14 Performance Measurement

Introduction

chapter 14

Performance Measurement Accounting Matters!

Corporate Reporting Proves to Be Fertile Ground Launched as a Crown Corporation by the Province of Saskatchewan in 1975, Potash Corporation of Saskatchewan Inc. (PotashCorp) became a public company in 1989. With the world's largest integrated production capacity for the three primary nutrients (potash, phosphate and nitrogen)—their products are used by fertilizer, feed and industrial customers on six continents—PotashCorp takes the transparency and accountability that comes with being a public company very seriously. The Saskatoon-based company took the Overall Award of Excellence at the Canadian Institute of Chartered Accountants' 2004 Corporate Reporting Awards. PotashCorp also won in the mining industry sector, and received awards of excellence for electronic disclosure and sustainable reporting, and an honourable mention for excellence in annual reporting. Like all annual reports, PotashCorp's document presented the year's financial results, a message from the president and CEO, management discussion and analysis (MD&A), and information on the company's directors. The report also stated what the company's goals for the current year were and how well it had met them, and listed targets for the next year. What impressed the judges was the fact that environmental policies, as well as social and economic issues being faced, were included in the MD&A section. The annual report is the most important document a company produces. It is a crucial tool for investors, creditors, and regulators to gather the information they require. To help them, PotashCorp's annual report includes a 10-year review of its financial performance, including production statistics, and detailed explanations of risks and how the company manages them. PotashCorp also addresses corporate governance and sustainable development issues. The judges described the Board/Governance/Responsibility section of the company's website as “outstanding,” http://edugen.wiley.com/edugen/courses/crs1562/pc/c14/content/kimmel6792c14_14_1.xform?course=crs1562&id=ref (1 of 3)14/04/2008 3:47:17 PM

Introduction

providing all the information you could need on the corporate mission and governance. PotashCorp was the first publicly traded fertilizer company in North America to produce a separate sustainability report to document its economic impact, social involvement, and progress in safety, health, and the environment. These accolades came from a year that was in fact poor in terms of financial performance. “We are especially proud to earn recognition for our reporting [this year],” said Chief Financial Officer Wayne Brownlee. “The fertilizer industry endured the sixth year of a down cycle and our company had the lowest financial returns in our history. We tackled that head on in our reporting.” By communicating effectively with its shareholders and other parties, the company demonstrates its commitment to keeping investors and other stakeholders informed—one of the most important issues in corporate governance today.

Potash: www.potashcorp.com

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Introduction

The Navigator Read Feature Story Scan Study Objectives Read Chapter Preview Read text and answer Before You Go On Work Using the Decision Toolkit Review Summary of Study Objectives Review Decision Toolkit—A Summary Work Demonstration Problem Answer Self-Study Questions Complete assignments

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Study Objectives and Preview

Study Objectives After studying this chapter, you should be able to: 1. Understand the concept of sustainable earnings and indicate how irregular items are presented. 2. Explain and apply horizontal analysis. 3. Explain and apply vertical analysis. 4. Identify and calculate ratios used to analyze liquidity, solvency, and profitability. 5. Understand the concept of quality of earnings.

Preview of Chapter 14 An important lesson can be learned from PotashCorp's annual report described in our feature story. Effective communication is the key to understanding. This has become even more important as a result of corporate scandals that have left a strong feeling of doubt about the usefulness of financial reporting. The purpose of this chapter is to give you a comprehensive review of financial state-ments—a company's most important means of communication. We will examine the impact of certain irregular items on financial results and analyses. In addition, we show how difficult it can be to develop highquality financial numbers because of the complexities of financial reporting. Finally, we will review all of the decision tools presented in this text and use them to analyze PotashCorp's financial statements. The chapter is organized as follows:

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Study Objectives and Preview

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Sustainable Earnings

Sustainable Earnings study objective 1 Understand the concept of sustainable earnings and indicate how irregular items are presented. Sustainable earnings are the most likely level of earnings to be obtained in the future. In other words, they indicate how accurately the most recent year's net earnings predict future years' net earnings. Sustainable earnings differ from actual net earnings by the amount of irregular, or non-typical, revenues, expenses, gains, and losses that are included in net earnings. Users are interested in sustainable earnings because the amount helps them estimate future earnings without the “noise” of irregular items. For example, suppose Rye Corporation reports that this year's net earnings are $500,000, but this amount includes a once-ina-lifetime gain of $400,000. In estimating next year's net earnings for Rye Corporation, we would likely ignore this $400,000 gain and estimate that next year's net earnings will be in the neighbourhood of $100,000, plus or minus any expected changes. That is, based on this year's results, the company's sustainable earnings are roughly $100,000. In earlier chapters, you learned that earnings are presented on both the statement of earnings and the statement of retained earnings. In this chapter, we will explain how irregular items affect the presentation of these two financial statements.

Irregular Items—Statement of Earnings To help determine sustainable earnings, irregular items are identified by type on the statement of earnings. Two types of irregular items are reported: (1) discontinued operations and (2) extraordinary items. Irregular items are reported net of income taxes; that is, the applicable income tax expense or tax savings is shown for earnings before income taxes and for each of the irregular items. The general concept is “Let the tax follow the earnings or loss.”

Discontinued Operations Discontinued operations refer to the disposal of an identifiable reporting or operating segment of the business. An identifiable business segment can be a separate subsidiary company, an operating division within the company, or even a group of assets, as long as it is a separate business that can be clearly distinguished from the company as a whole. Most large corporations have multiple business segments or divisions. PotashCorp, from our feature story, has three business segments that it reports financial and operating information about: potash, phosphate, and nitrogen.

