9 Suggested References

Transcription

1 Operational, Financial and Strategic Measures of Performance Part A Section 9 Suggested References When studying this topic you should refer to the following resources: Primary Reference Garrison, R.H., Noreen, E., and Brewer P. C., Managerial Accounting, 11 th edition, Chapters 10, 16 and 17. Supplementary References Atkinson, A.A., Banker, R., Kaplan, R.S. and Young, D.W., Management Accounting, 4 th edition, 2003, Chapter 9. Brigham, Eugene F., and Houston, Joel F., Fundamentals of Financial Management, 9 th edition, 1999, Chapter3. Epstein, Marc and Wisner, Priscilla, Using a Balanced Scorecard to Implement Sustainability, Environmental quality Management, Winter 2001 pp Hansen, Don R., and Mowen, Maryanne M., Management Accounting (8 th ed.), South Western Publishing Co., Cincinnati, Ohio, 2007, Chapter 10 and Chapter 13. Horngren, C.T., Datar S.M., and Foster, G., Ittner, C. and Rajan, M. Cost Accounting: A Managerial Emphasis, 13 th edition, 2008, Chapter 13. Hurle, Mike, Are You Balanced?, A Plus, September 2005, pp Kimmel, P.D., Carlon, S., Loftus, J., Mladenovic, R., Kieso D.E., and Weygandt J.J., Accounting: Building Business Skill, John Wiley and Sons, Ltd, Australia, 2003, Chapters 10 & 11. Robinson, Thomas R., Munter, Paul, Grant, Julia, Financial Statement Analysis: A Global Perspective, 2004 White, Gwendolen, How to Report a Company s Sustainability Activities, Management Accounting Quarterly, Fall 2005, pp Bibliographic References Kaplan, R.S. and D.P. Norton (1992). The Balanced Scorecard - Measures that Drive Performance. Harvard Business Review, January-February, Kaplan, R.S. and D.P. Norton (1996a). The Balanced Scorecard: Translating Strategy into Action. Harvard Business School Press, Boston. Kaplan, R.S. and D.P. Norton (1996b). Using the Balanced Scorecard as a Strategic Management System. Harvard Business Review, January-February, Kaplan, R.S. and D.P. Norton (1996c). Linking the Balanced Scorecard to Strategy. California Management Review, Fall, Kaplan, R.S and D.P. Norton (2001a). Transforming the Balanced Scorecard from Performance Measurement to Strategic Management: Part 1. Accounting Horizons, March, Kaplan, R.S and D.P. Norton (2001b). Transforming the Balanced Scorecard from Performance Measurement to Strategic Management: Part 2. Accounting Horizons, June, Financial Management Module (printed May 2010) 9-1

2 Part B Topic Operational, financial and strategic measures of performance: Overall performance measures Financial measures Profitability Economic value added (EVA ) Cash flow Growth Financial and operating ratios Non-financial measures The balanced scorecard The performance pyramid Reporting and evaluating sustainability Agency theory and managerial incentive schemes Learning Outcomes On completion of this module, you should be able to: i) Calculate financial, strategic and operational performance measures and understand the relationships between them. ii) iii) iv) Describe the role of cash flow analysis in the evaluation of the organisation s strategic and operational plan. Describe the interrelationships between shareholder wealth creation and performance measures aligned to that objective, including agency theory and its relationship to managerial incentive schemes Identify financial and non-financial measures of business profitability including cash flow measures. v) Describe measures of entity growth. vi) List the main steps in translating strategies and plans into goals, recognising their interrelationships. vii) List the limitations of benchmarking in facilitating organisational change. viii) Describe the relationships between financial and operating ratios and be able to interpret trends over time and across time. ix) Explain the key components of the balanced scorecard. You may choose to complete this topic in a step-by-step way or skip ahead, depending on your knowledge and assessment of your own competency in relation to the above Learning Outcomes. Part C Contents of this Section 9.1 Introduction Overall performance measures Financial measures Profitability Economic value added (EVA ) Cash flow Growth Financial and operating ratios Non-financial measures The balanced scorecard The performance pyramid Reporting and evaluating sustainability Agency theory and managerial incentive schemes Introduction In Section 8 we looked at designing and tailoring performance measures to suit the structure of an organisation. In this section we look at applying performance measures to an organisation to evaluate its financial, strategic and operational performance. First we consider the differences in performance measures and how to calculate some of the main types. The links between different types of measures are also examined. Secondly, cash flow analysis is presented, with a focus on its relevance to strategic planning and operational planning. Shareholder valuation techniques, such as EVA, are shown to be consistent with shareholder value maximisation. Financial Management Module (printed May 2010) 9-2

