Financial performance measures in the private sector p5

Assumed knowledge

 

8 builds on your knowledge of financial performance measures from PM.

 

2      Introduction

 

In the exam, you may be required to look at performance measures in a variety of contexts. In this   we focus on the principal measures used by the private sector. The emphasis will be on financial measures (non–financial measures will be reviewed in   11).

 

3      The objectives of profit-seeking organisations

 

3.1 Maximising shareholder wealth

 

  • The primary objective of a profit seeking organisation is to maximise shareholder wealth.

 

  • This is based on the argument that shareholders are the legal owners of a company and so their interests should be prioritised.

 

  • Shareholders are generally concerned with the following: – current earnings

 

–    future earnings

 

–    dividend policy

 

–    relative risk of their investment.

 

All of these are driven by financial performance.

 

 

Test your understanding 1

 

 

 

Required:

 

What will be the primary objective of a commercial bank? What might be some of its subsidiary or secondary objectives?

 

 

Objectives according to Drucker

 

 

 

Peter Drucker has suggested that profit -seeking organisations typically have objectives relating to the following:

 

  • market standing

 

  • innovation

 

  • productivity

 

  • physical and financial resources

 

  • profitability

 

  • manager performance and development

 

  • worker performance and attitude

 

  • public responsibility.

 

3.2 The relationship between profits and shareholder value

 

Rather than focusing on achieving higher profit levels, companies are under increasing pressure to look at the long-term value of the business. This is due to the following factors:

 

  • research has suggested a poor correlation between shareholder return and profits

 

  • investors are increasingly looking at long-term value

 

  • reported profits may not be comparable between companies.

 

 

ZBB

 

 

 

Total shareholder return (TSR) is the return shareholders receive both in dividends and capital growth.

 

Studies have found that there is little correlation between TSR and earnings per share (EPS) growth, and virtually no relationship at all with return on equity, yet many companies are still using profit as their only measure of performance.

 

Even where companies state that their objective is to maximise shareholder value, often directors’ bonuses are still based on short-term profitability or EPS targets.

 

However strong evidence has been found between shareholder value and future cash flows.

 

While these issues have been known for some time, they have come into sharp focus due to the performance of new technology/communications companies.

 

 

Illustration 1 – Profits and shareholder value

 

Timescales

 

In calculating shareholder value it is customary to make a distinction between the ‘planning’ period (usually less than 5 years), and the ‘continuing period’ beyond. Results for different industries show the following:

 

Industry % of value in the % of value in the
planning period continuing period
Tobacco 40 60
Sporting goods 20 80
Skin care 5 95
High tech –20 120

 

High tech companies, such as Apple, need to make decisions based on the long-term value of the business since these companies tend to make initial losses due to the high level of research and development required.

 

3.3 How to measure the long-term value of a business

 

A value based management (VBM) approach aligns the strategic, operational and management processes to focus management decision making on what activities create wealth for shareholders (VBM will be explored in more detail in   9).

 

4      Financial performance measures

 

4.1 Introduction

 

This   is concerned with measuring:

 

  • the financial performance of the organisation as a whole

 

  • the performance of the key projects.

 

9 will cover divisional performance and   11 will cover non-financial performance.

 

Although most of these indicators will be familiar to you from PM, there will be a different emphasis in APM questions. A common problem of APM candidates is that they throw every indicator that they can remember at a problem in an uncritical fashion. APM is all about the critical approach. It is about selecting from the range of indicators that you know from PM and using those which are most appropriate to the scenario. In addition, the examiner will not only expect you to calculate the numbers but to also give performance management advice based on what you have calculated.

 

Each of these measures will be reviewed in turn.

 

 

Performance measurement systems

 

 

 

A good performance measurement system should have the following characteristics:

 

  • Support corporate strategy, its communication and implementation.

 

  • Measure performance from a financial, non-financial, quantitative and qualitative perspective.

 

  • Attuned to the needs of decision makers and their activities.

 

  • Reporting is produced at sufficient regularity to properly support decision-making.

 

  • Attention to the accuracy of data and calculation of measures is important for trust in the information.

 

Any performance measurement system requires the identification of indicators which can identify past, current or potential future outcomes.

 

The aim:

 

  • Report past outcomes, both good and bad.

 

  • Identify where improvements should be made and what resources are required.

 

  • Determine the quality and robustness of business processes; and

 

  • Allow stakeholders to independently judge an organisation’s performance.

 

 

By embodying the key measures that are important for the organisation’s strategy they can indicate to the organisation what is important. (Often incorporated in strategic frameworks such as scorecards).

 

NB: As a general rule these measures are only meaningful when compared with:

 

  • other time periods

 

  • other measures of performance

 

  • other companies

 

  • other industries

 

 

4.2 Gross and operating profit

 

Despite concerns over the poor correlation between profit and shareholder value, many business use profit based targets. This is primarily for the following reasons:

 

  • The information is readily available internally as it is needed for statutory reporting

 

  • Most managers feel they understand it

 

  • It makes comparisons between companies easier as they also have to produce statutory reports.

