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Chapter 14
Financial
Performance
Measurement
Skyline College
Lecture Notes
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 who own
stock in the company
 Customers who have
agreements with the
company
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14–2
Management: Financial Objectives and
Related Performance Objectives
Liquidity
Able to pay bills when due and meet
unexpected needs for cash
Profitability
Earn a satisfactory net income
Long-term
solvency
Able to survive for many years
Cash flow
adequacy
Generate sufficient cash through
operating, investing, and financing
activities
Market strength
Able to increase stockholders’ wealth
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14–3
External Users
Use financial performance measurement to:
 Judge past and present position
 Assess future earnings potential and risk
 Assess future debt paying ability
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14–4
Assessment of Risk
• Well-established, stable
company
• Newly established,
small company
 Can predict future
profitability with higher
level of confidence
 Difficult to predict
future profitability
 Higher risk
 Lower risk
 Investors demand higher expected returns for high risk
investments
 Creditors demand higher interest rates from high risk
companies
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14–5
Standards of Comparison
When analyzing financial statements, decision makers often use
these three common methods to determine whether the results
are favorable or unfavorable:
Rule-of-thumb measures
 There is no proof that apply to all companies
 Must be used with caution
Past performance
 Provides a basis for judging whether the measure or ratio chnging
 It may also be helpful in showing possible future trends Past
performance may not be a useful indicator of adequacy for the future
Industry norms or averages
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14–6
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 in the same
industry may not be strictly
comparable
 Diversified companies are
difficult to compare
 Use of different accounting
procedures often makes
companies difficult to
compare
14–7
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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14–8
Executive Compensation
A public corporation’s board must establish a
compensation committee to determine how the
company’s top executives will be compensated and
report the details of compensation to the SEC.
Components of compensation:
Annual base salary
Incentive bonuses
Stock option awards
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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.
14–9
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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14–10
Horizontal Analysis
Computes changes from the previous year to the current year
in both dollar amounts and percentages
 Amount of Change 
Percentage Change  100  

 Base Year Amount 
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14–11
Starbucks’ Horizontal Analysis
Starbucks Corporation
Consolidated Income Statements
For the Years Ended October 3, 2004, and September 28, 2003
(Dollar amounts in thousands)
Increase (Decrease)
2004
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
2003
$ 5,294,247 $ 4,075,522
2,198,654
1,685,928
$ 3,095,593 $ 2,389,594
$ 1,790,168
171,648
280,024
304,293
$ 2,546,133
$
549,460
74,797
$
624,257
232,482
$
391,775
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Amount
$ 1,218,725
512,726
$ 705,999
$ 1,379,574 $
141,346
237,807
244,550
$ 2,003,277 $
$
386,317 $
50,018
$
436,335 $
167,989
$
268,346 $
410,594
30,302
42,217
59,743
542,856
163,143
24,779
187,922
64,493
123,429
Percentage
29.9
30.4
29.5
29.8
21.4
17.8
24.4
27.1
42.2
49.5
43.1
38.4
46.0
14–12
Trend Analysis
Calculation of percentage changes for several
successive years
Uses an index
number
 Index Year Amount 
Index  100  

 Base Year Amount 
Starbucks Corporation
Net Revenues and Operating Income
Trend Analysis
2004
Dollar values
(In thousands)
Net revenues
Operating income
Trend analysis
(In percentages)
Net revenues
Operating income
2003
2002
2001
2000
$5,294,247
549,460
$4,075,522
386,317
$3,288,908
282,893
$2,648,980
252,479
$2,177,614
191,952
243.1
286.2
187.2
201.3
151.0
147.4
121.6
131.5
100.0
100.0
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14–13
Vertical Analysis
Shows how the different 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 resulting statement, expressed entirely in
percentages, is called a common-size statement.