3 In the last part we analyse ratios, both in isolation and in conjunction with other ratios. 9.2 Overall Performance Measures Alignment with Strategic Goals Most management accounting commentators agree that a mixture of financial and non-financial measures is the appropriate methodology to judge business or business unit performance. This is known as the Balanced Scorecard approach (BSC) (Kaplan & Norton 1992). The performance measures should be aligned with the strategic goals of the organisation, which may be growth, profitability or survival. Both financial and non-financial performance measures are very important Comparisons and Benchmarking In order to measure performance, there must be comparisons made: To the organisations past performance or budget; Between divisions of the organisation; and With the organisation s competitors. Benchmarking is a continuous and systematic process of evaluating the products, services and work practices of an organisation against businesses that are considered to be the best performers in the practice or industry (competitors). It is a continuous process that allows an organisation to consider its financial and strategic position relative to world s best practice. The steps in benchmarking are as follows: identify the functions to be benchmarked; select benchmark partners; collect data and perform analysis to identify performance gaps; establish performance goals to narrow performance gap; implement plans. Benchmarking provides the opportunity to compare performance across sites and between companies to give an indication of current best practice. Potential sources for gathering data are: newspaper articles/ business magazines and journals; market research; inter-firm comparison reports (from government bodies); brokers/bankers or market analysts reports; exhibitions, trade fairs; and hiring of ex-employees. Accurate and relevant information is often difficult to obtain, as it is likely to be closely guarded by competitors, yet can be used as a comparative tool. Financial Management Module (printed May 2010) 9-3

4 9.3 Financial Measures Financial measures of performance are covered under the following headings: Profitability (section 9.4) Economic value added (EVA ) (section 9.5) Cash flow (section 9.6) Growth (section 9.7) Financial and operating ratios (section 9.8). 9.4 Profitability Return on Investment (ROI) and Residual Income (RI) In section 8 individual divisions were evaluated using ROI and RI. These techniques can also be applied to the organisation as a whole Return on Equity (ROE) ROE measures the performance of the firm s management in respect of their ability to invest shareholder s funds (equity). The usual calculation of ROE is: Operating profit Equity Example: Assume two firms Company A and Company B with Operating Profit and Equity balances of: Company A Company B Revenue $2,500,000 $9,600,000 Variable Expenses 1,880,000 6,560,000 Fixed Costs 300,000 2,400,000 Operating Profit 320, ,000 Total Assets 6,000,000 13,000,000 Total Liabilities 4,800,000 11,400,000 Equity 1,200,000 1,600,000 Company A has ROE of 26.67% ($320,000/$1,200,000) and Company B 40% ($640,000/$1,600,000). ROE would suggest Company B is more profitable but it is important to consider the level of debt as this affects both the profit and the equity balances. The Du Pont Formula, introduced by the Du Pont Company in the USA in the 1920s, can be used to further decompose the ROE into its component parts. For more details, see Section or any good Finance Text, such as Brigham and Houston (1999), Chapter 3. Financial Management Module (printed May 2010) 9-4

5 9.5 Economic Value Added (EVA ) 1 EVA has become widely used by profit-seeking organisations in recent years. The basic calculation is as follows: EVA = Net operating profit after tax (NOPAT) [Total assets less current liabilities] x Weighted average cost of capital The cost of capital is the required or minimum rate of return necessary to compensate the firm s capital contributors (equity investors and debt issuers) for the risk of the investment. Consider the following example. Information $ Sales 3,200,000 Operating expenses 2,000,000 Operating profit before tax 1,200,000 Income tax at 16% 192,000 Operating profit after tax 1,008,000 Total assets less current liabilities 10,000,000 Cost of capital 6% The EVA for this period is HK$408,000 because over this period, HK$408,000 of value has been added to the company s value. (The charge for the cost of capital was 6% of $10,000,000 or $600,000). There are some differences in application of the EVA number. Some commentators use average capital over the period while others use beginning of the period capital. It should be noted that there are more sophisticated EVA models advocated by Stearns and Stewart, the initial advocates of the method. However these models tend to be variations on the basic calculations above, and also suffer from the major problem with the calculation i.e. the numbers are based on accounting book values and do not necessarily reflect true economic value. 9.6 Cash Flow Overview The management of cash flow is very important as cash balances must be maintained at a sufficient level to ensure that enough cash is available to meet the organisation s short-term cash disbursement requirements and investment in idle cash balances is reduced to a minimum. The organisation must be able to maintain inventories or pay for purchases (Just in Time); offer competitive credit terms, and meet its short-term and long-term operating and financing costs as they fall due. Failure to meet maturing liabilities on time makes the organisation technically insolvent. Holding excess reserves of cash is also potentially dangerous as it can result in a loss in profitability and it may increase the attractiveness of the organisation as a potential takeover. 1 EVA is a registered trademark of the Stern Stewart Corporation. Financial Management Module (printed May 2010) 9-5

