Chapter 14
Financial
Performance Measurement
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Foundations of Financial
Performance Measurement
• Objective 1
– Describe the objectives, standards of comparison, sources
of information, and compensation issues in measuring
financial performance.
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14-2
Financial Performance
Measurement
Shows how important items in a company’s financial
statements relate to the company’s financial
objectives; also called financial statement analysis
Users of Financial Information
Internal
External
 Top managers
 Creditors
 Mid managers
 Investors
 Employees who
own stock in the
company
 Customers who have
cooperative agreements
with the company
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14-3
Management’s Objectives
Liquidity
Able to pay bills when due and meet needs for
cash
Profitability
Earn a satisfactory net income
Long-term solvency
Able to survive for several years
Cash flow adequacy Generate sufficient cash through operating,
investing, financing activities
Market strength
Able to increase shareholders’ wealth
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14-4
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
– Goal is to achieve a return that makes up for the risk
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14-5
Past Performance and Current
Position
• Past performance
– Good indicator of future performance
• Look at trends of past sales, expenses, net income, cash
flow, and return on investment
• Current position
–
–
–
–
–
What assets the business owns
What liabilities the business must pay
Cash position
Debt to equity
Levels of inventories and receivables
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14-6
Standards of Comparison
• Decision makers must judge whether the
relationships they have found are favorable or
unfavorable
• Three commonly used standards of comparison:
1. Rule-of-thumb measures
2. Past performance of the company
3. Industry norms
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Rule-of-Thumb Measures
• General standards, used by financial analysts,
investors, and lenders, for key financial ratios
• Found in Dun & Bradstreet’s Industry Norms and
Key Business Ratios
– Current debt to tangible net worth
– Inventory to net working capital
• Must be used with great care
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14-8
Past Performance
The comparison of financial measures or ratios of the
same company over a period of time
• An improvement over use of rule-of-thumb
measures
• Provides a basis for judging whether the measure or
ratio is improving or deteriorating
• It may also be helpful in showing possible future
trends
– Trends reverse at times, so projections must be made with
care
• Past performance may not be a useful indicator of
adequacy for the future
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14-9
Industry Norms
Tell how the company compares with the average
performance of other companies in the same
industry
• Industry norms probably offer the best available
standards for judging current performance as long
as they are used with care
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14-10
Limitations of Industry Norms
1. Companies in the same industry may not be
strictly comparable.
2. When analyzing consolidated financial statements
for diversified companies, there may be no
comparable companies.
– A partial solution is that diversified companies must
report revenues, income from operations, and
identifiable assets for each of their operating segments
3. Companies in the same industry with similar
operations may use different acceptable
accounting procedures.
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Reports Published by the
Corporation
• The annual report of a publicly held corporation is
an important source of financial information.
• The main parts of an annual report
– 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
– Financial highlights for a five- or a ten-year period
• Most publicly held companies also publish interim
financial statements, usually each quarter.
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14-12
SEC Reports
• Publicly held corporations must file annual reports,
quarterly reports, and current reports with the
Securities and Exchange Commission (SEC).
– Annual report (Form 10-K)
• Contains more information than the published annual
report
– Quarterly report (Form 10-Q)
• Presents important facts about interim financial
performance
– 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
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14-13
Executive Compensation
A public corporation’s board must establish a compensation
committee to determine how the company’s top executives
will be compensated and report the details of
compensation to the SEC.
Components of
compensation:
Annual base
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.
14-14
Tools and Techniques of Financial
Analysis
• Objective 2
– Apply horizontal analysis, trend analysis, vertical
analysis, and ratio analysis to financial statements.
