OPERATING
PERFORMANCE
ANALYSIS
Chapter 12
CHAPTER 12 OBJECTIVES
Explain the objectives for analyzing
operating performance.
 Describe the importance of earnings
quality in operating performance
analysis.
 Identify characteristics of sustainable
earnings.

CHAPTER 12 OBJECTIVES
(CONT.)
Distinguish between recurring and nonrecurring earnings and explain why they
produce different earnings quality.
 Discuss how managerial decisions affect
reported income.
 Present a preliminary analysis of a
company or industry’s operating
performance.

OBJECTIVES FOR ANALYZING
OPERATING PERFORMANCE
Understand the various types of income
and attach economic meaning to them
 Determine the sufficiency and
sustainability of corporate earnings
 Relate those earnings to a firm’s value
and share price

INCOME AND WEALTH

Pervasive concepts



Wealth is discrete; the amount of goods and
services that can be consumed at a given point in
time
Wealth changes: the extent to which the amount
wealth increases or decreases in a reporting
period
Analytical problem: wealth and wealth creation are
related to, but not the same as, cash balances and
cash flows
INCOME AND WEALTH
(CONT.)

Income theory



The economic view is that income represents the
amount of periodic consumption that does not
alter a store of wealth
Financial reporting bases its perspective of income
on economic theory
The financial reporting system measures income
as the difference between capital invested at the
beginning of a period less net assets at the end of
that period
INCOME AND WEALTH
(CONT.)
Financial reporting assumes a nominal
dollar concept of capital maintenance
and adheres to the historical cost
concept of asset valuation in measuring
income
 The financial reporting system reports
income on a transaction approach
(revenue and expense activities)

INCOME AND WEALTH
(CONT.)

Income composition (Exhibit 12-1)
The all-inclusive income concept reports
virtually all wealth related transactions in a
reporting period
 These transactions are categorized as
operating, non-operating, and irregular
income items

INCOME AND WEALTH
(CONT.)
Operating income represents wealth
created by core business activities
 Non-operating income results from
financing transactions (e.g., interest
expense) and non-core activities (e.g.,
loss on the disposal of fixed assets)

INCOME AND WEALTH
(CONT.)

Irregular items only sporadically affect
income
Often involve substantially monetary
amounts
 Reported on a net of tax basis
 Cover three types of gains (losses):
discontinued business operations,
extraordinary (unusual and infrequent)
items, and changes in accounting principles

INCOME AND WEALTH
(CONT.)

Comprehensive income
Items that affect wealth but are not
reported on the income statement (e.g.,
market adjustments to available-for-sale
securities)
 Usually reported as a separate component
of shareholders’ equity (i.e., the changes to
wealth bypass the income statement)

INCOME AND WEALTH
(CONT.)

Earnings per share (EPS)
Reports the amount of income earned by
one share of stock
 Eliminates the size bias inherent in
aggregate income disclosures
 Computed as (net income – preferred
dividends) / weighted number of
outstanding shares of common stock

INCOME AND WEALTH
(CONT.)

Capital structure determines EPS disclosure




A simple capital structure consists of common
stock and possibly preferred shares
A complex capital structure includes convertible
securities and stock options, which would dilute
EPS if they were exercised
An entity with a simple capital structure discloses
a single EPS number, called basic EPS
An entity with a complex capital structure
discloses two EPS numbers (dual disclosures),
referred to as basic and diluted EPS
EARNINGS QUALITY

An assessment as to the extent to
which reported income disclosures
change an entity’s underlying wealth
All income components do not affect
wealth in the same manner
 Analysts must judge the relative worth of
the various income disclosures

EARNINGS QUALITY (CONT.)
Earnings sustainability
 An enterprise’s capacity to produce
earnings on a recurring basis

Permanent in nature (i.e., they occur every
reporting period)
 Fundamental wealth increases
 Produced by central business operations
 Highly valued by analysts

EARNINGS QUALITY (CONT.)

Transitory earnings are not permanent
Marginal wealth increases
 Result from nonrecurring or intermittently
recurring items
 Not highly valued by analysts

EARNINGS QUALITY (CONT.)

Non-operating income items




Can have a recurring affect on wealth (e.g.,
interest income)
Can affect wealth sporadically (e.g., corporate
restructurings)
Corporate restructurings complicate assessment of
earnings sustainability
Multiple restructurings reduce earning quality to
an even greater degree than those resulting from
a single restructuring
EARNINGS QUALITY (CONT.)

