Principles of financial accounting 12e by needles crosson chapter 16

Concepts Underlying Financial Performance Measurement  Financial statement analysis or financial performance measurement is used to show how items in a company’s financial statement

Concepts Underlying Financial

Performance Measurement

 Financial statement analysis (or financial

performance measurement) is used to show how

items in a company’s financial statements relate to the company’s financial performance objectives

 When analyzing financial statements, decision

makers must judge whether the relationships they find in the statements are favorable or unfavorable – Many financial analysts, investors, and lenders apply

general standards, or rule-of-thumb measures, to key

financial ratios.

 Current ratio: The higher the ratio, the more likely the company will be able to meet its liabilities A ratio of 2 to 1 (2.0) or higher is desirable.

Past Performance and Industry Norms

 Comparing financial measures of the same company over time is an improvement over using rule-of-thumb measures

– Such a comparison gives the analyst some basis for judging whether the measure or ratio is getting better or worse

However, using a company’s past performance is not helpful

in judging its performance relative to that of other companies.

 Industry norms show how a company compares with other companies in the same industry, which

overcomes some of the limitations of comparing a

company’s measures over time

– However, diversified companies (or conglomerates)—

large companies that have multiple segments and operate

in more than one industry—may not be comparable to any

– Reports filed with the Securities and Exchange Commission

(SEC)

 Annual reports ( Form 10-K )

 Quarterly reports ( Form 10-Q )

 Current reports ( Form 8-K ) – Business periodicals and credit and investment advisory

services

Horizontal Analysis

 To gain insight into year-to-year

changes, analysts use horizontal

analysis , in which changes from the previous year to the current year are computed in both dollar amounts and percentages.

– The percentage change is computed as follows:

Percentage Change = 100 × Comparative Year Amount − Base Year Amount

Base Year Amount

- The base year is the first year considered in any set of

Trend Analysis

 Trend analysis is a variation of

horizontal analysis that calculates percentage changes for several

successive years instead of for just two years.

in related items over time.

 For an index number, the base year is set at 100 percent Other years are measured in relation to that number.

Vertical Analysis

 Vertical analysis shows how the different

components of a financial statement relate to a total figure in the statement.

– The analyst sets the total figure at 100 percent and computes each component’s percentage of that total – The resulting financial statement, which is expressed entirely in percentages, is called a common-size

statement

 Vertical analysis and common-size statements are useful in comparing the importance of specific components in the operation of a business and in identifying important changes

in the components from one year to the next They are often used to make comparisons between companies.

Financial Ratio Analysis

 Financial ratio analysis identifies key relationships between the components of the financial

statements.

– Investors and creditors use profit margin to evaluate a company’s

ability to earn a satisfactory income (profitability) They use asset

turnover to determine whether the company uses assets in a way

that maximizes revenue (total asset management) Their

combined effect is overall earning power—that is, return on assets.

– Liquidity is a company’s ability to pay bills when they are due and

to meet unexpected needs for cash To evaluate a company’s liquidity, analysts compute: cash flow yield; cash flows to sales; cash flows to assets; and free cash flow.

– Financial risk refers to a company’s ability to survive in good times and bad Ratios related to financial risk include debt to equity,

return on equity, and interest coverage.

Profit Margin and Asset Turnover

net income produced by each dollar of sales.

how efficiently assets are used

to produce sales.

Return on Assets and Cash Flow Yield

 Return on assets measures a

company’s overall earning power,

or profitability.

 Cash flow yield measures the

ability to generate operating cash flows in relation to net income.

Cash Flows to Sales and Cash Flows to Assets

 Cash flows to sales refers to the

ability of sales to generate

operating cash flows.

 Cash flows to assets measures the ability of assets to generate

operating cash flows.

Free Cash Flow

 Free cash flow is a measure of the cash remaining after providing for commitments.

Debt to Equity Ratio and Return on Equity

 The debt to equity ratio shows the amount of assets provided by

creditors in relation to the amount provided by stockholders.

 Return on equity measures the

return to stockholders.

