Chapter
13
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Chapter 13
Performance Measurement
After studying Chapter 13, you should
be able to:
Understand the concept of sustainable
income.
Indicate how irregular items are presented.
Explain the concept of comprehensive
income.
Describe and apply horizontal analysis.
Describe and apply vertical analysis.
2
Chapter 13
Performance Measurement
After studying Chapter 13, you should
be able to:
Identify and compute ratios used in
analyzing a company’s liquidity, solvency,
and profitability.
Understand the concept of quality of
earnings.
3
Sustainable Income...
Is the most likely level of income
to be obtained in the future.
Does not include irregular
revenues, expenses, gains, or
losses.
4
Irregular Items
Three types of irregular items
are reported -- (all net of taxes)
discontinued operations
extraordinary items
changes in accounting principle
5
Discontinued Operations...
Refers to the disposal of a
significant segment of a
business...
the elimination of a major class
of customers or
an entire activity.
6
Extraordinary Items...
Are events and
transactions
that meet two
conditions:
Unusual in
nature
Infrequent in
occurrence
7
Extraordinary Items
Change in
Accounting Principle
 Occur when the principle used in the current year
is different from the one used in the preceding
year.
 Is permitted, when
management can show that the new principle is
preferable to the old and
the effects of the change are clearly disclosed
in the income statement.
 Examples:
 a change in depreciation methods (such as
declining-balance to straight-line)
a change in inventory costing methods (such as
FIFO to average cost).
9
Change in
Accounting Principle
The new principle should be used in
reporting the results of operations of the
current year.
The cumulative effect of the change on all
prior-year income statements should be
disclosed net of applicable taxes in a
special section immediately preceding net
income.
10
Rozek Inc.
Partial Income Statement
For the Year Ended December 31, 2004
Income before income taxes
$800,000
Income tax expense
240,000
Income from continuing operations
560,000
Discontinued operations
Loss from disposal of chemical
division, net of $90,000 income
tax saving
(210,000)
Net income before extraordinary item
350,000
Extraordinary item
Expropriation of investment, net of
$21,000 income tax saving
(49,000)
Cumulative effect of change in accounting
principle
Effect on prior years of change in
depreciation method, net of $ 7,200 tax
(16,800)
Net Income
284,200
Estimating Sustainable
Income
SUMMARY
When evaluating a company,
it generally makes sense to
eliminate all irregular items.
12
Comprehensive Income...
Includes all changes in
stockholders' equity during a
period except those resulting
from investments by
stockholders and distributions
to stockholders.
13
Comprehensive Income
The FASB now requires that, in
addition to reporting net
income, a company must also
report comprehensive income.
14
Comprehensive Income
Most revenues, expenses, gains,
and losses recognized during the
period are included in net income.
Specific exceptions to this practice
have developed - these items
bypass income and are reported
directly in stockholders’ equity.
15
Comprehensive Income
Unrealized gains and losses on
available-for-sale securities are
excluded from net income because
disclosing them separately reduces the volatility of net income
due to fluctuations in fair value, yet
informs the financial statement
user of the gain or loss that would
be incurred if the securities were
sold at fair value.
16
Comparative Analysis
Whether the amount represents an
increase over prior years, or
whether it is adequate in relation
to the company's needs, cannot be
determined from the amount
alone.
The amount must be compared
with other financial data to
provide more information.
17
Comparative Analysis
There are three types of
comparisons to provide decision
usefulness of financial information:
Intracompany basis
Intercompany basis
Industry averages
18
Intracompany Basis
Comparisons within a company are often
useful to detect changes in financial
relationships and significant trends.
A comparison of Kellogg's current year's
cash amount with the prior year's cash
amount shows either an increase or a
decrease.
A comparison of Kellogg's year-end cash
amount with the amount of total assets at
year-end shows the proportion of total
assets in the form of cash.
19
Intercompany Basis
Comparisons with other companies
provide insight into a company's
competitive position.
Kellogg's total sales for the year can
be compared with the total sales of
its competitors such as Quaker Oats
and General Mills.
20
Industry Averages
Comparisons with industry averages
provide information about a
company's relative position within
the industry.
Kellogg's financial data can be
compared with the averages for its
industry compiled by financial
ratings organizations such as Dun &
Bradstreet, Moody's, and Standard &
Poor's.
21
Financial Statement Analysis
Three basic tools are used in financial
statement analysis :
1.
Horizontal analysis
2.
Vertical analysis
3.
Ratio analysis
22
Horizontal Analysis
Is a technique for evaluating a series
of financial statement data over a
period of time.
Purpose is to determine whether an
increase or decrease has taken
place.
The increase or decrease can be
expressed as either an amount or a
percentage.
