THE PRIVATE SECTOR: SHAREHOLDER BENEFITS
The overriding purpose of a business is to increase long-term owner wealth.
Carefully read the case study below.
Case Study
The statement of prospects below is adapted from the published accounts of a UK printing company with revenue in 2000 of £110m, operating profits of £16m, and post-tax profit of £10m.
You may be interested in the order of priorities of the sections/paragraphs.
Note: Wyndeham Group is now owned by Walstead Investments,, a private company, and their strategy may be different. But Wyndeham Group remains a leading printer. .
Wyndeham Press plc Group Strategy
- Our strategy is to build on our position as one of the leading printers of magazines, brochures etc. offering a complete service for the customer from pre-press and printing to finishing and despatch. We remain focused on making acquisitions to assist in achieving our goal as well as developing our existing businesses.
Capital investment – investment criteria and budgeted expenditure
- As referred to in the Chairman’s and the Chief Executive’s review, the last year has been a period of considerable investment for your company. We purchased new presses, finishing equipment and pre-press equipment, at a total cost of £14.1m. We plan to invest a further £14m this year on upgrading existing equipment and expanding capacity by installing additional machines.
Funding structure
- Our closing level of debt is £26.7m of which £23.2m is at fixed rates ranging from 5.9% to 8.1%. The balance is at 1% over base rate and this averaged 6.4% during the period. Given the high level of operating gearing within a printing business, we believe our optimal level of debt/ equity is between 50% – 70%.
- Interest cover has reduced from 14 times to 10.3 times, which is still a very healthy level, and gearing increased to 56%. Both ratios are well within our targets of a minimum of 8 times interest cover and a maximum of 70% gearing. The covenants under our debt facilities require a gearing of less than 85% and debt of less than twice EBITDA (earnings before interest, tax, depreciation and amortisation).
- The Group has a progressive dividend policy. Dividend growth will follow earnings growth and we will maintain dividend cover at our target of 3 times. We believe this level of cover should generate sufficient retained capital to support the equity component of our investment programme.
Key performance indicators and benchmarking of performance
- We benchmark our performance against a peer group of comparable businesses (A, B, C, D). We aim for top quartile performance compared to this group in the following categories: operating profit as a percentage of sales, return on capital employed, profit per employee, proportion of repeat business. We believe we currently rank in the top quartile of the printing sector on all these criteria.
- The group achieved a return on capital employed of 29%. In the long-term, our objective is a steady rise in return on capital employed as a result of acquisitions, capital expenditure programmes and improvements in efficiency and machine utilisation.
Risks and sensitivities
- The commercial risks we face in the coming year are:
- If sterling continues to increase in value, overseas companies will become even more competitive on the non-magazine work.
- Whilst we expect a very modest growth in the economy, if economic activity contracts there will be a resultant decline in demand for our services.
Trading prospects
- Our prospects for the current year are dependent on prices achieved and volume of work. We believe that volume of work will move ahead this year arising from the increased capacity generated by the installation of new plant.
- We remain confident about the prospects for our business.
Why are shareholders important?
In the case example above, the ‘statement of prospects’ is expressed almost exclusively in financial terms, with the exception of the 1st paragraph. The ‘prospects’ are not the prospects of the business but the prospects for the shareholders who have invested in the company and to whom the report is aimed.
As we saw in the previous chapters, organisations are likely to have a number of goals, objectives and targets which, despite managerial effort to attain goal congruence, are at times likely to conflict. This is often due to the difficulty in satisfying the differing objectives of the organisation’s various stakeholder groups.
But profit-making organisations tend to focus on financial performance in general and on the interests of shareholders in particular.
The traditional argument for this is that shareholders are the legal owners, the company belongs to them and so their interests are paramount.
Question
Go back to the case example above. Identify ways in which maximising long-term owner value was Wyndeham Press plc’s objective.
Answer
- Group strategy, to serve customers, is undertaken with profit in mind
- Capital investment – generate future profits by raising productivity
- Funding structure – there is generally an optimum mix of debt and equity capital. The firm monitors this to raise capital and funds at the cheapest cost – in the shareholders interests’
- Benchmarking of performance. Although these are accounting measures, they do contribute to the long-term performance on the company. Raising return on capital employed means rewarding shareholders more each year for their investment
Significance of long-term owner focus
- As maximising shareholder wealth is a long-term goal for a business, inevitably managers must decide between what funds they want to disburse now and what funds need to be maintained in the business to ensure the prospects of long-term profitability.
- Shareholders own the business, and so the directors of the company have a duty to safeguard their interests.
- What the shareholders require as a return is used to judge the validity of investment projects.
- Shareholders assess the quality of management by how well the business performs financially.
- Shareholders are the principal source of capital investment in a business. They provide funds on share issues or permit managers to retain profits for investment.
What are shareholders interested in?
- Current earnings
- Future earnings
- Dividend policy
- The relative risk of the investments compared to other investments and the return available
Difficulties of incorporating shareholder concerns in performance measurement for managers
- Shareholders are interested in future returns whereas accounts generally provide historic information. Accounting measures such as ROCE do not measure shareholder wealth.
- Shareholders have an assessment of risk different from managers. Managers, typically, worry about their careers, which concern shareholders not at all. Shareholders are concerned about the security of their investment and the likelihood of making a return.
- At operating level, it is not easy to identify exactly how well a business is doing in relation to other businesses.
- Any other yardstick than shareholders’ objectives effectively means that managers may run an organisation in their own
Why should managers bother to know who their shareholders are?
A company’s senior management should remain aware of who its major shareholders are, and it will often help to retain shareholders’ support if the chairman or the managing director meets occasionally with the major shareholders, to exchange views.
- The company’s management might learn about shareholders’ preferences for either high dividends or high retained earnings for profit growth and capital gain.
- For public companies, changes in shareholdings might help to explain recent share price movements.
- The company’s management should be able to learn about shareholders’ attitudes to both risk and gearing. If a company is planning a new investment, its management might have to consider the relative merits of seeking equity finance or debt finance, and shareholders’ attitudes would be worth knowing about before the decision is taken.
- Management might need to know its shareholders in the event of an unwelcome takeover bid from another company, to identify key shareholders whose views on the takeover bid might be crucial to the final outcome.