The policies and procedures used to
determine income define earnings
measurement, examples include
Costing inventory on a FIFO or LIFO basis
 Depreciating fixed assets on a straight-line
or accelerated basis

EARNINGS QUALITY (CONT.)

The continual selection of accounting
choices that increase income is known
as earnings management, examples
include a
Reluctance to reduce inventory costs to
their lower market value
 Overestimation of the life of fixed assets

EARNINGS QUALITY (CONT.)

Benchmarking
Evaluation of one entity’s accounting
principles and policies against the those of
its competition and against itself over time
 Incompatibility with other firms or
inconsistency over time may indicate
earnings management

EARNINGS QUALITY (CONT.)
Earnings sufficiency
 An assessment if an entity generates enough
profits to remain viable





Analysts evaluate various profit margins to gain
insight
Gross profit: revenues minus cost of good sold
Operating profit: gross profit minus operating
expenses
Net profit: operating expenses minus other
revenues and expenses
EARNINGS QUALITY (CONT.)

Sufficiency indicators




High gross and operating profit margins indicate
sufficient earnings
Increasing gross and operating profit margin
trends bode well for future earnings sufficiency
Low gross profit and operating profit margins
indicate insufficient earnings
Decreasing gross and operating profit margin
trends do not bode well for future earnings
sufficiency
EARNINGS QUALITY (CONT.)

Recurring and nonrecurring earnings
(Exhibits 12-3 and 12-4)
Correlation among the various profit
margins indicate recurring earnings or high
earnings quality
 Lack of correlation among the various
profit margins provide evidence of
nonrecurring earnings or low earnings
quality

EARNINGS QUALITY (CONT.)

Operating cash flows should coincide
with operating income (Exhibit 12-5)
Strong correlation between operating
income and operating cash flows indicates
high earnings quality
 Strong correlation between operating
income and operating cash flows indicates
high earnings quality

EARNINGS QUALITY (CONT.)

Operating income should coincide with
net income
Constant difference between the two
income numbers over time, which is
attributable to a constant tax rate,
indicates high earnings quality
 Variable differences between the two
income numbers over time indicate low
earnings quality

Strong Correlation
$140
($-000s)
$120
$100
$80
$60
$40
$20
$0
2005
2006
Operating Income
2007
2008
Operating Cash Flows
2009
($-000s)
Weak Correlation
$130
$120
$110
$100
$90
$80
$70
$60
$50
$40
$30
$20
$10
$0
($10)
2005
2006
Operating Income
2007
2008
Operating Cash Flows
2009
ANALYSIS OF THE PC
INDUSTRY

A relationship exists between market share
and earnings



Apple’s decreased market share contributed to a
decline in earnings, threatened profitability, and
raised doubt about earnings sufficiency
Dell’s rapid increase in market share paved the
way for greater earnings
Market share does not ensure profitability, as
Compaq demonstrated in 1998
PC Industry
Relative Market Share
1993 and 1998
1993
1998
9.2%
13.1%
10.4%
10.6%
42.2%
21.7%
54.8%
38.0%
Apple
Compaq
Dell
Gateway
Apple
Compaq
Dell
Gateway
ANALYSIS OF THE PC
INDUSTRY (CONT.)
Earnings sufficiency
 Apple’s failure to generate sufficient earnings
towards the end of the period analyzed was
the result of






An erosion of its technological superiority
Decrease in market share
Diminished technological superiority
A lower revenue base with which to cover fixed
costs
Research and development costs that exceeded
industry norms
Apple Computer
Operating Income and Cash Flow
1993-1998
$1,000
$750
$500
$ in Millions
$250
$0
($250)
1993
1994
1995
1996
1997
($500)
($750)
($1,000)
($1,250)
($1,500)
Operating Income
Operating Cash Flow
1998
ANALYSIS OF THE PC
INDUSTRY (CONT.)

Earnings sustainability
Industry growth contributed to variable
profit margins throughout the industry and
over time
 Earnings varied among the four companies
analyzed

ANALYSIS OF THE PC
INDUSTRY (CONT.)

Data indicate that Apple’s earning were
less sustainable that its competitors
because the company
Did not conform to industry manufacturing
standards
 Had an unfavorable cost structure (Exhibits
12-10A and 12-10B)
 Could not differentiate its products from
those of its competitors

Exhibit 12-11A
PC Industry
Research and Development Expenses
1993-1998
9%
8%
7%
% of Sales
6%
5%
4%
3%
2%
1%
0%
1993
1994
1995
Apple
1996
Compaq
1997
Dell
1998