 

Evaluation of gross versus operating profit

 

 

 

The relative pros and cons of using gross compared with operating profit are as follows:

 

Gross profit Operating profit
• Focusses purely on whether • Also considers selling,
the process of making and distribution and admin costs,
selling products is profitable so indicates whether gross
– i.e. does the price cover the profit is sufficient to cover
manufacturing cost, before wider costs.
considering selling,
distribution and admin costs.

 

 

 

  8
• Useful for highlighting • Useful for highlighting wider
product profitability issues – cost efficiency issues – for
for example, if gross profit example, a division may
has fallen, is this due to cost have improving gross profit
rises, pressure to drop prices but worsening operating
or a mixture of both? profit indicating underlying
Management response will good products but poor
depend on the underlying control over distribution
causes. and/or admin.
• For short term decision
making it could be argued
that contribution would be a
more useful metric.

Neither operating profit nor gross profit consider variables that management may have little control over, such as taxes or interest charges, which will be based on financing used. This allows those who review the income statement to judge management’s efficiency in running the business.

 

The gross profit margin and operating profit margin are often calculated: (Gross profit ÷ Sales) × 100%

 

(Operating profit ÷ Sales) × 100%

 

4.3 Return on capital employed (ROCE)

 

ROCE is a key measure of profitability. It shows the operating profit that is generated from every $1 of assets employed.

Operating profit

ROCE =                                                   × 100

Capital employed

 

Note:

 

  • If the operating profit is not given in the exam question, use the profit figure that is closest to it.

 

  • Capital employed = total assets less current liabilities or total equity plus long-term debt.

 

  • Capital employed may be based on net book value (NBV), gross book value or replacement cost (be guided by the exam question). It may be the average figure (if information for two periods is given), the figure at the start of the period (if an average can’t be calculated) or the figure at the end of the period (if this is all that is given in the question).

 

A high ROCE is desirable. An increase in ROCE could be achieved by:

 

  • Increasing operating profit, for example through an increase in sales price or better control of costs.

 

  • Reducing capital employed, for example through the repayment of its debt.

 

 

 

Advantages Disadvantages
• Easy to calculate. • Research shows a poor
• Figures are readily available. correlation between ROCE and
shareholder value.
• Measures how well a business is
• Care must be taken to ensure
utilising the funds invested in it. that like is compared with like,
• Often used by external when comparing with different
analysts/investors. companies – e.g. inclusion of
intangibles in capital employed.
• Can be distorted by accounting
policies.
• ROCE can be improved by
cutting back investment – this
may not be in the company’s
long-term best interest.

 

 

Test your understanding 2

 

 

 

Company A Company B
$ $
Profit from operations 20,000 1,000,000
Sales 200,000 2,000,000
Capital employed 100,000 10,000,000

 

Required:

 

For companies A and B, which of the following statements are true?

 

  • Company A has a higher ROCE than company B.

 

  • Company B has a higher ROCE than company A.

 

  • Company A is more profitable than company B.

 

  • Company A is better utilising the funds invested in it than company B.

 

Choose:

 

  • (1), (3) and (4)

 

  • (2) only

 

  • (1) and (4)

 

  • None of these

 

4.4 EPS

 

EPS is a measure of the profit attributable to each ordinary share.

 

Profit after tax less preference dividends

EPS = Weighted average number of ordinary shares in issue

As is the case for other ratios, for EPS to be truly meaningful, it must be set in context.

 

  • Is EPS growing or declining over time?

 

  • Is there likely to be significant dilution of EPS?

 

  • Is it calculated consistently?

 

Advantages Disadvantages
• Easily understood by • Research shows a poor
shareholders. correlation between EPS growth
• Calculation is precisely defined and shareholder value.
•
by accounting standards. Accounting treatment may cause
• Figures are readily available. ratios to be distorted.
• Often used as a performance
measure between companies,
sectors, periods within the same
organisation.

 

 

Test your understanding 3

 

A company’s share capital is as follows:

 

Ordinary shares ($1 each) $6,000,000

 

9% Preference shares $1,000,000

 

The company made profits before tax of $5,500,000. Corporation tax on this is calculated as $2,100,000.

 

Required:

 

Calculate the company’s EPS.

 

4.5 EBITDA

 

EBITDA is earnings before interest, tax, depreciation, amortisation and write-offs (such as goodwill).

