operating performance analysis chapter 12. chapter 12 objectives explain the objectives for...

OPERATING OPERATING PERFORMANCE PERFORMANCE ANALYSISANALYSIS

Chapter 12Chapter 12

CHAPTER 12 OBJECTIVESCHAPTER 12 OBJECTIVES

Explain the objectives for Explain the objectives for analyzing operating performance.analyzing operating performance.

Describe the importance of Describe the importance of earnings quality in operating earnings quality in operating performance analysis.performance analysis.

Identify characteristics of Identify characteristics of sustainable earnings.sustainable earnings.

CHAPTER 12 OBJECTIVES CHAPTER 12 OBJECTIVES (CONT.)(CONT.)

Distinguish between recurring and Distinguish between recurring and non-recurring earnings and explain non-recurring earnings and explain why they produce different why they produce different earnings quality.earnings quality.

Discuss how managerial decisions Discuss how managerial decisions affect reported income.affect reported income.

Present a preliminary analysis of a Present a preliminary analysis of a company or industry’s operating company or industry’s operating performance.performance.

OBJECTIVES FOR OBJECTIVES FOR ANALYZING OPERATING ANALYZING OPERATING PERFORMANCEPERFORMANCE

Understand the various types of Understand the various types of income and attach economic income and attach economic meaning to themmeaning to them

Determine the sufficiency and Determine the sufficiency and sustainability of corporate earningssustainability of corporate earnings

Relate those earnings to a firm’s Relate those earnings to a firm’s value and share pricevalue and share price

INCOME AND WEALTHINCOME AND WEALTH

Pervasive conceptsPervasive concepts Wealth is discrete; the amount of goods and Wealth is discrete; the amount of goods and

services that can be consumed at a given services that can be consumed at a given point in timepoint in time

Wealth changes: the extent to which the Wealth changes: the extent to which the amount wealth increases or decreases in a amount wealth increases or decreases in a reporting periodreporting period

Analytical problem: wealth and wealth Analytical problem: wealth and wealth creation are related to, but not the same as, creation are related to, but not the same as, cash balances and cash flowscash balances and cash flows

INCOME AND WEALTH INCOME AND WEALTH (CONT.)(CONT.)

Income theoryIncome theory The economic view is that income represents The economic view is that income represents

the amount of periodic consumption that does the amount of periodic consumption that does not alter a store of wealthnot alter a store of wealth

Financial reporting bases its perspective of Financial reporting bases its perspective of income on economic theoryincome on economic theory

The financial reporting system measures The financial reporting system measures income as the difference between capital income as the difference between capital invested at the beginning of a period less net invested at the beginning of a period less net assets at the end of that period assets at the end of that period


Financial reporting assumes a Financial reporting assumes a nominal dollar concept of capital nominal dollar concept of capital maintenance and adheres to the maintenance and adheres to the historical cost concept of asset historical cost concept of asset valuation in measuring incomevaluation in measuring income

The financial reporting system reports The financial reporting system reports income on a transaction approach income on a transaction approach (revenue and expense activities)(revenue and expense activities)


Income composition (Exhibit 12-1)Income composition (Exhibit 12-1) The all-inclusive income concept The all-inclusive income concept

reports virtually all wealth related reports virtually all wealth related transactions in a reporting periodtransactions in a reporting period

These transactions are categorized as These transactions are categorized as operating, non-operating, and operating, non-operating, and irregular income itemsirregular income items

INCOME AND WEALTH INCOME AND WEALTH (CONT.) (CONT.)

Operating income represents Operating income represents wealth created by core business wealth created by core business activitiesactivities

Non-operating income results from Non-operating income results from financing transactions (e.g., financing transactions (e.g., interest expense) and non-core interest expense) and non-core activities (e.g., loss on the disposal activities (e.g., loss on the disposal of fixed assets)of fixed assets)


Irregular items only sporadically Irregular items only sporadically affect incomeaffect income Often involve substantially monetary Often involve substantially monetary

amountsamounts Reported on a net of tax basisReported on a net of tax basis Cover three types of gains (losses): Cover three types of gains (losses):

discontinued business operations, discontinued business operations, extraordinary (unusual and infrequent) extraordinary (unusual and infrequent) items, and changes in accounting items, and changes in accounting principlesprinciples


Comprehensive incomeComprehensive income Items that affect wealth but are not Items that affect wealth but are not

reported on the income statement reported on the income statement (e.g., market adjustments to (e.g., market adjustments to available-for-sale securities)available-for-sale securities)

Usually reported as a separate Usually reported as a separate component of shareholders’ equity component of shareholders’ equity (i.e., the changes to wealth bypass (i.e., the changes to wealth bypass the income statement)the income statement)


