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Performance Measurement

CHAPTER. Performance Measurement . 14. 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)

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Performance Measurement

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  1. CHAPTER Performance Measurement 14

  2. Sustainable Earnings • Likely level of future cash flows is generated by earnings • Sustainable earnings is net earnings adjusted for irregular items

  3. Irregular Items • Three types of irregular items are reported (all net of taxes) • Discontinued operations • Extraordinary items • Change in accounting principle

  4. 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

  5. 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

  6. Extraordinary Items • Events and transactions that are: • Infrequent in occurrence • Unusual in nature • Not subject to management determination

  7. 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

  8. Comparative Analysis • Three types of comparisons: • Intracompany basis • Intercompany basis • Industry averages

  9. Comparative Analysis • Three tools: • Horizontal analysis • Vertical analysis • Ratio analysis

  10. ANY COMPANY INC. Assumed Net Sales (in thousands) 127% 121% 119% 112% 100% 2005 2004 2003 2002 2001 $ 6,562.8 $ 6,295.4 $ 6,190.6 $ 5,786.6 $ 5,181.4 Horizontal Analysis Change since base period

  11. Vertical Analysis • Expresses each item in a financial statement as a percent of a base amount (total assets or net sales)

  12. Liquidity Ratios Measure short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash Since 1892 Profitability Ratios Measure the earnings or operating success of an enterprise for a given period of time - Revenues Expenses = Net Earnings Solvency Ratios Measure the ability of the enterprise to survive over a long period of time XYZ Co. Ratio Analysis

  13. Liquidity Ratios • Working capital • Current ratio • Cash current debt coverage • Inventory turnover • Days in inventory • Receivables turnover • Average collection period • Acid-test (quick) ratio

  14. Working Capital • Measures short-term debt-paying ability

  15. Current Ratio • Measures short-term debt-paying ability

  16. Cash Current Debt Coverage • Measures short-term debt-paying ability (cash basis)

  17. Inventory Turnover • Measures liquidity of inventory

  18. Days in Inventory • Measures number of days inventory is on hand

  19. Receivables Turnover • Measures liquidity of receivables

  20. Average Collection Period • Measures number of days receivables are outstanding

  21. Acid-Test Ratio • Measures immediate short-term debt-paying ability

  22. Solvency Ratios • Debt to total assets • Cash total debt coverage • Times interest earned • Free cash flow

  23. Debt to Total Assets Ratio • Measures % of total assets provided by creditors

  24. Cash Total Debt Coverage • Measures long-term debt-paying ability (cash basis)

  25. Times Interest Earned • Measures ability to meet interest payments as they come due

  26. Free Cash Flow • Measures cash available for paying dividends or expanding operations

  27. 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

  28. Earnings Per Share (EPS) • Measures net earnings earned on each common share

  29. Price-Earnings (P-E) Ratio • Measures relationship between market price per share and earnings per share

  30. Gross Profit Margin • Measures margin between selling price and cost of goods sold

  31. Profit Margin • Measures net earnings generated by each dollar of sales

  32. Return On Assets • Measures overall profitability of assets

  33. Asset Turnover • Measures how efficiently assets are used to generate sales

  34. Return on CommonShareholders’ Equity • Measures profitability of common shareholders’ investment

  35. Payout Ratio • Measures % of earnings distributed in the form of cash dividends

  36. 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

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