Principles of Accounting 2002e

Principles of Accounting 2002e
Belverd E. Needles, Jr. Marian Powers Susan Crosson Multimedia Slides by: Harry Hooper Santa Fe Community College Copyright © by Houghton Mifflin Company. All rights reserved.

Chapter 18 Financial Performance Evaluation

Copyright © by Houghton Mifflin Company. All rights reserved.
LEARNING OBJECTIVES Describe and discuss financial performance evaluation by internal and external users. Describe and discuss the standards for financial performance evaluation. State the sources of information for financial performance evaluation. Copyright © by Houghton Mifflin Company. All rights reserved.

LEARNING OBJECTIVES (continued)
4. Apply horizontal analysis, trend analysis, and vertical analysis to financial statements. 5. Apply ratio analysis to financial statements in a comprehensive evaluation of a company's financial performance. Copyright © by Houghton Mifflin Company. All rights reserved.

Financial Performance Evaluation by Internal and External Users
OBJECTIVE 1 Describe and discuss financial performance evaluation by internal and external users. Copyright © by Houghton Mifflin Company. All rights reserved.

Financial Performance Evaluation
Financial performance evaluation, also called financial statement analysis, comprises all the techniques employed by users of financial statements to show important relationships in the financial statements. Users of financial statements fall into two broad categories: internal users and external users. Copyright © by Houghton Mifflin Company. All rights reserved. 6

Internal Users Management’s primary objective is to increase the wealth of the owners or stockholders of the business. Management’s main responsibility is to carry out plans to achieve the financial performance objectives. Management develops monthly, quarterly, and annual reports that compare actual performance with objectives for key financial measures. Copyright © by Houghton Mifflin Company. All rights reserved.

External Users Creditors 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 and for both the goal is to achieve a return that makes up for the risk. Copyright © by Houghton Mifflin Company. All rights reserved.

External Users and Risk
In general, the greater the risk taken, the greater the return required as compensation. Any one loan or any one investment can turn out badly. As a result, most creditors and investors put their funds into a portfolio, or a group of loans or investments. The portfolio allows creditors and investors to average both the returns and the risks. Copyright © by Houghton Mifflin Company. All rights reserved.

Uses of Financial Performance Evaluation
Financial performance evaluation is most useful for individual investment or loan decisions. It is in making individual investment or loan decisions that financial statement analysis is most useful. Creditors and investors use financial performance evaluation in two general ways. To judge past performance and current position. To judge future potential and the risk connected with that potential. Copyright © by Houghton Mifflin Company. All rights reserved.

Discussion Q. What role does risk play in making loans and investments? A. Risk refers to the uncertainty of future events. Risk is associated with the ease of predicting the future performance of a loan or investment. The more confident a creditor or investor is in predicting future liquidity or profitability, the less risk is associated with the loan or investment. Copyright © by Houghton Mifflin Company. All rights reserved.

Assessment of Past Performance and Current Position
Past performance is often a good indication of future performance. Current position indicates what assets are owned and how much is owed. Future potential includes the potential debt-paying ability of the company. The riskiness of an investment depends on how easy it is to predict future profitability or liquidity. Copyright © by Houghton Mifflin Company. All rights reserved.

Standards for Financial Performance Evaluation
OBJECTIVE 2 Describe and discuss the standards for financial performance evaluation. Copyright © by Houghton Mifflin Company. All rights reserved.

Standards for Financial Performance Evaluation
Decision makers must judge whether the relationships they have found are favorable or unfavorable. Three commonly used standards of comparison are: Rule-of-thumb measures. A company’s past performance. Industry norms. Copyright © by Houghton Mifflin Company. All rights reserved.

Rule-of-Thumb Measures
The credit-rating firm of Dun & Bradstreet, in its Industry Norms and Key Business Ratios, offers such rules of thumb as the following: Current debt to tangible net worth. Inventory to net working capital. Rule-of-thumb measures must be used with great care. Copyright © by Houghton Mifflin Company. All rights reserved.

Past Performance of the Company
An improvement over rule-of-thumb measures is the comparison of financial measures or ratios of the same company over a period of time. This standard provides a basis for judging whether the measure or ratio is getting better or worse. It may also be helpful in showing possible future trends. Since trends reverse at times, such projections must be made with care. Another problem with trend analysis is that the past may not be a useful measure of adequacy. Copyright © by Houghton Mifflin Company. All rights reserved. 12

Limitations to Using Industry Norms
Two companies that seem to be in the same industry may not be strictly comparable. Copyright © by Houghton Mifflin Company. All rights reserved.

Limitations to Using Industry Norms (continued…)
Most large companies today operate in more than one industry. There are simply no other companies that are similar enough. A requirement by FASB presented in Statement No. 131, states that diversified companies must report revenues, income from operations, and identifiable assets for each of their operating segments. Depending on specific criteria, segment information may be reported for operations in different industries or in different geographical areas, or for major customers. Copyright © by Houghton Mifflin Company. All rights reserved.

Limitations to Using Industry Norms (continued…)
3. Companies in the same industry with similar operations may use different acceptable accounting procedures. Industry norms probably offer the best available standards for judging current performance as long as they are used with care. Copyright © by Houghton Mifflin Company. All rights reserved.