6 9.6.2 Factors Affecting Cash Flows Organisations experience irregular increases in their cash holdings due to external and internal factors. External factors affecting cash inflows include sale of securities, such as ordinary shares, preference shares, bonds and debentures or non-marketable debt contracts, including loans from commercial banks. These cash flows tend to be irregular because there are usually large sums of money involved. Other sources of cash arise from internal operations and occur on a more regular basis. These usually comprise receipts from accounts receivable collections, cash sales and sales of fixed assets. Decreases in cash arise from the payment of preference and ordinary dividends, interest and principal repayments on debt, taxation liabilities; acquisition of fixed assets; and purchases of raw materials and inventories for production. If excess cash becomes temporarily available, the organisation purchases marketable securities or where a cash deficit is forecast, a portion of the organisation s marketable securities portfolio is liquidated or short term borrowings can be made Reasons for Holding Cash There are three reasons for holding cash: First to pay transactions arising in the ordinary course of business. Secondly, for precautionary reasons as a buffer to satisfy potential cash needs. Thirdly, for speculative purposes in order to take advantage of potential profit making situations Cash Flows and Performance Managing the organisation s cash flow involves simultaneous and interrelated decisions regarding investments in current and non-current assets and the use of current liabilities. Cash flow measures indicate the dividend or debt-paying ability of the firm, the ability of the firm to provide for future growth opportunities and the general solvency of the firm. a) Marginal Cash Flow Marginal cash flow shows the net of the variable cash inflows generated by operations after financing the variable working capital used by these operations. Marginal cash flow is the difference between the margin of a product and the marginal working capital required to support the sale of the product which includes trade debtors and inventory, less trade creditors required for the next unit of product or service. It helps to indicate what is likely to happen to cash flow in the future if these fundamental relationships are maintained. The marginal cash flow (MCF) calculation is: MCF = contribution margin - change in working capital where the change in working capital is an increase in working capital. b) Operating Cash Flow Operating cash flow measures the cash generated from operations, less the cash invested to fund operations and indicates whether the business ongoing ordinary operations are providing cash towards paying interest, tax, dividends, etc. If operating cash flow is negative there is not necessarily a problem. The business may be investing in fixed assets for future growth. Operating cash outflows are funded by increased borrowings or equity. The operating cash flow (OCF) calculation is: OCF = EBIT - change in net operating assets Financial Management Module (printed May 2010) 9-6

7 c) Net Cash Flow Net cash flow is the real cash flow, the change in borrowings for the year. Depreciation and other non-cash items are included in the determination of retained income and in the change in net assets. Net cash flow is the operating cash flow less interest, tax, dividends and extraordinary items (if applicable) and changes in equity, provision for tax and provision for dividend (if applicable). Example 1: Cash Flows The following information relates to Ling Industrial Ltd. Ling Industrial Limited: Balance Sheet as at 31 December 2009 Note $ $ $ Current assets Accounts receivable 2,732,315 2,442,357 1,833,349 Inventory 1 1,412,935 1,256,225 1,107,726 Sundry debtors 189, , ,300 4,334,950 3,869,122 3,043,375 Non-current assets Fixed assets 4,599,772 4,385,123 3,980,421 Total assets 8,934,722 8,254,245 7,023,796 Current liabilities Bank overdraft 2,224,053 2,075,421 1,567,820 Accounts payable 684,426 1,261, ,931 Other current liabilities 133,900 62,500 39,420 3,042,379 3,399,269 2,505,171 Non-current liabilities Commercial bill 3,500,000 2,500,000 2,000,000 Total liabilities 6,542,379 5,899,269 4,505,171 Net assets 2,392,343 2,354,976 2,518,625 Shareholders equity Share capital 1,000,000 1,000,000 1,000,000 Retained profits 1,392,343 1,354,976 1,518,625 2,392,343 2,354,976 2,518,625 Note 1: Inventory Raw materials 320, , ,511 WIP 274, , ,344 Finished goods 817, , ,871 1,412,935 1,256,225 1,107,726 Financial Management Module (printed May 2010) 9-7

8 Ling Industrial Limited: Profit and Loss Account for the year ended 31 December $ $ Sales 10,259,006 10,456,640 Cost of sales Direct materials 3,276,495 3,439,624 Direct labour 1,919,093 2,051,656 Production o/heads variable 404, ,150 Production o/heads fixed 1,063,775 1,131,185 6,663,621 7,046,615 Gross profit 3,595,385 3,410,025 Overhead expenses Admin salaries 838, ,010 Overhead expenses 2,160,977 2,225,549 2,999,549 3,106,559 Profit before interest and tax 595, ,466 Interest expense 551, ,115 Tax 7,040 - Net profit after tax 37,367 (163,649) Ling Industrial Limited: Statement of Cash Flows for the year ended 31 December 2009 Note 2009 $000 inflows (outflows) 2008 $000 inflows (outflows) Cash flows from operating activities Receipts from customers 9,950 9,779 Payments to suppliers and employees (9,887) (9,516) Interest paid (551) (467) Net cash used in operating activities 2 (488) (204) Cash flows from investing activities Payment for property, plant and equipment (669) (803) Net cash used in investing activities (669) (803) Cash flows from financing activities Proceeds from borrowings 1, Net cash provided by financing activities 1, Net increase (decrease) in cash held (157) (507) Cash at beginning of period (2,075) (1,568) Cash at end of period (2,232) (2,075) Note 2: Reconciliation of net cash used in operating activities to operating profit after tax Financial Management Module (printed May 2010) 9-8

