5th session:
Financial Accounting Measures of Performance
Performance Evaluation
IMSc in Business Administration
October-November 2008
1
Financial accounting measures of
performance
Computing Earnings per Share (EPS)
2
Computing Earnings per Share (EPS)
•
•
•
Earnings per share indicates the income
earned by each share of common stock.
Reported at the end of the income statement
Should report intermediate components as
well.
3
EPS on Simple Capital Structure
• Simple Capital Structure means that there is only
common stock and there is no potential common
stock (securities that can potentially be converted into
common stock and dilute EPS).
Net Income
EPS=
Weighted Average Number of Shares
4
Preferred Stock Dividends
• Preferred Stock Dividends are compensation not
available for common stockholders, therefore they are
subtracted from the Net Income.
EPS=
Net Income – Preferred Dividends
Weighted Average Number of Common Stock
5
Weighted Average Number od Shares
Outstanding
• Weighted by the fraction of the period they are
outstanding
• Find the equivalent number of whole shares
outstanding for the year.
6
Stock Dividends and Stock Splits
• When these happen computation of the average
number of shares outstanding needs to be
redone.
• A stock dividend or split does not change the
shareholders’ total investment.
7
Complex Capital Structure
• Dilutive securities are securities that can be
converted into common stock (through
conversion or exercise) and will dilute earnings
per share.
8
Diluted EPS
Note that:
Only dilutive securities are to be reported!
Antidilutive are not considered.
EPS=
Net income- Preferred
dividends
Weighted Average Shares
Outstanding
-
Impact of
Convertibles
-
Impact of
Option,
Warrants, and
Other Dilutive
Securities
9
Diluted EPS – Convertible Securities
If-Converted Method
1. Conversion of the convertible securities as
soon as possible (beginning of period or
issuance)
2. Elimination of related interest, net of tax.
– Logic is that if the convertible securities were
converted, then they didn’t produce any interest
and net income has to be filtered of this.
10
Diluted EPS – Options and Warrants
Treasury Stock Method
1. Exercise of options or warrants as soon as
possible (beginning of period or issuance)
2. Proceeds from the exercise are used to
purchase common stock.
11
Financial accounting measures of
performance
Financial Analysis through Ratio
Computation – a shortcut to evaluating
firm’s performances
12
Limitations of Financial Ratios
• Not useful in isolation – only valid when compared to
other firms or the company’s historical performance
• Different accounting treatments – particularly when
analyzing non-U.S. firms
• Finding comparable industry ratios for companies
that operate in multiple industries
• All ratios must be viewed relative to one another
• Determining the target or comparison value requires
some range of acceptable values
13
Financial Ratios – Analyst/Evaluator
Considerations
• Do firms have similar accounting practices?
• Are ratios comparable across firm divisions?
• Do different ratios give consistent information?
• Are the ratios reasonable for the industry?
14
Interpreting Ratios
1. Cross-sectional analysis:
Comparison to industry norm or average
2. Time-series analysis (trend analysis):
Comparison to a company’s past ratios
15
Ratio Analysis Context
1. Company goals and strategy
2. Industry norms
•
•
•
Ratios may be industry specific
Multiple lines of business distorts aggregate ratios
Differences in accounting methods
3. Economic conditions
•
Cyclical businesses and the stage of the business
cycle
16
Categories of Ratios
• Activity
Efficiency of day-to-day
tasks/operations
• Liquidity
Ability to meet short-term liabilities
• Solvency
Ability to meet long-term obligations
• Profitability
Ability to generate profitable
sales from asset base
• Valuation
Quantity of asset or flow associated
with an ownership claim
17
Ratio Analysis
Some general rules:
– For ratios that use only income statement items, use the
values from the current income statement
– For ratios using only balance sheet items, use the values
from the current balance sheet
– For ratios using both income statement and balance
sheet items, use the value from the current income
statement and the average value for the balance sheet
item
18
Integrated Financial Ratio Approach
• Important to analyze all ratios collectively
• Use information from one ratio category to
answer questions raised by another ratio
• Classic example = DuPont analysis
19
DuPont System: Original Equation
ROE =
Net Income
Revenue
×
Net Profit Margin
Net Income
Average Equity
Revenue
Average Total Assets
Asset Turnover
Average Total Assets
×
Average Equity
Leverage
20
DuPont System: Extended Equation
Average Total Assets
Net Income
Revenue
EBIT
Revenue
Revenue
× Average Equity
×
Average Total Assets
×
EBIT Margin
EBT
×
EBIT
Interest Burden
Net Income
EBT
Tax Burden
21
DuPont System: Extended Equation
EBIT
Interest
Tax
Asset
×
×
×
× Leverage
Margin Burden
Burden Turnover
Operating Profit
Margin
1 – Effective Tax
Rate
22
Per Share Ratios – for Valuation
P
=
Price Per Share
E
Earnings Per Share
P
CF
Price Per Share
P
=
Cash Flow Per Share
=
Price Per Share
S
Sales Per Share
P
Price Per Share
BV
=
Book Value Per Share
23
Per-Share Quantities
Basic EPS
=
NI – Pref Div
Weighted Ave #
Ordinary Shares
Diluted EPS =
Income Adjusted for Dilutive
Securities
Weighted Ave # Shares
Adjusted for Dilution
Cash Flow
per Share
=
CFO
Weighted Ave #
Shares
24
Dividend Related Quantities
Dividend
=
Payout Ratio
Common Dividend
Net Income – Pref Div
Net Income attributable to common shares
Retention
Rate (b)
=
Net income attributable to
common shares – common
dividend
Net income attributable to
common shares
25
Dividend Related Quantities
Sustainable
=
Growth Rate
Retention Rate
b × ROE
Return on Equity
1 – Dividend Payout Ratio
26
Sustainable Growth Rate – Problem
A firm has a dividend payout ratio of 35%, a net profit
margin of 10%, an asset turnover of 1.4, and an
equity multiplier leverage measure of 1.2. Estimate
the firm’s sustainable growth rate.
Growth rate =
b
(1 – 0.35)
×
ROE
0.1 × 1.4 × 1.2
=
0.1092
=
10.92%
27
Evaluating Past Financial Performance
 How have key ratios changed and why?
 How do key ratios and trends compare with
competitors/industry?
 What aspects of performance are critical for
a competitive advantage?
 How did the company perform in these
areas?
 What is the company’s business model and
strategy – are they reflected in key
measures?
28
Projecting Performance
1.
2.
3.
4.
5.
Forecast expected GDP growth
Forecast expected industry sales based on historical
relationship with GDP
Consider expected change of firm’s market share
Forecast expected firm sales
Use historical margins for stable firms (gross,
operating, net) or individual forecast for each expense
item


Remove nonrecurring items
Historical margins are not relevant to new, volatile, or high
fixed-cost industries
29