Interest Coverage

 The interest coverage ratio is a

supplementary ratio that measures the degree of protection creditors have from default on interest

payments.

Evaluating Operating Asset Management

and Market Strength with Ratios

 The operating cycle spans the time it takes to

purchase inventory, sell it, and collect for it The

financing cycle —the period between the time a

supplier must be paid and the end of the operating cycle—defines how much financing the company

must have to support its operations

– Because debt increases a company’s risk, it is important to keep the financing period at a manageable level Ratios that measure operating asset management include inventory turnover, days’ inventory on hand, receivables turnover, days’ sales uncollected, payables turnover, days’ payable, and current and quick ratio.

 Market price is the price at which stock is bought and sold.

- It must be related to earnings by considering the price/earnings

Inventory Turnover and

Days’ Inventory on Hand

 Inventory turnover measures the relative size of inventories.

 Day’s inventory on hand measures the average number of days that it takes to sell inventory.

Receivables Turnover and

Days’ Sales Uncollected

 Receivables turnover measures the relative size of accounts receivable and the effectiveness of credit

Payables Turnover and Days’ Payable

 Payables turnover measures the

relative size of accounts payable

and the credit terms extended to a company.

 Days’ payable measures the

average number of days it takes to pay accounts payable.

Financing Period

 The financing period is computed

by deducting the days’ payable

from the operating cycle (days’

inventory on hand + days’ sales

uncollected)

Current Ratio and Quick Ratio

 The current ratio measures term debt-paying ability by

short-comparing current assets with

current liabilities.

 The quick ratio differs from the

current ratio in that the numerator

of the quick ratio excludes

inventories and prepaid expenses.

Price/Earnings (P/E) and Dividend Yield

 Price/earnings (P/E) is the ratio of the market price per share to

earnings per share.

 Dividend yield measures a stock’s current return to an investor in the form of dividends.

Evaluating Quality of Earnings

 The quality of earnings refers to the substance of

earnings and their sustainability into future periods

– It is affected by accounting method, accounting estimates, and one-time items.

– Different accounting methods have different effects on net

income.

– The latitude that companies have in their choice of accounting method could cause problems in the interpretation of financial statements were it not for the conventions of full disclosure and consistency.

 Full disclosure requires management to explain, in a note

to the financial statements, the significant accounting policies used.

 Consistency requires that the same accounting procedures

be used from year to year.

Accounting Estimates and One-Time Items

 In allocating expenses among the periods that benefit from them, accountants must make estimates and

exercise judgment, which will affect net income.

– Areas that require accounting estimates include: useful life of assets; residual value of assets; uncollectible accounts

receivable; sales returns; total units of production; total

recoverable units of natural resources; amortization periods; warranty claims; and environmental cleanup costs.

 If earnings increase because of one-time items, that

portion of earnings will not be sustained in the future.

– Examples of one-time items include: gains and losses;

write-downs and restructurings; and nonoperating items.

Gains and Losses and Write-Downs

and Restructurings

 When a company sells or disposes of operating assets or

marketable securities, a gain or loss generally results.

– These gains or losses appear in the operating section of the income statement, but they usually represent one-time

events From an analyst’s standpoint, they should be ignored when considering operating income.

 A write-down (or write-of) is a reduction in the

value of an asset below its carrying value on the

balance sheet.

 A restructuring is the estimated cost of a change in

a company’s operations

– Both write-downs and restructurings reduce current

operating income and boost future income by shifting future

Nonoperating Items

of a company’s operations—and gains or losses

on the sale or disposal of these segments.

ongoing operations, GAAP requires that gains

and losses from discontinued operations be

reported separately on the income statement

Management Compensation

 Under the Sarbanes-Oxley Act, a public corporation’s

board of directors must establish a compensation

committee made up of independent directors to

determine how the company’s top executives will be

compensated.

– Typical components of the compensation of

executive officers include:

 Annual base salary

 Annual incentive bonuses—based on financial performance measures that the compensation committee identifies as important to the company’s long-term success

 Long-term incentive compensation (stock option awards)— usually based on how well the company is achieving its