Earnings per share (EPS)Earnings per share (EPS) Reports the amount of income earned Reports the amount of income earned

by one share of stockby one share of stock Eliminates the size bias inherent in Eliminates the size bias inherent in

aggregate income disclosuresaggregate income disclosures Computed as (net income – preferred Computed as (net income – preferred

dividends) / weighted number of dividends) / weighted number of outstanding shares of common stockoutstanding shares of common stock


Capital structure determines EPS disclosureCapital structure determines EPS disclosure A simple capital structure consists of common A simple capital structure consists of common

stock and possibly preferred sharesstock and possibly preferred shares A complex capital structure includes convertible A complex capital structure includes convertible

securities and stock options, which would dilute securities and stock options, which would dilute EPS if they were exercisedEPS if they were exercised

An entity with a simple capital structure An entity with a simple capital structure discloses a single EPS number, called basic EPSdiscloses a single EPS number, called basic EPS

An entity with a complex capital structure An entity with a complex capital structure discloses two EPS numbers (dual disclosures), discloses two EPS numbers (dual disclosures), referred to as basic and diluted EPSreferred to as basic and diluted EPS

EARNINGS QUALITYEARNINGS QUALITY

An assessment as to the extent to An assessment as to the extent to which reported income disclosures which reported income disclosures change an entity’s underlying change an entity’s underlying wealthwealth All income components do not affect All income components do not affect

wealth in the same mannerwealth in the same manner Analysts must judge the relative worth Analysts must judge the relative worth

of the various income disclosuresof the various income disclosures

EARNINGS QUALITY EARNINGS QUALITY (CONT.)(CONT.)

Earnings sustainabilityEarnings sustainability An enterprise’s capacity to produce An enterprise’s capacity to produce

earnings on a recurring basisearnings on a recurring basis Permanent in nature (i.e., they occur Permanent in nature (i.e., they occur

every reporting period)every reporting period) Fundamental wealth increases Fundamental wealth increases Produced by central business operationsProduced by central business operations Highly valued by analystsHighly valued by analysts


Transitory earnings are not Transitory earnings are not permanentpermanent Marginal wealth increasesMarginal wealth increases Result from nonrecurring or Result from nonrecurring or

intermittently recurring itemsintermittently recurring items Not highly valued by analystsNot highly valued by analysts


Non-operating income itemsNon-operating income items Can have a recurring affect on wealth (e.g., Can have a recurring affect on wealth (e.g.,

interest income)interest income) Can affect wealth sporadically (e.g., Can affect wealth sporadically (e.g.,

corporate restructurings)corporate restructurings) Corporate restructurings complicate Corporate restructurings complicate

assessment of earnings sustainabilityassessment of earnings sustainability Multiple restructurings reduce earning Multiple restructurings reduce earning

quality to an even greater degree than quality to an even greater degree than those resulting from a single restructuringthose resulting from a single restructuring


The policies and procedures used The policies and procedures used to determine income define to determine income define earnings measurement, examples earnings measurement, examples includeinclude Costing inventory on a FIFO or LIFO Costing inventory on a FIFO or LIFO

basisbasis Depreciating fixed assets on a Depreciating fixed assets on a

straight-line or accelerated basis straight-line or accelerated basis


The continual selection of The continual selection of accounting choices that increase accounting choices that increase income is known as earnings income is known as earnings management, examples include amanagement, examples include a Reluctance to reduce inventory costs Reluctance to reduce inventory costs

to their lower market valueto their lower market value Overestimation of the life of fixed Overestimation of the life of fixed

assetsassets


BenchmarkingBenchmarking Evaluation of one entity’s accounting Evaluation of one entity’s accounting

principles and policies against the principles and policies against the those of its competition and against those of its competition and against itself over timeitself over time

Incompatibility with other firms or Incompatibility with other firms or inconsistency over time may indicate inconsistency over time may indicate earnings managementearnings management

EARNINGS QUALITY EARNINGS QUALITY (CONT.) (CONT.)

Earnings sufficiencyEarnings sufficiency An assessment if an entity generates An assessment if an entity generates

enough profits to remain viableenough profits to remain viable Analysts evaluate various profit margins to Analysts evaluate various profit margins to

gain insightgain insight Gross profit: revenues minus cost of good Gross profit: revenues minus cost of good

soldsold Operating profit: gross profit minus Operating profit: gross profit minus

operating expensesoperating expenses Net profit: operating expenses minus other Net profit: operating expenses minus other

revenues and expensesrevenues and expenses


Sufficiency indicatorsSufficiency indicators High gross and operating profit margins High gross and operating profit margins

indicate sufficient earningsindicate sufficient earnings Increasing gross and operating profit margin Increasing gross and operating profit margin

trends bode well for future earnings sufficiencytrends bode well for future earnings sufficiency Low gross profit and operating profit margins Low gross profit and operating profit margins

indicate insufficient earningsindicate insufficient earnings Decreasing gross and operating profit margin Decreasing gross and operating profit margin

trends do not bode well for future earnings trends do not bode well for future earnings sufficiencysufficiency