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Sustainable Earnings

The company states that “these business segments are differentiated by the chemical nutrient contained in the product that each produces.” If a company sells a segment of its business, the sale is reported separately on the statement of earnings as a nonrecurring item called discontinued operations. Note that discontinued operations relate only to the disposal of an identifiable business segment, such as the elimination of an entire line of business or a product group. The phasing out of a model or part of a line of business is not considered a disposal of a business segment. When the disposal of an identifiable business segment occurs, the statement of earnings should report both the earnings (or loss) from continuing operations and the earnings (or loss) from discontinued operations. The earnings (loss) from discontinued operations consists of two parts: the earnings (loss) from operations and the gain (loss) on the disposal of the segment. To illustrate, assume that Rozek Inc. has sales of $2.5 million, cost of goods sold of $1.3 million, and operating expenses of $400,000 for the year ended December 31, 2006. The company therefore has earnings before income tax of $800,000. If we assume that Rozek has a 30-percent income tax rate, it would report $240,000 ($800,000 × 30%) income tax on these earnings, resulting in $560,000 of earnings from continuing operations. Also during 2006, Rozek discontinues and sells its unprofitable chemical division. The loss from chemical operations is $140,000 ($200,000 less $60,000 income tax savings). The loss on disposal of the chemical division is $70,000 ($100,000 less $30,000 income tax savings). The statement of earnings is presented below:

Note that the caption “earnings from continuing operations” is used and the section “discontinued operations” is added. Within the new section, both the operating loss and the loss on disposal are reported net of applicable income taxes. In addition, the impact of the discontinued operations on cash flow must also be reported separately on the cash flow statement. This presentation clearly indicates the separate effects of continuing operations and discontinued operations on net earnings. Discontinued operations are quite common. In a recent year, nearly 30 http://edugen.wiley.com/edugen/courses/crs1562/pc/c14/content/kimmel6792c14_14_3.xform?course=crs1562&id=ref (2 of 7)14/04/2008 3:47:43 PM

Sustainable Earnings

percent of the companies surveyed by Financial Reporting in Canada reported discontinued operations.

Extraordinary Items Extraordinary items are events and transactions that meet three conditions. They are (1) not expected to occur frequently, (2) not typical of normal business activities, and (3) not subject to management's discretion. To be infrequent, the item should not be expected again in the foreseeable future. To be atypical, the item should be only incidentally related to normal activities. To be outside of management's discretion, the item should not depend on decisions by management. All three criteria must be evaluated in terms of the environment in which the business operates. Thus, Alcan Aluminium Limited reported the government cancellation of a contract to supply power to B.C. Hydro as an extraordinary item because the event was infrequent, unusual, and not determined by management. In contrast, Canada West Tree Fruits Ltd. of the Okanagan Valley does not report frost damage to its fruit crop as an extraordinary item because frost damage is somewhat frequent there. Illustration 14-1 shows the appropriate classification of extraordinary and ordinary items.

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Sustainable Earnings

Illustration 14-1 Classification of extraordinary and ordinary items In reality, extraordinary items are rare. Financial Reporting in Canada notes that no public company has reported an extraordinary item since 2001. If a company does have an extraordinary item, it should be reported net of taxes in a separate section of the statement of earnings, immediately below discontinued operations. Further information about the extraordinary item is given in a note to the financial statement. As extraordinary items are rare, they are not illustrated here. If a transaction or event meets one but not all of the criteria for an extraordinary item, it should be reported in a separate line item in the upper half of the statement of earnings, rather than in the bottom half as an extraordinary item. Usually, these items are reported under either “other revenues” or “other expenses” at their gross amount (not net of tax). This is true, for example, of gains (losses) resulting from the sale of property, plant, and equipment, as explained in Chapter 9. We have shown in this section that irregular items can have a significant impact on net earnings. In general, in evaluating a company, it makes sense to eliminate all irregular items from net earnings when estimating future sustainable earnings.

Accounting Matters! International Perspective The criteria used to determine whether an item is extraordinary or not differ across countries. For example, in the United States extraordinary items do not rule out management involvement. Consequently, in the U.S., extraordinary items are far more frequent than in Canada and can include items such as losses from the retirement of debt that involve decisions by management. Canada, Australia, the U.S., and the UK report extraordinary items (they are called “exceptional” in the UK) separately from ordinary items. Many other countries, however, do not distinguish extraordinary and ordinary items.

Irregular Items—Statement of retained Earnings Alternative Terminology Accounting principles are also known as accounting policies and accounting standards. Another type of irregular item, one that affects earnings of prior periods, is a change in accounting principle. A change in accounting principle occurs when the principle used in the current year is different from the one used

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Sustainable Earnings

in the preceding year. To ensure comparability, accounting principles should be applied consistently from period to period. This does not mean, however, that changes can never be made. A change in accounting principle is permitted when management can show that the new accounting principle results in a more appropriate presentation of events or transactions in the financial statements. This type of change affects financial reporting in four ways: 1. The cumulative effect of the change in accounting principle should be reported (net of income tax) as an adjustment to opening retained earnings. Since prior-period earnings are affected, a change in accounting principle must be reported on the statement of retained earnings, rather than on the current period's statement of earnings. 2. The new principle should be used for reporting the results of operations in the current year. 3. All prior-period financial statements should be restated to make comparisons easier. 4. The effects of the change should be detailed and disclosed in a note. Examples of a change in accounting principle include a change in amortization methods (such as declining-balance to straight-line) and a change in inventory costing methods (such as FIFO to average cost). Often a change in accounting principle is required by the CICA. For example, in the notes to its 2004 financial statements, PotashCorp states that the company retroactively adopted the new CICA Handbook section “Accounting for Asset Retirement Obligations.” This new accounting principle requires companies to record an asset and related liability for the costs associated with the retirement of long-lived tangible assets. We will use our earlier illustration of Rozek Inc. to illustrate how changes in accounting principles are reported. Assume that at the beginning of 2006 Rozek changes from the straight-line method to the declining-balance method of amortization for equipment which had been purchased on January 1, 2002. This change results in increased amortization expense and accumulated amortization for the years 2002 to 2005. Retained earnings are reduced by the cumulative effect of the change in amortization expense for the prior periods. Assume that the total increase in amortization expense for the years 2002 through 2005 amounts to $24,000. Rozek has a 30-percent income tax rate, so the after-tax effect of the change on prior-period net earnings would be $16,800 ($24,000 − $7,200 [$24,000 × 30%]). The presentation of this change in the statement of retained earnings is shown in the following illustration. The opening retained earnings balance is assumed to be $500,000.