 

Advantages Disadvantages
• It is a measure of underlying • Poor correlation to shareholder
performance since it is a proxy wealth.
for cash flow generated from • Comparison between
operating profit.
organisations difficult due to
• Tax and interest are externally potential differences in
generated and therefore not accounting policies and the
relevant to the underlying calculation of an absolute figure.
success of the business. • It ignores changes in working
•
Depreciation and amortisation capital and their impact on cash
represent a write off of flow.
expenditure over a number of • It fails to consider the amount of
years and might therefore be
fixed asset replacement needed
excluded when examining the
by the business.
performance of a particular year.
• It can easily be manipulated by
• Easy to calculate.
aggressive accounting policies
•
Easy to understand. related to income recognition
and capitalisation of expenses.
4.6 Other profitability measures
Measure Calculation
Asset turnover Sales ÷ Capital employed
Dividend cover PAT ÷ Dividends paid during the year
Dividend yield (Dividend per share ÷ Current share price) × 100%
P/E ratio Share price ÷ EPS
Earnings yield (EPS ÷ Share price) × 100%
Return on equity Net profit after tax ÷ average shareholders’ equity

 

One additional measure of performance is economic value added (EVA). This will be discussed in   9.

 

4.7 Liquidity and risk indicators

 

Liquidity ratios

 

These ratios measure the ability of the company to meet its short-term obligations:

 

Measure Calculation
Current ratio Current assets ÷ Current liabilities
Acid test or quick ratio (Current assets – inventories) ÷ Current liabilities
Raw material period (Ave. value of raw materials ÷ Purchases) × 365
WIP period (Ave. value of WIP ÷ Cost of sales) × 365
Finished goods period (Ave. value of finished goods ÷ Cost of sales) × 365
Receivables period (Ave. receivables ÷ Sales) × 365
Payables period (Ave. payables ÷ Purchases) × 365

 

There is often a trade-off between liquidity and profitability. Companies can be highly profitable but get into trouble when they run out of cash (overtrading).

 

Therefore liquidity needs to be considered alongside profitability when appraising a company’s financial situation.

 

Risk ratios

 

These ratios measure the ability of the company to meet its long-term liabilities:

 

  • Financial gearing = (Long-term debt/Shareholder funds) × 100% or

 

  • Financial gearing = (Long-term debt/(Long-term debt + Shareholders funds)) × 100%

 

  • Operating gearing = (Fixed costs/Variable costs)

 

  • Interest cover = (PBIT/Interest charges).

 

4.8 Appraising individual projects

 

We will now review some of the techniques that are available for appraising individual projects. These include:

 

  • Net present value (NPV)

 

  • Internal rate of return (IRR)

 

  • Modified internal rate of return (MIRR).

 

4.9 Net present value (NPV)

 

The NPV is the present value (PV) of all cash inflows less the PV of all cash outflows of a project.

 

NPV represents the increase or decrease in the value of an organisation today as a result of accepting the project being reviewed.

 

Decision rule: any project that generates a positive NPV is viable.

 

 

Advantages Disadvantages
• Strong correlation with • Difficult to calculate/understand.
shareholder value. • It does not easily allow two
• It considers the time value of projects of very different scales
money. to be compared.
• Risk can be allowed for by • It is based on assumptions about
adjusting the cost of capital. cash flows, the timing of those
• Cash flows are less subject to cash flows and the appropriate
cost of capital.
manipulation and subjective
decisions than accounting • Many firms use NPV for
profits. investment appraisal and then
• Considers all cash flows of a switch to profit-based measures
to motivate managers.
project.
• Superior measure to IRR for
mutually exclusive projects.

 

 

Test your understanding 4

 

 

 

Oracle invests in a new machine at the beginning of Year 1 which costs $15,000. It is hoped that the net cash flows over the next five years will correspond to those given in the table below.

 

Year 1 2 3 4 5
Net cash flow ($) 1,500 2,750 4,000 5,700 7,500

 

Required:

 

  • Calculate the NPV assuming a 15% cost of capital.

 

  • Calculate the NPV assuming a 10% cost of capital.

 

  • Draw a conclusion based on your findings.

 

Sensitivity analysis

 

Sensitivity analysis calculates the percentage change in a variable, for example sales volume, that would have to occur before the original investment decision is reversed, i.e. the project NPV changes to $0.

 

Sensitivity = NPV × 100
PV of flows under consideration

 

Benchmarking

 

Benchmarking has already been covered in   1. In the exam, you may be required to assess the relative financial performance of a project or an organisation compared to appropriate benchmarks.

 

Test your understanding 5

 

 

 

JDL manufactures a range of solar panel heating. They have recently developed the new EF solar panel. The directors of JDL recently spent $20,000 on market research, the findings of which led them to believe that a market exists for the EF panels.

 

The finance director of JDL has gathered relevant information and prepared the following evaluation relating to the proposed manufacture and sale of the EF solar panels:

 

  • Sales are expected to be 2,700 units per annum at a selling price of $3,000 per unit.

 

  • Variable material, labour, and overhead costs are estimated at $1,580 per unit.

