CHAPTER
14
Performance Measurement
Sustainable Earnings
• Likely level of future cash flows is
generated by earnings
• Sustainable earnings is net earnings
adjusted for irregular items
Irregular Items
• Three types of irregular items are
reported (all net of taxes)
– Discontinued operations
– Extraordinary items
– Change in accounting principle
Discontinued Operations
• Disposal of a significant segment of a
business
• Report separately in statement of earnings
– Earnings (loss) from continuing operations,
and
– Earnings (loss) from discontinued operations
Discontinued Operations
• Earnings (loss) from discontinued operations
consists of:
– Earnings (loss) from operations and
– Gain (loss) on disposal of the segment
• Both components are reported net of
applicable taxes in a section entitled
Discontinued Operations, which follows
Earnings from Continuing Operations
Extraordinary Items
• Events and transactions that are:
– Infrequent in occurrence
– Unusual in nature
– Not subject to management determination
Change in
Accounting Principle
• Occurs when the principle used in the current
year is different from the one used in the
preceding year
• Is permitted, when:
– There has been a change in reporting
circumstances, and
– Management can show that the new principle
is preferable to the old
Comparative Analysis
• Three types of
comparisons:
– Intracompany basis
– Intercompany basis
– Industry averages
Comparative Analysis
• Three tools:
– Horizontal analysis
– Vertical analysis
– Ratio analysis
Horizontal Analysis
Change
since
base
period
Current year amount — Base year amount
———————————————————————
Base year amount
ANY COMPANY INC.
Assumed Net Sales (in thousands)
2005
$ 6,562.8
127%
2004
$ 6,295.4
121%
2003
2002
$ 6,190.6 $ 5,786.6
119%
112%
2001
$ 5,181.4
100%
Vertical Analysis
• Expresses each item in a financial statement as a
percent of a base amount (total assets or net sales)
ANY COMPANY, INC.
Condensed Balance Sheets
December 31 (in thousands)
2005
Assets
Current assets
Property, plant, and
equipment
Other assets
Total assets
Amount
2004
Percent
Amount
Percent
$1,496.5
29.6%
$1,467.7
30.1%
2,888.8
666.2
$5,051.5
57.2%
13.2%
100.0%
2,733.3
636.6
$4,837.6
56.9%
13.0%
100.0%
Ratio Analysis
Liquidity Ratios
Measure short-term ability of
the enterprise to pay its
maturing obligations and to
meet unexpected needs for
cash
Solvency Ratios
Since 1892
Measure the ability of the
enterprise to survive over a
long period of time
XYZ Co.
Profitability Ratios
Revenues
-
Expenses
=
Net
Earnings
Measure the earnings or
operating success of an
enterprise for a given period
of time
Liquidity Ratios
•
•
•
•
•
•
•
•
Working capital
Current ratio
Cash current debt coverage
Inventory turnover
Days in inventory
Receivables turnover
Average collection period
Acid-test (quick) ratio
Working Capital
• Measures short-term debt-paying ability
Working Capital = Current Assets – Current Liabilities
Current Ratio
• Measures short-term debt-paying ability
Current Ratio =
Current Assets
Current Liabilities
Cash Current Debt Coverage
• Measures short-term debt-paying ability
(cash basis)
Cash Current Debt
Coverage =
Cash Provided
by Operating Activities
Average Current Liabilities
Inventory Turnover
• Measures liquidity of inventory
Inventory Turnover =
Cost of Goods Sold
Average Inventory
Days in Inventory
• Measures number of days inventory is on
hand
Days in Inventory =
365 Days
Inventory Turnover
Receivables Turnover
• Measures liquidity of receivables
Net Credit Sales
Receivables Turnover =
Average Gross
Receivables
Average Collection Period
• Measures number of days receivables are
outstanding
Average Collection Period =
365 Days
Receivables Turnover
Acid-Test Ratio
• Measures immediate short-term
debt-paying ability
Acid-Test Ratio =
Cash + Short-Term
Investments + Net
Receivables
Current Liabilities
Solvency Ratios
•
•
•
•
Debt to total assets
Cash total debt coverage
Times interest earned
Free cash flow
Debt to Total Assets Ratio
• Measures % of total
assets provided by
creditors
Debt to Total Assets =
Total Liabilities
Total Assets
Cash Total Debt Coverage
• Measures long-term debt-paying ability
(cash basis)
Cash Total Debt Coverage =
Cash Provided by
Operating Activities
Average Total
Liabilities
Times Interest Earned
• Measures ability to meet interest payments
as they come due
Times Interest Earned =
Earnings Before Interest
Expense and Income Tax
Expense (EBIT)
Interest Expense
Free Cash Flow
• Measures cash available for paying
dividends or expanding operations
Cash
Capital
Provided
Expenditures
by
Operating
Activities
Dividends =
Paid
Free
Cash
Flow
Profitability Ratios
•
•
•
•
•
•
•
•
Earnings per share (EPS)
Price-earnings (P-E) ratio
Gross profit margin
Profit margin
Return on assets
Asset turnover
Return on common shareholders’ equity
Payout ratio
Earnings Per Share (EPS)
• Measures net earnings earned on each
common share
Earnings Per Share =
Earnings Available to
Common Shareholders
Average Number of
Common Shares
Price-Earnings (P-E) Ratio
• Measures relationship between market
price per share and earnings per share
Share Price
Price-Earnings Ratio = Earnings Per
Share
Gross Profit Margin
• Measures margin between selling price and
cost of goods sold
Gross Profit Margin =
Gross Profit
Net Sales
Profit Margin
• Measures net earnings generated by
each dollar of sales
Profit Margin =
Net Earnings
Net Sales
Return On Assets
• Measures overall profitability of assets
Return on Assets =
Net Earnings
Average Total Assets
Asset Turnover
• Measures how efficiently assets are used to
generate sales
Asset Turnover =
Net Sales
Average Total Assets
Return on Common
Shareholders’ Equity
• Measures profitability of common
shareholders’ investment
Return on Common
Shareholders’ Equity =
Net Earnings –
Preferred Dividends
Average Common
Shareholders’ Equity
Payout Ratio
• Measures % of earnings distributed in the
form of cash dividends
Cash Dividends
Payout Ratio =
Net Earnings
Quality of Earnings
• Increased importance today due to recent
corporate scandals
• Can be impacted by alternative accounting
principles (variation and discretion in
selection of GAAP)
• Companies report pro forma earnings which
are a non-GAAP earnings measure
• Quality of earnings also affected by improper
recognition of revenues and liabilities