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Sustainable Earnings

A financial statement from any prior year which is presented for comparative purposes would be restated using the declining-balance method of amortization. Rozek's statement of earnings will also show amortization expense for the current year, 2006, on a declining-balance basis (i.e., using the new method of amortization). Accumulated amortization on the balance sheet will be calculated as though declining-balance had always been used. An appropriately cross-referenced note to the statements should give details about the impact of the change and the fact that statements from prior years have been restated.

Decision Toolkit Decision Checkpoints

Info Needed for Decision

Tools to Use for Decision

How to Evaluate Results

Has the company sold an identifiable business segment?

Discontinued operations section of statement of earnings

Anything reported in this section indicates that the company has discontinued an identifiable business segment.

If an identifiable business segment has been discontinued, its results in the current period should not be included in estimates of future net earnings.

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Sustainable Earnings

Has the company experienced any extraordinary events or transactions?

Extraordinary item section of statement of earnings

Anything reported in this section indicates that the company experienced an event that was infrequent, unusual, and not determined by management.

These items should be ignored in estimating future net earnings.

Has the company changed any of its accounting principles?

Cumulative effect of change in accounting principle in statement of retained earnings

Anything reported in this manner indicates that the company has changed an accounting principle during the current year.

Financial statements are restated using the new principle to make them easy to compare.

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Comparative Analysis

Comparative Analysis As mentioned earlier, in assessing financial performance, investors and creditors are interested in the sustainable earnings of a company. In addition to this, they are also interested in making comparisons from period to period. Throughout this book, we have relied on three types of comparisons to improve the usefulness of financial information for decision-making: 1. Intracompany basis. Comparisons within a company are often useful to detect changes in financial relationships and significant trends. For example, a comparison of PotashCorp's current-year cash amount with its prior-year cash amount shows either an increase or a decrease. Likewise, a comparison of PotashCorp's year-end cash amount with the amount of its total assets at year end shows the proportion of total assets that is cash. 2. Intercompany basis. Comparisons with other companies give insight into a company's competitive position. For example, PotashCorp's net sales for the year can be compared with the net sales of Agrium Inc., one of its competitors in the agricultural chemicals industry. 3. Industry averages. Comparisons with industry averages give information about a company's relative position within the industry. For example, PotashCorp's financial data can be compared with the averages for its industry that are calculated by financial ratings organizations such as Dun & Bradstreet, the Financial Post, and Statistics Canada, or with information provided on the Internet by organizations such as Yahoo!, on its finance site. In assessing a company's financial performance, we usually start with the financial statements. But, it is important to also review other financial and non-financial information included in the company's annual report. Other financial information includes a management discussion and analysis (MD&A) of the company's financial position and a summary of historical key financial figures and ratios. Non-financial information includes a discussion of the company's mission, goals and objectives, market position, people, and products. Understanding a company's goals and objectives is important when interpreting financial performance. As mentioned in our feature story, PotashCorp's annual report not only presents the company's goals but also compares its performance to those goals and identifies its targets for the upcoming year. We must also consider the economic circumstances a company is operating in. Economic measures such as the rate of interest, inflation, unemployment, and changes in demand and supply can have a significant impact on a company's performance. For example, it would be difficult to properly interpret PotashCorp's performance without knowing that potash prices are at an all-time high due to increasing demand and tight supply. Financial analysis must also include non-financial measures in addition to financial measures, such as http://edugen.wiley.com/edugen/courses/crs1562/pc/c14/content/kimmel6792c14_14_5.xform?course=crs1562&id=ref (1 of 2)14/04/2008 3:47:56 PM

Comparative Analysis

those we have calculated in this textbook. Some analysts argue that non-financial, or qualitative, measures are even more important than financial, or quantitative, measures in assessing success. Financial measures can only evaluate past performance. Non-financial measures may be better predictors of future performance. Non-financial performance measures include factors such as customer satisfaction, employee satisfaction, product reputation, innovation, knowledge resources, sustainable development, and so on. As mentioned in our feature story, PotashCorp's annual report received an award of excellence for its non-financial reporting (in addition to its financial reporting). It was the first fertilizer producer in North America to include a sustainability report documenting the company's economic impact, social involvement, and progress in safety, health, and the environment. While non-financial measures are important, the focus of this chapter is on financial measures. Various tools are used to evaluate the significance of financial data. Three commonly used tools follow: 1. Horizontal analysis. This tool evaluates a series of financial statement data over a period of time. 2. Vertical analysis. This tool evaluates financial statement data by expressing each item in a financial statement as a percentage of a base amount for the same period of time. 3. Ratio analysis. This tool expresses relationships among selected items of financial statement data. Horizontal analysis is mostly used in intracompany comparisons. Two features in published financial statements make this type of comparison easier. First, each of the financial statements is presented on a comparative basis for a minimum of two years. Second, a summary of selected financial data is presented for a series of 5 to 10 years or more. Vertical analysis is used in both intracompany and intercompany comparisons. Ratio analysis is used in all three types of comparisons.

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Horizontal Analysis

Horizontal Analysis study objective 2 Explain and apply horizontal analysis. Horizontal analysis, also called trend analysis, is a technique for evaluating a series of financial statement data over a period of time. Its purpose is to determine the increase or decrease that has taken place, and this is expressed as either an amount or a percentage. For example, net sales for the last five years for PotashCorp are shown below in dollars (U.S. millions) and percentages: 2004

2003

2002

2001

2000

$2,901.4 130.0%

$2,465.8 110.5%

$1,913.8 85.8%

$2,072.7 92.9%

$2,231.6 100.0%

In the above illustration, we have assumed that 2000 is the base year, and have expressed net sales in each year as a percentage of the base-period amount. This is done by dividing the amount for the specific year we are analyzing by the base-year amount. For example, we can determine that net sales in 2004 are 130 percent of net sales in 2000 by dividing U.S. $2,901.4 million by U.S. $2,231.6 million. In other words, net sales in 2004 are 30 percent greater than sales five years earlier, in 2000. From this horizontal analysis, we can easily see PotashCorp's sales trend. Net sales declined in 2001 and 2002, before turning around and increasing in 2003 and 2004. We can also measure the percentage change for each specific period by dividing the dollar amount of the change between the specific year and the base year by the base-year amount. For example, if we set 2003 as our base year, we can see that net sales increased by U.S. $435.6 million ($2.901.4 − $2,465.8) between 2004 and 2003. This increase can then be expressed as a percentage, 17.7 percent, by dividing the amount of the change between the two years, U.S. $435.6 million, by the amount in the base year, U.S. $2,465.8. That is, in 2004 net sales increased by 17.7 percent compared to 2003.

