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Chapter 18 Financial Performance Evaluation Multimedia Slides by: Gail A. Mestas, MAcc, New Mexico State University Learning Objectives 1. Describe and discuss financial performance evaluation by internal and external users. 2. Describe and discuss the standards for financial performance evaluation. 3. Identify the sources of information for financial performance evaluation. Copyright © Houghton Mifflin Company. All rights reserved. 18–2 Learning Objectives (cont’d) 4. Apply horizontal analysis, trend analysis, vertical analysis, and ratio analysis to financial statements. 5. Apply ratio analysis to financial statements in a comprehensive evaluation of a company’s financial performance. Copyright © Houghton Mifflin Company. All rights reserved. 18–3 Financial Performance Evaluation by Internal and External Users • Objective 1 – Describe and discuss financial performance evaluation by internal and external users Copyright © Houghton Mifflin Company. All rights reserved. 18–4 Financial Performance Evaluation by Internal and External Users • Financial performance evaluation – Also called financial statement analysis – Shows important relationships in the financial statements and relates them to important financial objectives • Users of financial statements fall into two broad categories – Internal users – External users Copyright © Houghton Mifflin Company. All rights reserved. 18–5 Internal Users • Management – Uses financial performance evaluation in all stages of the management cycle – Primary objective • Increase the wealth of the owners or stockholders of the business Copyright © Houghton Mifflin Company. All rights reserved. 18–6 Internal Users (cont’d) • Management's primary objective divided into categories – Liquidity • Ability to pay bills when due and to meet unexpected needs for cash – Profitability • Ability to earn a satisfactory net income Copyright © Houghton Mifflin Company. All rights reserved. 18–7 Internal Users (cont’d) • Management's primary objective divided into categories – Long-term solvency • Ability to survive for many years – Cash flow adequacy • Ability to generate sufficient cash through operating, investing, and financing activities – Market strength • Ability to increase the wealth of owners Copyright © Houghton Mifflin Company. All rights reserved. 18–8 External Users • Creditors – Make loans in the form of trade accounts, notes, or bonds • Investors – Buy capital stock, from which they hope to receive dividends and an increase in value • Both groups face risks – Goal is to achieve a return that makes up for the risk Copyright © Houghton Mifflin Company. All rights reserved. 18–9 External Users and Risk • In general, the greater the risk taken, the greater the return required as compensation • Any one loan or any one investment can turn out badly • As a result, most creditors and investors put their funds into a portfolio, which is a group of loans or investments – The portfolio allows creditors and investors to average both the returns and the risks Copyright © Houghton Mifflin Company. All rights reserved. 18–10 Assessment of Past Performance and Current Position • Past performance – Good indicator of future performance • Look at trends of past sales, expenses, net income, cash flow, and return on investment • Current position – What assets the business owns – What liabilities the business must pay – Cash position – Debt to equity – Levels of inventories and receivables Copyright © Houghton Mifflin Company. All rights reserved. 18–11 Assessment of Future Potential and Related Risk • Information about the past is useful only to the extent that it bears on decisions about the future • Riskiness – Based on how easily future profitability or liquidity can be predicted • Well established, stable company – Can predict future profitability with higher level of confidence – Lower risk • Newly established, small company – Much more difficult to predict future profitability – Higher risk Copyright © Houghton Mifflin Company. All rights reserved. 18–12 Assessment of Future Potential and Related Risk (cont’d) • Investors demand higher expected returns for high risk investments • Creditors demand higher interest rates from high risk companies Copyright © Houghton Mifflin Company. All rights reserved. 18–13 The Sarbanes-Oxley Act • U.S. Congress passed broad legislation in an attempt to rectify problems with financial reporting – In response to financial reporting issues raised by the cases of Enron, WorldCom, and others • Designed to improve investor confidence in the financial reporting system as it applies to publicly traded companies The Sarbanes-Oxley Act does not apply to private (nonpublic) companies Copyright © Houghton Mifflin Company. All rights reserved. 18–14 Financial Reporting Under the SarbanesOxley Act • Public Oversight Board established for the accounting profession – Established auditing standards – Oversees other regulations involving auditors • Requires CEO and CFO to take responsibility for accuracy of annual and quarterly financial statements – Under criminal penalties Copyright © Houghton Mifflin Company. All rights reserved. 18–15 Financial Reporting Under the SarbanesOxley Act (cont’d) • Requires audit committee of public corporations to be made up of independent (nonofficer) board members – Some of whom must have financial expertise • Requires that the audit committee appoint the company’s auditor – The auditor is not allowed to do any consulting for the company Copyright © Houghton Mifflin Company. All rights reserved. 