurring items Not highly valued by analysts Not highly valued by analysts

EARNINGS QUALITY (CONT.) Non-operating income items Non-operating income items Can have a recurring affect on wealth (e.g., interest income) Can have a recurring affect on wealth (e.g., interest income) Can affect wealth sporadically (e.g., corporate restructurings) Can affect wealth sporadically (e.g., corporate restructurings) Corporate restructurings complicate assessment of earnings sustainability Corporate restructurings complicate assessment of earnings sustainability Multiple restructurings reduce earning quality to an even greater degree than those resulting from a single restructuring Multiple restructurings reduce earning quality to an even greater degree than those resulting from a single restructuring

EARNINGS QUALITY (CONT.) The policies and procedures used to determine income define earnings measurement, examples include The policies and procedures used to determine income define earnings measurement, examples include Costing inventory on a FIFO or LIFO basis Costing inventory on a FIFO or LIFO basis Depreciating fixed assets on a straight-line or accelerated basis Depreciating fixed assets on a straight-line or accelerated basis

EARNINGS QUALITY (CONT.) The continual selection of accounting choices that increase income is known as earnings management, examples include a The continual selection of accounting choices that increase income is known as earnings management, examples include a Reluctance to reduce inventory costs to their lower market value Reluctance to reduce inventory costs to their lower market value Overestimation of the life of fixed assets Overestimation of the life of fixed assets

EARNINGS QUALITY (CONT.) Benchmarking Benchmarking Evaluation of one entity’s accounting principles and policies against the those of its competition and against itself over time Evaluation of one entity’s accounting principles and policies against the those of its competition and against itself over time Incompatibility with other firms or inconsistency over time may indicate earnings management Incompatibility with other firms or inconsistency over time may indicate earnings management

EARNINGS QUALITY (CONT.) EARNINGS QUALITY (CONT.) Earnings sufficiency Earnings sufficiency An assessment if an entity generates enough profits to remain viable An assessment if an entity generates enough profits to remain viable Analysts evaluate various profit margins to gain insight Analysts evaluate various profit margins to gain insight Gross profit: revenues minus cost of good sold Gross profit: revenues minus cost of good sold Operating profit: gross profit minus operating expenses Operating profit: gross profit minus operating expenses Net profit: operating expenses minus other revenues and expenses Net profit: operating expenses minus other revenues and expenses

EARNINGS QUALITY (CONT.) Sufficiency indicators Sufficiency indicators High gross and operating profit margins indicate sufficient earnings High gross and operating profit margins indicate sufficient earnings Increasing gross and operating profit margin trends bode well for future earnings sufficiency Increasing gross and operating profit margin trends bode well for future earnings sufficiency Low gross profit and operating profit margins indicate insufficient earnings Low gross profit and operating profit margins indicate insufficient earnings Decreasing gross and operating profit margin trends do not bode well for future earnings sufficiency Decreasing gross and operating profit margin trends do not bode well for future earnings sufficiency

EARNINGS QUALITY (CONT.) Recurring and nonrecurring earnings (Exhibits 12-3 and 12-4) Recurring and nonrecurring earnings (Exhibits 12-3 and 12-4) Correlation among the various profit margins indicate recurring earnings or high earnings quality Correlation among the various profit margins indicate recurring earnings or high earnings quality Lack of correlation among the various profit margins provide evidence of nonrecurring earnings or low earnings quality Lack of correlation among the various profit margins provide evidence of nonrecurring earnings or low earnings quality

EARNINGS QUALITY (CONT.) Operating cash flows should coincide with operating income (Exhibit 12-5) Operating cash flows should coincide with operating income (Exhibit 12-5) Strong correlation between operating income and operating cash flows indicates high earnings quality Strong correlation between operating income and operating cash flows indicates high earnings quality

EARNINGS QUALITY (CONT.) Operating income should coincide with net income Operating income should coincide with net income Constant difference between the two income numbers over time, which is attributable to a constant tax rate, indicates high earnings quality Constant difference between the two income numbers over time, which is attributable to a constant tax rate, indicates high earnings quality Variable differences between the two income numbers over time indicate low earnings quality Variable differences between the two income numbers over time indicate low earnings quality

ANALYSIS OF THE PC INDUSTRY A relationship exists between market share and earnings A relationship exists between market share and earnings Apple’s decreased market share contributed to a decline in earnings, threatened profitability, and raised doubt about earnings sufficiency Apple’s decreased market share contributed to a decline in earnings, threatened profitability, and raised doubt about earnings sufficiency Dell’s rapid increase in market share paved the way for greater earnings Dell’s rapid increase in market share paved the way for greater earnings Market share does not ensure profitability, as Compaq demonstrated in 1998 Market share does not ensure profitability, as Compaq demonstrated in 1998

ANALYSIS OF THE PC INDUSTRY (CONT.) Earnings sufficiency Earnings sufficiency Apple’s failure to generate sufficient earnings towards the end of the period analyzed was the result of Apple’s failure to generate sufficient earnings towards the end of the period analyzed was the result of An erosion of its technological superiority An erosion of its technological superiority Decrease in market share Decrease in market share Diminished technological superiority Diminished technological superiority A lower revenue base with which to cover fixed costs A lower revenue base with which to cover fixed costs Research and development costs that exceeded industry norms Research and development costs that exceeded industry norms

ANALYSIS OF THE PC INDUSTRY (CONT.) Earnings sustainability Earnings sustainability Industry growth contributed to variable profit margins throughout the industry and over time Industry growth contributed to variable profit margins throughout the industry and over time Earnings varied among the four companies analyzed Earnings varied among the four companies analyzed

ANALYSIS OF THE PC INDUSTRY (CONT.) Data indicate that Apple’s earning were less sustainable that its competitors because the company Data indicate that Apple’s earning were less sustainable that its competitors because the company Did not conform to industry manufacturing standards Did not conform to industry manufacturing standards Had an unfavorable cost structure (Exhibits 12-10A and 12-10B) Had an unfavorable cost structure (Exhibits 12-10A and 12-10B) Could not differentiate its products from those of its competitors Could not differentiate its products from those of its competitors