1. Financial Performance Measurement
Chapter 14
Financial Performance Measurement

2. Starbucks Corporation
From 2005 to 2007, earnings per share increased 43% and net revenues increased 48%
The company ended the fiscal 2007 year with $281 million in total cash and cash equivalents
As you study this chapter, consider what other financial performance measures would be important to investors?
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3. LO1 Financial Performance Measurement
Shows important relationships in the financial statements and relates them to important financial objectives; also called financial statement analysis
Users of Financial Information
Internal
External
Top managers
Mid-level managers
Employees
Creditors
Investors
Customers
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4. Management: Financial Objectives and Related Performance Objectives
Liquidity
Ability to pay bills when due
Profitability
Earn a satisfactory net income
Long-term solvency
Able to survive for many years
Cash flow adequacy
Generate sufficient cash
Market strength
Able to increase stockholders’ wealth
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5. External Users Use financial performance measurement to:
past performance
present position
Assess future earnings potential and risk
Assess future debt paying ability
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6. Assessment of Risk Well-established, (stable company)
Can predict future profitability with higher level of confidence
Lower risk
Newly established,
(small company)
Difficult to predict future profitability
Higher risk
Investors demand higher expected returns for high risk investments
Creditors demand higher interest rates from high risk companies
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7. Standards of Comparison
When analyzing financial statements, decision makers often use these measures to determine whether the results are favorable or unfavorable:
Rule-of-thumb measures
Past performance
Industry norms
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8. Rule-of-Thumb Measures
General standards that financial analysts or lenders might apply to key ratios
WARNING!
USE WITH CAUTION
May not apply to all companies/industries
measures may simply suggest a need for further investigation
For example
A current ratio (current assets divided by current liabilities) of 2:1 is acceptable.
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9. Past Performance An improvement over rule-of-thumb measures
Comparison of financial measures or ratios of the same company over a period of time
An improvement over rule-of-thumb measures
basis for judging whether the measure or ratio is improving or deteriorating
helpful in showing possible future trends
Past performance may not be a useful indicator of adequacy for the future
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10. Shows how a company compares with other companies in the same industry
Industry Norms
Shows how a company compares with other companies in the same industry
Limitations:
Companies may not be strictly comparable
Diversified companies are difficult to compare
different accounting procedures often makes companies difficult to compare
Wal-Mart
Target
Return on assets
7.8%
6.1%
Profit margin
3.1%
3.4%
Return on equity
19.3%
18.5%
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11. Sources of Financial Information?
Reports published by the corporation
Annual report
interim financial statements
Reports filed with the SEC
Form 10-K (annual)
Form 10-Q (quarterly)
Business periodicals and credit and investment advisory services
The Wall Street Journal, Forbes, Barron’s
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12. Executive Compensation
Components of compensation:
Annual base salary
Incentive bonuses
Stock option awards
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Starbuck’s CEO received a base salary of $1,190,000, an incentive bonus of an equal amount, and a stock option award of 550,000 shares of common stock.
compensation committee on the board determines the company’s top executives compensation and reports to the SEC.
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13. Discussion: Ethics on the Job
Explain the following statement: As long as chief financial officers and other corporate managers' salaries, bonuses, or promotions are linked to earnings, the temptation to manage earnings will remain a problem.
A manager whose bonus or salary is tied to corporate performance stands to benefit personally if he or she boosts earnings, even if artificially so. This places an ethical dilemma before the officers of a corporation.
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14. Stop & Review
Q. What performance objective is tied to the financial objective of liquidity?
A. The ability to pay bills when due and to meet unexpected needs for cash
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15. Stop & Review
Q. Why would you expect the investment risk to be lower for a well-established, stable company?
A. Able to review prior performance and trends and predict future profitability with greater assurance than a newer company
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16. Stop & Review
Q. What three measures of comparison are often used to determine whether financial results are favorable or unfavorable?
A. Rule-of-thumb measures; past performance; industry norms
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17. LO2 Horizontal Analysis
Computes changes from the previous year to the current year divided by the previous year
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18. Starbucks’ Horizontal Analysis
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19. Calculation of changes for several years
Trend Analysis
Calculation of changes for several years
Uses an index
number
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20. Vertical Analysis or Common-Size Statement
how the components of a financial statement relate to a total figure on the statement
On the balance sheet, set total assets or total liabilities and stockholders’ equity to 100%.