18–16 Discussion Q. What role does risk play in making loans and investments? A. Risk refers to the uncertainty of future events. It is associated with the ease of predicting the future performance of a loan or investment The more confident a creditor or investor is in predicting future liquidity or profitability, the less risk is associated with the loan or investment Copyright © Houghton Mifflin Company. All rights reserved. 18–17 Standards for Financial Statement Analysis • Objective 2 – Describe and discuss the standards for financial performance evaluation Copyright © Houghton Mifflin Company. All rights reserved. 18–18 Standards for Financial Statement Analysis • Decision makers must judge whether the relationships they have found are favorable or unfavorable • Three commonly used standards of comparison 1. Rule-of-thumb measures 2. Past performance of the company 3. Industry norms Copyright © Houghton Mifflin Company. All rights reserved. 18–19 Rule-of-Thumb Measures … are general standards, used by financial analysts, investors, and lenders, for key financial ratios • Examples found in Dun & Bradstreet’s Industry Norms and Key Business Ratios – Current debt to tangible net worth – Inventory to net working capital • Must be used with great care Copyright © Houghton Mifflin Company. All rights reserved. 18–20 Past Performance of the Company … is the comparison of financial measures or ratios of the same company over a period of time • An improvement over rule-of-thumb measures • Provides a basis for judging whether the measure or ratio is improving or deteriorating • It may also be helpful in showing possible future trends – Trends reverse at times, so projections must be made with care • Past performance may not be a useful indicator of adequacy for the future Copyright © Houghton Mifflin Company. All rights reserved. 18–21 Industry Norms … tell how the company compares with the average performance of other companies in the same industry • Industry norms probably offer the best available standards for judging current performance as long as they are used with care Copyright © Houghton Mifflin Company. All rights reserved. 18–22 Limitations of Industry Norms 1. Two companies that seem to be in the same industry may not be strictly comparable 2. When analyzing consolidated financial statements for diversified companies, there may be no comparable companies Diversified companies, or conglomerates, operate in many unrelated industries – 3. A partial solution is that diversified companies must report revenues, income from operations, and identifiable assets for each of their operating segments Companies in the same industry with similar operations may use different acceptable accounting procedures Copyright © Houghton Mifflin Company. All rights reserved. 18–23 Selected Segment Information for Goodyear Tire & Rubber Co. 18–24 Discussion Q. Why would a financial analyst compare the ratios of Steelco, a steel company, with the ratios of other companies in the steel industry? What factors might invalidate such a comparison? A. Comparisons are made to determine how Steelco’s performance ranks in the industry. This type of analysis might not be valid if Steelco has characteristics that make it different from other steel companies Copyright © Houghton Mifflin Company. All rights reserved. 18–25 Sources of Information • Objective 3 – Identify the sources of information for financial performance evaluation Copyright © Houghton Mifflin Company. All rights reserved. 18–26 Sources of Information • Major sources of information about publicly held corporations – Reports published by the company – SEC reports – Business periodicals and credit and investment advisory services Copyright © Houghton Mifflin Company. All rights reserved. 18–27 Reports Published by the Company • The annual report of a publicly held corporation is an important source of financial information • The main parts of an annual report – Management's analysis of the past year's operations – The financial statements – The notes to the statements, including the principal accounting procedures used by the company – The auditors' report – A summary of operations for a five- or a ten-year period Copyright © Houghton Mifflin Company. All rights reserved. 18–28 Interim Financial Statements • Most publicly held companies also publish interim financial statements, usually each quarter – Present limited financial information • In the form of condensed financial statements • Full audit by independent auditor not required – Are watched by the financial community for early signs of important changes in a company's earnings trend Copyright © Houghton Mifflin Company. All rights reserved. 18–29 SEC Reports • Publicly held corporations must file the following reports with the Securities and Exchange Commission (SEC) – Annual report (Form 10-K) • Contains more information than the published annual report – Quarterly report (Form 10-Q) • Presents important facts about interim financial performance – Current report (Form 8-K) • Presents important changes that may affect a company’s financial position, such as the sale or purchase of a division Copyright © Houghton Mifflin Company. All rights reserved. 