Aligning shareholder and managerial goals
One way of rewarding managers is share options.
- This is regarded as a good thing as it means that managers have a direct financial interest in increasing owner wealth, ensuring goal congruence.
- Drawbacks are more subtle.
- Managers are rewarded for past performance, and the rewards are often They may be incentivised to take short-term measures, and ignore the long term.
- There may be a general rise in share prices which is not performance related.
Case Study
From The Times, London, Tues 13 November 2007
‘Bonnie Brown was not in a position to haggle. She was recently divorced and living with her sister so when a small technology start-up offered her a job in 1999 as a part-time masseuse she took it. The post paid RWF450 a week, plus a pile of what were then worthless stock options.
Today, on the back of that package, Ms Brown, Google employee No 41, is a multimillionaire.’
This story gives a flavour of some of the rewards possible from owning options. However, no-one would suggest that Ms Brown, or indeed the other 1,000 or so Google employees who are multimillionaires put in as much as they have reaped in rewards. The dramatic rise in Google’s share price is due to a range of factors from the hard work of its employees to market fever for Google shares.
Internet businesses
Between 1995 and 1999, investors in Internet companies offered managers share options, in return for a lower salary and long hours. The share options, potentially, could have made the managers into millionaires. For several years, managers worked long hours for reward that correlated neatly with the rewards offered to shareholders.
In 2000, the market lost confidence in Internet companies. Hired managers saw a potential RWF20m reward fall to $2m, and in many cases have left. Founders of the business have stayed on. (Financial Times 6/2/01).
It may therefore be unrealistic to expect managers to take the same risks with their rewards as investors, who are able to spread risks.
The growth in the internet has given shareholders an opportunity to organise and lobby the companies in which they hold shares..
SURVIVAL AND GROWTH
Achieving objectives of survival and growth ultimately depends on making profits.
Successful businesses might report expanding sales volumes, manufacture prestigious brands, receive awards and recognition and be a good company to work for. These may be desirable achievements and objectives, but they are not enough to guarantee the survival and growth of an organisation.
The clearest measure of success for a business is continued existence and expansion. It is widely accepted that growth requires profits and that growth can produce profits; growth without profits can mean a company is taken over or goes into liquidation, that it does not survive. So whatever else it aims to do, a business must make profits and make them in perpetuity.
Despite the overriding importance of profits, growth can be measured in a number of ways.
| Area of growth | Comment |
| Revenue | In the long term, growth in revenue is only really valuable to investors if it means growth in profits. |
| Profitability | There are many measures of this (see next section). Growing profitability is more useful if it is related to the level of investment. |
| Return of investment | A growing return on investment suggests that capital is being used more productively. |
| Market share | Growth in market share is generally regarded as a good thing, as it can generate economies of scale. |
| Number of employees | Shareholders are interested in productivity and profit per employee. An increasing head count is a measure of success if people are needed to deliver a service but people need to be employed productively. |
| Number of products | Growth in the number of products is only useful if the products are profitable. |
| Cash flow | This is one of the most important measures of growth as it ultimately determines how much a business has to invest. |
Most of the time, growth is a sign of success, provided it is profitable. This is why it is crucial. At other times, growth can be achieved in many different ways. Look at the case example below, noting the strategies for growth and performance measures.
Case Study
From Times Online, 15 April 2008
Tesco, Britain’s largest retailer, reported a 12 per cent jump in underlying pre-tax profit for the 12 months to February 23, and announced plans for 30,000 new jobs across the group.
The company gave no further details about the type or location of its new jobs.
The £30 billion supermarket chain made an underlying pre-tax profit of £2.8 billion, giving investors a 13 per cent increase in their annual dividend to 10.9p per share.
The underlying figures strip out costs such as pension payments and losses on financial instruments, as well as boosts such as rent-free periods. When these are added into the figures, Tesco’s pre-tax profit was up 5.7 per cent.
Tesco reported a strong start to the year, with a like-for-like increase of 4 percent in UK sales, excluding petrol, in the first five weeks of 2008.
Sir Terry Leahy, the chief executive, said: “We began the new financial year confidently, with a good start in the UK, excellent progress in our established international markets and promising early performance from our investments in future growth, particularly in the US, China and Turkey.”
Sir Terry’s confidence is in contrast to the gloom on Britain’s high streets. Last week the British Retail Consortium urged the Bank of England to cut interest rates by half a percentage point to avert a wave of job cuts as consumer spending slows down. Yesterday the BRC said that the like-for-like value of takings at the country’s tills fell by 1.6 per cent in March.
At Tesco, UK sales were up 6.7 per cent like-for-like to £37.9 billion last year despite what the company described as “challenging market conditions”. Without petrol sales, the percentage increase in sales was almost 4 per cent per cent, which Tesco said was slightly ahead of its planned performance.
The company said that attempts to lower prices had been hit by increased market prices for commodities and some seasonal fresh foods. Unseasonal summer weather slowed growth in the first half, Tesco said, while tougher competition from competitors and a downturn in customer demand for some of the company’s non-food products cut sales in the second half.
The company said earlier this month that it would halt plans to sell its clothing lines online so that it could “improve the offer”. Tesco Direct, the store’s online grocery deliver service, racked up initial operating losses of £90 million.
Tesco’s international division reported a 25 per cent increase in sales to £13.8 billion, with a £702 million contribution from China, which was consolidated in the accounts for the first time.
The company said last month that it would “pause for breath” in the US after opening 60 Fresh & Easy stores across Southern California and Arizona in five months. The stores are styled on the Tesco Express outlets in the UK but analysts have claimed that the shops are missing sales targets by as much as 70 per cent.
The company said today that it would separate out US sales and trading results in its interim results in September. Until then, they are included in the UK figures. Tesco said: “We are very encouraged by the start Fresh & Easy has made. … Whilst it is still early days, the response of customers to our offer has surpassed our expectations.” It insisted that US sales were ahead of budget and that plans to open about 150 new US stores this year were on track.
In its personal finance business, Tesco made a pre-tax profit of £64 million after a £11 million hit from household insurance claims from last summer’s floods in Yorkshire and the Midlands.