On the income statement, set net sales to 100%.
The statement, expressed entirely in percentages,
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21. Starbucks Common-Size Income Statement
All other figures are expressed in relation to net revenues
Cost of sales including occupancy costs is 42.5% of net revenues; depreciation and amortization expenses is 5.0% of net revenues
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22. Ratio Analysis
Identifies meaningful relationships between the components of the financial statements
Ratios may be expressed in several ways:
Net income is 1/10 of sales
Net income is 10 percent of sales
The ratio of sales to net income is 10 to 1 (10:1)
Sales are 10 times net income
For every dollar of sales, the company has an average net income of 10 cents
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23. Stop & Review
Q. If you were asked to perform a vertical analysis of an income statement, which figure would you set to 100 percent?
A. Net sales or net revenues
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24. Stop & Review
Q. What is the difference between trend analysis and horizontal analysis?
A. Horizontal analysis compares two years while trend analysis compares several consecutive years.
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25. Stop & Review
Q. The CEO of Roundtable Industries would like to know how the company’s sales and expenses have changed since the last year. Which type of analysis would be most useful?
A. Horizontal analysis of the income statement
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26. LO3 Illustration of Ratio Analysis Evaluating Liquidity
Selected liquidity ratios for Starbucks:
The company has insufficient current assets to cover current liabilities.
Starbuck’s management of receivables declined while inventory improved from 2003 to 2004.
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27. Evaluating Profitability
Selected profitability ratios for Starbucks:
Starbucks is doing a slightly worse job of managing its costs per dollar of sales in 2007.
From 2006 to 2007 return on assets weakened but return on equity improved.
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28. Evaluating Long-Term Solvency
Solvency ratio for Starbucks:
shows the amount of assets provided by creditors in relation to the amount provided by stockholders.
The ratio increased from 2003 to 2004 – indicating an increased reliance on debt financing.
Long-term solvency means that a company is expected to survive for many years.
Increased debt may mean it is becoming too heavily leveraged and can result in bankruptcy
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29. Evaluating Cash Flow Adequacy
Selected cash flow adequacy ratios for Starbucks:
The cash flow yield was stable from 2006 to 2007.
The cash-generating ability of sales decreased from 2006 to 2007.
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30. Evaluating Market Strength
Market price indicates how investors view the potential risk and return associated with owning the stock.
Ratios that combine market price with earnings or dividends help measure investors’ confidence in a company.
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31. Internet Research: Starbucks
Locate an investors guide or stock analysis website and find a current analysis of Starbucks’ stock (SBUX). Is the company considered a “buy,” “hold,” or “sell” stock? What discussion is provided that supports this opinion?
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32. Performance Evaluation at Harley Davidson
View this video to learn more about how companies like Harley Davidson evaluate their progress and performance.
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33. Stop & Review
Q. Why might some investors find liquidity a more immediate goal than profitability?
A. Some investors may feel that without sufficient cash to pay for debts, the company will not survive long enough to be profitable
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34. Stop & Review
Q. What types of ratios help investors determine liquidity?
A. Current, quick, receivable turnover, days’ sales uncollected, inventory turnover, days’ inventory on hand, payables turnover, days’ payable
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35. Chapter Review Problem
The balance sheet and income statement for Tray Companies are presented on the following screens. As a prospective investor, review the statements and analyze the company’s performance as required in the next five steps.
Required:
1. Perform a vertical analysis of the income statement.
2. How well is the company prepared to cover its current liabilities?
3. What is the company’s profit margin? How well does it compare to the industry norm of 9 percent?
4. Cash flows from operating activities were $563,535. What was the cash flow yield?
5. What is the return on assets? Total assets at the beginning of the year were $3,095,440.
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36. Chapter Review Problem
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37. Chapter Review Problem (cont’d)
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38. Chapter Review Problem (Solution)1.
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39. Chapter Review Problem (cont’d)2. 3.
This company is performing better than the industry norm of 9 percent. 4. 5.
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