OPERATING PERFORMANCE ANALYSIS

1. OPERATING PERFORMANCE ANALYSIS Chapter 12

2. CHAPTER 12 OBJECTIVES • Explain the objectives for analyzing operating performance. • Describe the importance of earnings quality in operating performance analysis. • Identify characteristics of sustainable earnings.

3. CHAPTER 12 OBJECTIVES (CONT.) • Distinguish between recurring and non-recurring earnings and explain why they produce different earnings quality. • Discuss how managerial decisions affect reported income. • Present a preliminary analysis of a company or industry’s operating performance.

4. OBJECTIVES FOR ANALYZING OPERATING PERFORMANCE • Understand the various types of income and attach economic meaning to them • Determine the sufficiency and sustainability of corporate earnings • Relate those earnings to a firm’s value and share price

5. INCOME AND WEALTH • Pervasive concepts • Wealth is discrete; the amount of goods and services that can be consumed at a given point in time • Wealth changes: the extent to which the amount wealth increases or decreases in a reporting period • Analytical problem: wealth and wealth creation are related to, but not the same as, cash balances and cash flows

6. INCOME AND WEALTH (CONT.) • Income theory • The economic view is that income represents the amount of periodic consumption that does not alter a store of wealth • Financial reporting bases its perspective of income on economic theory • The financial reporting system measures income as the difference between capital invested at the beginning of a period less net assets at the end of that period

7. INCOME AND WEALTH (CONT.) • Financial reporting assumes a nominal dollar concept of capital maintenance and adheres to the historical cost concept of asset valuation in measuring income • The financial reporting system reports income on a transaction approach (revenue and expense activities)

8. INCOME AND WEALTH (CONT.) • Income composition (Exhibit 12-1) • The all-inclusive income concept reports virtually all wealth related transactions in a reporting period • These transactions are categorized as operating, non-operating, and irregular income items

9. INCOME AND WEALTH (CONT.) • Operating income represents wealth created by core business activities • Non-operating income results from financing transactions (e.g., interest expense) and non-core activities (e.g., loss on the disposal of fixed assets)

10. INCOME AND WEALTH (CONT.) • Irregular items only sporadically affect income • Often involve substantially monetary amounts • Reported on a net of tax basis • Cover three types of gains (losses): discontinued business operations, extraordinary (unusual and infrequent) items, and changes in accounting principles

11. INCOME AND WEALTH (CONT.) • Comprehensive income • Items that affect wealth but are not reported on the income statement (e.g., market adjustments to available-for-sale securities) • Usually reported as a separate component of shareholders’ equity (i.e., the changes to wealth bypass the income statement)

12. INCOME AND WEALTH (CONT.) • Earnings per share (EPS) • Reports the amount of income earned by one share of stock • Eliminates the size bias inherent in aggregate income disclosures • Computed as (net income – preferred dividends) / weighted number of outstanding shares of common stock

13. INCOME AND WEALTH (CONT.) • Capital structure determines EPS disclosure • A simple capital structure consists of common stock and possibly preferred shares • A complex capital structure includes convertible securities and stock options, which would dilute EPS if they were exercised • An entity with a simple capital structure discloses a single EPS number, called basic EPS • An entity with a complex capital structure discloses two EPS numbers (dual disclosures), referred to as basic and diluted EPS

14. EARNINGS QUALITY • An assessment as to the extent to which reported income disclosures change an entity’s underlying wealth • All income components do not affect wealth in the same manner • Analysts must judge the relative worth of the various income disclosures

15. EARNINGS QUALITY (CONT.) • Earnings sustainability • An enterprise’s capacity to produce earnings on a recurring basis • Permanent in nature (i.e., they occur every reporting period) • Fundamental wealth increases • Produced by central business operations • Highly valued by analysts

16. EARNINGS QUALITY (CONT.) • Transitory earnings are not permanent • Marginal wealth increases • Result from nonrecurring or intermittently recurring items • Not highly valued by analysts

17. EARNINGS QUALITY (CONT.) • Non-operating income items • Can have a recurring affect on wealth (e.g., interest income) • Can affect wealth sporadically (e.g., corporate restructurings) • Corporate restructurings complicate assessment of earnings sustainability • Multiple restructurings reduce earning quality to an even greater degree than those resulting from a single restructuring

18. EARNINGS QUALITY (CONT.) • The policies and procedures used to determine income define earnings measurement, examples include • Costing inventory on a FIFO or LIFO basis • Depreciating fixed assets on a straight-line or accelerated basis

19. EARNINGS QUALITY (CONT.) • The continual selection of accounting choices that increase income is known as earnings management, examples include a • Reluctance to reduce inventory costs to their lower market value • Overestimation of the life of fixed assets

20. EARNINGS QUALITY (CONT.) • Benchmarking • Evaluation of one entity’s accounting principles and policies against the those of its competition and against itself over time • Incompatibility with other firms or inconsistency over time may indicate earnings management

21. EARNINGS QUALITY (CONT.)  • Earnings sufficiency • An assessment if an entity generates enough profits to remain viable • Analysts evaluate various profit margins to gain insight • Gross profit: revenues minus cost of good sold • Operating profit: gross profit minus operating expenses • Net profit: operating expenses minus other revenues and expenses

22. EARNINGS QUALITY (CONT.) • Sufficiency indicators • High gross and operating profit margins indicate sufficient earnings • Increasing gross and operating profit margin trends bode well for future earnings sufficiency • Low gross profit and operating profit margins indicate insufficient earnings • Decreasing gross and operating profit margin trends do not bode well for future earnings sufficiency

23. EARNINGS QUALITY (CONT.) • Recurring and nonrecurring earnings (Exhibits 12-3 and 12-4) • Correlation among the various profit margins indicate recurring earnings or high earnings quality • Lack of correlation among the various profit margins provide evidence of nonrecurring earnings or low earnings quality

24. EARNINGS QUALITY (CONT.) • Operating cash flows should coincide with operating income (Exhibit 12-5) • Strong correlation between operating income and operating cash flows indicates high earnings quality • Strong correlation between operating income and operating cash flows indicates high earnings quality

25. EARNINGS QUALITY (CONT.) • Operating income should coincide with net income • Constant difference between the two income numbers over time, which is attributable to a constant tax rate, indicates high earnings quality • Variable differences between the two income numbers over time indicate low earnings quality

28. ANALYSIS OF THE PC INDUSTRY • A relationship exists between market share and earnings • Apple’s decreased market share contributed to a decline in earnings, threatened profitability, and raised doubt about earnings sufficiency • Dell’s rapid increase in market share paved the way for greater earnings • Market share does not ensure profitability, as Compaq demonstrated in 1998

30. ANALYSIS OF THE PC INDUSTRY (CONT.) • Earnings sufficiency • Apple’s failure to generate sufficient earnings towards the end of the period analyzed was the result of • An erosion of its technological superiority • Decrease in market share • Diminished technological superiority • A lower revenue base with which to cover fixed costs • Research and development costs that exceeded industry norms

32. ANALYSIS OF THE PC INDUSTRY (CONT.) • Earnings sustainability • Industry growth contributed to variable profit margins throughout the industry and over time • Earnings varied among the four companies analyzed

33. ANALYSIS OF THE PC INDUSTRY (CONT.) • Data indicate that Apple’s earning were less sustainable that its competitors because the company • Did not conform to industry manufacturing standards • Had an unfavorable cost structure (Exhibits 12-10A and 12-10B) • Could not differentiate its products from those of its competitors