Chapter 14: Financial Performance Evaluation 1

Chapter 14: Financial Performance Evaluation 1

CHAPTER 17

Financial Performance Measurement

reviewing the chapter

Objective 1: Describe the objectives, standards of comparison, sources of information, and compensation issues in measuring financial performance.

1.Financial performance measurement, or financial statement analysis, comprises all the techniques users of financial statements employ to show important relationships in an organization’s financial statements and to relate them to important financial objectives. Internal users of financial statements include top managers, who set and strive to achieve financial performance objectives; middle-level managers of business processes; and lower-level employee stockholders. External users are creditors and investors who want to assess how well management has accomplished its financial objectives, as well as customers who have cooperative agreements with the company.

2.Management is responsible for devising, executing, monitoring, and reporting on a complete financial plan for the business. Such a plan should focus on the financial objectives of liquidity, or the ability to pay bills when due and to meet unexpected needs for cash; profitability, the ability to earn a satisfactory net income; long-term solvency, the ability to survive for many years; cash flow adequacy, the ability to generate sufficient cash through operating, investing, and financing activities; and market strength, the ability to increase the wealth of owners.

3.Investors and creditors use financial performance to judge a company’s past performance, present position, and future potential. They also use it to assess the risk connected with acting on that potential.

a.In judging a company’s past performance and current status, investors and creditors look at trends in past sales, expenses, net income, cash flows, and return on investment. They also look at a company’s assets and liabilities, its debt in relation to equity, and its levels of inventories and receivables.

b.Information about a company’s past and present enables creditors and investors to make more accurate projections about its future—and the more accurate their projections are, the lower their risk of realizing a loss will be. In return for assuming a higher risk, creditors may charge higher interest rates or demand security on their loans; stock investors look for a higher return in the form of dividends or an increase in market price.

4.When analyzing financial statements, decision makers commonly use three standards of comparison: rule-of-thumb measures, past performance of the company, and industry norms.

a.Rule-of-thumb measures for key financial ratios are helpful but should not be the only basis for making a decision. For example, a company may report high earnings per share but lack the assets needed to pay current debts.

b.Analysis of a company’s past performance is helpful in showing current trends and may also indicate future trends. However, trends reverse at times, so projections based on past performance should be made with care.

c.Using industry norms to compare a company’s performance with the performance of other companies in the same industry has advantages, but it also has three limitations. First, the operations of two companies in the same industry may be so different that the companies cannot be compared. Second, diversified companies, or conglomerates, operate in many unrelated industries, which makes it difficult if not impossible to use industry norms as standards. (The FASB requirement that financial information be reported by segments has provided a partial solution to this problem.) Third, companies may use different acceptable accounting procedures for recording similar items.

5.The major sources of information about publicly held corporations are reports published by the company, SEC reports, business periodicals, and credit and investment advisory services.

a.A corporation’s annual report provides much useful financial information. Its main sections are management’s analysis of the past year’s operations; the financial statements; the notes to the financial statements, which include a summary of significant accounting policies; the auditors’ report; and financial highlights for a five- or ten-year period. Most public companies also publish interim financial statements each quarter. These reports present limited financial information in the form of condensed financial statements and may indicate significant trends in a company’s earnings.

b.Publicly held corporations must file an annual report with the SEC on Form 10-K, a quarterly report on Form 10-Q, and a current report of significant events on Form 8-K. These reports are available to the public and are a valuable source of financial information.

c.Financial analysts obtain information from such sources as The Wall Street Journal, Forbes, Barron’s, Fortune, the Financial Times, Moody’s, Standard & Poor’s, and Dun & Bradstreet.

6.Under the Sarbanes-Oxley Act of 2002, a public corporation’s board of directors must establish a compensation committee comprised of independent directors to determine how the company’s top executives will be compensated. Companies must disclose the components of compensation (such as a base salary, incentive bonuses, and stock option awards) and the criteria they use to remunerate top executives in documents they file with the SEC.

Objective 2: Apply horizontal analysis, trend analysis, vertical analysis, and ratio analysis to financial statements.