 

  • In addition, a royalty of $250 per unit would be payable to EF (Environmental Friends), for the use of their brand name.

 

  • Fixed overheads are estimated at $900,000 per annum. These overheads cannot be avoided until the end of the year in which the EF solar panels is withdrawn from the market.

 

  • An initial investment of $7 million would be required. A government grant equal to 50% of the initial investment would be received on the date the investment is made. No tax allowances would be available on this initial investment. The estimated life cycle of the EF solar panels is six years.

 

  • Corporation tax at the rate of 30% per annum is payable in the year in which profit occurs.

 

  • The cost of capital is 12%.

 

Required:

 

  • Calculate the net present value (NPV) of the EF solar panels proposal and recommend whether it should be undertaken by the directors of JDL.

 

  • Using sensitivity analysis, estimate by what percentage each of the under-mentioned items, taken separately, would need to change before the recommendation in (a) above is varied:

 

  • Initial outlay of $3,500 (i.e. initial investment of $7,000 minus grant of $3,500).

 

  • Annual contribution.

 

  • Comment on THREE factors other than NPV that the directors of JDL should consider when deciding whether to manufacture the EF solar panels.

 

  • Explain the term ‘benchmarking’ and briefly discuss the potential benefits that JDL can obtain as a result of undertaking a successful programme of benchmarking.

 

 

4.10 Internal rate of return (IRR)

 

When presented with uncertainty about the cost of capital, some managers prefer to assess projects by reference to the IRR.

 

Decision rule: the project should be accepted if the IRR is greater than the firm’s cost of capital.

 

The IRR is the discount rate when the NPV = 0.

L = lower cost of capital

 

H = higher cost of capital

 

NPVL = the NPV at the lower cost of capital

 

NPVH = the NPV at the higher cost of capital

 

 

Test your understanding 6

 

 

 

A project’s predicted cash flows give:

 

  • a NPV of $50,000 at a cost of capital of 10%

 

  • a NPV of ($10,000) at a cost of capital of 15%.

 

Required:

 

Calculate the IRR.

 

4.11 Modified internal rate of return (MIRR)

 

One drawback of IRR is that it is possible to get multiple rates of return.

 

MIRR eliminates this possibility.

 

The MIRR represents the actual return generated by a project.

 

The MIRR assumes that funds will be reinvested at the investor’s required return (cost of capital). It is calculated as follows:

 

Method:

 

Step 1: The cash inflows after the initial investment are converted to a single cash inflow at the end of the last year of the project by assuming that the cash inflows are reinvested at the investor’s required rate of return (cost of capital).

 

Step 2: The present value of the cash outflows is then calculated.

 

Step 3: The MIRR is calculated as the return which equates to the present value of the outflows to this single inflow, using present value tables.

 

Illustration 2 – MIRR

 

 

 

The following information is available for a project:

 

Year 0 1 2 3 4
Cash flow ($) (5,000) 2,000 (1,000) 3,500 3,800

 

The cost of capital is 10%.

 

Required:

 

Calculate the MIRR of the project.

 

Solution:

 

Step 1: Find the value of the cash inflows at the end of the project

 

Year Cash inflows ($) Value at the end of year 4 ($)
1 2,000 2,000 × (1.10)3 = 2,662
3 3,500 3,500 × 1.10 = 3,850
4 3,800 = 3,800
Total = 10,312
Step 2: Find the present value of the cash outflows
Year Cash outflows ($) Value in year 0 ($)
0 5,000 5,000
2 1,000 1,000 ÷ (1.10)2 = 826

Total = 5,826

 

Step 3: Calculate the MIRR

 

10,312 × Discount factor yr 4 @ MIRR = 5,826

 

Discount factor yr 4 @ MIRR    = 5,826 ÷ 10,312

 

= 0.565

 

From tables, MIRR is approximately 15%

 

Alternatively, a formula can be used to calculate the MIRR:

 

(Present value of inflows ÷ present value of outflows)1/n × (1 + cost of capital)

– 1

 

where n = the life of the project in years

 

 

Illustration 3 – MIRR alternative solution

 

 

 

Required:

 

Using the information from the previous illustration, calculate the MIRR using the formula.

 

Solution:

 

Start by calculating the present value of the cash inflows:

 

Year Cash inflows ($) DF 10% Present value ($)
1 2,000 0.909 1,818
3 3,500 0.751 2,629
4 3,800 0.683 2,595
Total = 7,042
Next, calculate the present value of the cash outflows:
Year Cash outflows ($) DF 10% Present value ($)
0 5,000 1 5,000
2 1,000 0.826 826

Total = 5,826

 

Finally, use the formula to calculate the MIRR:

 

MIRR = (7,042 ÷ 5,826)1/4 × 1.1 – 1

 

MIRR = 15.3% (as per illustration 3)

 

Decision rule: the project should be accepted if the MIRR is greater than the firm’s cost of capital.

