Chapter 13 `

2 Chapter 13 Performance Measurement After studying Chapter 13, you should be able to: zUnderstand the concept of sustainable income. zIndicate how irregular items are presented. zExplain the concept of comprehensive income. zDescribe and apply horizontal analysis. zDescribe and apply vertical analysis.

3 After studying Chapter 13, you should be able to: zIdentify and compute ratios used in analyzing a company’s liquidity, solvency, and profitability. zUnderstand the concept of quality of earnings. Chapter 13 Performance Measurement

4 Sustainable Income... zIs the most likely level of income to be obtained in the future. zDoes not include irregular revenues, expenses, gains, or losses.

5 Irregular Items Three types of irregular items are reported -- (all net of taxes) zdiscontinued operations zextraordinary items zchanges in accounting principle

6 Discontinued Operations... Refers to the disposal of a significant segment of a business... ythe elimination of a major class of customers or yan entire activity.

7 Extraordinary Items... Are events and transactions that meet two conditions: yUnusual in nature yInfrequent in occurrence

Extraordinary Items

9 Change in Accounting Principle zOccur when the principle used in the current year is different from the one used in the preceding year. zIs permitted, when ymanagement can show that the new principle is preferable to the old and ythe effects of the change are clearly disclosed in the income statement. zExamples: y a change in depreciation methods (such as declining-balance to straight-line) ya change in inventory costing methods (such as FIFO to average cost).

10 zThe new principle should be used in reporting the results of operations of the current year. zThe cumulative effect of the change on all prior-year income statements should be disclosed net of applicable taxes in a special section immediately preceding net income. Change in Accounting Principle

Rozek Inc. Partial Income Statement For the Year Ended December 31, 2004 Income before income taxes $800,000 Income tax expense 240,000 Income from continuing operations 560,000 Discontinued operations Loss from disposal of chemical division, net of $90,000 income tax saving (210,000) Net income before extraordinary item 350,000 Extraordinary item Expropriation of investment, net of $21,000 income tax saving (49,000) Cumulative effect of change in accounting principle Effect on prior years of change in depreciation method, net of $ 7,200 tax (16,800) Net Income 284,200

12 SUMMARY When evaluating a company, it generally makes sense to eliminate all irregular items. Estimating Sustainable Income

13 Comprehensive Income... Includes all changes in stockholders' equity during a period except those resulting from investments by stockholders and distributions to stockholders.

14 zThe FASB now requires that, in addition to reporting net income, a company must also report comprehensive income. Comprehensive Income

15 zMost revenues, expenses, gains, and losses recognized during the period are included in net income. zSpecific exceptions to this practice have developed - these items bypass income and are reported directly in stockholders’ equity. Comprehensive Income

16 Unrealized gains and losses on available-for-sale securities are excluded from net income because disclosing them separately - yreduces the volatility of net income due to fluctuations in fair value, yet yinforms the financial statement user of the gain or loss that would be incurred if the securities were sold at fair value. Comprehensive Income

17 zWhether the amount represents an increase over prior years, or whether it is adequate in relation to the company's needs, cannot be determined from the amount alone. zThe amount must be compared with other financial data to provide more information. Comparative Analysis

18 There are three types of comparisons to provide decision usefulness of financial information: zIntracompany basis zIntercompany basis zIndustry averages Comparative Analysis

19 Intracompany Basis zComparisons within a company are often useful to detect changes in financial relationships and significant trends. zA comparison of Kellogg's current year's cash amount with the prior year's cash amount shows either an increase or a decrease. zA comparison of Kellogg's year-end cash amount with the amount of total assets at year-end shows the proportion of total assets in the form of cash.

20 Intercompany Basis zComparisons with other companies provide insight into a company's competitive position. zKellogg's total sales for the year can be compared with the total sales of its competitors such as Quaker Oats and General Mills.

21 zComparisons with industry averages provide information about a company's relative position within the industry. zKellogg's financial data can be compared with the averages for its industry compiled by financial ratings organizations such as Dun & Bradstreet, Moody's, and Standard & Poor's. Industry Averages

22 Financial Statement Analysis Three basic tools are used in financial statement analysis : 1.Horizontal analysis 2.Vertical analysis 3.Ratio analysis

23 Horizontal Analysis zIs a technique for evaluating a series of financial statement data over a period of time. zPurpose is to determine whether an increase or decrease has taken place. zThe increase or decrease can be expressed as either an amount or a percentage.

24 CURRENT-YEAR AMOUNT - BASE-YEAR AMOUNT BASE-YEAR AMOUNT Horizontal Analysis

25 Percentage Change in Sales The percentage change in sales for each of the 5 years, assuming 1997 as the base period is: Kellogg Company Net Sales (in millions) Base Period $8,853.3 $6,954.7 $6,984.2 $ $6, % % % 99% 100.0%

26 Horizontal Analysis of a Balance Sheet KELLOGG COMPANY, INC. Condensed Balance Sheets December 31 (In millions) Increase (Decrease) during Amount Percent Assets Current Assets $1,902.0 $1,617.1 $ Plant assets 2, , Other assets5, , Total assets $10,368.6 $4,886.0 $5,

Increase (Decrease) during Amount Percent Liabilities and Stockholders' Equity Current liabilities$2,207.6$2,482.3 (274.7) (11.1) Long-term liabilities 7, ,506.25, Total liabilities 9, ,988.55, Stockholders' equity Common stock (10.5) (5.1) Retained earnings and other 1, ,065.7 (52.4) (4.9) Treasury stock (337.1) (374.0) Total stockholders' equity (26.0) (2.9) Total liabilities and stockholders' equity $10,368.6$4,886.0 $5, Horizontal Analysis of a Balance Sheet

KELLOGG COMPANY, INC. Condensed Income Statement For the Years Ended December 31 (In millions) Increase (Decrease) during Amount Percent Net sales$8,853.3 $6,954.7 $1, Cost of goods sold 4, , Gross profit 4, , , Selling & Admin. 3, , Nonrecurring charges (53.2) (61.5) Income from operations 1, Interest expense Other income (expense), net (12.3) 15.4 (27.7) (179.9) Income before taxes (63.6) (7.3) Income tax expense Net income $482.0 $587.7 ($105.7) (18.0)

29 Vertical Analysis zIs a technique for evaluating financial statement data that expresses each item in a financial statement as a percent of a base amount. zTotal assets is always the base amount in vertical analysis of a balance sheet. zNet sales is always the base amount in vertical analysis of an income statement.

