1. Performance Measurement CHAPTER 14

2. Sustainable Earnings Likely level of future cash flows is generated by earningsLikely level of future cash flows is generated by earnings Sustainable earnings is net earnings adjusted for irregular itemsSustainable earnings is net earnings adjusted for irregular items

3. Irregular Items Three types of irregular items are reported (all net of taxes)Three types of irregular items are reported (all net of taxes) –Discontinued operations –Extraordinary items –Change in accounting principle

4. Discontinued Operations Disposal of a significant segment of a businessDisposal of a significant segment of a business Report separately in statement of earningsReport separately in statement of earnings –Earnings (loss) from continuing operations, and –Earnings (loss) from discontinued operations

5. Discontinued Operations Earnings (loss) from discontinued operations consists of:Earnings (loss) from discontinued operations consists of: –Earnings (loss) from operations and –Gain (loss) on disposal of the segment Both components are reported net of applicable taxes in a section entitled Discontinued Operations, which follows Earnings from Continuing OperationsBoth components are reported net of applicable taxes in a section entitled Discontinued Operations, which follows Earnings from Continuing Operations

6. Extraordinary Items Events and transactions that are:Events and transactions that are: –Infrequent in occurrence –Unusual in nature –Not subject to management determination

7. Change in Accounting Principle Occurs when the principle used in the current year is different from the one used in the preceding yearOccurs when the principle used in the current year is different from the one used in the preceding year Is permitted, when:Is permitted, when: –There has been a change in reporting circumstances, and –Management can show that the new principle is preferable to the old

8. Comparative Analysis Three types of comparisons:Three types of comparisons: –Intracompany basis –Intercompany basis –Industry averages

9. Comparative Analysis Three tools:Three tools: –Horizontal analysis –Vertical analysis –Ratio analysis

10. Horizontal Analysis 127%121%119%112%100% ANY COMPANY INC. Assumed Net Sales (in thousands) 20052004200320022001 $ 6,562.8$ 6,295.4$ 6,190.6$ 5,786.6$ 5,181.4 Change since base period

11. Vertical Analysis Expresses each item in a financial statement as a percent of a base amount (total assets or net sales)Expresses each item in a financial statement as a percent of a base amount (total assets or net sales) ANY COMPANY, INC. Condensed Balance Sheets December 31 (in thousands) 2005 2005 2004 2004 AssetsAmountPercentAmountPercent Current assets Property, plant, and equipment Other assets Total assets $1,496.52,888.8 666.2 666.2$5,051.5 29.6% 29.6% 57.2% 57.2% 13.2% 13.2% 100.0% 100.0%$1,467.72,733.3 636.6 636.6$4,837.6 30.1% 30.1% 56.9% 56.9% 13.0% 13.0% 100.0% 100.0%

12. Liquidity Ratios Measure short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash Profitability Ratios Measure the earnings or operating success of an enterprise for a given period of time Solvency Ratios Measure the ability of the enterprise to survive over a long period of time RevenuesExpenses - = Net Earnings XYZ Co. Since 1892 Ratio Analysis

13. Liquidity Ratios Liquidity Ratios Working capitalWorking capital Current ratioCurrent ratio Cash current debt coverageCash current debt coverage Inventory turnoverInventory turnover Days in inventoryDays in inventory Receivables turnoverReceivables turnover Average collection periodAverage collection period Acid-test (quick) ratioAcid-test (quick) ratio

14. Working Capital Measures short-term debt-paying abilityMeasures short-term debt-paying ability Working Capital = Current Assets – Current Liabilities

15. Current Ratio Measures short-term debt-paying abilityMeasures short-term debt-paying ability Current Ratio = Current Assets Current Liabilities

16. Cash Current Debt Coverage Measures short-term debt-paying ability (cash basis)Measures short-term debt-paying ability (cash basis) Cash Current Debt Coverage = Cash Provided by Operating Activities Average Current Liabilities

17. Inventory Turnover Measures liquidity of inventoryMeasures liquidity of inventory Inventory Turnover = Cost of Goods Sold Average Inventory