 

4.12 Assessing performance and giving performance management advice

 

The examiner will expect you to be able to assess and comment on the financial performance of an organisation using a range of appropriate measures. In the APM exam it is more important that you can give performance management advice rather than just being able to calculate a long list of ratios. Bear this in mind when attempting the questions below.

 

 

Test your understanding 7

 

 

 

AK is a privately owned manufacturing company and has been experiencing difficulties.

 

Required:

 

You have been asked to assess the current position of AK using appropriate performance measures:

20X6 20X5
$000 $000
Receivables 5,200 3,120
Inventory 2,150 2,580
Cash 350 1,350
–––––– ––––––
Total current assets 7,700 7,050
Non-current assets 14,500 14,500
Total payables 4,500 3,150
Sales 17,500 16,625
Operating costs 14,000 12,950
–––––– ––––––
Operating profit 3,500 3,675
–––––– ––––––
Earnings 2,625 2,756

 

There are 2.5 million shares in issue.

 

 

Additional example on assessing financial performance

 

 

 

BPG is a Telecommunications company that commenced trading in 20X1 in the country of Brean. In 20X6 it created a similar division in the country of Portlet.

 

Required:

 

Assess the financial performance of BPG and its operations in Brean and Portlet during the years ended 20X8 and 20X9. Using the data provided below.

 

Note: you should highlight any information that would be required to make a more comprehensive assessment of financial performance.

 

 

Summary Income Statements

 

20X9 20X8
Brean Portlet Company Brean Portlet Company
$000 $000 $000 $000 $000 $000
Revenue 14,400 2,900 17,300 14,040 1,980 16,020
–––––– ––––– –––––– –––––– ––––– ––––––
Salaries 4,450 1,340 5,790 4,125 1,185 5,310
Consumables 2,095 502 2,597 1,950 380 2,330
Other operating
costs 2,921 695 3,616 2,754 620 3,374
–––––– ––––– –––––– –––––– ––––– ––––––
9,466 2,537 12,003 8,829 2,185 11,014
–––––– ––––– –––––– –––––– ––––– ––––––
Marketing 2,456 600 3,056 2,092 480 2,572
Interest 850 900
Depreciation and
amortisation 400 160 560 400 100 500
–––––– ––––– –––––– –––––– ––––– ––––––
2,856 760 4,466 2,492 580 3,972
–––––– ––––– –––––– –––––– ––––– ––––––
Total costs 12,322 3,297 16,469 11,321 2,765 14,986
–––––– ––––– –––––– –––––– ––––– ––––––
Profit/(loss) 2,078 (397) 831 2,719 (785) 1,034

 

Statement of financial position

 

20X9 20X8
Brean Portlet Company Brean Portlet Company
$000 $000 $000 $000 $000 $000
Assets
Non-current
assets 9,000 1,600 10,600 8,000 1,000 9,000
Current assets 4,550 1,000 5,550 5,000 800 5,800
––––– ––––– –––––– ––––– ––––– ––––––
Total assets 13,550 2,600 16,150 13,000 1,800 14,800
––––– ––––– –––––– ––––– ––––– ––––––
Equity and liabilities 9,150 7,800
Share capital
Non-current liabilities
Long term borrowings 4,000 4,500
Current
liabilities 2,400 600 3,000 2,000 500 2,500
–––––– ––––––
16,150 14,800
–––––– ––––––

 

 

Solution:

 

Company 20X9 20X8
ROCE = PBIT/D+E 12.8% 15.7%
EBITDA = EBITDA 2,241 2,434
Gearing = D/E 43.7% 57.7%
or gearing = D/D+E 30.4% 36.6%
Each operation

 

20X9 20X9 20X8 20X8
Profit/revenue Brean Portlet Brean Portlet
Sales margin = 14.4 (13.7) 19.4 (39.6)
(%)
Non-current asset Revenue/non- 1.6 1.8 1.76 1.98
turnover = curr assets

 

Brean Portlet Company
% Revenue growth 2.6 46.5 8
% Profit growth (23.6) 49.4
% Increase in costs:
Salaries 7.9 13.1
Marketing 7.4 32.1
Operating costs 6.1 12.1

 

The turnover in Brean has increased by 2.6% whilst in Portlet turnover has increased by 46.5% which is excellent since the business only commenced trading in 20X6. The overall growth amounted to 8% which is an acceptable level.

 

The profits in Brean are down by nearly 24% whilst in Portlet the loss has fallen by 49%. Portlet will need to make further growth in sales and monitor costs in order to become more profitable.

 

The costs within Brean have risen by 8% for salaries, 7% for marketing and 6% for operating costs yet sales have only increased by 2.6%.