9 $ $ Operating profit after tax 38 (164) Depreciation Increase in tax payable 7 Changes in assets and liabilities Increase in trade debtors (290) (609) Increase in inventories (157) (148) Increase in sundry debtors (19) (68) Decrease in trade creditors (577) 363 Increase in other current liabilities Net cash used in operating activities (488) (204) Required Calculate and analyse the marginal, operating and net cash flows for Ling Industrial Limited for 2008 and Suggested Solution Example 1 Cash Flows i. Marginal cash flow $ $ Contribution margin 4,659,160 4,541,210 Less/(add) inventory increase/(decrease) (156,710) (148,499) debtors increase/(decrease) (289,958) (609,008) Add/(less) trade creditors decrease/(increase) ( 576,922) 363,417 3,635,570 4,147,120 Marginal cash flow has declined dramatically from 2008 to 2009 (a decrease of $511,550 or 12.3% on 2006 figures). This decline is largely due to an increase in debtors of approximately $300,000 and a decrease in creditors of almost $600,000. ii. Operating cash flow Profit before interest and tax 595, ,466 Less increase in net operating assets 2 1,185, ,952 (590,163) (540,486) Ling Industrial Limited s operating cash flow is negative in both years under review, underlining the increase in net debt over the period. The increase in net operating assets of $1,186,000 in 2008 is largely due to an increase in debtors of approximately $300,000, fixed assets of $200,000 and a reduction in creditors of $600,000. iii. Net cash flow Opening net operating debt* 4,575,421 3,567,820 Less: closing net operating debt** 5,724,053 4,575,421 (1,148,632) (1,007,601) 2 Net operating assets equals increase in current assets plus increase in non-current assets less increase in current liabilities less increase in cash-on-hand plus increase in bank overdraft = $214, , , ,246 (Note: current liabilities have decreased therefore the difference is added rather than subtracted = 825, , , ,601) Financial Management Module (printed May 2010) 9-9

10 *Opening net debt Total liabilities 5,899,269 4,505,171 less a/c payable 1,261, ,931 less other liabilities 62,500 39,420 net debt 4,575,421 3,567,820 **Closing net debt Total liabilities 6,542,379 5,899,269 less a/c payable 684,426 1,261,348 less other liabilities 133,900 62,500 net debt 5,724,053 4,575,421 Net Cash Flow The cash flow or change in net debt can also be calculated for 2009 as follows: Net profit after tax for the year ended 31 December ,367 Less: Increase in net operating assets 1,185,999 Net cash outflow (1,148,632) Net cash flow can be reconciled to operating cash flow in 2009 as follows: Operating cash flow (590,163) Less: interest (551,429) Less: tax (7,040) Net cash outflow (1,148,632) 9.7 Growth Overview Short term financial growth measures include percentage changes in: gross sales revenue, net profit and earnings per share Percentage Change in Gross Sales Revenue This is used to indicate growth at either the strategic level (i.e. organisation-wide) or at the business unit (operational) level. Reasons for changes should be carefully scrutinised relying on trends and comparisons with competitors Percentage Change in Net Profit Net profit can also change for a number of reasons, including changes to cost structures, changes to selling prices and external changes such as new accounting standards Percentage Change in Earnings Per Share Brokers, analysts and other capital market participants frequently use EPS and EPS changes in determining firm performance and growth prospects. The specific changes in EPS should be determined because many non-operating change type factors influence changes in EPS such as, non-payment of dividends, buying back ordinary shares, increasing debt level, and acquisitions and divestitures of companies with different price-to-earnings ratios and/or different capital structures. Financial Management Module (printed May 2010) 9-10

11 9.7.5 Sustainable Growth Organisational growth is normally a strategic objective yet a firm must be able to fund its growth. Future expansion requires the generation of funds sufficient to maintain the current or required capital structure. The sustainable growth concept is used by businesses to manage the financial performance of their organisation so that the longer-term growth requirements can be achieved. The level of growth depends on such factors as market size, demand, and ability to deliver the quantity of products/services necessary to achieve the desired growth rate. Sustainable growth is measured by the relationship between retained income and opening funding, as follows: Sustainable growth % = where dividend payout ratio is Divided payout ratio = Retained income Opening equity Cash dividends Net profit x (1 - dividend payout ratio) 3 The sustainable growth rate highlights the level of growth capable of being funded from retained income and existing debt. The measure helps management plan future expansion by highlighting the fact that while growth opportunities are unlimited, the resources to fund growth are not. Using the data from the previous example, we can calculate the sustainable growth rate for Ling Industrial Limited for 2008 and Sustainable growth = retained income/opening equity as follows: $ $ Retained income (163,649) 37,367 Opening equity 2,518,625 2,354,976 =( 6.50%) = 1.58% A negative ratio cannot be compared with a positive ratio value. The measure must be compared to sales growth projections, after taking into account changes in the operating structure of the business. Examples of changes in operating structure could be changes in the debt to equity structure; changes in gross profit percentage; purchases or sales of fixed assets, etc. 3 When the entity pays no cash dividends for the period this calculation reduces to: Sustainable growth % = Retained income Opening equity Financial Management Module (printed May 2010) 9-11

