14–1 chapter 14 financial performance measurement

14–1

Chapter 14

Financial Performance Measurement

14–2Copyright © Cengage Learning. All rights reserved.

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?

© Royalty Free/ Getty Images


LO1 Financial Performance Measurement

Shows important relationships in the financial statements and relates them to important financial objectives; also called financial statement analysis

Internal External

Top managers

Mid-level managers

Employees

Creditors

Investors

Customers

Users of Financial Information


Management: Financial Objectives and Related Performance Objectives

Able to increase stockholders’ wealthMarket strength

Generate sufficient cash

Cash flow adequacy

Able to survive for many yearsLong-term solvency

Earn a satisfactory net incomeProfitability

Ability to pay bills when dueLiquidity


External Users

Use financial performance measurement to:

past performance present position Assess future earnings

potential and riskAssess future debt

paying ability

© Royalty Free/ Corbis


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 profitabilityHigher risk

Investors demand higher expected returns for high risk investments

Creditors demand higher interest rates from high risk companies


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


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.


Past Performance

An improvement over rule-of-thumb measures

basis for judging whether the measure or ratio is improving or deteriorating

helpful in showing possible future trendsPast performance may not be a useful

indicator of adequacy for the future

Comparison of financial measures or ratios of the same company over a period of time


Industry Norms

Limitations: Companies may not be

strictly comparable Diversified companies are

difficult to compare different accounting

procedures often makes companies difficult to compare

Shows how a company compares with other companies in the same industry

Wal-Mart Target

Return on assets

7.8% 6.1%

Profit margin

3.1% 3.4%

Return on equity

19.3% 18.5%


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


Executive Compensation

compensation committee on the board determines the company’s top executives compensation and reports to the SEC.

Components of compensation:Annual base salaryIncentive bonusesStock option awards

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.



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.


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


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


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


LO2 Horizontal Analysis

AmountYear Base

Change ofAmount Change Percentage

Computes changes from the previous year to the current year divided by the previous year


Starbucks’ Horizontal Analysis

(Dollar amounts in thousands) 2007 2006 Amount Percentage

Net revenues 9,411,497$ 7,786,942$ 1,624,555$ 20.9Cost of sales, including occupancy costs 3,999,124 3,178,791 820,333 25.8Gross margin 5,412,373$ 4,608,151$ 804,222$ 17.5Operating expenses: Store operating expenses 3,215,889$ 2,687,815$ 528,074$ 19.6 Other operating expenses 294,136 253,724 40,412 15.9 Deprec. and amortization expenses 467,160 387,211 79,949 20.6 General and adminstrative expenses 489,249 479,386 9,863 2.1 Total operating expenses 4,466,434$ 3,808,136$ 658,298$ 17.3Operating income 945,939$ 800,015$ 145,924$ 18.2Other income, net 110,425 106,228 4,197 4Income before income taxes 1,056,364$ 906,243$ 150,121$ 16.6Provision for income taxes 383,726 324,770 58,956 18.2Net income 672,638$ 581,473$ 91,165$ 15.7

Increase (Decrease)

Starbucks CorporationConsolidated Income Statements

For the Years Ended September 30, 2007, and October 1, 2006


Trend Analysis

Calculation of changes for several years

2007 2006 2005 2004 2003

Dollar values(In thousands)Net revenues $9,411,497 $7,786,942 $6,369,300 $5,294,247 $4,075,522Operating income 945,939 800,015 703,870 549,460 386,317

Trend analysis(In percentages)Net revenues 230.9 191.1 156.3 129.9 100.0Operating income 244.9 207.1 182.2 142.2 100.0

Starbucks CorporationNet Revenues and Operating Income

Trend Analysis

AmountYear Base

AmountYear Index Index Uses an index

number


Vertical Analysisor 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,


Starbucks Common-Size Income Statement

2007* 2006*

Net revenues 100.0 % 100.0 %Cost of sales, including occupancy costs 42.5 40.8Gross margin 57.5 % 59.2 %Operating expenses: Store operating expenses 34.2 % 34.5 % Other operating expenses 3.1 3.3 Depreciation and amortization expenses 5.0 5.0 General and administrative expenses 5.2 6.2 Total operating expenses 47.5 % 48.9 %Operating income 10.1 % 10.3 %Other income, net 1.2 1.4Income before income taxes 11.2 % 11.6 %Provision for income taxes 4.1 4.2Net income 7.1 % 7.2 %

*Percentages don't always add up due to rounding.