The company’s £5 billion programme to release value from its property portfolio delivered proceeds of £1.2 billion over the past year. The company admitted that yields had increased only modestly in recent months but said that demand for its property remained strong. The cash raised is used to fund a share buyback programme that has seen £1.1 billion worth of shares repurchased so far.
Tesco opened 17 new superstores and 103 express stores last year, taking its total number of outlets to 1,608 — which has raised concerns among campaigners who claim that the supermarket giants are killing Britain’s high streets.
Tesco said that it was continuing to work with the Competition Commission on its inquiry into the grocery industry but issued a warning against red tape that would halt its expansion. “This is a very competitive industry from which consumers benefit hugely,” the company said today. “We hope that the regulatory authorities will give due weight to this and to the need to avoid costly and burdensome new regulation.”
PROFITABILITY
Measures relating to profit include sales margin, EBITDA and EPS. More sophisticated measures (ROCE, ROI) take the size of investment into account. Later on in the chapter we consider how measures of profitability are used for short-run or long-run performance measurement. Bear this in mind particularly when you study the sections on RI, ROI and NPV and go through the examples covering these.
Case Study
Pearson, the education and publishing group, listed the following as ‘financial highlights’ in its 2007 annual accounts.
- Sales
- Operating profit (before goodwill, exceptional and non-operating items)
- Adjusted earnings per share
- EBITDA
- Operating cash flow
- Operating free cash flow
- Return on invested capital
- Net debt
Pearson actively targets sales growth, EBITDA and adjusted earnings per share.
You need to be able to discuss the appropriateness of the measures of ‘profitability’ covered in this section.
As a general principle, these measures of performance, which we will be looking at, are only meaningful if they are used for comparison.
- Over time (equivalent time periods)
- With other companies
- With other measures of performance
- With other industries
Profitability
A company ought of course to be profitable, and there are obvious checks on profitability.
- Whether the company has made a profit or a loss on its ordinary activities
- By how much this year’s profit or loss is bigger or smaller than last year’s profit or loss
It is probably better to consider separately the profits or losses on exceptional items if there are any. Such gains or losses should not be expected to occur again, unlike profits or losses on normal trading.
Profit on ordinary activities before taxation is generally thought to be a better figure to use than profit after taxation, because there might be unusual variations in the tax charge from year to year which would not affect the underlying profitability of the company’s operations.
Another profit figure that should be calculated is PBIT: profit before interest and tax.
- This is the amount of profit which the company earned before having to pay interest to the providers of loan capital. By providers of loan capital, we usually mean longer-term loan capital, such as debentures and medium-term bank loans, which will be shown in the statement of financial position (balance sheet) as ‘Suppliers: amounts falling due after more than one year.’ This figure is of particular importance to bankers and lenders.
- How is profit before interest and tax calculated? The profit on ordinary activities before taxation plus Interest charges on long-term loan capital
- To calculate PBIT, in theory, all we have to do is to look at the interest payments in the relevant note to the accounts. Do not take the net interest figure in the income statement itself, because this represents interest payments less interest received, and PBIT is profit including interest received but before interest payments.
) Lessons to be learnt
- Sales margin as a measure is not really any use in comparing different industries.
- Sales margin is influenced by the level of fixed costs.
- Trends in sales margin are of interest. A falling sales margin suggests an organisation has not been able to pass on input price rises to customers.
- Comparisons with similar companies are of interest. If an organisation has a lower sales margin than a similar business, this suggests problems in controlling input costs.
In short, the value of sales margin as a measure of performance depends on the cost structure of the industry and the uses to which it is put.
EBITDA
EBITDA is earnings before interest, tax, depreciation and amortisation.
To see what EBITDA actually does, it is worth identifying what it omits.
| Item | Comment |
| Earnings | In practice this equals profit after tax for the financial year with some adjustments, as you should be aware from your financial accounting studies. |
| Interest | Essentially this is a financing cost. Pearson’s statement of financial position (balance sheet) at 31/12/05 showed net assets of £3,733m. Suppliers due over one year were £2,500m, most of which were bonds and commercial paper. |
| Tax | The government’s take is not relevant to the operating performance of the business.
|
| Depreciation and amortisation | This is the income statement charge for tangible and intangible assets. Depreciation generally represents the writing off of expenditure incurred several years ago, not in itself relevant to performance in any particular financial year. |
Advantages of EBITDA
- It is a good proxy for cash flow from operations, and therefore is a measure of underlying performance. It can be seen as the proportion of operating profits converted to cash.
- Tax and interest – while important – are effectively distributions to the government (tax) and a finance charge (interest). They are not relevant to the underlying success of this particular business.
- EBITDA is easy to calculate and understand.
- EBITDA can be used to assess the performance of a manager who has no control over acquisition and financing policy as it excludes costs associated with assets (depreciation) and debt (interest).
Question
When might interest be relevant in a significant way to the operating performance of the business?
Solution
- It depends. Short term bank interest can be a significant operating expense.
- Also, a bank itself earns money from an interest margin so interest is at the heart of what it does.
Earnings per share (EPS)
EPS is a convenient measure as it shows how well the shareholder is doing.
EPS is widely used as a measure of a company’s performance, especially in comparing results over a period of several years. A company must be able to sustain its earnings in order to pay dividends and re-invest in the business so as to achieve future growth. Investors also look for growth in the EPS from one year to the next.
Earnings per share (EPS) is defined (in Financial Reporting Standard 3) as the profit in cents attributable to each equity (ordinary) share. EPS is calculated as follows.
Profit of the period after tax, minority interests and extraordina items, and after deducting preference dividends
Number of equity shares in issue and ranking for dividend
Extraordinary items are unusual, non-repeating items that affect profit but have effectively been outlawed by FRS 3.
EPS on its own does not really tell us anything. It must be seen in context.
- EPS is used for comparing the results of a company over time. Is its EPS growing? What is the rate of growth? Is the rate of growth increasing or decreasing?
- Is there likely to be a significant dilution of EPS in the future, perhaps due to the exercise of share options or warrants, or the conversion of convertible loan stock into equity?