12 9.8 Financial and Operating Ratios Financial Ratios i) Liquidity Ratios Short Term The current ratio and quick ratio are used to assess liquidity and the formulae should be familiar. The current ratio is calculated by dividing current assets by current liabilities. The quick ratio is calculated by dividing current assets (except for inventory) by current liabilities. As they become larger, these ratios indicate better liquidity but it is important to analyse trends, industry comparisons and the mix of current assets. Consider the following simple example Trend $ $ $ Inventory 5,800,000 1,000,000 Cash 100,000 1,000,000 Bank accepted bills 100,000 1,000,000 Total current assets 6,000,000 3,000,000 Current liabilities 3,000,000 3,000,000 Current ratio Improving Quick ratio Worsening The working capital turnover ratio is calculated by dividing sales by working capital. Working capital is defined as total current assets less total current liabilities. Year-end, beginning-of-theyear or average-for-the-year working capital numbers can be used. This ratio provides a number that indicates the length of the firm s operating cycle, i.e. the time from purchase of inventory to receipt of cash from sale of that inventory. This can also be calculated by dividing 365 (days) by the working capital turnover ratio. Consider the following example: Chang Ltd has the following information for the past four years: Year Sales ($000) 3,500 2,800 1,950 1,500 Current assets ($000) Current liabilities ($000) Working capital (average working capital) 11.9 (3,500/295 4 ) 11.2 (2,800/250) 10.3 (1,950/190) Working capital (ending working capital) 11.7 (3,500/300) 9.7 (2,800/290) 9.3 (1,950/210) 8.8 (1,500/170) Days working capital turned over (ending working capital ratio) 31.1 days (365/11.7) 37.6 days (365/9.7) 39.3 days (365/9.3) 41.4 days (365/8.8) 4 (Opening balance + closing balance)/2 = ( )/2 = 295 Financial Management Module (printed May 2010) 9-12

13 The trend in these ratios is favourable, indicating that working capital is turning over more quickly each year. The usual reason would be that sales are increasing at a faster rate than the inventory, but other factors can increase this ratio. For instance, increases in creditors (ceteris paribus) lower the denominator, increasing the working capital ratio and reducing the days working capital turned over, yet this may also indicate liquidity problems for the firm (paying creditors late). ii) Liquidity Ratios Long Term The debt to total funds ratio total debt divided by total funds (total debt plus total equity). The debt to equity ratio is calculated as total debt divided by total equity. Both ratios provide an indication of the financial viability of an organisation, the lower the ratio, the better the financial viability. Changes occur to the ratio when the financial structure of the entity is altered. The long-term debt to equity ratio indicates the solvency for the long term. Future expectations about a downturn in the economy, for example, might suggest that firms with high numbers for this ratio will suffer solvency problems and/or incur higher interest rates. The interest coverage ratio is calculated by dividing (net profit before income tax plus interest expense) by interest expense. This ratio is called interest coverage because the resulting number shows how many times the interest expense for a period is covered by the profit before interest and tax. Higher coverage numbers are better. The number can change due to changes in the debt structure and poor sales, increasing operating expenses, or both. Non-current Assets to Equity: A high level for this ratio might indicate that investment in non-current assets is too great. It should be compared with industry averages or with a number of competitors. A lower ratio suggests that some working capital is funded by equity, which is expected because a firm cannot operate with non-current assets alone Operating Ratios Net profit to net sales indicates the amount of net profit that one dollar of sales generates. Gross profit to net sales indicates the ability of the organisation to cover other operating and non-operating expenses. Factors affecting both these ratios include increased competition, changes to sales revenue due to quantity and/or price changes Financial and Operating Ratio Relationships Sales to accounts receivable is also called the debtors or accounts receivable turnover ratio because it indicates the number of times that the amount of money equal to current debtors has been received during the period. Low ratios can be due to inadequate credit collection policies and procedures, bad debt write-offs, or credit terms for poor-paying customers. It is also possible to calculate the average number of days that debtors have been outstanding by dividing 365 (days) by the accounts receivable turnover ratio. The ratios should be compared with prior periods and industry averages. Industry averages are important because the nature of the business will affect this ratio. Financial Management Module (printed May 2010) 9-13

14 9.8.4 Stock (Inventory) Ratios The stock turnover ratio is calculated as cost of goods sold divided by average stock. The ratio should be as high as possible. Possible reasons for changes include having too much or too little stock in anticipation of a price rise or fall respectively. The cost of sales to sales ratio indicates the number of dollars of cost of goods sold to each dollar of sales revenue for the period. The lower the ratio the better. It can also be expressed as days inventory held by dividing 365 days by the stock turnover ratio. A lowering trend is desirable. Increasing days inventory held numbers usually indicates stock is becoming obsolete and is becoming more difficult to sell. Take the following example. XZY Ltd has the following information for the past six years: Sales ($000 s) 7,800 7,900 8,000 5,000 2,500 1,000 Cost of sales ($000 s) 3,900 5,100 5,000 3,200 1, Average stock ($000 s) 1,600 2,100 2,000 1, Stock turnover (times) Days Inventory held 2.4 (3,900/ 1,600) (5,100/ 2,100) (5,000/ 2,000) (3,200/ 1,200) (1,700/ 600) (600/ 150) 91 Both the declining turnover ratio and the days inventory held indicate that inventory is moving more slowly. Further investigation would be needed to identify the specific cause. Additionally, there may be other inter-related effects of lower inventory turnover. For example, there may be an adverse effect on profitability. 5 = 365/2.4 To calculate the percentages in the table above we divide each number by the total sales for the company. E.g. the gross profit percentage for Company C is: $200,000 / $800,000 x 100 = 25%. Financial Management Module (printed May 2010) 9-14

