Chapter 14
Financial
Performance
Measurement
14–1
Starbucks Corporation
 From 2005 to 2007, earnings
per share increased 43% and
net revenues increased 48%
 The company ended the fiscal
2007 year with $281 million
in total cash and cash
equivalents
 As you study this chapter,
consider what other financial
performance measures would
be important to investors?
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14–2
LO1 Financial Performance Measurement
Shows important relationships in the financial
statements and relates them to important financial
objectives; also called financial statement analysis
Users of Financial Information
Internal
External
 Top managers
 Creditors
 Mid-level managers
 Investors
 Employees
 Customers
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14–3
Management: Financial Objectives and
Related Performance Objectives
Liquidity
Ability to pay bills when due
Profitability
Earn a satisfactory net income
Long-term
solvency
Able to survive for many years
Cash flow
adequacy
Generate sufficient cash
Market strength
Able to increase stockholders’ wealth
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14–4
External Users
Use financial performance measurement to:
 past performance
 present position
 Assess future earnings
potential and risk
 Assess future debt
paying ability
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14–5
Assessment of Risk
Well-established,
(stable company)
Newly established,
(small company)
 Can predict future
profitability with
higher level of
confidence
 Lower risk
 Difficult to predict
future profitability
 Higher risk
 Investors demand higher expected returns for high risk
investments
 Creditors demand higher interest rates from high risk
companies
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14–6
Standards of Comparison
When analyzing financial statements, decision makers
often use these measures to determine whether the
results are favorable or unfavorable:
Rule-of-thumb measures
Past performance
Industry norms
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14–7
Rule-of-Thumb Measures
General standards that
financial analysts or
lenders might apply to
key ratios
For
example
A current ratio (current assets
divided by current liabilities)
of 2:1 is acceptable.
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WARNING!
USE WITH CAUTION
May not apply to all
companies/industries
measures may simply
suggest a need for
further investigation
14–8
Past Performance
Comparison of financial measures or ratios of the
same company over a period of time
An improvement over rule-of-thumb
measures
basis for judging whether the measure or
ratio is improving or deteriorating
helpful in showing possible future trends
Past performance may not be a useful
indicator of adequacy for the future
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14–9
Industry Norms
Shows how a company compares with other
companies in the same industry
Wal-Mart Target
Return
7.8%
on assets
6.1%
Profit
margin
3.4%
3.1%
Return
19.3%
on equity
18.5%
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Limitations:
 Companies may not be
strictly comparable
 Diversified companies are
difficult to compare
 different accounting
procedures often makes
companies difficult to
compare
14–10
Sources of Financial Information?
 Reports published by the corporation
Annual report
interim financial statements
 Reports filed with the SEC
Form 10-K (annual)
Form 10-Q (quarterly)
 Business periodicals and credit and investment
advisory services
The Wall Street Journal, Forbes, Barron’s
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14–11
Executive Compensation
Components of compensation:
Annual base salary
Incentive bonuses
Stock option awards
© Royalty Free/ Corbis
compensation
committee on the
board determines the
company’s top
executives
compensation and
reports to the SEC.
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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.
14–12
Discussion: Ethics on the Job
Explain the following statement: As long as
chief financial officers and other corporate
managers' salaries, bonuses, or promotions
are linked to earnings, the temptation to
manage earnings will remain a problem.
A manager whose bonus or salary is tied to
corporate performance stands to benefit personally
if he or she boosts earnings, even if artificially so.
This places an ethical dilemma before the officers of
a corporation.
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14–13
Stop & Review
Q. What performance objective is tied to the
financial objective of liquidity?
A. The ability to pay bills when due and to
meet unexpected needs for cash
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14–14
Stop & Review
Q. Why would you expect the investment risk to
be lower for a well-established, stable
company?
A. Able to review prior performance and trends
and predict future profitability with greater
assurance than a newer company
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14–15
Stop & Review
Q. What three measures of comparison are
often used to determine whether financial
results are favorable or unfavorable?