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14-15
Tools and Techniques of Financial
Analysis
The tools of financial performance evaluation are
intended to show relationships and changes
– Few numbers are very significant when looked at
individually
– It is the relationship between various numbers or their
change from one period to another that is important
•
•
•
•
Horizontal analysis
Trend analysis
Vertical analysis
Ratio Analysis
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14-16
Horizontal Analysis
Computes changes from the previous year to the
current year in both dollar amounts and percentages
• The base year is the first year considered
 Amount of Change 
Percentage Change  100  

 Base Year Amount 
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14-17
Starbucks Horizontal Analysis
(Dollar amounts in thousands)
Net revenues
Cost of sales, including occupancy costs
Gross margin
Operating expenses
Store operating expenses
Other operating expenses
Deprec. and amortization expenses
General and adminstrative expenses
Total operating expenses
Operating income
Other income, net
Income before taxes
Provision for income taxes
Income before cumulative change
Cumulative effect of FIN47 (net of tax)
Net income
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Increase (Decrease)
2007
2006
Amount
Percentage
$9,411,497
3,999,124
$5,412,373
$7,786,942
3,178,791
$4,608,151
$1,624,555
820,333
$804,222
20.9
25.8
17.5
3,215,889
294,136
467,160
489,249
$4,466,434
945,939
110,425
$1,056,364
383,726
$672,638
-$672,638
2,687,815
253,724
387,211
479,386
$3,808,136
800,015
106,228
$906,243
324,770
$581,473
$17,214
$564,259
528,074
40,412
79,949
9,863
$658,298
145,924
4,197
$150,121
58,956
$91,165
-$17,214
$108,379
19.6
15.9
20.6
2.1
17.3
18.2
4
16.6
18.2
15.7
-100
19.2
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Trend Analysis
A type of horizontal analysis in which percentage
changes are calculated for several successive years
instead of for just two years
• Important because it may point to basic changes in
the nature of a business
• Uses an index number to show changes in related
items over a period of time
 Amount of Change 
Index  100  

 Base Year Amount 
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14-19
Trend Analysis for Starbucks
Starbucks Corporation
Net Revenues and Operating Income
Trend Analysis
2007
Dollar values
(In thousands)
Net revenues
Operating income
Trend analysis
(In percentages)
Net revenues
Operating income
2006
2005
2004
2003
$9,411,497
945,939
$7,786,942
800,015
$6,369,300
703,870
$5,294,247
549,460
$4,075,522
386,317
230.9
244.9
191.1
207.1
156.3
182.2
129.9
142.2
100.0
100.0
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14-20
Vertical Analysis
Shows how the different components of a financial
statement relate to a total figure in the statement
• The total figure in the statement set to equal to
100%
– Each component’s percentage of that total is computed
• Also called a common-size statement
• Useful for comparing
– The importance of specific components in the operation
of a business
– Changes in the components from one year to the next
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14-21
Starbucks Common-Size
Income Statement
All other figures
are expressed in
relation to net
revenues
Cost of sales are
42.5% of net
revenues;
Depreciation is
5.0% of net sales
Net revenues
Cost of sales including occupancy costs
Gross margin
Operating expenses:
Store operating expenses
Other operating expenses
Depreciation and amortization expenses
General and administrative expenses
Total operating expenses
Operating income
Other income, net
Earnings before income taxes
Provision for income taxes
Income before cumulative change
Cumulative effect of FIN47, net of taxes
Net earnings
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2007
2006
100.0 %
42.5
57.5 %
100.0 %
40.8
59.2 %
34.2
3.1
5.0
5.2
47.5
10.1
1.2
11.2
4.1
7.1
--7.1
%
%
%
%
%
34.5
3.3
5.0
6.2
48.9
10.3
1.4
11.6
4.2
7.5
0.2
7.2
%
%
%
%
%
%
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Ratio Analysis
A technique of evaluation that identifies key
relationships between components of the
financial statements
• 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.
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Comprehensive Illustration of
Ratio Analysis
• Objective 3
– Apply ratio analysis to financial statements in a
comprehensive evaluation of a company’s financial
performance.