15 9.8.5 Trends Analysing ratios over time can give valuable insights into a firm s performance. Common size analysis can be used to compare or benchmark financial performance against other firms within the same industry; and to get a different picture about trends for one firm. Using this approach each line item in the Profit and Loss Account (or Balance Sheet) is expressed as a percentage of sales (or total assets). Consider the following Profit and Loss Accounts and common size Profit and Loss Accounts for three firms in the electronics industry 6. Company A Company B Company C $(000 s) % $(000 s) % $(000 s) % Sales % % % Cost of sales % % % Gross profit % % % R & D % % % Sales & admin % % % Other expenses % % % Total expenses % % % Profit before tax % % % Income tax % % % Net profit % % % Company B has the highest gross and net profit percentages of the three companies indicating better profitability. To see if these percentages are due to better efficiency, better strategy, some other reason or a combination of these, further investigation is necessary. To establish a starting point to answer these questions more fully, we could review the notes in the published financial reports. Often, such reports can be obtained from the Internet in spreadsheet format so that analyses can be carried out easily. 6 To calculate the percentages in the table we divide each number by the total sales for the company. E.g. the gross profit percentage for Company C is: $200,000 / $800,000 x 100 = 25%. Financial Management Module (printed May 2010) 9-15

16 Common size analysis can also be used for within-company comparisons as shown in the table below: Zhou Company Inc Amount ($000 s) % Amount ($000 s) % Amount ($000 s) % Cash % % % Debtors 1, % 1, % 2, % Stock 1, % 1, % 2, % Other % % % Total current assets 3, % 3, % 5, % Plant and equipment 1, % 2, % 2, % Other % % % Total non-current assets 1, % 2, % 2, % Total assets 5, % 5, % 7, % Creditors % 1, % 1, % Short-term loan % % % Other % % % Total current liabilities 1, % 1, % 2, % Long-term loan 1, % 1, % 1, % Total non-current liabilities 1, % 1, % 1, % Paid up capital 2, % 2, % 3, % Retained profits % % % Total equity 2, % 2, % 4, % Total liabilities & equity 5, % 5, % 7, % The best way to start this analysis is to look at the trends in the subtotals and the totals. For example, we see that non-current assets percentages have decreased from 2008 to 2009 and we see that current assets percentages have increased. We would then look to the individual accounts to determine the main reasons for this pattern. Cash has increased over the three-year period, and debtors fell for the first year and then increased. A decline in accounts receivable may be good news unless it has been caused by writing off bad debts or a decline in currentperiod sales or some combination of these. Stock also decreased slightly relative to total assets - good news as stock earns no return sitting in a warehouse, yet some stock levels need to be maintained in order to satisfy customer demand (unless the firm uses a JIT system and are very confident that our suppliers can deliver - but this is not always the case, especially in Hong Kong). Other current assets have remained relatively stable over the three-year period, while investment in non-current assets has decreased relative to total assets from 2008 to This may be due to accounting or to real economic reasons or both. Further investigation is required. 7 To calculate the common size balance sheet numbers we just divide each number by total assets. So, for example, the percentage for plant and equipment for 2008 is 33.72% (2,000/5, = 33.72%). Financial Management Module (printed May 2010) 9-16

17 The mix of how the assets are funded can be seen in the total liabilities and equity section. Total debt (short and long-term debt) has fallen as a percentage of total assets, with some of this being taken up by paid up capital. This means less of a future cash burden on the company because paid up capital represents funding which does not attract a requirement to pay a regular cash payment. This is because dividends are paid at the discretion of the directors. Debt, on the other hand means the company must pay interest (and principal) each period regardless of how the company is performing. Zhou Company also seems to be making much better use of its accounts payable funding. Accounts payable is (usually), interest free so the longer the payment can be deferred the better. However, relationships with suppliers are very important and they must be nurtured and maintained at a good level so the company can carry out its operations and satisfy its own customers. A balance needs to be achieved. Index Analysis We can also perform an index analysis when looking at trends. Index analysis expresses the amounts of a particular profit and loss or balance sheet item as a percentage of the amounts of that same item in the base year. The base year is selected by the analyst as the starting point for the trend analysis. With index analysis we see how an item has changed over time relative to itself. For example it may be seen from the index analysis below, that the cash balance in 2009 is 6.89 times the balance of cash in 2007 i.e. 310 / 45. Index Analysis Amount Index Amount Index Amount Index (HK$000) (HK$000) (HK$000) Cash Debtors 1, , , Stock 1, , , Other Total current assets 3, , , Plant & equipment 1, , , Other Total non-current assets 1, , , Total assets 5, , , Creditors , , Short-term loan Other Total current liabilities 1, , , Long-term loan 1, , , Total non-current liabilities 1, , , Paid up capital 2, , , Retained profits Total equity 2, , , Total liabilities & equity 5, , Financial Management Module (printed May 2010) 9-17