Recurring and nonrecurring Recurring and nonrecurring earnings (Exhibits 12-3 and 12-4)earnings (Exhibits 12-3 and 12-4) Correlation among the various profit Correlation among the various profit

margins indicate recurring earnings or margins indicate recurring earnings or high earnings qualityhigh earnings quality

Lack of correlation among the various Lack of correlation among the various profit margins provide evidence of profit margins provide evidence of nonrecurring earnings or low earnings nonrecurring earnings or low earnings qualityquality


Operating cash flows should Operating cash flows should coincide with operating income coincide with operating income (Exhibit 12-5)(Exhibit 12-5) Strong correlation between operating Strong correlation between operating

income and operating cash flows income and operating cash flows indicates high earnings qualityindicates high earnings quality

Strong correlation between operating Strong correlation between operating income and operating cash flows income and operating cash flows indicates high earnings qualityindicates high earnings quality


Operating income should coincide Operating income should coincide with net incomewith net income Constant difference between the two Constant difference between the two

income numbers over time, which is income numbers over time, which is attributable to a constant tax rate, attributable to a constant tax rate, indicates high earnings quality indicates high earnings quality

Variable differences between the two Variable differences between the two income numbers over time indicate income numbers over time indicate low earnings qualitylow earnings quality

Strong Correlation

$0

$20

$40

$60

$80

$100

$120

$140

2005 2006 2007 2008 2009

($-0

00s)

Operating Income Operating Cash Flows

Weak Correlation

($10)

$0

$10

$20

$30

$40

$50

$60

$70

$80

$90

$100

$110

$120

$130

2005 2006 2007 2008 2009

($-0

00s)

Operating Income Operating Cash Flows

ANALYSIS OF THE PC ANALYSIS OF THE PC INDUSTRYINDUSTRY

A relationship exists between market A relationship exists between market share and earningsshare and earnings Apple’s decreased market share contributed Apple’s decreased market share contributed

to a decline in earnings, threatened to a decline in earnings, threatened profitability, and raised doubt about profitability, and raised doubt about earnings sufficiencyearnings sufficiency

Dell’s rapid increase in market share paved Dell’s rapid increase in market share paved the way for greater earningsthe way for greater earnings

Market share does not ensure profitability, Market share does not ensure profitability, as Compaq demonstrated in 1998as Compaq demonstrated in 1998

1993

42.2%

38.0%

10.6%

9.2%

Apple Compaq Dell Gateway

1998

10.4%

54.8%

21.7%

13.1%

Apple Compaq Dell Gateway

PC IndustryRelative Market Share

1993 and 1998

ANALYSIS OF THE PC ANALYSIS OF THE PC INDUSTRY (CONT.)INDUSTRY (CONT.)

Earnings sufficiencyEarnings sufficiency Apple’s failure to generate sufficient Apple’s failure to generate sufficient

earnings towards the end of the period earnings towards the end of the period analyzed was the result of analyzed was the result of An erosion of its technological superiorityAn erosion of its technological superiority Decrease in market shareDecrease in market share Diminished technological superiority Diminished technological superiority A lower revenue base with which to cover A lower revenue base with which to cover

fixed costsfixed costs Research and development costs that Research and development costs that

exceeded industry normsexceeded industry norms

Apple ComputerOperating Income and Cash Flow

1993-1998

($1,500)

($1,250)

($1,000)

($750)

($500)

($250)

$0

$250

$500

$750

$1,000

1993 1994 1995 1996 1997 1998

$ in

Mill

ions

Operating Income Operating Cash Flow


Earnings sustainabilityEarnings sustainability Industry growth contributed to Industry growth contributed to

variable profit margins throughout variable profit margins throughout the industry and over timethe industry and over time

Earnings varied among the four Earnings varied among the four companies analyzed companies analyzed


Data indicate that Apple’s earning Data indicate that Apple’s earning were less sustainable that its were less sustainable that its competitors because the companycompetitors because the company Did not conform to industry Did not conform to industry

manufacturing standardsmanufacturing standards Had an unfavorable cost structure Had an unfavorable cost structure

(Exhibits 12-10A and 12-10B)(Exhibits 12-10A and 12-10B) Could not differentiate its products Could not differentiate its products

from those of its competitorsfrom those of its competitors

Exhibit 12-11APC Industry

Research and Development Expenses1993-1998

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

1993 1994 1995 1996 1997 1998

% o

f S

ale

s

Apple Compaq Dell

operating performance analysis chapter 12. chapter 12 objectives explain the objectives for...

Documents

wealth cont

reported income

period income

perspective of income

income statementincome

wealth increases

wealth creation

irregular income itemsincome