Balance Sheet To further illustrate horizontal analysis, we will use PotashCorp's financial statements. Condensed balance sheets for 2004 and 2003, showing dollar and percentage changes for the two-year period, are shown in Illustration 14-2.

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Horizontal Analysis

Illustration 14-2 Horizontal analysis of balance sheet Note that, in a horizontal analysis, while the amount column of the increase or decrease is additive (the total change is an increase of U.S. $559.5 million), the percentage column is not additive (12.3 percent is not a total). The horizontal analysis of PotashCorp's comparative balance sheet shows that several changes occurred between 2003 and 2004. In the current assets section, cash and cash equivalents appear to have increased by a whopping 9,663.8 percent! This number appears disproportionately large because we are calculating a percentage change based on a very small number in 2003 (U.S. $4.7 million). Accounts receivable increased by U.S. $47.6 million, or 15.6 percent. We will look at the statement of earnings in the next section to determine if sales increased proportionately to the receivables increase. If not, this may be an indicator of slow-moving receivables. Prepaid expenses and other current assets increased by U.S. $6.3 million, or 21.7 percent. In the long-term assets section, intangible and other assets increased by U.S. $59 million, or 8.1 percent. The notes to PotashCorp's financial statements explain that this increase is mostly due to its long-term investments, which have increased by the amount of equity investees' earnings.

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Horizontal Analysis

PotashCorp's current liabilities rose by U.S. $145.9 million, or 26.2 percent. Details in the notes to the financial statements about the company's current liabilities indicate that its accounts payable and income taxes payable both increased significantly in 2004. Its long-term liabilities increased only marginally. In the shareholders' equity section, increased earnings accounted for most of the U.S. $411.8-million increase. We can see that PotashCorp is financing its business by retaining earnings, rather than by assuming additional longterm debt.

Statement of Earnings Illustration 14-3 presents a horizontal analysis of PotashCorp's condensed statement of earnings for the years 2004 and 2003.

Illustration 14-3 Horizontal analysis of statement of earnings A horizontal analysis of the statement of earnings shows that net sales increased by U.S. $435.6 million, or 17.7 percent. This appears to be reasonably consistent with the 15.6 percent increase in accounts receivable we noted in the balance sheet. That is, if sales increase, it is not surprising to also have an increase in receivables. The fact that the increase in accounts receivables is less than the increase in sales reassures us about how collectible the receivables are. Interestingly, while net sales increased by 17.7 percent, cost of goods sold increased by only 6.5 percent.

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Horizontal Analysis

Helpful Hint When using horizontal analysis, both dollar amount changes and percentage changes need to be examined. It is not necessarily bad if a company's earnings are growing at a declining rate. The amount of increase may be the same as or more than the base year, but the percentage change may be less because the base is greater each year. PotashCorp's selling and administrative expenses increased by U.S. $34.5 million, or 35.9 percent—a higher percentage increase than net sales. However, its other expenses decreased by U.S. $257.2 million, or 68.9 percent. This was due to expenses incurred in 2003 related to plant shutdowns in Tennessee, Louisiana, North Carolina, and Chile that were not incurred in 2004. Note that these expenses are not reported as discontinued operations because only a few plants were shut down, not all. That is, PotashCorp did not discontinue operations of an entire business segment. Its other revenue increased by U.S. $46.2 million, or 139.2 percent, mainly due to a gain on the sale of long-term investments. Note that the gain on sale of long-term investments is not an irregular item. It may be unusual, but it is not irregular. PotashCorp did not report any irregular items in 2004 or 2003. If it had, these items should be excluded from our comparisons. The measurement of changes from period to period in percentages is fairly straightforward and quite useful. However, the calculations can be affected by complications. As mentioned earlier about the change in cash and cash equivalents, if an item has a small value in a base year and a large value in the next year, the percentage change may not be meaningful. In addition, if an item has no value in a base year and a value in the next year, no percentage change can be determined. And, if a negative amount appears in the base year, and a positive amount in the following year, or vice versa, no percentage change can be calculated. For example, no percentage could be calculated for PotashCorp's earnings figures because it incurred a net loss in 2003. We have not done a horizontal analysis of PotashCorp's statement of retained earnings and cash flow statement as this is not as useful as horizontal analyses done on the balance sheet and statement of earnings. The amounts presented in the statement of retained earnings and cash flow statement already give details of the changes between two periods (the opening and ending balance sheet dates).

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Horizontal Analysis

Decision Toolkit Decision Checkpoints

How do the company's financial position and operating results compare with those of previous periods?

Info Needed for Decision

Balance sheet and statement of earnings

Tools to Use for Decision

Comparative financial statements should be prepared over at least two years, with the first year reported as the base year. Changes in each line item relative to the base year should be presented both by amount and by percentage. This is called horizontal analysis.

How to Evaluate Results

A significant change should be investigated to determine what caused it.