- EPS should not be used blindly to compare the earnings of one company with another. For example, if A Co has an EPS of RWF120 for its 10,000,000 RWF100 shares and B Co has an EPS of RWF240 for its 50,000,000 RWF250 shares, we must take account of the numbers of shares. When earnings are used to compare one company’s shares with another, this is done using the P/E ratio or perhaps the earnings yield.
- If EPS is to be a reliable basis for comparing results, it must be calculated consistently. The EPS of one company must be directly comparable with the EPS of others, and the EPS of a company in one year must be directly comparable with its published EPS figures for previous years. Changes in the share capital of a company during the course of a year cause problems of comparability.
Note that EPS is a figure based on past data, and it is easily manipulated by changes in accounting policies and by mergers or acquisitions. The use of the measure in calculating management bonuses makes it particularly liable to manipulation. The attention given to EPS as a performance measure by City analysts is arguably disproportionate to its true worth. Investors should be more concerned with future earnings, but of course estimates of these are more difficult to reach than the readily available figure.
A fully diluted EPS (FDEPS) can be measured where the company has issued securities that might be converted into ordinary shares at some future date, such as convertible loan stock, share warrants or share options. The FDEPS gives investors an appreciation of by how much EPS might be affected if and when the options, warrants or conversion rights are exercised.
Profitability and return: the return on capital employed (ROCE)
It is impossible to assess profits or profit growth properly without relating them to the amount of funds (the capital) employed in making the profits. An important profitability ratio is therefore return on capital employed (ROCE), which states the profit as a percentage of the amount of capital employed.
Profit is usually taken as PBIT, and capital employed is shareholders’ capital plus ‘suppliers: amount falling due after more than one year’ plus long-term provisions for liabilities and charges. This is the same as total assets less current liabilities. The underlying principle is that we must compare like with like, and so if capital means share capital and reserves plus long-term liabilities and debt capital, profit must mean the profit earned by all this capital together. This is PBIT, since interest is the return for loan capital.
Return on capital employed (ROCE) indicates the productivity of capital employed. It is calculated as:
Profit before interest and tax x 100
Average capital employed
The denominator is normally calculated as the average of the capital employed at the beginning and end of the year. Problems of seasonality, new capital introduced or other factors may necessitate taking the average of a number of periods within the year.
Evaluating the ROCE
What does a company’s ROCE tell us? What should we be looking for? There are three comparisons that can be made.
- The change in ROCE from one year to the next
- The ROCE being earned by other companies, if this information is available
- A comparison of the ROCE with current market borrowing rates
- What would be the cost of extra borrowing to the company if it needed more loans, and is it earning an ROCE that suggests it could make high enough profits to make such borrowing worthwhile?
- Is the company making an ROCE which suggests that it is making profitable use of its current borrowing?
Analysing profitability and return in more detail: the secondary ratios
We may analyse the ROCE, to find out why it is high or low, or better or worse than last year. There are two factors that contribute towards a return on capital employed, both related to revenue.
- Profit margin. A company might make a high or a low profit margin on its sales. For example, a company that makes a profit of RWF250 per RWF1,000 of sales is making a bigger return on its revenue than another company making a profit of only RWF100 per RWF1,000 of sales.
- Asset turnover. Asset turnover is a measure of how well the assets of a business are being used to generate sales. For example, if two companies each have capital employed of RWF100,000, and company A makes sales of RWF400,000 a year whereas company B makes sales of only RWF200,000 a year, company A is making a higher revenue from the same amount of assets and this will help company A to make a higher return on capital employed than company B. Asset turnover is expressed as ‘x times’ so that assets generate x times their value in annual revenue. Here, company A’s asset turnover is 4 times and company B’s is 2 times.
Profit margin and asset turnover together explain the ROCE, and if the ROCE is the primary profitability ratio, these other two are the secondary ratios. The relationship between the three ratios is as follows.
Profit margin × asset turnover = ROCE
PBIT × Sales = PBIT
Sales Capital employed Capital employed
It is also worth commenting on the change in revenue from one year to the next. Strong sales growth will usually indicate volume growth as well as revenue increases due to price rises, and volume growth is one sign of a prosperous company.
Return on investment (ROI)
Return on investment (ROI) is a form of ROCE and is calculated as:
Profit before interest and tax x 100
Operations management capital employed
The ROI compares income with the operational assets used to generate that income. Profit is taken before tax and interest because tax is an appropriation of profit made from the use of the investment, and the introduction of interest charges introduces the effect of financing decisions into an appraisal of operating performance.
ROI is normally used to apply to investment centres or profit centres. These normally reflect the existing organisation structure of the business.
Main reasons for the widespread use of ROI
- Financial reporting. It ties in directly with the accounting process, and is identifiable from the income statement and statement of financial position (balance sheet), the firm’s most important communications media with investors.
- Aggregation. ROI is a very convenient method of measuring the performance for a division or company as an entire unit.
Other advantages include its ability to permit comparisons to be drawn between investment centres that differ in their absolute size.
Measurement problems: non-current assets
- It is probably most common to use return on net assets.
- If an investment centre maintains the same annual profit, and keeps the same assets without a policy of regular non-current asset replacement, its ROI will increase year by year as the assets get older. This can give a false impression of improving ‘real’ performance over time.
- It is not easy to compare fairly the performance of one investment centre with another. Non-current assets may be of different ages or may be depreciated in different ways.
- Inflation and technological change alter the cost of non-current assets. If one investment centre has non-current assets bought ten years ago with a gross cost of RWF1,000 million, and another investment centre, in the same area of business operations, has non-current assets bought very recently for RWF1,000 million, the quantity and technological character of the non-current assets of the two investment centres are likely to be very different.
- Measuring ROI as return on gross assets ignores the age factor. Older noncurrent assets usually cost more to repair and maintain. An investment centre with old assets may therefore have its profitability reduced by repair costs.
- Measurement problems: what are ‘assets’ anyway?
Prudence and other accounting principles require that items such as research and development should only be carried forward as an investment in special circumstances. Many ‘costs’ do have the effect of enhancing the long-term revenue-earning capacity of the business. A good example is brands: many firms have capitalised brands for this reason. For decision-making and control purposes, the expenditure on brands might be better treated as an investment.
