Chapter 13

1. Chapter 13 `

2. Chapter 13Performance Measurement After studying Chapter 13, you should be able to: • Understand the concept of sustainable income. • Indicate how irregular items are presented. • Explain the concept of comprehensive income. • Describe and apply horizontal analysis. • Describe and apply vertical analysis.

3. Chapter 13Performance Measurement After studying Chapter 13, you should be able to: • Identify and compute ratios used in analyzing a company’s liquidity, solvency, and profitability. • Understand the concept of quality of earnings.

4. Sustainable Income... • Is the most likely level of income to be obtained in the future. • Does not include irregular revenues, expenses, gains, or losses.

5. Irregular Items Three types of irregular items are reported -- (all net of taxes) • discontinued operations • extraordinary items • changes in accounting principle

6. Discontinued Operations... Refers to the disposal of a significant segment of a business... • the elimination of a major class of customers or • an entire activity.

7. Extraordinary Items... Are events and transactions that meet two conditions: • Unusual in nature • Infrequent in occurrence

8. Extraordinary Items

9. Change in Accounting Principle • Occur when the principle used in the current year is different from the one used in the preceding year. • Is permitted, when • management can show that the new principle is preferable to the old and • the effects of the change are clearly disclosed in the income statement. • Examples: • a change in depreciation methods (such as declining-balance to straight-line) • a change in inventory costing methods (such as FIFO to average cost).

10. Change in Accounting Principle • The new principle should be used in reporting the results of operations of the current year. • The cumulative effect of the change on all prior-year income statements should be disclosed net of applicable taxes in a special section immediately preceding net income.

11. Rozek Inc. Partial Income Statement For the Year Ended December 31, 2004 Income before income taxes $800,000 Income tax expense 240,000 Income from continuing operations 560,000 Discontinued operations Loss from disposal of chemical division, net of $90,000 income tax saving (210,000) Net income before extraordinary item 350,000 Extraordinary item Expropriation of investment, net of $21,000 income tax saving (49,000) Cumulative effect of change in accounting principle Effect on prior years of change in depreciation method, net of $ 7,200 tax (16,800) Net Income 284,200

12. Estimating Sustainable Income SUMMARY When evaluating a company, it generally makes sense to eliminate all irregular items.

13. Comprehensive Income... Includes all changes in stockholders' equity during a period except those resulting from investments by stockholders and distributions to stockholders.

14. Comprehensive Income • The FASB now requires that, in addition to reporting net income, a company must also report comprehensive income.

15. Comprehensive Income • Most revenues, expenses, gains, and losses recognized during the period are included in net income. • Specific exceptions to this practice have developed - these items bypass income and are reported directly in stockholders’ equity.

16. Comprehensive Income Unrealized gains and losses on available-for-sale securities are excluded from net income because disclosing them separately - • reduces the volatility of net income due to fluctuations in fair value, yet • informs the financial statement user of the gain or loss that would be incurred if the securities were sold at fair value.

17. Comparative Analysis • Whether the amount represents an increase over prior years, or whether it is adequate in relation to the company's needs, cannot be determined from the amount alone. • The amount must be compared with other financial data to provide more information.

18. Comparative Analysis There are three types of comparisons to provide decision usefulness of financial information: • Intracompany basis • Intercompany basis • Industry averages

19. Intracompany Basis • Comparisons within a company are often useful to detect changes in financial relationships and significant trends. • A comparison of Kellogg's current year's cash amount with the prior year's cash amount shows either an increase or a decrease. • A comparison of Kellogg's year-end cash amount with the amount of total assets at year-end shows the proportion of total assets in the form of cash.

20. Intercompany Basis • Comparisons with other companies provide insight into a company's competitive position. • Kellogg's total sales for the year can be compared with the total sales of its competitors such as Quaker Oats and General Mills.

21. Industry Averages • Comparisons with industry averages provide information about a company's relative position within the industry. • Kellogg's financial data can be compared with the averages for its industry compiled by financial ratings organizations such as Dun & Bradstreet, Moody's, and Standard & Poor's.