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Before You Go On #2

Before You Go On . . . Review It 1. Distinguish between intracompany, intercompany, and industry comparisons. 2. What are the different tools that are used to compare financial information? 3. How is a percentage change from a base period calculated? Do It Summary financial information for Bonora Ltd. is as follows: 2006

2005

Current assets $234,000 $180,000 Noncurrent assets 756,000 420,000 Total assets

$990,000 $600,000

Calculate the amount and percentage changes for 2006, using horizontal analysis. Action Plan Find the percentage change by dividing the amount of the increase by the 2005 (base year) amount. Solution Increase in 2006 Amount

Percent

$ 54,000 30% [($234,000 − $180,000) ÷ $180,000] Noncurrent assets 336,000 80% [($756,000 − $420,000) ÷ $420,000] Current assets

Total assets

$390,000 65% [($990,000 − $600,000) ÷ $600,000]

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Before You Go On #2 Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved.

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Vertical Analysis

Vertical Analysis study objective 3 Explain and apply vertical analysis. Vertical analysis is a technique for evaluating financial statement data that expresses each item in a financial statement as a percentage of a base amount. For example, on a balance sheet we might say that current assets are 24.3 percent of total assets (total assets being the base amount). Or, on a statement of earnings we might say that cost of goods sold is 76.5 percent of net sales (net sales being the base amount).

Balance Sheet Illustration 14-4 presents a vertical analysis of PotashCorp's comparative balance sheet. The base for the asset items is total assets, and the base for the liability and shareholders' equity items is total liabilities and shareholders' equity, which equals total assets.

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Vertical Analysis

Illustration 14-4 Vertical analysis of a balance sheet Vertical analysis shows the relative size of each category in the balance sheet. It also allows us to compare the percentage sizes of the individual asset, liability, and shareholders' equity items. For example, we can see that even though accounts receivable increased by 15.6 percent from 2003 to 2004 in our horizontal analysis in Illustration 14-2, they remained relatively constant as a percentage of total assets at 6.7 percent in 2003 and 6.9 percent in 2004. Property, plant, and equipment changed very little (0.3 percent) between 2003 and 2004, according to our horizontal analysis in Illustration 14-2. However, it decreased as a percentage of total assets, from 68.1 percent in 2003 to 60.4 percent in 2004. Intangible and other assets increased by 8.1 percent in our horizontal analysis, but it changed very little as a percentage of total assets, from 15.8 percent in 2003 to 15.3 percent in 2004. As the increase was mostly due to an increase in its investee's equity earnings, it makes sense that total assets would also increase proportionately. Current liabilities increased only slightly from 12.2 percent to 13.7 percent as a percentage of total liabilities and shareholders' equity from 2003 to 2004, despite reporting a 26.2-percent horizontal increase in Illustration 14-2. Long-term liabilities actually decreased from 44.6 percent in 2003 to 39.8 percent in 2004 as a percentage of total http://edugen.wiley.com/edugen/courses/crs1562/pc/c14/content/kimmel6792c14_14_8.xform?course=crs1562&id=ref (2 of 5)14/04/2008 3:48:27 PM

Vertical Analysis

liabilities and shareholders' equity. Shareholders' equity increased from 43.2 percent in 2003 to 46.5 percent in 2004 as a percentage of total liabilities and shareholders' equity.

Statement of Earnings Illustration 14-5 presents a vertical analysis of PotashCorp's comparative statement of earnings on the following page. The base for this analysis is net sales.

Illustration 14-5 Vertical analysis of statement of earnings Although cost of goods sold increased by 6.5 percent in 2004 in our horizontal analysis in Illustration 14-3, it actually declined as a percentage of sales from 84.6 percent in 2003 to 76.5 percent in 2004. As we found in our horizontal analysis, selling and administrative expenses increased and other operating expenses decreased. And, of course, net earnings increased significantly to 10.3 percent of sales in 2004, compared to a net loss of 5.1 percent reported in 2003. Although vertical analysis can also be performed on the statement of retained earnings and the cash flow statement, this is seldom done. As mentioned earlier, the value of these statements comes from the analysis of the changes during the year, and not from percentage comparisons of these changes against a base amount. Vertical analysis also make it easier to compare different companies. For example, one of PotashCorp's main competitors is Agrium Inc. Using vertical analysis, we can make a more meaningful comparison of the condensed statements of earnings of PotashCorp and Agrium, as shown in Illustration 14-6. http://edugen.wiley.com/edugen/courses/crs1562/pc/c14/content/kimmel6792c14_14_8.xform?course=crs1562&id=ref (3 of 5)14/04/2008 3:48:27 PM

Vertical Analysis

Illustration 14-6 Intercompany comparison by vertical analysis PotashCorp's cost of goods sold is a higher percentage of net sales at 76.5 percent than Agrium's at 67.9 percent. PotashCorp's selling and administrative expenses, however, are significantly lower than Agrium's, while its interest expense is slightly higher. PotashCorp's net earnings are also slightly higher at 10.3 percent of net sales than Agrium's at 9.7 percent of net sales. Although PotashCorp and Agrium are roughly the same size, vertical analysis clearly shows the differences between the two companies. Vertical analysis is also useful in comparing companies of different sizes, reducing each financial statement item to a comparable percentage.

Decision Toolkit

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Vertical Analysis

Decision Checkpoints

How do the relationships between items in this year's financial statements compare with last year's relationships or those of competitors?

Info Needed for Decision

Balance sheet and statement of earnings

Tools to Use for Decision

How to Evaluate Results

Each line item on the balance sheet should be presented as a percentage of total assets (total liabilities and shareholders' equity). Each line item on the statement of earnings should be presented as a percentage of net sales. This is called vertical analysis.

Any difference, either across years or between companies, should be investigated to determine the cause.

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Before You Go On #3

Before You Go On . . . Review It 1. What is vertical analysis? 2. What base is used to calculate the percentage size of an amount reported in a balance sheet? In a statement of earnings? 3. How can vertical analysis be used to compare two companies of differing sizes? Do It Summary financial information for Bonora Ltd. is as follows: 2006

2005

Current assets $234,000 $180,000 Noncurrent assets 756,000 420,000 Total assets

$990,000 $600,000

Calculate the percentage sizes of each category for each year, using vertical analysis. Action Plan Find the relative percentage by dividing the specific asset amount by total assets for each year. Solution 2006 Amount

Percent

2005 Amount

Percent

Current assets $234,000 23.6% ($234,000 ÷ $990,000) $180,000 30% ($180,000 ÷ $660,000) Noncurrent assets 756,000 76.4% ($756,000 ÷ $990,000 420,000 70% ($420,000 ÷ $600,000) Total assets

$990,000 100.0%

$600,000 100%

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Before You Go On #3 Copyright © 2008 John Wiley & Sons Canada, Ltd. All rights reserved.