18 While the cash balance has increased significantly relative to itself over the three-year period, its amount is not material when compared with total current assets. Of more interest are the index changes for debtors and for stock. Based on the common size analysis percentages in the previous table, the trends in these accounts did not appear to stand out (both remained at around 30% of total assets). The 2009 balance for debtors is about 1.5 times the balance in 2007 and for stock it is about 1.4 times. Further analysis of debtors could include inspection of an aged trial balance (if possible), to determine if the build up is due to an increase in cash collection times or changes in credit sales over the period. The stock change is consistent with sales growth explaining the change because stock would be expected to increase if sales and accounts receivable are also increasing, yet other factors need to be considered. The increase in plant and equipment seems to have been funded mainly from the increase in retained profits and paid up capital (total equity). Common size and index analysis complement one another yet the presentation of the information in different ways makes certain relationships easier to see. 9.9 Non-financial Measures Common Non-financial Measures It is now commonly recognised that a balanced scorecard (BSC) should be used to measure performance. The BSC requires the use of both financial and non-financial measures. Common non-financial measures include: customer satisfaction; percentage of on-time deliveries; delivery response time; internal efficiency; cycle time; good output per employee; sales per employee; creativity; time for product to reach market from initial idea; time between new product and a competitor s new product; and percentage of new products reaching the market before competitors products. Financial Management Module (printed May 2010) 9-18

19 9.10 The Balanced Scorecard Description The BSC provides an organisation with a comprehensive framework that translates the organisation's vision and strategy into a coherent set of performance measures (Kaplan and Norton, 1996a, p.24). Kaplan and Norton (1992) brought the BSC into prominence and it has evolved from a performance measurement system to a core management system that is now widely used across many sectors, including service, government, not for profit and for profit. The performance measures in the BSC are organised under four perspectives: financial, customer, internal business processes and learning and growth. Each perspective has a short term goal with one or more critical success factors identified with that goal. The general BSC model is illustrated in Figure One. Financial Perspective Return on Investment Operating Income Return on Equity Cash flow Customer Perspective Customer Satisfaction Surveys Customer Retention Market Share New Customer Acquisition Organisation s Vision and Strategy Internal Business Perspective Production Flexibility % of Sales for New Products Product Quality After Sales Service Learning and Growth Perspective Employee Training Employee Satisfaction Strategic Investment Decisions Figure 1: The Balanced Scorecard (Examples of Measures) Adapted from Kaplan and Norton (1992) Benefits of the Balanced Scorecard The balanced scorecard approach can lead to consensus on organisational priorities, clear specification of goals, rigorous planning and improvement processes, alignment of strategic goals with shorter term actions, clearer communication, team working and knowledge sharing and clearer accountability for results. Financial Management Module (printed May 2010) 9-19

20 Potential Problems Although the method may assist in highlighting organisational issues, it cannot always resolve them easily. For example, some measures in the scorecard will conflict and difficult choices must be made to resolve these issues (e.g. R & D investment versus short term profitability); organisational culture may over-emphasise some measures and ignore others (e.g. an organisation with a strong sales culture may ignore underlying profitability). Top management commitment to the balanced scorecard approach is necessary for it to succeed. The BSC leads to a better basis for managers performance bonuses. However, all performance measures are open to manipulation by managers The Performance Pyramid The Vision Corporate level Market satisfaction Financial measures SBU level Customer satisfaction Flexibility Productivity Operational Quality Delivery Process time Cost Operation External effectiveness Internal efficiency The performance pyramid shows how goals are set within a BSC. At the top of the pyramid is the firms vision. All goals are set in line with this vision. At the corporate level, the goals are concerned with market satisfaction (external) and financial performance (internal). At the Strategic Business Unit level, the strategic goals are customer satisfaction, flexibility (responsiveness of the SBU to changing demands) and productivity (efficient use of resources). At the operational level, the criteria are quality (fitness for purpose); efficiency of delivery; efficiency of processes resulting in fast process times; and elimination of non value added activities, resulting in leaner costs. Financial Management Module (printed May 2010) 9-20

21 9.12 Reporting and Evaluating Sustainability Many firms are recognising the benefits of operating in a sustainable manner. These benefits include; keeping the environment clean, treating people with respect and operating profitably. Firms that implement a BSC can extend this to monitor and measure their sustainability efforts and link corporate sustainability objectives with appropriate corporate actions and performance outcomes. When appropriate strategic measures are included in a firm s BSC, sustainability can be improved. For example toxic emissions are a lag measure of a firm s process efficiency and also a lead indicator of future environmental costs. When choosing sustainability measures consideration should be given to ensuring the measures are: quantifiable, either in absolute or percentage terms complete, in that the measure sums up in one number multiple measures of performance e.g. profit is a summary measure of revenue generation and cost control. Controllable, in that employees can influence improvement Some firms choose to integrate sustainability measures into the existing perspective of the BSC. Sustainability is typically included in the Internal business process perspective, however research shows that sustainability measures can be incorporated into any of the four perspectives of the BSC. Incorporation into an existing BSC can help to show the interrelationships between the measures and other areas of the firm to fulfil corporate strategy. Other firms add a fifth perspective to the BSC. By including social and environmental performance indicators that link the other four perspectives the importance of social and environmental responsibilities is highlighted as a corporate objective. Benefits of firms including sustainability measures into a BSC include: Increased employee satisfaction Lower operational and administrative costs Improved productivity Enhanced image and reputation Increased market opportunities Improved shareholder relationships Share market premiums Financial Management Module (printed May 2010) 9-21