A. Rule-of-thumb measures; past performance;
industry norms
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14–16
LO2 Horizontal Analysis
Computes changes from the previous year to
the current year divided by the previous year
 Amount of Change 
Percentage Change  

 Base Year Amount 
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14–17
Starbucks’ Horizontal Analysis
Starbucks Corporation
Consolidated Income Statements
For the Years Ended September 30, 2007, and October 1, 2006
(Dollar amounts in thousands)
Increase (Decrease)
2007
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 income taxes
Provision for income taxes
Net income
2006
$ 9,411,497 $ 7,786,942
3,999,124
3,178,791
$ 5,412,373 $ 4,608,151
$ 3,215,889
294,136
467,160
489,249
$ 4,466,434
$
945,939
110,425
$ 1,056,364
383,726
$
672,638
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Amount
$ 1,624,555
820,333
$ 804,222
$ 2,687,815 $
253,724
387,211
479,386
$ 3,808,136 $
$
800,015 $
106,228
$
906,243 $
324,770
$
581,473 $
528,074
40,412
79,949
9,863
658,298
145,924
4,197
150,121
58,956
91,165
Percentage
20.9
25.8
17.5
19.6
15.9
20.6
2.1
17.3
18.2
4
16.6
18.2
15.7
14–18
Trend Analysis
Calculation of changes for several years
 Index Year Amount 
Index  

 Base Year Amount 
Uses an index
number
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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14–19
Vertical Analysis
or Common-Size Statement
how the components of a financial statement
relate to a total figure on the statement
 On the balance sheet, set total assets or total
liabilities and stockholders’ equity to 100%.
 On the income statement, set net sales to 100%.
The statement, expressed entirely in percentages,
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14–20
Starbucks Common-Size
Income Statement
All other figures
are expressed in
relation to net
revenues
Cost of sales
including
occupancy costs is
42.5% of net
revenues;
depreciation and
amortization
expenses is 5.0%
of net revenues
Starbucks Corporation
Common-Size Income Statements
For the Years Ended September 30, 2007 and October 1, 2006
2007*
Net revenues
100.0
Cost of sales, including occupancy costs
42.5
Gross margin
57.5
Operating expenses:
Store operating expenses
34.2
Other operating expenses
3.1
Depreciation and amortization expenses
5.0
General and administrative expenses
5.2
Total operating expenses
47.5
Operating income
10.1
Other income, net
1.2
Income before income taxes
11.2
Provision for income taxes
4.1
Net income
7.1
*Percentages don't always add up due to rounding.
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2006*
%
%
%
%
%
%
%
100.0 %
40.8
59.2 %
34.5
3.3
5.0
6.2
48.9
10.3
1.4
11.6
4.2
7.2
%
%
%
%
%
14–21
Ratio Analysis
Identifies meaningful relationships between the
components of the financial statements
• Ratios may be expressed in several ways:
 Net income is 1/10 of sales
 Net income is 10 percent of sales
 The ratio of sales to net income is 10 to 1 (10:1)
 Sales are 10 times net income
 For every dollar of sales, the company has an average
net income of 10 cents
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14–22
Stop & Review
Q. If you were asked to perform a vertical
analysis of an income statement, which
figure would you set to 100 percent?
A. Net sales or net revenues
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14–23
Stop & Review
Q. What is the difference between trend
analysis and horizontal analysis?
A. Horizontal analysis compares two years
while trend analysis compares several
consecutive years.
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14–24
Stop & Review
Q. The CEO of Roundtable Industries would
like to know how the company’s sales and
expenses have changed since the last year.
Which type of analysis would be most
useful?
A. Horizontal analysis of the income statement
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14–25
LO3 Illustration of Ratio Analysis
Evaluating Liquidity
Selected liquidity ratios for Starbucks:
2007
Current
Ratio
Current Assets
Current Liabilities
=
=
$1,696,487
$2,155,566
2006
=
0.8 times
0.8 times
The company has insufficient current assets to cover current liabilities.
2007
Receivable
Turnover
=
Net Sales
Average A/R
2006
$9,411,497
= 36.7 times 37.5 times
($287,925 + $224,271) ÷ 2
=
2007
Inventory
Turnover
=
Cost of Goods Sold
Average Inventory
=
$3,999,124
=
($691,658 + $636,222) ÷ 2
2006
6.0 times
5.4 times
Starbuck’s management of receivables declined while inventory
improved from 2003 to 2004.
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14–26
Evaluating Profitability
Selected profitability ratios for Starbucks:
Profit
Margin
Net Income
Net Sales
=
2007
$672,638
$9,411,497
=
2006
= 7.1%
7.2%
Starbucks is doing a slightly worse job of managing its costs per
dollar of sales in 2007.
2007
Return on
Assets
=
Net Income
Average Total Assets
$672,638
$4,886,410
=
2006
=
13.8%
2007
Return
Net Income
=
on Equity
Average Stockholders' Equity
=
$672,638
$2,256,312
14.2%
2006
=
29.8%
26.1%
From 2006 to 2007 return on assets weakened but return on equity
improved.
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14–27
Evaluating Long-Term Solvency
Solvency ratio for Starbucks:
2007
Debt-toEquity Ratio
=
Total Liabilities
Stockholders' Equity
=
$3,059,761
$2,284,117
2006
=
1.3 times
1.0 times
shows the amount of assets provided by creditors in relation to the
amount provided by stockholders.