The target return for a group of companies
If a group of companies sets a target return for the group as a whole, or if a company sets a target return for each SBU, it might be company policy that no investment project should go ahead in any subsidiary or investment centre unless the project promises to earn at least the target return. Here is an example.
- There should be no new investment by any subsidiary in the group unless it is expected to earn at least a 15% return.
- Similarly, no non-current asset should be disposed of if the asset is currently earning a return in excess of 15% of its disposal value.
- Investments which promise a return of 15% or more ought to be undertaken.
Problems with such a policy include:
- Investments are appraised by DCF whereas actual performance will probably be measured on the basis of ROI.
- The target return makes no allowance for the different risk of each investment centre.
- In a conglomerate, an identical target return may be unsuitable to many businesses in a group.
Since managers will be judged on the basis of the ROI that their centre earns each year, they are likely to be motivated into taking those decisions which increase their centre’s shortterm ROI.
- An investment might be desirable from the group’s point of view, but would not be in the individual investment centre’s ‘best interest’ to undertake. Thus there is a lack of goal congruence.
- In the short term, a desire to increase ROI might lead to projects being taken on without due regard to their risk.
- Any decisions which benefit the company in the long term but which reduce the ROI in the immediate short term would reflect badly on the manager’s reported performance.
Divisional performance: residual income (RI)
An alternative way of measuring the performance of an investment centre, instead of using ROI, is residual income (RI).
Residual income is a measure of the centre’s profits after deducting a notional or imputed interest cost.
Its use highlights the finance charge associated with funding.
The imputed cost of capital might be the organisation’s cost of borrowing or its weighted average cost of capital. Alternatively, the cost of capital can be adjusted to allow for the risk characteristics of each investment centre, with a higher imputed interest rate being applied to higher risk centres.
The advantages and weaknesses of RI compared with ROI
Advantages of RI
Residual income increases in the following circumstances.
Investments earning above the cost of capital are undertaken
Investments earning below the cost of capital are eliminated
Residual income is more flexible since a different cost of capital can be applied to investments with different risk characteristics.
Weaknesses of RI
The first is that it does not facilitate comparisons between investment centres nor does it relate the size of a centre’s income to the size of the investment, other than indirectly through the interest charge. The second is that it can be difficult to decide on an appropriate and accurate measure of the capital employed upon which to base the imputed interest charge (see comments on ROI).
Cash flows: NPV and IRR
The Study Guide mentions NPV and IRR as measures of ‘profitability’ to be considered in this context.
The advantages and weaknesses of NPV compared with ROI and RI Advantages include:
- Cash flows are less subject to manipulation and subjective decisions than accounting profits.
- It considers the opportunity cost of not holding money.
- Risk can be allowed for by adjusting the cost of capital.
- Shareholders are interested in cash flows (both in the short term and long term).
The disadvantages of the NPV approach are centred on the assumptions underlying the values of critical variables within the model. For example:
- The duration of the cash flows
- The timing of the cash flows
- The appropriate cost of capital
NPV and IRR are typically used to evaluate capital investment or other discrete items of expenditure, or to compare investment projects.
Cash flows and NPVs for strategic control: shareholder wealth
Control and performance measures at a strategic level do need to pay some attention to wealth. Shareholders are interested in cash flow as the safest indicator of business success. According to one model of share valuations, the market value of the shares is based on the expected future dividend.
Control at a strategic level should be based on measurements of cash flows (actual cash flows for the period just ended and revised forecasts of future cash flows). Since the objective of a company might be to maximise the wealth of its shareholders, a control technique based on the measurement of cash flows and their NPV could be a very useful technique to apply. A numerical example might help to illustrate this point.
The control information shows that by the end of 20X1, ABC Co shows signs of not achieving the strategic targets it set itself at the start of 20X1. This is partly because actual cash flows in 20X1 fell short of target by (200-180) RWF2 m, but also because the revised forecast for the future is not as good now either. In total, the company has a lower NPV by RWF47,000,000.
The reasons for the failure to achieve target should be investigated. Here are some possibilities.
- A higher-than-expected pay award to employees, which will have repercussions for the future as well as in 20X1
- An increase in the rate of tax on profit.
- A serious delay in the implementation of some major new projects
- The slower-than-expected growth of an important new market
Strategic progress can therefore be measured by reconciling successive net present values and the intervening cash flows. The arithmetic is straightforward and can be summed up as follows.
Step 1 The previous NPV is uplifted by the cost of capital applicable to the current period.
Step 2 The result is the ‘benchmark NPV’ indicating what the new NPV needs to be if long-term health has been maintained.
Step 3 Comparison of the new NPV with the benchmark produces a variance which can be analysed by cause and by time frame.
Attempt your own solution to the following question.
Internal rate of return
IRR is another way of reviewing investments. The IRR of a project can be compared to the cost of capital. It should be possible in theory to assess an IRR for a company, but other models or measures may be simpler.
GEARING
As well as profitability, liquidity and gearing are key measures of performance.
Capital structure
The assets of a business must be financed somehow, and when a business is growing, the additional assets must be financed by additional capital. Capital structure refers to the way in which an organisation is financed, by a combination of long-term capital (ordinary shares and reserves, preference shares, debentures, bank loans, convertible loan stock and so on) and short-term liabilities, such as a bank overdraft and trade suppliers.
Debts and financial risk
There are two main reasons why companies should keep their debt burden under control.
- When a company is heavily in debt, and seems to be getting even more heavily into debt, banks and other would-be lenders are very soon likely to refuse further borrowing and the company might well find itself in trouble.
- When a company is earning only a modest profit before interest and tax, and has a heavy debt burden, there will be very little profit left over for shareholders after the interest charges have been paid. And so if interest rates were to go up or the company were to borrow even more, it might soon be incurring interest charges in excess of PBIT. This might eventually lead to the liquidation of the company.
A high level of debt creates financial risk. Financial risk can be seen from different points of view.
- The company as a whole. If a company builds up debts that it cannot repay when they fall due, it will be forced into liquidation.
- Suppliers. If a company cannot pay its debts, the company will go into liquidation owing suppliers money that they are unlikely to recover in full.