22 9.13 Agency Theory and Managerial Incentive Schemes An agency relationship exists whenever one party (the principal) hires another party (the agent) to perform some service, and this service requires the principal to delegate some decision making authority to the agent. Two types of principal-agent relationships arise in connection with managerial incentive schemes. First, the organization s owners or shareholders, acting as the principal (usually through the board of directors), hire the chief executive group to be their agents in managing the firm in their best interests. In the second principal - agent relationship, the firm s chief executive group acts as the principal and hires division managers as agents to manage subunits of the organization. Agency theory assumes that all individuals - principals and agents - care not only about financial compensation but also about such properties as attractive working conditions and flexibility in hours worked. Managers are assumed to prefer leisure to hard or routine work, although for some top management an aversion to work may not be a realistic assumption. Nevertheless, the argument goes that agents require incentives to minimize the net costs of the divergence of interests between them and the principal. Among other things, the agency model argues that if top executives of the company are compensated only by straight salary, they may not be motivated to take actions that increase the value of the firm to the shareholders. They may overconsume in such areas as leisure, attractive working conditions, and company perquisites, or will not spend enough time and effort to increase shareholder wealth. If the firm s owners knew what actions were optimal for the firm and could observe without cost the actions of the top managers, they could direct the managers to implement these optimal actions, with the threat of withholding compensation or dismissal if these actions were not carried out. However, a dispersed group of owners will probably have inadequate information and will find monitoring costly. Accordingly, the owners are unlikely either to know what the optimal actions should be or to be able to direct and monitor the actions of the top executives. Therefore, to encourage managers to take actions that are in the firm s best interests, the owners may introduce incentive compensation plans that enable the managers to share in the firm s increased wealth. These schemes can take a variety of forms, including merit raises, bonuses based on reported performance, and various types of share ownership plans. Executive incentive compensation bonus plans are designed to create a commonality of interest between the owners (principal) and the executives (agents). However, some divergence of interest will always exist between the principal and the agents. This is due to differences in risk attitudes, the existence of private information (managers always know more about the firm than shareholders), and limited or costly observability. The principal will usually attempt to limit this divergence by establishing appropriate incentives for the agents, and by incurring monitoring costs designed to limit actions that increase the agents welfare at the expense of the principal. Annual audited financial statements are an excellent example of costly monitoring of managerial behaviour. Financial Management Module (printed May 2010) 9-22

23 Part D Practice Question 1 Financial information for Chang Inc is provided below for 2009 and 2010: [30 Marks] Chang Inc Corporation Income Statement and Statement of Retained Earnings For the Year Ended June 30, 2010 (in thousands) Revenue: Net sales $480,000 Other 36,000 Total revenue 516,000 Expenses: Cost of goods sold 324,000 Selling and administrative 93,000 Depreciation 15,000 Interest 12,000 Total expenses 444,000 Income before income taxes 72,000 Income taxes (assumed 15%) 10,800 Net income 61,200 Less: Dividends 15,300 Net income added to retained earnings 45,900 Retained earnings, 1/7/ ,400 Retained earnings, 30/06/2009 $114,300 Financial Management Module (printed May 2010) 9-23

24 Chang Inc Comparative Balance Sheets June 30, 2010 and 2009 ($ thousands) Assets Current assets: Cash and marketable securities $28,700 $12,600 Net Receivables $28,800 $30,000 Inventories $39,000 $37,200 Other current assets $3,000 $1,800 Total current assets $99,500 $81,600 Investments $79,600 $68,400 Property, plant, and equipment: Land $7,200 $7,200 Buildings and equipment $160,800 $148,800 Total property, plant, and equipment. $168,000 $156,000 Total assets $347,100 $306,000 Liabilities and Shareholders' Equity Current liabilities: Bank Overdraft $13,200 $14,400 Accounts payable $43,200 $42,600 Salaries payable $15,600 $16,200 Total current liabilities $72,000 $73,200 Long-term debt. $96,000 $102,600 Total liabilities $168,000 $175,800 Shareholders' equity: Share capital $64,800 $61,800 Retained earnings $114,300 $68,400 Total shareholders' equity $179,100 $130,200 Total liabilities and shareholders' equity $347,100 $306,000 The following industry ratios apply: Required 1. Net profit as a percentage of sales 10% 2. Return on assets 15% 3. Return on equity 22% 4. Current ratio Quick ratio Debt-equity ratio Interest coverage Dividend payout ratio 35% a) Calculate the ratios listed below for Chang Inc for 2010: 1. Net profit as a percentage of sales. 2. Return on assets. 3. Return on equity. 4. Current ratio. 5. Quick ratio. 6. Debt-equity ratio. 7. Interest coverage. 8. Dividend payout ratio. b) Analyse Chang Inc s performance using two years of data where appropriate and the industry ratios provided. Financial Management Module (printed May 2010) 9-24