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14-24
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
Quick Ratio
Receivable Turnover
Days’ Sales Uncollected
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Inventory Turnover
Days’ Inventory on Hand
Payables Turnover
Days’ Payable
14-25
Evaluating Liquidity (cont’d)
• Current ratio
– Measures short-term debt-paying ability
Current Ratio 
Current Assets
Current Liabilitie s
• Quick ratio
– Also measures short-term debt-paying ability
Quick Ratio 
Cash  Marketable Securities  Receivable s
Current Liabilitie s
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14-26
Evaluating Liquidity (cont’d)
• Receivable turnover
– Measures relative size of receivables and effectiveness
of credit policies
Receivable Turnover 
Net Sales
Average Accounts Receivable
• Days’ sales uncollected
– Measures average days taken to collect receivables
Days' Sales Uncollect ed 
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Days in a Year
Receivable Turnover
14-27
Evaluating Liquidity (cont’d)
• Inventory turnover
– Measures relative size of inventory
Inventory Turnover 
Cost of Goods Sold
Average Inventory
• Days’ inventory on hand
– Measures average days taken to sell inventory
Days' Inventory on Hand 
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Days in a Year
Inventory Turnover
14-28
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
Profit Margin
Asset Turnover
Return on Assets
Return on Equity
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14-29
Evaluating Profitability (cont’d)
• Profit margin
– Measures net income produced by each sales dollar
Net Income
Profit Margin 
Net Sales
• Asset turnover
– Measures how efficiently assets are used to produce sales
Asset Turnover 
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Net Sales
Average Total Assets
14-30
Evaluating Profitability (cont’d)
• Return on assets
– Measures overall earning power
Net Income
Return on Assets 
Average Total Assets
• Return on equity
– Measures profitability of stockholders’ investments
Net Income
Return on Equity 
Average Stockholde rs' Equity
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14-31
Evaluating Long-Term Solvency
• Refers to 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
– Declining profitability and liquidity ratios
– Unfavorable debt to equity ratio
– Unfavorable interest coverage ratio
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Evaluating Long-Term Solvency
(cont’d)
• Debt to equity ratio
– Measure of capital structure and leverage by showing the
amount of a company’s assets provided by creditors in
relation to the amount provided by stockholders
Debt to Equity 
Total Liabilitie s
Stockholde rs' Equity
• Interest coverage ratio
– Measure of creditors’ protection from default on interest
payments
Interest Coverage Ratio 
Income Before Income Taxes  Interest Expense
Interest Expense
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14-33
Evaluating the Adequacy of
Cash Flows
• Cash flow measures are closely related to the
objectives of liquidity and long-term solvency
– Because cash flows are needed to pay debts when they
are due
Cash flow yield
Cash flows to sales
Cash flows to assets
Free cash flow
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14-34
Evaluating Cash Flow Adequacy
(cont’d)
• Cash flow yield
– Measures overall ability to generate operating cash
flows in relation to net income
Cash Flow Yield 
Net Cash Flows from Operating Activities
Net Income
• Cash flows to sales
– Measures ability of sales to generate operating cash flows
Cash Flows to Sales 
Net Cash Flows from Operating Activities
Net Sales
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Evaluating the Adequacy of Cash
Flows (cont’d)
• Cash flow to assets
– Measures ability of assets to generate operating cash
flows
Net Cash Flows from Operating Activities
Cash Flows to Assets 
Average Total Assets
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Evaluating Market Strength
• Market price
– Price at which a company’s stock is bought and sold
– Represents what investors as a whole think of the
company at a point in time
– Provides information about how investors view the
potential return and risk connected with owning the
company's stock
– Is not very informative unless related to earnings by
considering the price/earnings ratio and the dividends
yield
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14-37
Evaluating Market Strength (cont’d)
• Price/earnings ratio
– Measures investor confidence in a company
Market Price per Share
Price/Earn ings Ratio 
Earnings per Share
• Dividends yield
– Measures a stock’s current return to an investor in the
form of dividends
Dividends Yield 
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Dividends per Share
Market Price per Share
14-38
Stop & Review
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.
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14-39
Chapter Review
1. Describe the objectives, standards of comparison,
sources of information, and compensation issues in
measuring financial performance.
2. Apply horizontal analysis, trend analysis, vertical
analysis, and ratio analysis to financial statements.
3. Apply ratio analysis to financial statements in a
comprehensive evaluation of a company’s
financial performance.
4. Textbook definition of free cash flow is different
from the definition that we use in finance
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14-40