7.The most widely used tools of financial analysis are horizontal analysis, trend analysis, vertical analysis, and ratio analysis.

a.Horizontal analysis is commonly used to study comparative financial statements, which present data for the current year and previous year side by side. Horizontal analysis computes both dollar and percentage changes in specific items from one year to the next. The first year is called the base year, and the percentage change is computed by dividing the amount of the change by the base year amount.

b.Trend analysis is like horizontal analysis, except that it calculates percentage changes for several consecutive years. To show changes in related items over time, trend analysis uses an index number, which is calculated by setting the base year equal to 100 percent.

c.Vertical analysis uses percentages to show the relationship of individual items on a statement to a total within the statement (e.g., cost of goods sold as a percentage of net sales). The result is a common-size statement. On a common-size balance sheet, total assets are set at 100 percent, as are total liabilities and stockholders’ equity; on a common-size income statement, net sales or net revenues are set at 100 percent. Comparative common-size statements enable analysts to identify changes both within a period and between periods They also make it easier to compare companies.

d.Ratio analysis identifies meaningful relationships between the components of the financial statements. The primary purpose of ratios is to identify areas needing further investigation.

Objective 3: Apply ratio analysis to financial statements in a comprehensive evaluation of a company’s financial performance.

8.The ratios used in ratio analysis provide information about a company’s liquidity, profitability, long-term solvency, cash flow adequacy, and market strength. The most common ratios are shown in the table that follows.

Ratio / Components / Use
Liquidity Ratios
Current ratio / Current Assets / Measure of short-term debt-
Current Liabilities / paying ability
Quick ratio / Cash + Marketable Securities + Receivables / Measure of short-term debt-
Current Liabilities / paying ability
Receivable turnover / Net Sales / Measure of relative size of
Average Accounts Receivable / accounts receivable and
effectiveness of credit policies
Days’ sales / Days in Year / Measure of average days taken
uncollected / Receivable Turnover / to collect receivables
Inventory turnover / Cost of Goods Sold / Measure of relative size of
Average Inventory / inventory
Days’ inventory / Days in Year / Measure of average days taken
on hand / Inventory Turnover / to sell inventory
Payables turnover / Cost of Goods Sold +/− Change in Inventory / Measure of relative size of
Average Accounts Payable / accounts payable
Days’ payable / Days in Year / Measure of average days taken
Payables Turnover / to pay accounts payable
(Note: The operating cycle is the time taken to sell and collect for products sold. It equals days’ inventory on hand plus days’ sales uncollected.)
Profitability Ratios
Profit margin / Net Income / Measure of net income produced
Net Sales / by each dollar of sales
Asset turnover / Net Sales / Measure of how efficiently assets
Average Total Assets / are used to produce sales
Return on assets / Net Income / Measure of overall earning
Average Total Assets / power or profitability
Return on equity / Net Income / Measure of the profitability of
Average Stockholders’ Equity / stockholders’ investments
Long-Term Solvency Ratios
Debt to equity ratio / Total Liabilities / Measure of capital structure and
Stockholders’ Equity / leverage
Interest coverage / Income Before Inc. Taxes + Interest Expense / Measure of creditors’ protection
ratio / Interest Expense / from default on interest payments
Cash Flow Adequacy Ratios
Cash flow yield / Net Cash Flows from Operating Activities / Measure of the ability to generate
Net Income / operating cash flows in relation to net income
Cash flows to sales / Net Cash Flows from Operating Activities / Measure of the ability of sales to
Net Sales / generate operating cash flows
Cash flows to assets / Net Cash Flows from Operating Activities / Measure of the ability of assets to
Average Total Assets / generate operating cash flows
Free cash flow / Net Cash Flows from Operating Activities / Measure of cash generated or
− Dividends − Net Capital Expenditures / cash deficiency after providing
for commitments
Market Strength Ratios
Price/earnings (P/E) / Market Price per Share / Measure of investor confidence
ratio / Earnings per Share / in a company
Dividends yield / Dividends per Share / Measure of a stock’s current
Market Price per Share / return to an investor