- Ordinary shareholders. A company will not make any distributable profits unless it is able to earn enough profit before interest and tax to pay all its interest charges, and then tax. The lower the profits or the higher the interest-bearing debts, the less there will be, if there is anything at all, for shareholders.
When a company has preference shares in its capital structure, ordinary shareholders will not get anything until the preference dividend has been paid.
The appraisal of capital structures
One way in which the financial risk of a company’s capital structure can be measured is by a gearing ratio. A gearing ratio should not be given without stating how it has been defined.
Gearing ratios
Gearing ratios measure the financial risk of a company’s capital structure. Business risk can be measured by calculating a company’s operational gearing.
Financial gearing/leverage is the use of debt finance to increase the return on equity by using borrowed funds in such a way that the return generated is greater than the cost of servicing the debt. If the return on borrowed funds is less than the cost of servicing the debt, the effect of gearing is to reduce the return on equity.
Gearing measures the relationships between shareholders’ capital plus reserves, and either prior charge capital or borrowings or both.
Prior charge capital is capital which has a right to the receipt of interest or preference dividends before any claim is made by ordinary shareholders on distributable earnings. On winding up, the claims of holders of prior charge capital rank before those of ordinary shareholders.
Prior charge capital is:
- Any preference share capital
- Interest-bearing long-term capital
- Interest-bearing short-term debt capital with less than 12 months to maturity, including any bank overdraft
However, (c) might be excluded.
Here are some commonly used measures of financial gearing, which are based on the statement of financial position (balance sheet) values (book values) of the fixed interest
and equity capital.
Equity capital (including reserv Total capital employe
Prior charge capital Prior charge capital
The effect of gearing on earnings
The level of gearing has a considerable effect on the earnings attributable to the ordinary shareholders. A highly geared company must earn enough profits to cover its interest charges before anything is available for equity. On the other hand, if borrowed funds are invested in projects which provide returns in excess of the cost of debt capital, then shareholders will enjoy increased returns on their equity.
Gearing, however, also increases the probability of financial failure occurring through a company’s inability to meet interest payments in poor trading circumstances.
Operating gearing
Financial risk, as we have seen, can be measured by financial gearing. Business risk refers to the risk of making only low profits, or even losses, due to the nature of the business that the company is involved in. One way of measuring business risk is by calculating a company’s operating gearing or ‘operational gearing’.
Operating gearing or leverage = Profit before interest and tax (PBContribution
If contribution is high but PBIT is low, fixed costs will be high, and only just covered by contribution. Business risk, as measured by operating gearing, will be high. If contribution is not much bigger than PBIT, fixed costs will be low, and fairly easily covered. Business risk, as measured by operating gearing, will be low.
LIQUIDITY
A company can be profitable but at the same time get into cash flow problems. Liquidity ratios (current and quick) and working capital turnover ratios give some idea of a company’s liquidity.
Profitability is of course an important aspect of a company’s performance, and debt or gearing is another. Neither, however, addresses directly the key issue of liquidity. A company needs liquid assets so that it can meet its debts when they fall due.
Liquidity is the amount of cash a company can obtain quickly to settle its debts (and possibly to meet other unforeseen demands for cash payments too).
Liquid assets
Liquid funds include:
- Cash
- Short-term investments for which there is a ready market, such as investments in shares of other companies (NB not subsidiaries or associates)
- Fixed-term deposits with a bank or building society, for example six month deposits with a bank
- Trade customers
- Bills of exchange receivable
Some assets are more liquid than others. Inventories of goods are fairly liquid in some businesses. Inventories of finished production goods might be sold quickly, and a supermarket will hold consumer goods for resale that could well be sold for cash very soon. Raw materials and components in a manufacturing company have to be used to make a finished product before they can be sold to realise cash, and so they are less liquid than finished goods. Just how liquid they are depends on the speed of inventory turnover and the length of the production cycle.
Non-current assets are not liquid assets. A company can sell off non-current assets, but unless they are no longer needed, or are worn out and about to be replaced, they are necessary to continue the company’s operations. Selling non-current assets is certainly not a solution to a company’s cash needs, and so although there may be an occasional non-current asset item which is about to be sold off, probably because it is going to be replaced, it is safe to disregard non-current assets when measuring a company’s liquidity.
In summary, liquid assets are current asset items that will or could soon be converted into cash, and cash itself. Two common definitions of liquid assets are all current assets or all current assets with the exception of inventories.
The main source of liquid assets for a trading company is sales. A company can obtain cash from sources other than sales, such as the issue of shares for cash, a new loan or the sale of non-current assets. But a company cannot rely on these at all times, and in general, obtaining liquid funds depends on making sales and profits.
Why does profit not provide an indication of liquidity?
If a company makes profits, it should earn money, and if it earns money, it might seem that it should receive more cash than it pays out. In fact, profits are not always a good guide to liquidity. Two examples will show why this is so.
Liquidity ratios
Current ratio
The standard test of liquidity is the current ratio. It can be obtained from the statement of financial position (balance sheet), and is current assets/current liabilities.
A company should have enough current assets that give a promise of ‘cash to come’ to meet its commitments to pay its current liabilities. Obviously, a ratio in excess of 1 should be expected. Otherwise, there would be the prospect that the company might be unable to pay its debts on time. In practice, a ratio comfortably in excess of 1 should be expected, but what is ‘comfortable’ varies between different types of businesses.
Companies are not able to convert all their current assets into cash very quickly. In particular, some manufacturing companies might hold large quantities of raw material inventories, which must be used in production to create finished goods. Finished goods might be warehoused for a long time, or sold on lengthy credit. In such businesses, where inventory turnover is slow, most inventories are not very liquid assets, because the cash cycle is so long. For these reasons, we calculate an additional liquidity ratio, known as the quick ratio or acid test ratio.
Quick ratio
The quick ratio, or acid test ratio, is (current assets less inventories)/current liabilities.
This ratio should ideally be at least 1 for companies with a slow inventory turnover. For companies with a fast inventory turnover, a quick ratio can be less than 1 without suggesting that the company is in cash flow difficulties.
Do not forget the other side of the coin. The current ratio and the quick ratio can be bigger than they should be. A company that has large volumes of inventories and customers might be over-investing in working capital, and so tying up more funds in the business than it needs to. This would suggest poor management of customers or inventories by the company.