18. Days in Inventory Measures number of days inventory is on handMeasures number of days inventory is on hand Days in Inventory = 365 Days Inventory Turnover

19. Receivables Turnover Measures liquidity of receivablesMeasures liquidity of receivables Receivables Turnover = Net Credit Sales Average Gross Receivables

20. Average Collection Period Measures number of days receivables are outstandingMeasures number of days receivables are outstanding Average Collection Period = 365 Days Receivables Turnover

21. Acid-Test Ratio Measures immediate short-term debt-paying abilityMeasures immediate short-term debt-paying ability Acid-Test Ratio = Cash + Short-Term Investments + Net Receivables Current Liabilities

22. Solvency Ratios Debt to total assetsDebt to total assets Cash total debt coverageCash total debt coverage Times interest earnedTimes interest earned Free cash flowFree cash flow

23. Debt to Total Assets Ratio Measures % of total assets provided by creditorsMeasures % of total assets provided by creditors Debt to Total Assets = Total Liabilities Total Assets

24. Cash Total Debt Coverage Measures long-term debt-paying ability (cash basis)Measures long-term debt-paying ability (cash basis) Cash Total Debt Coverage = Cash Provided by Operating Activities Average Total Liabilities

25. Times Interest Earned Measures ability to meet interest payments as they come dueMeasures ability to meet interest payments as they come due Times Interest Earned = Earnings Before Interest Expense and Income Tax Expense (EBIT) Interest Expense

26. Free Cash Flow Measures cash available for paying dividends or expanding operationsMeasures cash available for paying dividends or expanding operations Cash Provided by Operating Activities - Capital Expenditures - Dividends Paid = Free Cash Flow

27. Profitability Ratios Earnings per share (EPS)Earnings per share (EPS) Price-earnings (P-E) ratioPrice-earnings (P-E) ratio Gross profit marginGross profit margin Profit marginProfit margin Return on assetsReturn on assets Asset turnoverAsset turnover Return on common shareholders’ equityReturn on common shareholders’ equity Payout ratioPayout ratio

28. Earnings Per Share (EPS) Measures net earnings earned on each common shareMeasures net earnings earned on each common share Earnings Per Share = Earnings Available to Common Shareholders Average Number of Common Shares

29. Price-Earnings (P-E) Ratio Measures relationship between market price per share and earnings per shareMeasures relationship between market price per share and earnings per share Price-Earnings Ratio = Share Price Earnings Per Share

30. Gross Profit Margin Measures margin between selling price and cost of goods soldMeasures margin between selling price and cost of goods sold Gross Profit Margin = Gross Profit Net Sales

31. Profit Margin Measures net earnings generated by each dollar of salesMeasures net earnings generated by each dollar of sales Profit Margin = Net Earnings Net Sales

32. Return On Assets Measures overall profitability of assetsMeasures overall profitability of assets Return on Assets = Net Earnings Average Total Assets

33. Asset Turnover Measures how efficiently assets are used to generate salesMeasures how efficiently assets are used to generate sales Asset Turnover = Net Sales Average Total Assets

34. Return on Common Shareholders’ Equity Measures profitability of common shareholders’ investmentMeasures profitability of common shareholders’ investment Return on Common Shareholders’ Equity = Net Earnings – Preferred Dividends Average Common Shareholders’ Equity

35. Payout Ratio Measures % of earnings distributed in the form of cash dividendsMeasures % of earnings distributed in the form of cash dividends Payout Ratio = Cash Dividends Net Earnings

36. Quality of Earnings Increased importance today due to recent corporate scandalsIncreased importance today due to recent corporate scandals Can be impacted by alternative accounting principles (variation and discretion in selection of GAAP)Can be impacted by alternative accounting principles (variation and discretion in selection of GAAP) Companies report pro forma earnings which are a non-GAAP earnings measureCompanies report pro forma earnings which are a non-GAAP earnings measure Quality of earnings also affected by improper recognition of revenues and liabilitiesQuality of earnings also affected by improper recognition of revenues and liabilities