Discussion Q. Why would a financial analyst compare the ratios of Steelco, a steel company, with the ratios of other companies in the steel industry? What factors might invalidate such a comparison? Copyright © by Houghton Mifflin Company. All rights reserved.

Discussion (continued…) A. A financial analyst might compare the ratios of Steelco with those of other steel companies to determine how Steelco’s performance ranks in the industry. This type of analysis might not be valid if Steelco has characteristics that make it different from other steel companies. Copyright © by Houghton Mifflin Company. All rights reserved.

Sources of Information
OBJECTIVE 3 State the sources of information for financial performance evaluation. Copyright © by Houghton Mifflin Company. All rights reserved.

Reports Published by the Company
The annual report of a publicly held corporation is an important source of financial information. The main parts of an annual report are: 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. A summary of operations for a five- or ten-year period. Most publicly held companies also publish interim financial statements, usually each quarter. Copyright © by Houghton Mifflin Company. All rights reserved.

SEC Reports Publicly held corporations must file annual reports, quarterly reports, and current reports with the Securities and Exchange Commission (SEC). The SEC calls for several standard forms, two of which are: The annual report (Form 10-K) that contains more information than the published annual report. The quarterly report (Form 10-Q) presents important facts about interim financial performance. The 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. Copyright © by Houghton Mifflin Company. All rights reserved. 20

Business Periodicals and Credit and Investment Advisory Services
Financial analysts must keep up with current events in the financial world. Sources of financial information include: The Wall Street Journal, Forbes, Barron's, Fortune, and the Financial Times. The publications of Moody's Investors Service, Inc. and Standard & Poor's are useful for further details about the financial history of companies. Copyright © by Houghton Mifflin Company. All rights reserved. 22

Business Periodicals and Credit and Investment Advisory Services (continued…) Data on industry norms, average ratios and relationships, and credit ratings are available from The Dun & Bradstreet Corp. Annual Statement Studies, published by Robert Morris Associates, presents many facts and ratios for 223 different industries. Moody's Handbook of Dividend Achievers profiles companies that have increased their dividends consistently over the past ten years. Copyright © by Houghton Mifflin Company. All rights reserved. 22

Discussion Q. For each of the following pieces of information, indicate whether the best source would be: Reports published by the company. SEC reports. Business periodicals. Credit and investment advisory services. 1. Current market value of a company’s stock. 2. Management’s analysis of the past year’s operations. 3. Objective assessment of a company’s financial performance. 4. Most complete body of financial disclosures. 5. Current events affecting the company. Copyright © by Houghton Mifflin Company. All rights reserved.

Discussion Q. For each of the following pieces of information, indicate whether the best source would be: Reports published by the company. SEC reports. Business periodicals. Credit and investment advisory services. Answers in Red 1. Current market value of a company’s stock 2. Management’s analysis of the past year’s operations 3. Objective assessment of a company’s financial performance 4. Most complete body of financial disclosures 5. Current events affecting the company = c = a = d = b Copyright © by Houghton Mifflin Company. All rights reserved.

Tools and Techniques of Performance Evaluation
OBJECTIVE 4 Apply horizontal analysis, trend analysis, and vertical analysis to financial statements. Copyright © by Houghton Mifflin Company. All rights reserved.

Tools and Techniques of Financial Performance Evaluation
Few numbers are very significant when looked at individually. It is the relationship between various numbers or their change from year to year that is important. The tools of financial performance evaluation are intended to show relationships and changes. Copyright © by Houghton Mifflin Company. All rights reserved.

Horizontal Analysis GAAP require the presentation of comparative financial statements that give financial information for the current year and the previous year. Horizontal analysis begins with the computation of changes from the previous year to the current year. The base year is the first year considered. Horizontal analysis uses both dollar amounts and percentages. Amount of Change Base Year Amount Percentage Change = 100 x ( ) Copyright © by Houghton Mifflin Company. All rights reserved.

Trend Analysis Changes are calculated for several successive years instead of for two years. Trend analysis is important because it may point to basic changes in the nature of a business. Trend analysis uses an index number to show changes in related items over a period of time. ( ) Index Year Amount Base Year Amount Index = 100 x Copyright © by Houghton Mifflin Company. All rights reserved. 26

Trend Analysis Presented Graphically for Sun Microsystems, Inc.
Copyright © by Houghton Mifflin Company. All rights reserved.

Vertical Analysis Percentages are used to show the relationship of the different parts to a total in a single statement. The analyst sets a total figure in the statement equal to 100% and computes each component’s percentage of that total. The statement of percentages is called a common-size statement. Vertical analysis is useful for comparing the importance of specific components in the operation of a business and changes in the components from one year to the next. Copyright © by Houghton Mifflin Company. All rights reserved. 28

Common-Size Balance Sheets Presented Graphically

Common-Size Income Statements Presented Graphically

Ratio Analysis Ratios are guides or shortcuts that are 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. Copyright © by Houghton Mifflin Company. All rights reserved. 30

Discussion Q. What is the difference between horizontal and vertical analysis? A. Horizontal analysis is a year-to-year analysis of the components of a series of financial statements. Vertical analysis, on the other hand, is concerned with the relationship of items within a single financial statement. Copyright © by Houghton Mifflin Company. All rights reserved.