The ratio increased from 2003 to 2004 – indicating an increased reliance
on debt financing.
 Long-term solvency means that a company is expected
to survive for many years.
 Increased debt may mean it is becoming too heavily
leveraged and can result in bankruptcy
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14–28
Evaluating Cash Flow Adequacy
Selected cash flow adequacy ratios for Starbucks:
2007
Cash
Flow
Net Cash Flows from Operating Activities
Net Income
=
$1,331,221
$672,638
=
2006
=
2.0 times
2.0 times
The cash flow yield was stable from 2006 to 2007.
2007
Cash Flows
to Sales
=
Net Cash Flows from Operating Activities
Net Sales
=
$1,331,221
$9,411,497
=
2006
14.1%
14.5%
The cash-generating ability of sales decreased from 2006 to 2007.
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14–29
Evaluating Market Strength
 Market price indicates how
investors view the potential
risk and return associated
with owning the stock.
 Ratios that combine market
price with earnings or
dividends help measure
investors’ confidence in a
company.
© Royalty Free/ Corbis
Starbucks'
Price/Earnings
Ratio
2007
=
Market Price per Share
Earnings per Share
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=
$27.08
$0.90
2006
= 30.1 times 45.6 times
14–30
Internet Research: Starbucks
Locate an investors guide or stock analysis
website and find a current analysis of
Starbucks’ stock (SBUX). Is the company
considered a “buy,” “hold,” or “sell” stock?
What discussion is provided that supports
this opinion?
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14–31
Performance Evaluation at
Harley Davidson
View this video to
learn more about how
companies like Harley
Davidson evaluate
their progress and
performance.
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14–32
Stop & Review
Q. Why might some investors find liquidity a
more immediate goal than profitability?
A. Some investors may feel that without
sufficient cash to pay for debts, the company
will not survive long enough to be profitable
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14–33
Stop & Review
Q. What types of ratios help investors determine
liquidity?
A. Current, quick, receivable turnover, days’
sales uncollected, inventory turnover, days’
inventory on hand, payables turnover, days’
payable
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14–34
Chapter Review Problem
The balance sheet and income statement for Tray
Companies are presented on the following screens. As a
prospective investor, review the statements and analyze the
company’s performance as required in the next five steps.
Required:
1. Perform a vertical analysis of the income statement.
2. How well is the company prepared to cover its current liabilities?
3. What is the company’s profit margin? How well does it compare to the
industry norm of 9 percent?
4. Cash flows from operating activities were $563,535. What was the cash
flow yield?
5. What is the return on assets? Total assets at the beginning of the year were
$3,095,440.
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14–35
Chapter Review Problem
Tray Companies
Income Statement
For the Year Ended December 31, 20x6
Net revenues
Cost of sales
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 income taxes
Provision for income taxes
Net income
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$1,435,339.00
765,339.00
$ 670,000.00
174,930.00
121,861.00
59,539.00
85,334.00
$ 441,664.00
228,336.00
34,797.00
$ 263,133.00
52,626.60
$ 210,506.40
14–36
Chapter Review Problem (cont’d)
Tray Companies
Balance Sheet
December 31, 20x6
Assets
Current assets
Property, plant, and equipment, net
Long-term investments
Other assets
Goodwill
Other intangible assets
Total assets
$ 654,833
1,353,659
935,353
65,343
93,335
45,338
$ 3,147,861
Liabilities and Stockholders’ Equity
Current liabilities
Deferred income taxes
Long-term debt and other obligations
Stockholders’ equity
Total liabilities and stockholders' equity
$ 353,987
34,985
1,183,533
1,575,356
$ 3,147,861
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14–37
Chapter Review Problem (Solution)
1.
Tray Companies
Income Statement
For the Year Ended December 31, 20x6
Net revenues
Cost of sales
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 income taxes
Provision for income taxes
Net income
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$1,435,339
765,339
$670,000
100.0%
53.3
46.7%
$174,930
121,861
59,539
85,334
$441,664
$228,336
34,797
$263,133
52,627
$210,506
12.2%
8.5
4.1
5.9
30.8%
15.9%
2.4
18.3%
3.7
14.7%
14–38
Chapter Review Problem (cont’d)
2.
Current
Ratio
=
3.
Profit
Margin
=
Current Assets
Current Liabilities
Net Income
Net Sales
$654,833
$353,987
=
1.8 times
$210,506
$1,435,339
=
14.7%
=
=
This company is performing better than the industry norm of 9
percent.
4.
Cash Flow
Net Cash Flows from Oper. Activities
=
Yield
Net Income
5.
Return on
Net Income
=
Assets
Average Total Assets
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=
=
$563,535
$210,506
$210,506
$3,121,651
=
=
2.7 times
6.7%
14–39