 

The costs within Portlet have risen substantially more than in Brean. Marketing for example has risen by 32%. This may be due to the fact that this is a necessary cost to develop the growth in revenue within the newly established operation.

 

Salaries and operating costs have risen by between 12 and 13%, yet sales have increased by 46%. These costs should be monitored as the business grows further.

 

The EBITDA has fallen by 8% from $2,434,000 to $2,241,000 and ROCE has also fallen from 13.1 % to 10.4%. This is not a very good sign for the company.

 

 

The non -current asset utilisation ratios of Brean show a decrease from 20X8 to 20X9. Portlet also shows a decrease from 2 to 1.8, this is less surprising given that the operation has only recently been established.

 

Portlet is clearly in a rapid growth phase hence the need for investment in non-current assets.

 

It would be useful to have previous years data for Brean to observe longer term trends for revenue and costs. Data for Portlet from its first year of operation in 20X6 would enable a complete picture to be taken.

 

Competitor information would allow us to establish the market share and establish how well the operations are performing in comparison to competitors.

 

It is clear that long term borrowings have decreased from 20X8 to 20X9 and that BPG has sufficient cash flow to repay some of the debt finance. However it would be useful to have a breakdown of working capital for each operation.

 

It would also be useful to have future market and financial projections for Brean and Porlet, which should reflect the actual results in 20X8 and 20X9.

 

Budgeted data would be useful to see if they have managed to meet the targets set.

 

Note: You may be tempted to review the cash flows. This is not required in the question and the examiner is unlikely to expect this from you in this type of question.

 

 

Test your understanding 8

 

 

 

Water Supply Services (WSS) and Enterprise Activities (EA) are two wholly-owned subsidiaries of Aqua Holdings. You have recently qualified as an accountant and have joined the finance team of Aqua Holdings at headquarters. Your finance director is not satisfied with the performance of these two subsidiaries and has asked you to prepare a report covering the following issues:

 

  • The profitability of the two subsidiaries.

 

  • The competence of the EA manager to make financial decisions.

 

  • The consequences of having a common management information system serving both companies.

 

The finance director has also provided you with the following background information on the two companies.

 

 

WSS

 

The company holds a licence issued by the government to be the sole supplier of drinking water to a large town. The business necessitates a considerable investment in infrastructure assets and is therefore highly capital intensive. To comply with the licence the company has to demonstrate that it is maintaining guaranteed service standards to its customers. WSS is extensively regulated requiring very detailed annual returns concerning costs, prices, profits and service delivery standards. The government enforces a price-capping regime and therefore the company has limited freedom in tariff determination – the government will normally only sanction a price increase following a demonstrable rise in costs.

 

EA

 

In contrast to WSS, EA operates in a very competitive market offering a plumbing service to domestic properties. The business has the following characteristics:

 

  • rapidly changing market conditions

 

  • a high rate of new entrants and business failures

 

  • occasional shortages of skilled plumbers

 

  • fluctuating profits.

 

In addition to this background information you also have summarised income statements and statements of financial position for the last two years for both companies.

 

Water Supply Services
Summary income statement
Year
20X9 20X8
$m $m
Turnover 31 30
Less: Staff costs 3 2
General expenses 2 2
Depreciation 12 9
Interest 5 5
Profit 9 12

 

Summary statement of financial position
Year
20X9 20X8
$m $m
Non-current assets 165 134
Current assets 5 6
Total assets 170 140
Current liabilities (3) (6)
Debentures (47) (47)
Net assets 120 87
Shareholders’ equity 120 87
Enterprise activities – summary income statement
Year
20X9 20X8
$m $m
Turnover 20 35
Less: Staff costs 5 6
General expenses 10 10
Materials 3 6
Depreciation 1 1
Profit 1 12
Summary statement of financial position
Year
20X9 20X8
$m $m
Non-current assets 22 22
Current assets 13 12
Total assets 35 34
Current liabilities (4) (4)
Net assets 31 30
Shareholders’ equity 31 30

 

Required:

 

Prepare a report on the comparative financial performance of Water Supply Services and Enterprise Activities from the above financial statements. Your report should incorporate an assessment of the potential limitations of undertaking such a comparison.

 

 

5      Short and long-term financial performance

 

5.1 Introduction

 

Short-term financial performance measures are used for:

 

  • control purposes, e.g. variance analysis is carried out comparing actual and budgeted results and investigating any differences.

 

  • determining executive rewards – rewards may be linked to the achievement of short-term targets.

 

  • assessing the quality of past decisions and assessing the impact of decisions yet to be made.

 

5.2 Problems of using short-term targets to appraise performance

 

A focus on short-term performance (and the measurement of manager’s performance based on short-term results) can threaten a company’s ability to create long-term value for its shareholders. Managers may feel the pressure to achieve short-term targets (such as a target ROCE or gross profit margin) and, as a result, long-term performance may be compromised. For example:

 

  • Investment in new assets is cut. This may lead to a short-term boost in profits but long-term profitability may suffer as a result of old, and potentially inefficient, assets being used.