23
Horizontal Analysis
CURRENT-YEAR AMOUNT - BASE-YEAR AMOUNT
BASE-YEAR AMOUNT
24
Percentage Change in Sales
The percentage change in sales for each of
the 5 years, assuming 1997 as the base
period is:
Kellogg Company
Net Sales (in millions)
Base Period 2000
2001
$8,853.3
129.62%
2000
$6,954.7
1999
$6,984.2
101.82 % 102.26%
1998
1997
$6762.1
$6,830.1
99%
100.0%
25
Horizontal Analysis
of a Balance Sheet
KELLOGG COMPANY, INC.
Condensed Balance Sheets
December 31
(In millions)
Increase (Decrease)
during 2001
2001
2000 Amount
Percent
Assets
Current Assets $1,902.0 $1,617.1 $ 284.9
Plant assets
2,952.8
2,526.9
425.9
Other assets
5,513.8
742.0 4,771.8
Total assets $10,368.6 $4,886.0 $5,482.6
17.6
16.9
643.1
112.2
26
Horizontal Analysis
of a Balance Sheet
2001
Liabilities and
Stockholders' Equity
Current liabilities
$2,207.6
Long-term liabilities
7,289.5
Total liabilities
9,497.1
Stockholders' equity
Common stock
195.3
Retained earnings
and other
1,013.3
Treasury stock
(337.1)
Total stockholders'
equity
871.5
Total liabilities and
stockholders' equity $10,368.6
Increase (Decrease)
during 2001
2000
Amount Percent
$2,482.3
1,506.2
3,988.5
(274.7)
5,783.3
5,508.6
(11.1)
384.0
138.1
205.8
(10.5)
(5.1)
1,065.7
(374.0)
897.5
$4,886.0
(52.4)
36.9
(4.9)
9.9
(26.0)
(2.9)
$5,482.6
112.2
KELLOGG COMPANY, INC.
Condensed Income Statement
For the Years Ended December 31
(In millions)
2001
Net sales
$8,853.3
Cost of goods sold
4,128.5
Gross profit
4,724.8
Selling & Admin.
3,523.6
Nonrecurring charges
33.3
Income from operations 1,167.9
Interest expense
1351.5
Other income
(expense), net
(12.3)
Income before taxes
804.1
Income tax expense
322.1
Net income
$482.0
Increase (Decrease)
during 2001
2000
Amount Percent
$6,954.7
$1,898.6
27.3
3,327.0
801.5
24.1
3,627.7
1,097.1
30.2
2,551.4
972.2
38.1
86.5
(53.2)
(61.5)
989.8
178.1
18.0
137.5
214.0
155.6
15.4
867.7
280.0
$587.7
(27.7) (179.9)
(63.6)
(7.3)
42.1
15.0
($105.7) (18.0)
Vertical Analysis
Is a technique for evaluating financial
statement data that expresses each item
in a financial statement as a percent of
a base amount.
Total assets is always the base amount
in vertical analysis of a balance sheet.
Net sales is always the base amount in
vertical analysis of an income
statement.
29
KELLOGG COMPANY, INC.
Condensed Balance Sheets
December 31
(In millions)
2001
Assets
Amount
Percent
Current Assets $1,902.0
18.3
Property Assets 2,952.8
28.5
Other assets
5,513.8
53.2
Total assets
$10,368.6 100.0%
2000
z
Amount
Percent
$1,617.1
33.1
2,526.9
51.7
742.0
15.2
$4,886.0
100.0%
KELLOGG COMPANY, INC.
Condensed Balance Sheets
December 31
(In millions)
Liabilities and
Stockholders' Equity
Current liabilities
Long-term liabilities
Total liabilities
Stockholders' equity
Common stock
Retained earnings
and other
Treasury stock
Total stockholders'
equity
Total liabilities and
stockholders' equity
2001
Amount
Percent
2000
Amount Percent
$2,207.6
7,289.5
9,497.1
21.3
70.3
91.6
$2,482.3 50.8
1,506.2 30.8
3,988.5 81.6
195.3
1.9
1,013.3
(337.1)
9.8
(3.3)
1,065.7 21.8
(374.0) (7.6)
871.5
8.4
897.5 18.4
$10,368.6
100.0
205.8
4.2
$4,886.0 100.0
KELLOGG COMPANY, INC.
Condensed Income Statement
For the Years Ended December 31
(In millions)
2001
Amount Percent
$8,853.3
100.0
Net sales
Cost of goods sold
Gross profit
Selling & Admin.
Nonrecurring Chgs
Income operations
Interest expense
Other income
(expense),net
Income before
income taxes
Income tax expense
Net income
4,128.5
4,724.8
3,523.6
33.3
1,167.9
351.5
46.6
53.4
39.8
0.4
13.2
4.0
(12.3)
804.1
322.1
$482.0
2000
Amount
Percent
$6,954.7
100.0
3,327.0
3,627.7
2,551.4
86.5
989.8
137.5
47.8
52.2
36.7
1.2
14.3
2.0
(0.1)
15.4
0.2
9.1
3.6
5.5
867.7
280.0
$587.7
12.5
4.0
8.5
Condensed Income Statements
For the Year Ended December 31, 2001
(in millions)
Kellogg Company, Inc.