22. Financial Statement Analysis Three basic tools are used in financial statement analysis : 1. Horizontal analysis 2. Vertical analysis 3. Ratio analysis

23. Horizontal Analysis • Is a technique for evaluating a series of financial statement data over a period of time. • Purpose is to determine whether an increase or decrease has taken place. • The increase or decrease can be expressed as either an amount or a percentage.

24. Horizontal Analysis CURRENT-YEAR AMOUNT - BASE-YEAR AMOUNT BASE-YEAR AMOUNT

25. Percentage Change in Sales The percentage change in sales for each of the 5 years, assuming 1997 as the base period is: Kellogg Company Net Sales (in millions) Base Period 2000 20012000199919981997 $8,853.3 $6,954.7 $6,984.2 $6762.1 $6,830.1 129.62% 101.82 % 102.26% 99% 100.0%

26. Horizontal Analysis of a Balance Sheet KELLOGG COMPANY, INC. Condensed Balance Sheets December 31 (In millions) Increase (Decrease) during 2001 20012000AmountPercent Assets Current Assets $1,902.0 $1,617.1 $ 284.9 17.6 Plant assets 2,952.8 2,526.9 425.9 16.9 Other assets 5,513.8 742.04,771.8643.1 Total assets $10,368.6 $4,886.0 $5,482.6 112.2

27. Horizontal Analysis of a Balance Sheet Increase (Decrease) during 2001 20012000AmountPercent Liabilities and Stockholders' Equity Current liabilities $2,207.6 $2,482.3 (274.7) (11.1) Long-term liabilities 7,289.5 1,506.25,783.3384.0 Total liabilities 9,497.1 3,988.5 5,508.6 138.1 Stockholders' equity Common stock 195.3 205.8 (10.5) (5.1) Retained earnings and other 1,013.3 1,065.7 (52.4) (4.9) Treasury stock (337.1) (374.0) 36.99.9 Total stockholders' equity 871.5897.5(26.0)(2.9) Total liabilities and stockholders' equity $10,368.6 $4,886.0 $5,482.6 112.2

28. KELLOGG COMPANY, INC. Condensed Income Statement For the Years Ended December 31 (In millions) Increase (Decrease) during 2001 20012000AmountPercent Net sales $8,853.3 $6,954.7 $1,898.6 27.3 Cost of goods sold 4,128.53,327.0801.524.1 Gross profit 4,724.8 3,627.7 1,097.1 30.2 Selling & Admin. 3,523.6 2,551.4 972.2 38.1 Nonrecurring charges 33.3 86.5(53.2)(61.5) Income from operations 1,167.9 989.8 178.1 18.0 Interest expense 1351.5 137.5 214.0 155.6 Other income (expense), net (12.3) 15.4 (27.7)(179.9) Income before taxes 804.1 867.7 (63.6) (7.3) Income tax expense 322.1 280.0 42.115.0 Net income $482.0 $587.7 ($105.7) (18.0)

29. Vertical Analysis • Is a technique for evaluating financial statement data that expresses each item in a financial statement as a percent of a base amount. • Total assets is always the base amount in vertical analysis of a balance sheet. • Net sales is always the base amount in vertical analysis of an income statement.

30. KELLOGG COMPANY, INC. Condensed Balance Sheets December 31 (In millions) 2001 2000 z AssetsAmountPercentAmountPercent Current Assets $1,902.0 18.3 $1,617.1 33.1 Property Assets 2,952.8 28.5 2,526.9 51.7 Other assets 5,513.853.2 742.015.2 Total assets $10,368.6 100.0% $4,886.0 100.0%

31. KELLOGG COMPANY, INC. Condensed Balance Sheets December 31 (In millions) 2001 2000 Liabilities andAmountPercent AmountPercent Stockholders' Equity Current liabilities $2,207.6 21.3 $2,482.3 50.8 Long-term liabilities 7,289.570.3 1,506.230.8 Total liabilities 9,497.191.63,988.581.6 Stockholders' equity Common stock 195.3 1.9 205.8 4.2 Retained earnings and other 1,013.3 9.8 1,065.7 21.8 Treasury stock (337.1)(3.3) (374.0)(7.6) Total stockholders' equity 871.5 8.4 897.5 18.4 Total liabilities and stockholders' equity $10,368.6 100.0 $4,886.0 100.0