Turnover periods
We can calculate turnover periods for inventory, customers and suppliers (the question below revises these calculations). The time taken to collect amounts due from customers is known as the accounts receivable collection period. Credit from suppliers is known as the accounts payable payment period. If we add together the inventory days and the days taken to collect accounts owed from customers, this should give us an indication of how soon inventory is convertible into cash. This gives us a further indication of the company’s liquidity.
SHORT-RUN AND LONG-RUN FINANCIAL PERFORMANCE
Short-termism is often due to the fact that managers’ performance is measured on short-term results.
In the previous chapter we saw how organisations often have to make a trade-off between short-term and long-term objectives which can, of course, be focused on financial performance. Advertising expenditure may be cut to increase short-term profit, but this is likely to be at the expense of long-term financial results.
Earlier on in this chapter we looked at how RI, ROI and NPV are used to measure profitability. Exam questions may test how useful these measures are for long-run and short-run performance measurement.
Case Study
In April 2001, the Financial Times reported on how efforts to cut costs to boost short-term profits at Marks & Spencer had long-term implications.
To fulfil expectations during the 1990s, staff numbers were limited or reduced, store enhancements were restricted, and relationships with suppliers squeezed. As a result, earnings matched market expectations for a while but eventually ‘customers started to notice that value for money was not quite as good as it could have been. That you had to wait to get the attention of a sales assistant. That the shops were dowdy and so was some of the merchandise. These impressions accumulated. Gradually the positive Marks & Spencer anecdotes were replaced by negative ones. Suddenly the company’s reputation fell off a cliff. And so did its profits.’
In view of the low accounting ROI in year 1, should the investment be undertaken or not?
- Strictly speaking, investment decisions should be based on DCF yield, and should not be guided by short-term accounting ROI.
- Even if accounting ROI is used as a guideline for investment decisions, ROI should be looked at over the full life of the investment, not just in the short term. In the short term (in the first year or so of a project’s life) the accounting ROI is likely to be low because the net book value of the asset will still be high.
DCF v ROI
In spite of the superiority of DCF yield over accounting ROI as a means of evaluating investments, and in spite of the wisdom of taking a longer-term view rather than a short-term view with investments, it is nevertheless an uncomfortable fact that the consideration of short-run accounting ROI does often influence investment decisions.
In our example, it is conceivable that the group’s management might disapprove of the project because of its low accounting ROI in year 1. This approach is short-sighted, but it nevertheless can make some sense to a company or group of companies which has to show a satisfactory profit and ROI in its published accounts each year, to keep its shareholders satisfied with performance.
A similar misguided decision would occur where a divisional manager is worried about the low ROI of his division, and decides to reduce his investment by scrapping some machinery which is not currently in use. The reduction in both depreciation charges and assets would immediately improve the ROI. When the machinery is eventually required the manager would then be obliged to buy new equipment. Such a situation may seem bizarre, but it does occur in real life.
Short-term ROI should not be used to guide management decisions but there is a difficult motivational problem. If management performance is measured in terms of ROI, any decisions which benefit the company in the long term but which reduce the ROI in the immediate short term would reflect badly on the manager’s reported performance. In other words, good investment decisions would make a manager’s performance seem worse than if the wrong investment decision were taken instead.
PROFITS AND SHARE VALUE
The value of the P/E ratio reflects the market’s appraisal of the shares’ future prospects.
Shareholders value shares on the basis not of past performance but of expectations of future performance.
Note that past performance is useful, however, in that it gives information about the quality of the management team, and the business’ success at devising and executing strategies to maximise shareholders’ wealth, to date.
Shareholders may have a view towards a particular industry sector as well as an individual business. No matter how well a business is run, it may operate in an unattractive or mature industry sector.
Investors may have a genuinely different view of the prospects of a sector from managers, so even well-run companies in an industry may feel starved of capital at an appropriate rate. This is because they are always compared with other companies.
The management issues are contradictory.
- Managers have a personal interest in the long-term survival of the business.
- Shareholders want a long-term increase in their wealth from investment in a business or other companies in the sector.
Short-termism often occurs, however.
- Managers’ performance is measured on short-term results (for example quarterly reporting in the US).
- Even investors are under pressure to maximise the growth in value of their portfolios in a particular period.
The price/earnings (P/E) ratio: profits and share value
The P/E ratio is the most important yardstick for assessing the relative worth of a share. It is:
Market price in ce which is the same as Total market value of eq
EPS in cents Total earnings
The value of the P/E ratio reflects the market’s appraisal of the shares’ future prospects. In other words, if one company has a higher P/E ratio than another it is because investors either expect its earnings to increase faster than the other’s or consider that it is a less risky company or in a more ‘secure’ industry. The P/E ratio is, simply, a measure of the relationship between the market value of a company’s shares and the earnings from those shares.
Internet companies
In 1999/2000 share prices in the US and Europe rose to unprecedented heights. The drivers for this were the rise of technology stocks, particularly those relating to internet companies. There were a number of causes of this.
- The internet appeared to offer unrivalled opportunities for growth. Everybody wanted to jump on the bandwagon.
- There were influential proponents of the ‘new economy’ who felt that some economic laws had been re-written.
- Internet firms offered increasing returns to scale thanks to network effects. In other words, the more people using the Internet, the more useful it becomes for others to use.
- However, despite exciting websites and huge marketing expenditure, internet companies (such as Boo.com) were made or broken on issues of logistics and distribution.
Many internet firms used up large amounts of cash before attaining any profits, and so have collapsed.
- B2C (business-to-consumer companies) such as Boo.com lost money. Other retailing sites kept going, however. Even so, amazon.com laid off staff. One of the most successful Internet retailers in the UK is ‘old economy’ Tesco.
- B2B (business-to-business internet companies) have had more success, if they offer something of value.
In fact, a recent study of ‘tech’ companies by Merrill Lynch reported that their earnings were overstated by an average of 25% compared with what they would be if determined on the basis of generally accepted accounting principles.
Despite the heady days of 2000, it is a fallacy that Internet companies can avoid the need for profit and positive cash inflows.