KELLOGG COMPANY, INC. Condensed Balance Sheets December 31 (In millions) z Assets Amount Percent Amount Percent Current Assets $1, $1, Property Assets 2, , Other assets 5, Total assets $10, % $4, %

Liabilities and Amount Percent Amount Percent Stockholders' Equity Current liabilities $2, $2, Long-term liabilities 7, , Total liabilities 9, , Stockholders' equity Common stock Retained earnings and other 1, , Treasury stock (337.1) (3.3) (374.0) (7.6) Total stockholders' equity Total liabilities and stockholders' equity $10, $4, KELLOGG COMPANY, INC. Condensed Balance Sheets December 31 (In millions)

KELLOGG COMPANY, INC. Condensed Income Statement For the Years Ended December 31 (In millions) Amount Percent Amount Percent Net sales $8, $6, Cost of goods sold 4, , Gross profit 4, , Selling & Admin. 3, , Nonrecurring Chgs Income operations 1, Interest expense Other income (expense),net (12.3) (0.1) Income before income taxes Income tax expense Net income $ $

33 Condensed Income Statements For the Year Ended December 31, 2001 (in millions) Kellogg Company, Inc. General Mills,Inc Amount Percent Amount Percent Net sales $8, $7, Cost of goods sold 4, , Gross profit 4, , Selling and administrative expenses 3, , Nonrecurring charges Income from operations 1, , Other expenses and revenues (including income taxes) Net income $ $

34 Ratios èThree types: èLiquidity ratios èSolvency ratios èProfitability ratios èCan provide clues to underlying conditions that may not be apparent from an inspection of the individual components. èSingle ratio by itself is not very meaningful.

35 Liquidity Ratios Measure the short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash. WHO CARES? Short-term creditors such as bankers and suppliers

36 zWorking capital zCurrent ratio zCurrent cash debt coverage ratio zInventory turnover ratio zDays in inventory zReceivables turnover ratio zAverage collection period Liquidity Ratios

37 Working Capital Indicates immediate short- term debt-paying ability Current Capital - Current liabilities

38 Current Ratio Indicates short-term debt- paying ability Current Assets Current Liabilities

39 Current Cash Debt Coverage Ratio Indicates short-term debt- paying ability (cash basis) Cash provided by operations Average current liabilities

40 Inventory Turnover Ratio Indicates liquidity of inventory Cost of Goods Sold Average Inventory

41 Indicates liquidity of inventory and inventory management 365 days Inventory Turnover Ratio Days in Inventory

42 Receivables Turnover Ratio Indicates liquidity of receivables Net Credit Sales Average Gross Receivables

43 Average Collection Period Indicates liquidity of receivables and collection success 365 days Receivables Turnover Ratio

44 Solvency Ratios Measure the ability of the enterprise to survive over a long period of time WHO CARES? Long-term creditors and stockholders

45 zDebt to total assets ratio zCash debt coverage ratio zTimes interest earned ratio zFree cash flow Solvency Ratios Illustration 13-18

46 Debt to Total Assets Ratio Indicates % of total assets provided by creditors Total Liabilities Total Assets

47 Cash Debt Coverage Ratio Indicates long-term debt- paying ability (cash basis) Cash provided by operations Average total liabilities

48 Times Interest Earned Ratio Indicates company’s ability to meet interest payments as they come due Net Income Before Interest Expense & Income Tax Interest Expense

49 Indicates cash available for paying dividends or expanding operations Cash Provided By Operations - Capital Expenditures - Dividends Paid Free Cash Flow

50 Profitability Ratios Measure the income or operating success of an enterprise for a given period of time WHO CARES? Everybody WHY? A company’s income affects: éits ability to obtain debt and equity financing éits liquidity position éits ability to grow é

51 zEarnings per share (EPS) zPrice-earnings ratio zGross profit rate zProfit margin ratio zReturn on assets ratio zAssets turnover ratio zPayout ratio zReturn on equity ratio Profitability Ratios

52 Earnings Per Share (EPS) Indicates net income earned on each share of common stock sales Net Income - Preferred Stock Average common shares outstanding

53 Price Earnings Ratio Indicates relationship between market price per share and earnings per share Stock Price Per Share Earnings Per Share

54 Gross Profit Rate Indicates margin between selling price and cost of good sold Gross profit Net sales

55 Profit Margin Ratio Indicates net income generated by each dollar of sales Higher value suggests favorable return on each dollar of sales. Net income Net sales

56 Return On Assets Ratio Reveals the amount of net income generated by each dollar invested Net income Average total assets Higher value suggests favorable efficiency.

57 Asset Turnover Ratio Indicates how efficiently assets are used to generate sales Net sales Average total assets

58 Payout Ratio Indicates % of earnings distributed in the form of cash dividends Cash Dividends Declared on Common Stock Net Income

59 Return on Equity Ratio Indicates profitability of common stockholders’ investment Net income - preferred stock dividends Average common stockholders’ equity

60 Pro Forma Income A measure of the net income generated that usually excludes items that the company thinks are unusual or nonrecurring.