Starbucks CorporationCommon-Size Income Statements

For the Years Ended September 30, 2007 and October 1, 2006All 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


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


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


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.


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


LO3 Illustration of Ratio Analysis Evaluating Liquidity

Selected liquidity ratios for Starbucks:2006

Current Assets $1,696,487Current Liabilities $2,155,566

Current Ratio

2007

0.8 times= = 0.8 times=

2006Net Sales $9,411,497

Average A/R ($287,925 + $224,271) ÷ 2Receivable Turnover

2007


2006Cost of Goods Sold $3,999,124Average Inventory ($691,658 + $636,222) ÷ 2

Inventory Turnover

2007


Starbuck’s management of receivables declined while inventory improved from 2003 to 2004.

The company has insufficient current assets to cover current liabilities.


Evaluating Profitability

2006Net Income $672,638Net Sales $9,411,497

Profit Margin

2007

7.2%= = 7.1%=

Selected profitability ratios for Starbucks:

2006Net Income $672,638

Average Stockholders' Equity $2,256,312Return on Equity

2007

26.1%= = 29.8%=

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.

2006Net Income $672,638

Average Total Assets $4,886,410Return on Assets

2007

14.2%= = 13.8%=


Evaluating Long-Term Solvency

Solvency ratio for Starbucks:2006

Total Liabilities $3,059,761Stockholders' Equity $2,284,117

Debt-to-Equity Ratio

2007


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

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.


Evaluating Cash Flow Adequacy

2006Net Cash Flows from Operating Activities $1,331,221

Net Income $672,638Cash Flow

2007


2006Net Cash Flows from Operating Activities $1,331,221

Net Sales $9,411,497Cash Flows

to Sales

2007

14.5%= = 14.1%=

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.


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.

Starbucks' 2006Market Price per Share $27.08

Earnings per Share $0.90Price/Earnings

Ratio

2007




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?


Performance Evaluation at Harley Davidson

View this video to learn more about how companies like Harley

Davidson evaluate their progress and

performance.


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


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


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.


Chapter Review Problem

Net revenues 1,435,339.00$ Cost of sales 765,339.00 Gross margin 670,000.00$ Operating expenses Store operating expenses 174,930.00 Other operating expenses 121,861.00 Deprec. and amortization expenses 59,539.00 General and adminstrative expenses 85,334.00 Total operating expenses 441,664.00$ Operating income 228,336.00 Other income, net 34,797.00 Income before income taxes 263,133.00$ Provision for income taxes 52,626.60 Net income 210,506.40$

Tray CompaniesIncome Statement

For the Year Ended December 31, 20x6


Chapter Review Problem (cont’d)

AssetsCurrent assets 654,833$ Property, plant, and equipment, net 1,353,659 Long-term investments 935,353 Other assets 65,343 Goodwill 93,335 Other intangible assets 45,338 Total assets 3,147,861$

Liabilities and Stockholders’ EquityCurrent liabilities 353,987$ Deferred income taxes 34,985 Long-term debt and other obligations 1,183,533 Stockholders’ equity 1,575,356 Total liabilities and stockholders' equity 3,147,861$

Balance SheetDecember 31, 20x6

Tray Companies


Chapter Review Problem (Solution)

Net revenues $1,435,339 100.0%Cost of sales 765,339 53.3Gross margin $670,000 46.7%Operating expenses Store operating expenses $174,930 12.2% Other operating expenses 121,861 8.5 Deprec. and amortization expenses 59,539 4.1 General and adminstrative expenses 85,334 5.9 Total operating expenses $441,664 30.8%Operating income $228,336 15.9%Other income, net 34,797 2.4Income before income taxes $263,133 18.3%Provision for income taxes 52,627 3.7Net income $210,506 14.7%

Tray Companies Income Statement

For the Year Ended December 31, 20x6

1.


Chapter Review Problem (cont’d)

2. Current Assets $654,833Current Liabilities $353,987

Current

Ratio= = 1.8 times=

3. Net Income $210,506Net Sales $1,435,339

Profit

Margin= = 14.7%=

This company is performing better than the industry norm of 9 percent.

4. Net Cash Flows from Oper. Activities $563,535Net Income $210,506

Cash Flow Yield

= = 2.7 times=

5. Net Income $210,506Average Total Assets $3,121,651

Return on Assets

= = 6.7%=

14–1 chapter 14 financial performance measurement

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