‘From peak to trough, Amazon.com’s market value sank by $35 billion as Jeff Bezos (Time magazine’s ‘person of the year’ in 1999) claimed that his company was profitable on a ‘proforma basis’. But let’s get real: its proforma profits were found by ignoring interest payments on nearly $2 billion of debt. That’s like saying my holiday home doesn’t cost me anything – as long as I ignore the mortgage payments.'(Ted Stone, ‘Trade Secrets‘, CIMA Insider, June 2002)
The Internet share market has learnt its lesson. Here’s a recent example of how Google can generate accounting profits and still excite the stock market into huge valuations.
Case Study
‘In the interests of decorum, professionalism, etc., analysts will no doubt offer careful assessments of Google’s Q3 results. And the wires will bustle with stories about how ridiculous it is that a stock that went public at US$85 Aug 2004 is now trading at $350ish, etc.
The real story? These results are absolutely staggering.
Google’s stock price – shocking though it is – is much less amazing than Google’s fundamental performance, which is simply not to be believed. A 7 year old company with a revenue run-rate of $6 billion, an annual growth rate near 100%, 43% EBITDA margins, 100% plus return-on-invested-capital, a dominant global franchise, and already about half the cash flow of Time Warner (a 100 year-old company with 85,000 employees). ‘
Source: Internet Outsider, October 2005
[In Jan 2102 Google is trading between $500- $600s – editor’s note]
COMPARISONS OF ACCOUNTING FIGURES
Comparisons might be made between a company’s results and the results of the most recent year/previous years, other companies in the same industry and other companies in other industries.
Results of the same company over successive accounting periods
Although a company might present useful information in its five-year or ten-year summary, it is quite likely that the only detailed comparison you will be able to make is between the current year’s and the previous year’s results. The comparison should give you some idea of whether the company’s situation has improved, worsened or stayed much the same between one year and the next.
Useful comparisons over time include:
- Percentage growth in profit (before and after tax) and percentage growth in revenue
- Increases or decreases in the debt ratio and the gearing ratio
- Changes in the current ratio, the inventory turnover period and the accounts receivable collection period
- Increases in the EPS, the dividend per share, and the market price
The principal advantage of making comparisons over time is that they give some indication of progress: are things getting better or worse? However, there are some weaknesses in such comparisons.
- The effect of inflation should not be forgotten.
- The progress a company has made, needs to be set in the context of what other companies have done, and whether there have been any special environmental or economic influences on the company’s performance.
Putting a company’s results into context
The financial and accounting ratios of one company should be looked at in the context of what other companies have been achieving, and also any special influences on the industry or the economy as a whole. Here are two examples.
- If a company achieves a 10% increase in profits, this performance taken in isolation might seem commendable, but if it is then compared with the results of rival companies, which might have been achieving profit growth of 30% the performance might in comparison seem very disappointing.
- An improvement in ROCE and profits might be attributable to a temporary economic boom, and an increase in profits after tax might be attributable to a cut in the rate of corporation tax. When improved results are attributable to factors outside the control of the company’s management, such as changes in the economic climate and tax rates other companies might be expected to benefit in the same way.
Comparisons between different companies in the same industry
Making comparisons between the results of different companies in the same industry is a way of assessing which companies are outperforming others.
- Even if two companies are in the same broad industry (for example retailing) they might not be direct competitors. For example, in the UK, the Kingfisher group (hardware and garden supplies) does not compete directly with the Arcadia group (clothes). Even so, they might still be expected to show broadly similar performance, in terms of growth, because a boom or a depression in retail markets will affect all retailers. The results of two such companies can be compared, and the company with the better growth and accounting ratios might be considered more successful than the other.
- If two companies are direct competitors, a comparison between them would be particularly interesting. Which has achieved the better ROCE, sales growth, or profit growth? Does one have a better debt or gearing position, a better liquidity position or better working capital ratios? How do their P/E ratios, dividend cover and dividend yields compare? And so on.
Comparisons between companies in the same industry can help investors to rank them in order of desirability as investments, and to judge relative share prices or future prospects. It is important, however, to make comparisons with caution: a large company and a small company in the same industry might be expected to show different results, not just in terms of size, but in terms of:
- Percentage rates of growth in sales and profits
- Percentages of profits re-invested (Dividend cover will be higher in a company that needs to retain profits to finance investment and growth.)
- Non-current assets (Large companies are more likely to have freehold property in their statement of financial position (balance sheet) than small companies.)
Comparisons between companies in different industries
Useful information can also be obtained by comparing the financial and accounting ratios of companies in different industries. An investor ought to be aware of how companies in one industrial sector are performing in comparison with companies in other sectors. For example, it is important to know:
- Whether sales growth and profit growth is higher in some industries than in others (For example, how does growth in the financial services industry compare with growth in heavy engineering, electronics or leisure?)
- How the return on capital employed and return on shareholder capital compare between different industries
- How the P/E ratios and dividend yields vary between industries (For example, if a publishing company has a P/E ratio of, say, 20, which is average for its industry, whereas an electronics company has a P/E ratio of, say, 14, do the better growth performance and prospects of the publishing company justify its higher P/E ratio?
CHAPTER ROUNDUP
- The overriding purpose of a business is to increase owner wealth in the long-term.
- Achieving objectives of survival and growth ultimately depends on making profits.
- Measures relating to profit include sales margin, EBITDA and EPS. More sophisticated measures (ROCE, ROI) take the size of investment into account. Later on in the chapter we considered how measures of profitability are used for short-run or long-run performance measurement. Bear this in mind particularly when you study the sections on RI, ROI and NPV and go through the example covering these.
- As well as profitability, liquidity and gearing are key measures of performance.
- Gearing ratios measure the financial risk of a company’s capital structure. Business risk can be measured by calculating a company’s operational gearing.
- A company can be profitable but at the same time get into cash flow problems. Liquidity ratios (current and quick) and working capital turnover ratios give some idea of a company’s liquidity.
- Short-termism is often due to the fact that managers’ performance is measured on short-term results.
- The value of the P/E ratio reflects the market’s appraisal of the shares’ future prospects.
- Comparisons might be made between a company’s results and the results of the most recent year/previous years, other companies in the same industry and other companies in other industries.