Amount Percent
Net sales
$8,853.3 100.0
Cost of goods sold
4,128.5 46.6
Gross profit
4,724.8 53.4
Selling and administrative
expenses
3,523.6 39.8
Nonrecurring charges
33.3
0.4
Income from operations 1,167.9 13.2
Other expenses and
revenues (including
income taxes)
685.9
7.7
Net income
$482.0
5.5
General Mills,Inc
Amount Percent
$7,949.0 100.0
4,767.0 60.0
3,182.0 40.0
1,909.0
190.0
1,083.0
24.0
2.4
13.6
622.0
$461.0
7.8
5.8
33
Ratios
Three types:
Liquidity ratios
Solvency ratios
Profitability ratios
Can provide clues to underlying conditions
that may not be apparent from an
inspection of the individual components.
Single ratio by itself is not very meaningful.
34
Liquidity Ratios
Measure the short-term
ability of the enterprise to
pay its maturing obligations
and to meet unexpected
needs for cash.
WHO CARES?
Short-term creditors such as
bankers and suppliers
35
Liquidity Ratios
Working capital
Current ratio
Current cash debt coverage ratio
Inventory turnover ratio
Days in inventory
Receivables turnover ratio
Average collection period
36
Working Capital
Indicates immediate shortterm debt-paying ability
Current Capital - Current liabilities
37
Current Ratio
Indicates short-term debtpaying ability
Current Assets
Current Liabilities
38
Current Cash Debt
Coverage Ratio
Indicates short-term debtpaying ability (cash basis)
Cash provided by operations
Average current liabilities
39
Inventory Turnover Ratio
Indicates liquidity of inventory
Cost of Goods Sold
Average Inventory
40
Days in Inventory
Indicates liquidity of
inventory and inventory
management
365 days
Inventory Turnover Ratio
41
Receivables Turnover Ratio
Indicates liquidity of
receivables
Net Credit Sales
Average Gross Receivables
42
Average Collection Period
Indicates liquidity of
receivables and collection
success
365 days
Receivables Turnover Ratio
43
Solvency Ratios
Measure the ability of the
enterprise to survive over a
long period of time
WHO CARES?
Long-term creditors and
stockholders
44
Illustration 13-18
Solvency Ratios
Debt to total assets ratio
Cash debt coverage ratio
Times interest earned ratio
Free cash flow
45
Debt to Total Assets Ratio
Indicates % of total assets
provided by creditors
Total Liabilities
Total Assets
46
Cash Debt Coverage Ratio
Indicates long-term debtpaying ability (cash basis)
Cash provided by operations
Average total liabilities
47
Times Interest Earned Ratio
Indicates company’s ability to
meet interest payments as they
come due
Net Income Before Interest
Expense & Income Tax
Interest Expense
48
Free Cash Flow
Indicates cash available for paying
dividends or expanding operations
Cash Provided By Operations
-
Capital Expenditures
-
Dividends Paid
Free Cash Flow
49
Profitability Ratios
Measure the income or operating
success of an enterprise for a given
period of time
WHO CARES? Everybody
WHY? A company’s income affects:
its ability to obtain debt and equity
financing
its liquidity position
its ability to grow
50
Profitability Ratios
Earnings per share (EPS)
Price-earnings ratio
Gross profit rate
Profit margin ratio
Return on assets ratio
Assets turnover ratio
Payout ratio
Return on equity ratio
51
Earnings Per Share (EPS)
Indicates net income earned on
each share of common stock
sales
Net Income - Preferred Stock
Average common shares outstanding
52
Price Earnings Ratio
Indicates relationship between
market price per share and
earnings per share
Stock Price Per Share
Earnings Per Share
53
Gross Profit Rate
Indicates margin between
selling price and cost of
good sold
Gross profit
Net sales
54
Profit Margin Ratio
Indicates net income
generated by each dollar of
sales
Net income
Net sales
Higher value suggests favorable
return on each dollar of sales.
55
Return On Assets Ratio
Reveals the amount of net
income generated by each
dollar invested
Net income
Average total assets
Higher value suggests favorable
efficiency.
56
Asset Turnover Ratio
Indicates how efficiently
assets are used to
generate sales
Net sales
Average total assets
57
Payout Ratio
Indicates % of earnings
distributed in the form of cash
dividends
Cash Dividends Declared on Common Stock
Net Income
58
Return on Equity Ratio
Indicates profitability of common
stockholders’ investment
Net income - preferred stock dividends
Average common stockholders’ equity
59
Pro Forma Income
A measure of the net income generated
that usually excludes items that the
company thinks are unusual or
nonrecurring.
60