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5th session:Financial Accounting Measures of

Performance

Performance EvaluationIMSc in Business Administration

September 2010

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Financial accounting measures of performance

Computing Earnings per Share (EPS)

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Computing Earnings per Share (EPS)

• Earnings per share indicates the income earned by each share of common stock.

• Reported at the end of the income statement

• Should report intermediate components as well.

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EPS on Simple Capital Structure

• Simple Capital Structure means that there is only common stock and there is no potential common stock (securities that can potentially be converted into common stock and dilute EPS).

EPS=

Net Income

Weighted Average Number of Shares

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Preferred Stock Dividends

• Preferred Stock Dividends are compensation not available for common stockholders, therefore they are subtracted from the Net Income.

EPS=

Net Income – Preferred Dividends

Weighted Average Number of Common Stock

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Weighted Average Number od Shares Outstanding

• Weighted by the fraction of the period they are outstanding

• Find the equivalent number of whole shares outstanding for the year.

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Stock Dividends and Stock Splits

• When these happen computation of the average number of shares outstanding needs to be redone.

• A stock dividend or split does not change the shareholders’ total investment.

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Complex Capital Structure

• Dilutive securities are securities that can be converted into common stock (through conversion or exercise) and will dilute earnings per share.

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Diluted EPS

Note that:Only dilutive securities are to be reported! Antidilutive are not considered.

EPS=

Net income- Preferred dividends

-Impact of Convertibl

es-

Impact of Option,

Warrants, and Other Dilutive

Securities

Weighted Average Shares Outstanding

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Diluted EPS – Convertible Securities

If-Converted Method1. Conversion of the convertible

securities as soon as possible (beginning of period or issuance)

2. Elimination of related interest, net of tax.– Logic is that if the convertible

securities were converted, then they didn’t produce any interest and net income has to be filtered of this.

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Diluted EPS – Options and Warrants

Treasury Stock Method1. Exercise of options or warrants as

soon as possible (beginning of period or issuance)

2. Proceeds from the exercise are used to purchase common stock.

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Financial accounting measures of performance

Financial Analysis through Ratio Computation – a

shortcut to evaluating firm’s performances

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Limitations of Financial Ratios

• Not useful in isolation – only valid when compared to other firms or the company’s historical performance

• Different accounting treatments – particularly when analyzing non-U.S. firms

• Finding comparable industry ratios for companies that operate in multiple industries

• All ratios must be viewed relative to one another

• Determining the target or comparison value requires some range of acceptable values

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Financial Ratios – Analyst/Evaluator

Considerations• Do firms have similar accounting practices?

• Are ratios comparable across firm divisions?

• Do different ratios give consistent information?

• Are the ratios reasonable for the industry?

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Interpreting Ratios

1. Cross-sectional analysis:

Comparison to industry norm or average

2. Time-series analysis (trend analysis):

Comparison to a company’s past ratios

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Ratio Analysis Context

1. Company goals and strategy2. Industry norms

• Ratios may be industry specific• Multiple lines of business distorts

aggregate ratios• Differences in accounting methods

3. Economic conditions• Cyclical businesses and the stage of the

business cycle

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Categories of Ratios• Activity

• Liquidity

• Solvency

• Profitability

• Valuation

Efficiency of day-to-day tasks/operations

Ability to meet short-term liabilities

Ability to meet long-term obligations

Ability to generate profitable sales from asset base

Quantity of asset or flow associated with an ownership claim

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Ratio AnalysisSome general rules:

– For ratios that use only income statement items, use the values from the current income statement

– For ratios using only balance sheet items, use the values from the current balance sheet

– For ratios using both income statement and balance sheet items, use the value from the current income statement and the average value for the balance sheet item

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Integrated Financial Ratio Approach

• Important to analyze all ratios collectively

• Use information from one ratio

category to answer questions raised by another ratio

• Classic example = DuPont analysis

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DuPont System: Original Equation

ROE =Average Equity

Net Income

Net Income

Revenue

Revenue

Average Total Assets

Average Total Assets

Average Equity× ×

Net Profit Margin Asset Turnover Leverage

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DuPont System: Extended Equation

Net Income

Revenue

Revenue

Average Total Assets

Average Total Assets

Average Equity× ×

EBIT

Revenue

EBT

EBIT

Net Income

EBT× ×

EBIT Margin Interest Burden Tax Burden

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EBIT Margin

DuPont System: Extended Equation

Interest Burden

Tax Burden

Asset Turnover Leverage× × × ×

Operating Profit Margin

1 – Effective Tax Rate

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Per Share Ratios – for ValuationPrice Per ShareP

Earnings Per Share=

E

Price Per ShareP

Cash Flow Per Share=

CF

Price Per ShareP

Sales Per Share=

S

Price Per ShareP

Book Value Per Share=

BV

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Per-Share QuantitiesNI – Pref Div

Basic EPSWeighted Ave # Ordinary Shares

=

Income Adjusted for Dilutive Securities

Weighted Ave # Shares Adjusted for Dilution

=Diluted EPS

Cash Flow per Share

CFO

Weighted Ave # Shares

=

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Dividend Related QuantitiesDividend

Payout Ratio

Common Dividend

Net Income – Pref Div=

Retention Rate (b)

Net income attributable to common shares – common

dividend=

Net Income attributable to common shares

Net income attributable to common shares

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Dividend Related Quantities

Sustainable Growth Rate

b × ROE=

Retention Rate

1 – Dividend Payout Ratio

Return on Equity

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Sustainable Growth Rate – Problem

A firm has a dividend payout ratio of 35%, a net profit margin of 10%, an asset turnover of 1.4, and an equity multiplier leverage measure of 1.2. Estimate the firm’s sustainable growth rate.

Growth rate = b × ROE

(1 – 0.35) 0.1 × 1.4 × 1.2

= 0.1092

= 10.92%

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Evaluating Past Financial Performance

How have key ratios changed and why?

How do key ratios and trends compare with competitors/industry?

What aspects of performance are critical for a competitive advantage?

How did the company perform in these areas?

What is the company’s business model and strategy – are they reflected in key measures?

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Projecting Performance1. Forecast expected GDP growth2. Forecast expected industry sales based

on historical relationship with GDP3. Consider expected change of firm’s

market share4. Forecast expected firm sales5. Use historical margins for stable firms

(gross, operating, net) or individual forecast for each expense item Remove nonrecurring items Historical margins are not relevant to new,

volatile, or high fixed-cost industries