Sustainable Earnings

1
Sustainable Earnings

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

2
What We Learn Today?

• A comprehensive understanding of
• business
• A comprehensive analysis of financial
• statements

3
Irregular Items

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

4
Discontinued Operations

• Disposal of a significant segment of a business
• Report separately in statement of earnings
• Earnings (loss) from continuing operations, and
• Earnings (loss) from discontinued operations

5
Discontinued Operations

• Earnings (loss) from discontinued operations
  consists of
• Earnings (loss) from operations and
• Gain (loss) on disposal of the segment
• Both components are reported net of applicable
  taxes in a section entitled Discontinued
  Operations, which follows Earnings from
  Continuing Operations

6
Extraordinary Items

• Events and transactions that are
• Infrequent in occurrence
• Unusual in nature
• Not subject to management determination

7
Change in Accounting Principle

• Occurs when the principle used in the current
  year is different from the one used in the
  preceding year
• Is permitted, when
• There has been a change in reporting
  circumstances, and
• Management can show that the new principle is
  preferable to the old

8
Comparative Analysis

• Three types of comparisons
• Intracompany basis
• Intercompany basis
• Industry averages

9
Comparative Analysis

• Three tools
• Horizontal analysis
• Vertical analysis
• Ratio analysis

10
Horizontal Analysis
Change since base period
11
Vertical Analysis

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

12
Ratio Analysis
13
Liquidity Ratios

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

14
Working Capital

• Measures short-term debt-paying ability

15
Current Ratio

• Measures short-term debt-paying ability

16
Cash Current Debt Coverage

• Measures short-term debt-paying ability (cash
  basis)

17
Inventory Turnover

• Measures liquidity of inventory

18
Days in Inventory

• Measures number of days inventory is on hand

19
Receivables Turnover

• Measures liquidity of receivables

20
Average Collection Period

• Measures number of days receivables are
  outstanding

21
Acid-Test Ratio

• Measures immediate short-term debt-paying ability

22
Solvency Ratios

• Debt to total assets
• Cash total debt coverage
• Times interest earned
• Free cash flow

23
Debt to Total Assets Ratio

• Measures of total assets provided by creditors

24
Cash Total Debt Coverage

• Measures long-term debt-paying ability (cash
  basis)

25
Times Interest Earned

• Measures ability to meet interest payments as
  they come due

26
Free Cash Flow

• Measures cash available for paying dividends or
  expanding operations

27
Profitability Ratios

• Earnings per share (EPS)
• Price-earnings (P-E) ratio
• Gross profit margin
• Profit margin
• Return on assets
• Asset turnover
• Return on common shareholders equity
• Payout ratio

28
Earnings Per Share (EPS)

• Measures net earnings earned on each common share

29
Price-Earnings (P-E) Ratio

• Measures relationship between market price per
  share and earnings per share

30
Gross Profit Margin

• Measures margin between selling price and cost of
  goods sold

31
Profit Margin

• Measures net earnings generated by each dollar of
  sales

32
Return On Assets

• Measures overall profitability of assets

33
Asset Turnover

• Measures how efficiently assets are used to
  generate sales

34
Return on CommonShareholders Equity

• Measures profitability of common shareholders
  investment

35
Payout Ratio

• Measures of earnings distributed in the form of
  cash dividends

36
Quality of Earnings

• Increased importance today due to recent
  corporate scandals
• Can be impacted by alternative accounting
  principles (variation and discretion in selection
  of GAAP)
• Companies report pro forma earnings which are a
  non-GAAP earnings measure
• Quality of earnings also affected by improper
  recognition of revenues and liabilities