18–30 Business Periodicals and Credit and Investment Advisory Services • Newspapers – The Wall Street Journal • Magazines – Forbes – Barron’s – Fortune – Financial Times • Other publications for further details about the financial history of companies – Available from services such as Moody's Investors Service, Inc. and Standard & Poor's Copyright © Houghton Mifflin Company. All rights reserved. 18–31 Business Periodicals and Credit and Investment Advisory Services (cont’d) • Data on industry norms, average ratios and relationships, and credit ratings – Dun & Bradstreet Corp • Industry Norms and Key Business Ratios – Robert Morris Associates • Annual Statement Studies • Specialized financial reporting – Moody’s Investor Service, Inc. • Handbook of Dividend Achievers Copyright © Houghton Mifflin Company. All rights reserved. 18–32 Discussion For each of the following pieces of information, indicate the best source a) b) c) d) c a d b c Reports published by the company SEC reports Business periodicals Credit and investment advisory services 1. Current market value of a company’s stock 2. Management’s analysis of the past year’s operations 3. Objective assessment of a company’s financial performance 4. Most complete body of financial disclosures 5. Current events affecting the company Copyright © Houghton Mifflin Company. All rights reserved. 18–33 Tools and Techniques for Financial Analysis • Objective 4 – Apply horizontal analysis, trend analysis, vertical analysis, and ratio analysis to financial statements Copyright © Houghton Mifflin Company. All rights reserved. 18–34 Tools and Techniques of Financial Analysis Horizontal analysis Trend analysis Vertical analysis Ratio analysis • The tools of financial performance evaluation are intended to show relationships and changes – Few numbers are very significant when looked at individually – It is the relationship between various numbers or their change from one period to another that is important Copyright © Houghton Mifflin Company. All rights reserved. 18–35 Horizontal Analysis … computes changes from the previous year to the current year in both dollar amounts and percentages • Required by GAAP • The base year is the first year considered  Amount of Change  Percentage Change 100    Base Year Amount  Copyright © Houghton Mifflin Company. All rights reserved. 18–36 Comparative Balance Sheets with Horizontal Analysis 18–37 Trend Analysis … is a type of horizontal analysis in which percentage changes are calculated for several successive years instead of for two years • Important because it may point to basic changes in the nature of a business • Uses an index number to show changes in related items over a period of time  Amount of Change  Index 100    Base Year Amount  Copyright © Houghton Mifflin Company. All rights reserved. 18–38 Trend Analysis Copyright © Houghton Mifflin Company. All rights reserved. 18–39 Vertical Analysis … is a technique for analyzing financial statements that uses percentages to show the relationship of the different parts to a total in a single statement Copyright © Houghton Mifflin Company. All rights reserved. 18–40 Vertical Analysis (cont’d) • The total figure in the statement set to equal 100% – Each component’s percentage of that total is computed • Also called a common-size statement • Useful for comparing – The importance of specific components in the operation of a business – Changes in the components from one year to the next Copyright © Houghton Mifflin Company. All rights reserved. 18–41 Common-Size Balance Sheets Copyright © Houghton Mifflin Company. All rights reserved. 18–42 Common-Size Balance Sheets Presented Graphically Copyright © Houghton Mifflin Company. All rights reserved. 18–43 Common-Size Income Statements Copyright © Houghton Mifflin Company. All rights reserved. 18–44 Common-Size Income Statements Presented Graphically Copyright © Houghton Mifflin Company. All rights reserved. 18–45 Ratio Analysis … is a technique of financial performance evaluation that identifies meaningful relationships between the components of the financial statements • Useful in – Evaluating a company’s financial position and operations – Making comparisons with results in previous years or with other companies • The primary purpose of ratios is to point out areas needing further investigation Copyright © Houghton Mifflin Company. All rights reserved. 18–46 Ratio Analysis (cont’d) • Ratios may be expressed in several ways – Net income is 1/10 of sales – Net income is 10 percent of sales – The ratio of net income to sales 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 Copyright © Houghton Mifflin Company. All rights reserved. 18–47 Discussion Q. What is the difference between horizontal and vertical analysis? A. Horizontal analysis is a year-to-year analysis of the components of a series of financial statements Vertical analysis is concerned with the relationship of items within a single financial statement Copyright © Houghton Mifflin Company. All rights reserved. 18–48 Comprehensive Illustration of Ratio Analysis • Objective 5 – Apply ratio analysis to financial statements in a comprehensive evaluation of a company’s financial performance Copyright © Houghton Mifflin Company. All rights reserved. 18–49 Evaluating Liquidity • Liquidity is a company's ability to pay bills when they are due and to meet unexpected needs for cash • All ratios that relate to liquidity involve working capital or some part of it Copyright © Houghton Mifflin Company. All rights reserved. 