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Ratio Analysis

Ratio Analysis study objective 4 Identify and calculate ratios used to analyze liquidity, solvency, and profitability. Ratio analysis expresses the relationship between selected financial statement items. Ratios are generally classified into three types: 1. Liquidity ratios. These measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. 2. Solvency ratios. These measure the ability of the company to survive over a long period of time. 3. Profitability ratios. These measure the earnings or operating success of a company for a specific period of time. In previous chapters, we presented liquidity, solvency, and profitability ratios to evaluate the financial position and performance of a company. In this section, we provide a summary listing of these ratios. Chapter and page references to earlier discussions are included so you can review any individual ratio. In addition, there is an example of a comprehensive financial analysis using these ratios in the appendix to this chapter. This analysis uses three categories of comparisons: (1) intracompany, comparing two years of data for PotashCorp, (2) inter-company, comparing PotashCorp and Agrium, and (3) industry, comparing both companies to industry averages for the fertilizer industry.

Liquidity Ratios Liquidity ratios measure the short-term ability of a company to pay its maturing obligations and to meet unexpected needs for cash. Short-term creditors, such as bankers and suppliers, are particularly interested in assessing liquidity. Illustration 14-7 lists the liquidity ratios we have seen in this textbook. It is important to remember that these are only examples of commonly used liquidity ratios. You will find more examples as you learn more about financial analysis.

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Ratio Analysis

Ratio

Formula

Purpose

Working capital

Current assets − Current liabilities

Measures shortterm debtpaying ability Measures shortterm debtpaying ability Measures liquidity of inventory Measures the of number days inventory is on hand Measures liquidity of receivables Measures number of days receivables are outstanding Measures shortterm debtpaying ability (cash basis)

Current ratio

Inventory turnover Days in inventory

Receivables turnover Average collection period

Cash current debt coverage

Cash provided (used) by

Discussion Ch. 2, p. 65

Ch. 2, p. 65

Ch. 6, p. 280

Ch. 6, p. 280

Ch. 8, p. 374

Ch. 8, p. 374

Ch. 13, p. 639

Illustration 14-7 Summary of liquidity ratios

Solvency Ratios Solvency ratios measure the ability of a company to survive over a long period of time. Long-term creditors and shareholders are interested in a company's long-run solvency, particularly its ability to pay interest as it comes due and to repay the face value of debt at maturity. Illustration 14-8 lists the solvency ratios we have seen in this textbook.

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Ratio Analysis

Ratio

Formula

Debt to total assets

Free cash flow

Cash provided (used) by operating activities − Net capital expenditures − Dividends paid

Times interest earned

Cash total debt coverage

Purpose Measures percentage of total assets provided by creditors Measures cash available for expanding operations or paying more dividends Measures ability to meet interest payments Measures long-term debtpaying ability (cash basis)

Discussion Ch. 2, p. 66

Ch. 2, p. 68

Ch. 10, p. 478

Ch. 13, p. 640

Illustration 14-8 Summary of solvency ratios

Profitability Ratios Profitability ratios measure the earnings or operating success of a company for a specific period of time. A company's earnings, or lack of them, affect its ability to obtain debt and equity financing, its liquidity position, and its growth. As a result, both creditors and investors are interested in evaluating profitability. Profitability is frequently used as the ultimate test of management's operating effectiveness. Illustration 14-9 lists the profitability ratios we have seen in this textbook.

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Ratio Analysis

Ratio Earnings per share

Price-earnings ratio

Gross profit margin

Profit margin

Return on assets

Asset turnover

Payout ratio

Dividend yield

Formula

Purpose Measures net earnings earned on each common share Measures relationship between market price per share and earnings per share Measures margin between selling price and cost of goods sold Measures net earnings generated by each dollar of sales Measures overall profitability of assets Measures how effi ciently assets are used to generate sales Measures percentage of earnings distributed as cash dividends Measures earnings generated by each share, based on the market price per share

Discussion Ch. 2, p. 62

Ch. 2, p. 63

Ch. 5, p. 225

Ch. 5, p. 226

Ch. 9, p. 425

Ch. 9, p. 425

Ch. 11, p. 533

Ch. 11, p. 533

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Ratio Analysis

Return on common shareholders' equity

Measures profitability of shareholders' investment

Ch. 11, p. 535

Illustration 14-9 Summary of profitability ratios As analysis tools, ratios can give clues about underlying conditions that may not be seen from an inspection of the individual components of a particular ratio. But a single ratio by itself is not very meaningful. Accordingly, ratios must be interpreted along with the information gained from a detailed review of the financial information, including horizontal and vertical analyses, and non-financial information described earlier in the chapter.

Accounting Matters! Investor Perspective Al and Mark Rosen recommend the following five steps in analyzing a company: (1) force yourself to read the company's quarterly and annual financial statements, including all the notes and the management discussion and analysis, (2) watch for too-good-to-be-true situations, (3) be careful about who you trust, (4) watch for specific accounting games and poor financial statement disclosures, and (5) look out for executive compensation schemes that base management performance bonuses on slippery accounting figures. Source: Al Rosen and Mark Rosen, “Dig Deeper,” Canadian Business, January 17–30, 2005, 27.

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Quality of Earnings

Quality of Earnings study objective 5 Understand the concept of quality of earnings. In evaluating the financial performance of a company, the quality of earnings is extremely important to analysts. A company that has a high quality of earnings provides full and transparent information that will not confuse or mislead users of the financial statements. PotashCorp, described in our feature story, has a high quality of earnings, as the information it gives users is thorough and clear. Some of the factors that can affect the quality of earnings include the choice of accounting principles, the use of professional judgement, and pro forma earnings. These topics are discussed in the next sections.

