CHAPTER
14
Performance Measurement
Sustainable Earnings
• Likely level of future cash flows is
generated by earnings
• Sustainable earnings is net earnings
adjusted for irregular items
Irregular Items
• Three types of irregular items are
reported (all net of taxes)
– Discontinued operations
– Extraordinary items
– Change in accounting principle
Discontinued Operations
• Disposal of a significant segment of a
business
• Report separately in statement of earnings
– Earnings (loss) from continuing operations,
and
– Earnings (loss) from discontinued operations
Discontinued Operations
• Earnings (loss) from discontinued operations
consists of:
– Earnings (loss) from operations and
– Gain (loss) on disposal of the segment
• Both components are reported net of
applicable taxes in a section entitled
Discontinued Operations, which follows
Earnings from Continuing Operations
Extraordinary Items
• Events and transactions that are:
– Infrequent in occurrence
– Unusual in nature
– Not subject to management determination
Change in
Accounting Principle
• Occurs when the principle used in the current
year is different from the one used in the
preceding year
• Is permitted, when:
– There has been a change in reporting
circumstances, and
– Management can show that the new principle
is preferable to the old
Comparative Analysis
• Three types of
comparisons:
– Intracompany basis
– Intercompany basis
– Industry averages
Comparative Analysis
• Three tools:
– Horizontal analysis
– Vertical analysis
– Ratio analysis
Horizontal Analysis
Change Current year amount — Base year amount
since
———————————————————————
base
Base year amount
period
ANY COMPANY INC.
Assumed Net Sales (in thousands)
2005 2004 2003 2002 2001
$ 6,562.8 $ 6,295.4 $ 6,190.6 $ 5,786.6 $ 5,181.4
127% 121% 119% 112% 100%
Vertical Analysis
• Expresses each item in a financial statement as a
percent of a base amount (total assets or net sales)
ANY COMPANY, INC.
Condensed Balance Sheets
December 31 (in thousands)
2005 2004
Assets Amount Percent Amount Percent
Current assets $1,496.5 29.6% $1,467.7 30.1%
Property, plant, and
equipment 2,888.8 57.2% 2,733.3 56.9%
Other assets 666.2 13.2% 636.6 13.0%
Total assets $5,051.5 100.0% $4,837.6 100.0%
Ratio Analysis
Liquidity Ratios
Measure short-term ability of
the enterprise to pay its
maturing obligations and to
meet unexpected needs for
cash
Since 1892 Solvency Ratios
Measure the ability of the
enterprise to survive over a
XYZ Co.
long period of time
Profitability Ratios
Revenues Expenses Measure the earnings or
- = Net
Earnings
operating success of an
enterprise for a given period
of time
Liquidity Ratios
• Working capital
• Current ratio
• Cash current debt coverage
• Inventory turnover
• Days in inventory
• Receivables turnover
• Average collection period
• Acid-test (quick) ratio
Working Capital
• Measures short-term debt-paying ability
Working Capital = Current Assets – Current Liabilities
Current Ratio
• Measures short-term debt-paying ability
Current Assets
Current Ratio =
Current Liabilities
Cash Current Debt Coverage
• Measures short-term debt-paying ability
(cash basis)
Cash Provided
Cash Current Debt by Operating Activities
Coverage =
Average Current Liabilities
Inventory Turnover
• Measures liquidity of inventory
Cost of Goods Sold
Inventory Turnover =
Average Inventory
Days in Inventory
• Measures number of days inventory is on
hand
365 Days
Days in Inventory =
Inventory Turnover
Receivables Turnover
• Measures liquidity of receivables
Net Credit Sales
Receivables Turnover =
Average Gross
Receivables
Average Collection Period
• Measures number of days receivables are
outstanding
365 Days
Average Collection Period =
Receivables Turnover
Acid-Test Ratio
• Measures immediate short-term
debt-paying ability
Cash + Short-Term
Investments + Net
Receivables
Acid-Test Ratio =
Current Liabilities
Solvency Ratios
• Debt to total assets
• Cash total debt coverage
• Times interest earned
• Free cash flow
Debt to Total Assets Ratio
• Measures % of total
assets provided by
creditors
Total Liabilities
Debt to Total Assets =
Total Assets
Cash Total Debt Coverage
• Measures long-term debt-paying ability
(cash basis)
Cash Provided by
Operating Activities
Cash Total Debt Coverage =
Average Total
Liabilities
Times Interest Earned
• Measures ability to meet interest payments
as they come due
Earnings Before Interest
Expense and Income Tax
Expense (EBIT)
Times Interest Earned =
Interest Expense
Free Cash Flow
• Measures cash available for paying
dividends or expanding operations
Cash - Capital - Dividends = Free
Provided Expenditures Paid Cash
by Flow
Operating
Activities
Profitability Ratios
• Earnings per share (EPS)
• Price-earnings (P-E) ratio
• Gross profit margin
• Profit margin
• Return on assets
• Asset turnover
• Return on common shareholders’ equity
• Payout ratio
Earnings Per Share (EPS)
• Measures net earnings earned on each
common share
Earnings Available to
Common Shareholders
Earnings Per Share =
Average Number of
Common Shares
Price-Earnings (P-E) Ratio
• Measures relationship between market
price per share and earnings per share
Share Price
Price-Earnings Ratio = Earnings Per
Share
Gross Profit Margin
• Measures margin between selling price and
cost of goods sold
Gross Profit
Gross Profit Margin =
Net Sales
Profit Margin
• Measures net earnings generated by
each dollar of sales
Net Earnings
Profit Margin =
Net Sales
Return On Assets
• Measures overall profitability of assets
Net Earnings
Return on Assets =
Average Total Assets
Asset Turnover
• Measures how efficiently assets are used to
generate sales
Net Sales
Asset Turnover =
Average Total Assets
Return on Common
Shareholders’ Equity
• Measures profitability of common
shareholders’ investment
Net Earnings –
Return on Common Preferred Dividends
Shareholders’ Equity =
Average Common
Shareholders’ Equity
Payout Ratio
• Measures % of earnings distributed in the
form of cash dividends
Cash Dividends
Payout Ratio =
Net Earnings
Quality of Earnings
• Increased importance today due to recent
corporate scandals
• Can be impacted by alternative accounting
principles (variation and discretion in
selection of GAAP)
• Companies report pro forma earnings which
are a non-GAAP earnings measure
• Quality of earnings also affected by improper
recognition of revenues and liabilities