18–50 Evaluating Liquidity (cont’d) • Current ratio – Measures short-term debt-paying ability Current Assets Current Ratio  Current Liabilities • Quick ratio – Also measures short-term debt-paying ability Quick Ratio  Cash  Marketable Securities  Receivables Current Liabilities Copyright © Houghton Mifflin Company. All rights reserved. 18–51 Evaluating Liquidity (cont’d) • Receivable turnover – Measures relative size of receivables and effectiveness of credit policies Receivable Turnover  Net Sales Average Accounts Receivable • Average days’ sales uncollected – Measures average days taken to collect receivables Days in a Year Average Days' Sales Uncollected  Receivable Turnover Copyright © Houghton Mifflin Company. All rights reserved. 18–52 Evaluating Liquidity (cont’d) • Inventory turnover – Measures relative size of inventory Cost of Goods Sold Inventory Turnover  Average Inventory • Average days’ inventory on hand – Measures average days taken to sell inventory Days in a Year Average Days' Inventory on Hand  Inventory Turnover Copyright © Houghton Mifflin Company. All rights reserved. 18–53 Evaluating Profitability • Profitability reflects a company's ability to earn a satisfactory income • A company's profitability is closely linked to its liquidity because earnings ultimately produce cash flow Copyright © Houghton Mifflin Company. All rights reserved. 18–54 Evaluating Profitability (cont’d) • Profit margin – Measures net income produced by each sales dollar Net Income Profit Margin  Net Sales • Asset turnover – Measures how efficiently assets are used to produce sales Net Sales Asset Turnover  Average Total Assets Copyright © Houghton Mifflin Company. All rights reserved. 18–55 Evaluating Profitability (cont’d) • Return on assets – Measures overall earning power Return on Assets  Net Income Average Total Assets • Return on equity – Measures profitability of stockholders’ investments Net Income Return on Equity  Average Stockholders' Equity Copyright © Houghton Mifflin Company. All rights reserved. 18–56 Evaluating Long-Term Solvency … refers to a company's ability to survive for many years • The aim of long-term solvency analysis is to detect early signs that a company is headed for financial difficulty – Declining profitability and liquidity ratios – Unfavorable debt to equity ratio – Unfavorable interest coverage ratio Copyright © Houghton Mifflin Company. All rights reserved. 18–57 Evaluating Long-Term Solvency (cont’d) • Interest coverage ratio – Measure of creditors’ protection from default on interest payments Income Before Income Taxes  Interest Expense Interest CoverageRatio  Interest Expense Copyright © Houghton Mifflin Company. All rights reserved. 18–58 Evaluating Cash Flow Adequacy • Cash flow measures are closely related to the objectives of liquidity and longterm solvency – Because cash flows are needed to pay debts when they are due Copyright © Houghton Mifflin Company. All rights reserved. 18–59 Evaluating Cash Flow Adequacy (cont’d) • Cash flow yield – Measures overall ability to generate operating cash flows in relation to net income Net Cash Flows from Operating Activities Cash Flow Yield  Net Income • Cash flows to sales – Measures ability of sales to generate operating cash flows Cash Flows to Sales  Net Cash Flows from Operating Activities Net Sales Evaluating Cash Flow Adequacy (cont’d) • Cash flow to assets – Measures ability of assets to generate operating cash flows Cash Flows to Assets  Net Cash Flows from Operating Activities Average Total Assets • Free cash flow – Measures cash generated or cash deficiency after providing for commitments Free Cash Flow Net Cash Flows from Operating Activities - Dividends - Net Capital Expenditures Evaluating Market Strength • Market price – Price at which a company’s stock is bought and sold – Represents what investors as a whole think of the company at a point in time – Provides information about how investors view the potential return and risk connected with owning the company's stock – Is not very informative • Must be related to earnings by considering the price/earnings ratio and the dividends yield Copyright © Houghton Mifflin Company. All rights reserved. 18–62 Evaluating Market Strength (cont.) • Price/earnings ratio – Measures investor confidence in a company Price/Earnings Ratio  Market Price per Share Earnings per Share • Dividends yield – Measures a stock’s current return to an investor in the form of dividends Dividends Yield  Copyright © Houghton Mifflin Company. All rights reserved. Dividends per Share Market Price per Share 18–63 Discussion Q. What is the difference between liquidity and solvency? A. Liquidity is a firm’s ability to meet its current obligations, whereas solvency is a firm’s ability to meet all its maturing obligations as they come due, without losing the ability to continue operations Copyright © Houghton Mifflin Company. All rights reserved. 18–64 Time for Review 1. Describe and discuss financial performance evaluation by internal and external users 2. Describe and discuss the standards for financial performance evaluation 3. Identify the sources of information for financial performance evaluation Copyright © Houghton Mifflin Company. All rights reserved. 18–65 … And Finally 4. Apply horizontal analysis, trend analysis, vertical analysis, and ratio analysis to financial statements 5. Apply ratio analysis to financial statements in a comprehensive evaluation of a company’s financial performance Copyright © Houghton Mifflin Company. All rights reserved. 18–66