Alternative Accounting Principles Variations among companies in their use of generally accepted accounting principles may lessen comparability and reduce the quality of earnings. For example, Agrium, one of PotashCorp's competitors, chose to adopt the new accounting principle for asset retirement obligations early, effective January 1, 2003. PotashCorp adopted this principle effective January 1, 2004. Consequently, Agrium would have higher assets and liabilities than PotashCorp in 2003 simply because of the early inclusion of asset retirement costs in Agrium's property, plant, and equipment and long-term liabilities. It would also have a higher amortization expense and lower net earnings in comparison to PotashCorp. Companies may choose from a large number of acceptable accounting principles, such as different inventory cost flow assumptions (FIFO or average) or amortization methods (straight-line, decliningbalance, or units-of-activity). Different choices result in differing financial positions, which again affect comparability. All of these are what we call “artificial,” or timing, differences. Although there may be differences year by year, in total, over the life of the asset, there is no difference. As well, in more and more industries, competition is global. To evaluate a company's standing, an investor must make comparisons to companies from other countries. For example, although both PotashCorp and Agrium are Canadian, other competitors include Yara International, of Norway, and the Mosaic Company in the United States. Although differences in accounting principles might be detectable from reading the notes to the financial statements, adjusting the financial data to compensate for the different principles is difficult, if not impossible, in some cases.

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Quality of Earnings

We must accept that management has to use professional judgement in choosing the most appropriate principle for the circumstances. So, different accounting principles are likely to be used by different companies. In addition, many estimates are required in preparing financial information. Estimates are used, for example, in determining the allowance for uncollectible receivables, periodic amortization, and market values of trading and available-for-sale securities. When managers choose accounting principles and estimates to manage earnings, the quality of the earnings will decrease. Fortunately, the chief executive officer and chief financial officer of publicly traded companies must ensure, and personally declare, that the reported financial information is accurate, relevant, and understandable. In addition, audit committees are held responsible for quizzing management on the degree of aggressiveness or conservatism that has been applied and on the quality of underlying accounting principles, key estimates, and judgements. A strong corporate governance process, including an active board of directors and audit committee, is essential to ensure the quality of earnings. As mentioned in our feature story, PotashCorp won an award for its corporate governance disclosure. Following best practices in corporate governance helps a company commit to transparency and accountability. Betty-Ann Heggie, senior vice-president of corporate relations at PotashCorp, says, “Reputation is the most valuable asset any business can have and only by disclosing entirely transparent corporate information can we hope to win people's trust and, in the course of events, enhance our value with investors.”

Pro Forma Earnings Publicly traded companies are required to present their earnings in accordance with generally accepted accounting principles. Many companies also report another measure of earnings in addition to GAAP earnings. This measure is called pro forma earnings. Pro forma earnings are a non-GAAP earnings measure that excludes items which the company thinks are unusual or nonrecurring. Different companies use different definitions of pro forma earnings. These definitions have been known to exclude costs such as interest expense, stock compensation expenses, and impairment losses. For example, fibre-optics manufacturer JDS Uniphase Corporation, with headquarters in Ottawa and San Jose, reported U.S. $67 million of pro forma earnings in a recent year. These pro forma earnings excluded things like goodwill, stock-option charges, and losses on investments. Once these costs were added back, they resulted in a staggering U.S. $50.6 billion loss—a difference of nearly U.S. $50.7 billion! Such a large difference in earnings between GAAP numbers and pro forma numbers is not all that unusual. At one time, the 100 largest companies on the Nasdaq stock exchange reported total pro forma earnings of U.S. $19.1 billion. This was U.S. $101.4 billion more than GAAP-based numbers, which added up to a loss of U.S. $82.3 billion. Since there are no rules as to how to prepare pro forma earnings, companies have free rein to exclude any items they consider inappropriate for measuring their performance. Consequently, comparisons of http://edugen.wiley.com/edugen/courses/crs1562/pc/c14/content/kimmel6792c14_14_12.xform?course=crs1562&id=ref (2 of 4)14/04/2008 3:49:01 PM

Quality of Earnings

pro forma earnings among companies can be tricky. Recently, Canadian securities regulators have cracked down on companies that abuse the flexibility that pro forma numbers allow. Publicly traded companies are now expected to give GAAP numbers alongside non-GAAP earnings, explain how pro forma numbers are calculated, and detail why they exclude certain items required by GAAP. Everyone seems to agree that pro forma numbers can be useful and can provide insights into a company's sustainable earnings, as long as they are clearly detailed and explained.

Accounting Matters! Investor Perspective Biovail Corporation, a Mississauga-based pharmaceutical company, reported three different net earnings figures in a recent set of financial statements. It reported U.S. $89 million of net earnings using U.S. GAAP, which was significantly lower than the U.S. $468 million of net earnings it reported using Canadian GAAP. In addition, Biovail also reported $757 million of pro forma earnings, which excluded one-time items as well as some research and development expenses. Which of these widely different numbers should investors use? There is no easy answer to that question. However, an educated investor who understands the differences between these numbers is the best informed investor. Source: Al Rosen, “All's Fair in Accounting,” Canadian Business, November 23, 2003, 27.

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Quality of Earnings

Decision Toolkit Decision Checkpoints

Info Needed for Decision

Tools to Use for Decision

Are efforts to evaluate the company helped or hampered by the quality of earnings?

Financial statements as well as other information disclosed

Review accounting principles, estimates, and pro forma earnings for reasonableness. Assess strength of corporate governance processes.

How to Evaluate Results

If there are any irregularities, the analysis should be relied on with caution.

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Using the Decision Toolkit

Using the Decision Toolkit When analyzing a company, financial data for an extended period of time should be reviewed, as this helps determine whether the condition and performance of the company are changing. The condensed financial statements of PotashCorp for 2001 and 2002 follow. They supplement the data presented earlier in the chapter for 2003 and 2004, giving us a four-year period for preparing a vertical analysis.