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14–14
Starbucks Common-Size
Income Statement
All other figures
are expressed in
relation to net
revenues
Cost of sales
including
occupancy costs is
41.5% of net
revenues;
Depreciation and
amortization is
5.3% of net sales
Starbucks Corporation
Common-Size Income Statements
For the Years Ended October 3, 2004, and September 28, 2003
2004*
Net revenues
100.0
Cost of sales, including occupancy costs
41.5
Gross margin
58.5
Operating expenses:
Store operating expenses
33.8
Other operating expenses
3.2
Depreciation and amortization expenses
5.3
General and administrative expenses
5.7
Total operating expenses
48.1
Operating income
10.4
Other income, net
1.4
Income before income taxes
11.8
Provision for income taxes
4.4
Net income
7.4
*Percentages don't always add up due to rounding.
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2003*
%
%
%
%
%
%
%
100.0 %
41.4
58.6 %
33.9
3.5
5.8
6.0
49.2
9.5
1.2
10.7
4.1
6.6
%
%
%
%
%
14–15
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 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
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14–16
Evaluating Liquidity
Selected liquidity ratios for Starbucks:
2004
Current
Ratio
Current Assets
Current Liabilities
=
=
$1,368,485
$782,980
2003
=
1.7 times
1.5 times
The company has sufficient current assets to cover current liabilities.
2004
Receivable
Turnover
=
Net Sales
Average A/R
2003
$5,294,247
= 41.6 times 38.4 times
($140,226 + $114,448) ÷ 2
=
2004
Inventory
Turnover
=
Cost of Goods Sold
Average Inventory
=
$2,198,654
=
($422,663 + $342,944) ÷ 2
2003
5.7 times
5.6 times
Starbuck’s management of receivables and inventory improved from
2003 to 2004.
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14–17
Evaluating Profitability
Selected profitability ratios for Starbucks:
Profit
Margin
Net Income
Net Sales
=
2004
$391,775
$5,294,247
=
2003
=
7.4%
6.6%
Starbucks is doing a better job of managing its costs per dollar of
sales in 2004.
2004
Return on
Assets
=
Net Income
Average Total Assets
$391,775
$3,028,957
=
2003
=
12.9%
2004
Return
Net Income
=
on Equity
Average Stockholders' Equity
=
$391,775
$2,284,591
10.9%
2003
=
17.1%
14.1%
Both return on assets and return on equity improved from 2003 to 2004.
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14–18
Evaluating Long-Term Solvency
Solvency ratio for Starbucks:
2004
Debt-toEquity Ratio
=
Total Liabilities
Stockholders' Equity
=
$841,413
$2,486,755
2003
=
0.3 times
0.3 times
This ratio shows the amount of Starbucks’ assets provided by creditors in
relation to the amount provided by stockholders. The ratio is stable from
2003 to 2004 – a positive indicator.
 Long-term solvency means that a company is expected
to survive for many years.
 Increasing amounts of debt may mean that it is
becoming too heavily leveraged and can result in
bankruptcy
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14–19
Evaluating Cash Flow Adequacy
Selected cash flow adequacy ratios for Starbucks:
2004
Cash
Flow
=
Net Cash Flows from Operating Activities
Net Income
=
$793,848
$391,775
=
2003
2.0 times
2.1 times
The cash flow yield decreased, revealing that net income increased faster
than net cash flows provided by operating activities.
2004
Cash Flows
to Sales
Net Cash Flows from Operating Activities
=
=
Net Sales
$793,848
$5,294,247
=
2003
15.0%
13.9%
The cash-generating ability of sales increased from 2003 to 2004.
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14–20
Evaluating Market Strength
 Market price indicates how investors view the
potential risk and return of owning the stock.
 Ratios that combine market price with earnings or
dividends help measure investors’ confidence in a
company.
Starbucks'
Price/Earnings
Ratio
2004
=
Market Price per Share
Earnings per Share
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=
$45.23
$0.99
2003
= 45.7 times 39.7 times
14–21