 

  • The development and training budget may be cut to boost short-term profitability. However, employees are a vital resource for many organisations and a lack of investment in this area could lead to a loss of competitive advantage and a resultant fall in long-term profits.

 

5.3 Steps to reduce short termism

 

  • Use financial and non-financial measures: these should focus manager’s attention on long-term financial performance. Methods such as the balanced scorecard can be used (these methods will be discussed in detail in  11).

 

  • Switch from a budget-constrained style: a switch should be made to a profit-conscious or non-accounting style (Hopwood). Both of these approaches have a more long-term focus.

 

  • Share options: if these are given to management they should focus their attention on improving share price and hence long-term performance.

 

  • Bonuses: these should be linked to profits over timescales greater than one year.

 

 

  • NPV and IRR: should be used to appraise investments. Discounted cash flow techniques recognise the future economic benefits of current investments.

 

  • Reduce decentralisation: this should increase central control and reduce the problem of dysfunctional behaviour.

 

  • Value-based techniques: focus on the key drivers of shareholder wealth. These techniques can be incorporated and will be discussed in more detail in

 

5.4 Should a short-term approach ever be taken?

 

It is generally accepted that a focus on long-term performance is superior. However, there are some situations when it is important to measure the achievement of short-term targets and to link rewards to these targets.

 

The best example of this would be an organisation which is fighting to survive. It is only by overcoming short-term hurdles and building short -term profits that long-term survival (and profitability) can be achieved. Cash flow measures may be more important than profit measures at this stage.

 

6      Exam focus

 

Exam sitting Area examined Question Number of
number marks
Sept/ Dec 2017 ROCE, EBITDA 2(a) 16
Sept/Dec 2016 Evaluation of performance 1(ii)(iii) 23
measures, ROCE
June 2014 Fixed and variable costs 1(ii) 6
June 2013 Evaluation of strategic performance 1(ii) 8
report and metrics
December 2012 ROCE 3(b) 7
December 2012 Financial performance evaluation 1(i)(ii) 20
and choice of measures
June 2012 Evaluation of performance 1(ii)(iii) 24
measures

Test your understanding 1

 

 

 

A bank’s primary objective will be profit maximisation for the benefit of the shareholders.

 

Secondary objectives may include:

 

  • market share

 

  • customer satisfaction

 

  • revenue growth

 

  • employee satisfaction.

 

 

Test your understanding 2

 

 

 

Answer is C.

 

Company A has a ROCE of 20% ($20k ÷ $100k) compared with only 10% for Company B ($1 m ÷ $10m). A higher ROCE means that the company is better at utilising the funds invested in it.

 

 

Test your understanding 3

 

 

 

Profits before tax $5,500,000
Less tax $2,100,000
Less preference dividends (9% × 1,000,000) $90,000
––––––––––
Earnings $3,310,000
––––––––––
Number of ordinary shares 6,000,000

 

EPS = (Profit after tax, – preference dividends)/Weighted average number of ordinary shares in issue

 

  • $3.31 m/6m

 

  • 2 cents

 

 

  8
Test your understanding 4
Year Cash flow DF PV DF PV
$ 15% $ 10% $
0 (15,000) 1.00 (15,000) 1.00 (15,000)
1 1,500 0.870 1,305 0.909 1,364
2 2,750 0.756 2,079 0.826 2,272
3 4,000 0.658 2,632 0.751 3,004
4 5,700 0.572 3,260 0.683 3,893
5 7,500 0.497 3,727 0.621 4,657
NPV (1,997) 190
(i)   NPV @ 15% = ($1,997)
(ii)   NPV @ 10% = $190
(iii)  If the company’s cost of capital is 10% the project would be
accepted, if it were 15% it wouldn’t.
Test your understanding 5
(a)
All figures in $000 0 1 2 3 4 5 6
Sales revenue 8,100 8,100 8,100 8,100 8,100 8,100
Variable costs (4,266) (4,266) (4,266) (4,266) (4,266) (4,266)
Royalties (675) (675) (675) (675) (675) (675)
Fixed costs (900) (900) (900) (900) (900) (900)
––––– ––––– ––––– ––––– ––––– –––––
Cash inflow from operations 2,259 2,259 2,259 2,259 2,259 2,259
Tax payable (30%) (678) (678) (678) (678) (678) (678)
Initial investment (7,000)
Government grant 3,500
received
–––––  –––––  –––––  –––––  ––––– ––––– –––––
(3,500) 1,581 1,581 1,581 1,581 1,581 1,581
Discount factor @ 12% 1 0.893 0.797 0.712 0.636 0.567 0.507
(3,500) 1,412 1,260 1,126 1,006 897 802
NPV 3,002
Alternatively, an annuity approach can be taken:
Time Narrative CF DF PV
0 Investment (7,000) 1 (7,000)
0 Grant 3,500 1 3,500
1 – 6 Net inflow (see above) 2,259 4.111 9,287
1 – 6 Tax 30% (678) 4.111 (2,787)
––––––
NPV 3,000