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Using the Decision Toolkit

Instructions (a) Prepare a vertical analysis of PotashCorp's balance sheet and statement of earnings, inserting the appropriate percentages in the spaces provided above. (b) Comment on any relevant trends between 2001 and 2002, and in comparison to the vertical analysis for 2003 and 2004 presented earlier in the chapter in Illustrations 14-4 and 14-5.

Solution (a) Vertical analysis: The following lists the percentages for each of the four years—2001 and 2002 that you calculated above, and 2003 and 2004 presented in Illustrations 14-4 and 14-5 in the chapter—in a side-byside format for easier reference.

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Using the Decision Toolkit

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Using the Decision Toolkit

(b) Current assets have remained relatively constant from 2001 to 2003. An increase in cash and cash equivalents increased current assets in 2004. PotashCorp's current assets were fairly consistent with current liabilities from 2001 to 2003, and in 2004 current assets were much higher than current liabilities. PotashCorp's property, plant, and equipment has been decreasing as a percentage of total assets each year from 2001. Longterm liabilities have decreased between 2003 and 2004. PotashCorp's liquidity and solvency would appear to be improving over the four years, with decreasing percentages of liabilities. We would have to do further analysis (e.g., ratio analysis as detailed in Appendix 14A) to determine whether this is actually the case and, if so, the reasons for this decline. In terms of profitability, PotashCorp appears to be controlling its costs and expenses in 2004. The selling and administrative expenses are consistent with 2001 and 2002. Other operating expenses in 2003 were high due to provisions for plant shutdowns. The gross profit margin has increased significantly in 2004, due in part to the efficiency of maintaining control over inventory and thus over the cost of goods sold. The company's profitability also appears to be on the increase in 2004, especially after a decline in 2003 and 2002.

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Summary of Study Objectives

Summary of Study Objectives 1. Understand the concept of sustainable earnings and indicate how irregular items are presented. Sustainable earnings refer to a company's ability to sustain its profits from operations. Irregular items —discontinued operations and extraordinary items—are presented on the statement of earnings, net of tax, below “Earnings from continuing operations” to highlight their infrequent nature. Another irregular item—the cumulative effect on prior-period earnings of a change in accounting principle— is presented on the statement of retained earnings, net of tax, as an adjustment to opening retained earnings. For comparability, all prior-period financial statements that are presented are restated using the new principle. 2. Explain and apply horizontal analysis. Horizontal analysis is a technique for evaluating a series of data over a period of time to determine the increase or decrease that has taken place, expressed as either an amount or a percentage. 3. Explain and apply vertical analysis. Vertical analysis is a technique that expresses each item in a financial statement as a percentage of a relevant total (base amount). 4. Identify and calculate ratios used to analyze liquidity, solvency, and profitability. The formula and purpose of each ratio is presented in Illustration 14-7 (liquidity), Illustration 14-8 (solvency), and Illustration 14-9 (profitability). 5. Understand the concept of quality of earnings. A high quality of earnings means giving full and transparent information that will not confuse or mislead users of the financial statements. Issues related to quality of earnings are (1) alternative accounting principles, (2) professional judgement, and (3) pro forma earnings.

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Decision ToolkitA Summary

Decision Toolkit—A Summary Decision Checkpoints

Info Needed for Decision

Tools to Use for Decision

How to Evaluate Results

Has the company sold an identifiable business segment?

Discontinued operations section of statement of earnings

Anything reported in this section indicates that the company has discontinued an identifiable business segment.

If an identifiable business segment has been discontinued, its results in the current period should not be included in estimates of future net earnings.

Has the company experienced any extraordinary events or transactions?

Extraordinary item section of statement of earnings

Anything reported in this section indicates that the company experienced an event that was infrequent, unusual, and not determined by management.

These items should be ignored in estimating future net earnings.

Has the company changed any of its accounting principles?

Cumulative effect of change in accounting principle in statement of retained earnings

Anything reported in this manner indicates that the company has changed an accounting principle during the current year.

Financial statements are restated using the new principle to make them easy to compare.

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Decision ToolkitA Summary

How do the company's financial position and operating results compare with those of previous periods?

Balance sheet and statement of earnings

Comparative financial statements should be prepared over at least two years, with the first year reported as the base year. Changes in each line item relative to the base year should be presented both by amount and by percentage. This is called horizontal analysis.

A significant change should be investigated to determine what caused it.

How do the relationships between items in this year's financial statements compare with last year's relationships or those of competitors?

Balance sheet and statement of earnings

Each line item on the balance sheet should be presented as a percentage of total assets (total liabilities and shareholders' equity). Each line item on the statement of earnings should be presented as a percentage of net sales. This is called vertical analysis.

Any difference, either across years or between companies, should be investigated to determine the cause.

Are efforts to evaluate the company helped or hampered by the quality of earnings?

Financial statements as well as other information disclosed

Review accounting principles, estimates, and pro forma earnings for reasonableness. Assess strength of corporate governance processes.

If there are any irregularities, the analysis should be relied on with caution.

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Decision ToolkitA Summary

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Demonstration Problem

Demonstration Problem The events and transactions of Dever Corporation for the year ending December 31, 2006, resulted in these data: Cost of goods sold Net sales Operating expenses Other expenses Other revenues Earnings from operations of plastics division (discontinued operations) Gain on sale of plastics division (discontinued operations) Cumulative effect of changing from straight-line amortization to double declining-balance (increase in amortization expense) Retained earnings, January 1 Dividends

$2,600,000 4,400,000 1,100,000 9,600 5,600 70,000 500,000 300,000 3,926,000 40,000

All items are before the applicable income tax rate of 30%.

Instructions Prepare statements of earnings and retained earnings for the year. Action Plan Remember that items not typical of operations are reported in separate sections, net of income tax. Cumulative effects from changes in accounting principles affect prior periods and are adjusted through opening retained earnings, not current earnings.

Solution to Demonstration Problem

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Demonstration Problem

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