Chapter 14 Financial Performance Measurement 14 1 Starbucks

Chapter 14 Financial Performance Measurement 14– 1

Starbucks Corporation ü From 2005 to 2007, earnings per share increased 43% and net revenues increased 48% ü The company ended the fiscal 2007 year with $281 million in total cash and cash equivalents ü As you study this chapter, consider what other financial performance measures would be important to investors? © Royalty Free/ Getty Images Copyright © Cengage Learning. All rights reserved. 14– 2

LO 1 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 ü Top managers ü Creditors ü Mid-level managers ü Investors ü Employees ü Customers Copyright © Cengage Learning. All rights reserved. 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 Copyright © Cengage Learning. All rights reserved. 14– 4

External Users Use financial performance measurement to: ü past performance ü present position ü Assess future earnings potential and risk ü Assess future debt paying ability © Royalty Free/ Corbis Copyright © Cengage Learning. All rights reserved. 14– 5

Assessment of Risk Well-established, (stable company) Newly established, (small company) ü Can predict future profitability with higher level of confidence ü Lower risk ü Difficult to predict future profitability ü Higher risk q Investors demand higher expected returns for high risk investments q Creditors demand higher interest rates from high risk companies Copyright © Cengage Learning. All rights reserved. 14– 6

Standards of Comparison When analyzing financial statements, decision makers often use these measures to determine whether the results are favorable or unfavorable: üRule-of-thumb measures üPast performance üIndustry norms Copyright © Cengage Learning. All rights reserved. 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. Copyright © Cengage Learning. All rights reserved. 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 ü An improvement over rule-of-thumb measures ü basis for judging whether the measure or ratio is improving or deteriorating ü helpful in showing possible future trends ü Past performance may not be a useful indicator of adequacy for the future Copyright © Cengage Learning. All rights reserved. 14– 9

Industry Norms Shows how a company compares with other companies in the same industry Wal-Mart Target Return on assets 7. 8% 6. 1% Profit margin 3. 1% 3. 4% Return 19. 3% on equity 18. 5% Copyright © Cengage Learning. All rights reserved. Limitations: ü Companies may not be strictly comparable ü Diversified companies are difficult to compare ü different accounting procedures often makes companies difficult to compare 14– 10

Sources of Financial Information? ü Reports published by the corporation Annual report interim financial statements ü Reports filed with the SEC Form 10 -K (annual) Form 10 -Q (quarterly) ü Business periodicals and credit and investment advisory services The Wall Street Journal, Forbes, Barron’s Copyright © Cengage Learning. All rights reserved. 14– 11

Executive Compensation Components of compensation: üAnnual base salary üIncentive bonuses üStock option awards © Royalty Free/ Corbis compensation committee on the board determines the company’s top executives compensation and reports to the SEC. Copyright © Cengage Learning. All rights reserved. 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. Copyright © Cengage Learning. All rights reserved. 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 Copyright © Cengage Learning. All rights reserved. 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 Copyright © Cengage Learning. All rights reserved. 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 Copyright © Cengage Learning. All rights reserved. 14– 16

LO 2 Horizontal Analysis Computes changes from the previous year to the current year

Starbucks’ Horizontal Analysis Copyright © Cengage Learning. All rights reserved. 14– 18

Trend Analysis Calculation of changes for several years Uses an index number Copyright ©

Vertical Analysis or Common-Size Statement how the components of a financial statement relate to a total figure on the statement ü On the balance sheet, set total assets or total liabilities and stockholders’ equity to 100%. ü On the income statement, set net sales to 100%. The statement, expressed entirely in percentages, Copyright © Cengage Learning. All rights reserved. 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 Copyright © Cengage Learning. All rights reserved. 14– 21

Ratio Analysis Identifies meaningful relationships between the components of the financial statements • Ratios may be expressed in several ways: ü Net income is 1/10 of sales ü Net income is 10 percent of sales ü The ratio of sales to net income is 10 to 1 (10: 1) ü Sales are 10 times net income ü For every dollar of sales, the company has an average net income of 10 cents Copyright © Cengage Learning. All rights reserved. 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 Copyright © Cengage Learning. All rights reserved. 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. Copyright © Cengage Learning. All rights reserved. 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 Copyright © Cengage Learning. All rights reserved. 14– 25

LO 3 Illustration of Ratio Analysis Evaluating Liquidity Selected liquidity ratios for Starbucks: The company has insufficient current assets to cover current liabilities. Starbuck’s management of receivables declined while inventory improved from 2003 to 2004. Copyright © Cengage Learning. All rights reserved. 14– 26

Evaluating Profitability Selected profitability ratios for Starbucks: Starbucks is doing a slightly worse job of managing its costs per dollar of sales in 2007. From 2006 to 2007 return on assets weakened but return on equity improved. Copyright © Cengage Learning. All rights reserved. 14– 27

Evaluating Long-Term Solvency ratio for Starbucks: 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. ü Long-term solvency means that a company is expected to survive for many years. ü Increased debt may mean it is becoming too heavily leveraged and can result in bankruptcy Copyright © Cengage Learning. All rights reserved. 14– 28

Evaluating Cash Flow Adequacy Selected cash flow adequacy ratios for Starbucks: The cash flow yield was stable from 2006 to 2007. The cash-generating ability of sales decreased from 2006 to 2007. Copyright © Cengage Learning. All rights reserved. 14– 29

Evaluating Market Strength ü Market price indicates how investors view the potential risk and return associated with owning the stock. ü Ratios that combine market price with earnings or dividends help measure investors’ confidence in a company. © Royalty Free/ Corbis Copyright © Cengage Learning. All rights reserved. 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? Copyright © Cengage Learning. All rights reserved. 14– 31

Performance Evaluation at Harley Davidson View this video to learn more about how companies like Harley Davidson evaluate their progress and performance. Copyright © Cengage Learning. All rights reserved. 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 Copyright © Cengage Learning. All rights reserved. 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 Copyright © Cengage Learning. All rights reserved. 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. Copyright © Cengage Learning. All rights reserved. 14– 35