Comprehensive Illustration of Ratio Analysis
OBJECTIVE 5 Apply ratio analysis to financial statements in a comprehensive evaluation of a company’s financial performance. Copyright © by Houghton Mifflin Company. All rights reserved.

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: measures short-term debt-paying ability. Quick ratio: measures short-term debt-paying ability. Receivable turnover: measures relative size of receivables and effectiveness of credit policies. Average days’ sales uncollected: measures average days to collect receivables. Inventory turnover: measures relative size of inventory. Average days’ inventory on hand: measures average days to sell inventory. Average days’ payable: measures average days to pay payables. Copyright © by Houghton Mifflin Company. All rights reserved. 32

Liquidity Current Ratio = Current Assets Current Liabilities Quick Ratio = Cash + Marketable Securities + Receivables Receivable Turnover = Net Sales Average Accounts Receivable Inventory Turnover = Cost of Goods Sold Average Inventory Copyright © by Houghton Mifflin Company. All rights reserved.

Liquidity Average Day’s Inventory = Days in Year on hand Inventory Turnover Payable Turnover = Cost of Goods Sold +/- Change in Inventory Average Accounts Payable Average Day’s Payable = Days in Year Payables Turnover Copyright © by Houghton Mifflin Company. All rights reserved.

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. Profitability ratios include: Profit margin: measures net income produced by each sales dollar. Asset turnover: measures how efficiently assets produce sales. Return on assets: measures overall earning power. Return on equity: measures profitability of stockholder investments. Copyright © by Houghton Mifflin Company. All rights reserved. 34

Profitability Profit Margin = Net Income Net Sales Asset Turnover = Net Sales Average Total Assets Return on Assets = Net Income Return on Equity = Net Income Average Stockholders’ Equity Copyright © by Houghton Mifflin Company. All rights reserved.

Evaluating Long-Term Solvency
Long-term solvency has to do with 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. Early signs that a company is on the road to bankruptcy include: Declining profitability and liquidity ratios. Unfavorable debt to equity ratio. Unfavorable interest coverage ratio. Copyright © by Houghton Mifflin Company. All rights reserved.

Long-Term Solvency Debt to Equity Ratio = Total Liabilities Stockholders’ Equity Measures capital structure and leverage. Failure to honor debt can result in bankruptcy, so debt is risky. BUT debt provides flexible financing: It can be temporary. Interest is tax deductible. It leverages stockholders’ investments if the company earns a return on assets greater than the cost of interest. Copyright © by Houghton Mifflin Company. All rights reserved.

Long-Term Solvency (continued…)
Interest Coverage Ratio = Income Before Income Taxes + Interest Expense Interest Expense Measures creditors’ protection from default on interest payments. Copyright © by Houghton Mifflin Company. All rights reserved.

Evaluating Cash Flow Adequacy
Because cash flows are needed to pay debts when they are due, cash flow measures are closely related to the objectives of liquidity and long-term solvency. Net cash flows from operating activities. Cash flow yield: measures overall operating liability to generate cash flows in relation to net income. Cash flows to sales: measures ability of sales to generate cash. Cash flows to assets: measures ability of assets to generate cash. Free cash flow: measures cash generated after providing for commitments. Copyright © by Houghton Mifflin Company. All rights reserved.

Cash Flow Adequacy Cash Flow Yield = Net Cash Flows from Operating Activities Net Income Cash Flows to Sales = Net Cash Flows from Operating Activities Net Sales Cash Flows to Assets = Net Cash Flows from Operating Activities Average Total Assets Free Cash Flow = N.C.F. from O.A. – Dividends – Net Capital Expenditures Copyright © by Houghton Mifflin Company. All rights reserved.

Evaluating Market Strength
Market price is the price at which people are willing to buy or sell the stock. Market price provides information about how investors view the potential return and risk connected with owning the company's stock. Market price by itself is not very informative. Market price must be related to earnings by considering the price/earnings ratio and the dividends yield. Copyright © by Houghton Mifflin Company. All rights reserved. 43

Market Strength Ratios
Price/Earnings Ratio = Market Price per Share Earnings per Share Measures investor confidence in a company. Is useful for comparing the value placed on a company’s shares in relation to the overall market. Dividends Yield = Dividends per Share Market Price per Share Measures a stock’s current return to an investor. Copyright © by Houghton Mifflin Company. All rights reserved. 43

Discussion 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. Copyright © by Houghton Mifflin Company. All rights reserved.

OK, LET’S REVIEW . . . Describe and discuss financial performance evaluation by internal and external users. Describe and discuss the standards for financial performance evaluation. State the sources of information for financial performance evaluation. Copyright © by Houghton Mifflin Company. All rights reserved.

AND FINALLY . . . Apply horizontal analysis, trend analysis, and vertical analysis to financial statements. Apply ratio analysis to financial statements in a comprehensive evaluation of a company's financial performance. Copyright © by Houghton Mifflin Company. All rights reserved.

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