32. KELLOGG COMPANY, INC. Condensed Income Statement For the Years Ended December 31 (In millions) 2001 2000 AmountPercentAmountPercent Net sales $8,853.3 100.0 $6,954.7 100.0 Cost of goods sold 4,128.5 46.6 3,327.0 47.8 Gross profit 4,724.8 53.4 3,627.7 52.2 Selling & Admin. 3,523.6 39.8 2,551.4 36.7 Nonrecurring Chgs 33.30.4 86.5 1.2 Income operations 1,167.9 13.2 989.8 14.3 Interest expense 351.5 4.0 137.5 2.0 Other income (expense),net (12.3) (0.1) 15.4 0.2 Income before income taxes 804.1 9.1 867.7 12.5 Income tax expense 322.1 3.6 280.04.0 Net income $482.0 5.5 $587.7 8.5

33. Condensed Income StatementsFor the Year Ended December 31, 2001(in millions) Kellogg Company, Inc.General Mills,Inc AmountPercent AmountPercent Net sales $8,853.3 100.0 $7,949.0 100.0 Cost of goods sold 4,128.546.6 4,767.0 60.0 Gross profit 4,724.8 53.4 3,182.0 40.0 Selling and administrative expenses 3,523.6 39.8 1,909.0 24.0 Nonrecurring charges 33.3 0.4 190.0 2.4 Income from operations 1,167.9 13.2 1,083.0 13.6 Other expenses and revenues (including income taxes) 685.9 7.7 622.0 7.8 Net income $482.0 5.5 $461.0 5.8

34. Ratios • Three types: • Liquidity ratios • Solvency ratios • Profitability ratios • Can provide clues to underlying conditions that may not be apparent from an inspection of the individual components. • Single ratio by itself is not very meaningful.

35. Liquidity Ratios Measure the short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash. WHO CARES? Short-term creditors such as bankers and suppliers

36. Liquidity Ratios • Working capital • Current ratio • Current cash debt coverage ratio • Inventory turnover ratio • Days in inventory • Receivables turnover ratio • Average collection period

37. Working Capital Indicates immediate short-term debt-paying ability Current Capital - Current liabilities

38. Current Ratio Indicates short-term debt-paying ability Current Assets Current Liabilities

39. Current Cash Debt Coverage Ratio Indicates short-term debt-paying ability (cash basis) Cash provided by operations Average current liabilities

40. Indicates liquidity of inventory Cost of Goods Sold Average Inventory Inventory Turnover Ratio

41. Days in Inventory Indicates liquidity of inventory and inventory management 365 days Inventory Turnover Ratio

42. Receivables Turnover Ratio Indicates liquidity of receivables Net Credit Sales Average Gross Receivables

43. Average Collection Period Indicates liquidity of receivables and collection success 365 days Receivables Turnover Ratio

44. Solvency Ratios Measure the ability of the enterprise to survive over a long period of time WHO CARES? Long-term creditors and stockholders

45. Illustration 13-18 Solvency Ratios • Debt to total assets ratio • Cash debt coverage ratio • Times interest earned ratio • Free cash flow

46. Debt to Total Assets Ratio Indicates % of total assets provided by creditors Total Liabilities Total Assets

47. Cash Debt Coverage Ratio Indicates long-term debt-paying ability (cash basis) Cash provided by operations Average total liabilities

48. Times Interest Earned Ratio Indicates company’s ability to meet interest payments as they come due Net Income Before Interest Expense & Income Tax Interest Expense

49. Free Cash Flow Indicates cash available for paying dividends or expanding operations Cash Provided By Operations - Capital Expenditures - Dividends Paid Free Cash Flow

50. Profitability Ratios Measure the income or operating success of an enterprise for a given period of time WHO CARES? Everybody WHY? A company’s income affects: • its ability to obtain debt and equity financing • its liquidity position • its ability to grow