 

Figures in $000 1 2 3 4 5 6
Sales revenue 8,100 8,100 8,100 8,100 8,100 8,100
Variable costs (4,266) (4,266)  (4,266)  (4,266)  (4,266)  (4,266)
Royalties (675) (675) (675) (675) (675) (675)
––––– –––––   –––––   –––––   –––––   –––––
Contribution before tax 3,159 3,159 3,159 3,159 3,159 3,159
Tax payable (30%) (948) (948) (948) (948) (948) (948)
––––– –––––   –––––   –––––   –––––   –––––
Contribution after tax 2,211 2,211 2,211 2,211 2,211 2,211
Discount factor 0.893 0.797 0.712 0.636 0.567 0.507
@ 12%
1,975 1,762 1,574 1,406 1,254 1,121
NPV contribution = 9,089
Or using annuities:

 

Time Narrative CF DF PV
1 – 6 Contribution 3,159 4.111 12,987
1 – 6 Tax @ 30% (948) 4.111 3,897
PV contribution –––––
9,089

 

Sensitivity = NPV/PV of contribution = 3002/9089 = 33% i.e. the annual contribution would have to decrease by 33% before the project was rejected.

 

  • Factors that should be considered by the directors of JDL include:

 

– How the cash flows are estimated. How accurate they are requires detailed consideration.

 

– The cost of capital used by the finance director might be inappropriate. For example if the EF solar panels proposal is less risky than other projects undertaken by JDL then a lower cost of capital should be used.

 

– How strong is the EF brand name? The directors are proposing to pay royalties equivalent to 8% of sales revenue during the six years of the anticipated life of the project. Should they market the EF solar panels themselves?

 

– Would competitors enter the market and what would be the likely effect on sales volumes and selling prices?

 

N.B: Only three factors were required.

 

  • Benchmarking is the use of a yardstick to compare performance. The yardstick for benchmarking is based on best in class.

 

A major problem facing the management of JDL lies in the accessing of information regarding the activities of a competitor firm that may be acknowledged to display best practice. Internal benchmarking i.e. using another function within the same firm as the standard can help in the avoidance of the problems of information access, but that clearly limits the scope of what can be achieved. The most common approach is process benchmarking, where the standard of comparison is a firm which is not a direct competitor but is best in practice for a particular process or activity.

 

The objective is to improve performance. This is best achieved by means of the sharing of information which should prove of mutual benefit to both parties to the benchmarking programme. As a result of receiving new information each party will be able to review their policies and procedures. The very process of comparing respective past successes and failures can serve as a stimulus for greater innovation within each organisation.

 

To evaluate the performance JDL they need to establish a basis for targets which reflects the performance of an organisation which displays ‘Best Practice’. As a direct consequence of a comparison of existing standards with the ‘Best Practice’ organisation, managers can focus upon areas where improvements can be achieved and evaluate measures to help attain those improvements.

 

A principal benefit that will be derived by JDL as a result of undertaking a successful programme of benchmarking will be the identification of areas where cost savings are possible. Hence the levels of cost of sales and operating expenses can be reduced leading to increased profitability.

 

 

Test your understanding 6

 

 

 

50,000

IRR = 10% + 50,000 +10,000 × (15% –10%)

 

= 14.17%

 

Test your understanding 7

 

 

 

20X6 20X7
Current ratio 7,700 ÷ 4,500 = 1.7 7,050 ÷ 3,150 = 2.2
Acid test ratio 5,550 ÷ 4,500 = 1.2 4,470 ÷ 3,150 = 1.4
Receivable (5,200 ÷ 17,500) × 365 = (3,120 ÷ 16,625) × 365 =
days 108 days 68 days
Inventory days (2,150 ÷ 14,000) × 365 = (2,580 ÷ 12,950) × 365 =
56 days 73 days
Asset turnover 17,500 ÷ 17,700 = 1.0 16,625 ÷ 18,400 = 0.9
times times
ROCE (3,500 ÷ 17,700) × 100 = (3,675 ÷ 18,400) × 100 =
19.8% 20.0%
EPS 2,625 ÷ 2,500 = 1.05 2,756 ÷ 2,500 = 1.10

 

The company has high receivables, low inventories, a low cash balance and high trade payables.

 

The philosophy is to chase sales by offering lax trade credit to customers, while attempting to maintain adequate liquidity by taking extensive credit from suppliers.

 

This is a risky policy since it involves the risk of:

 

  • long-standing receivables balances going bad

 

  • discouraging potential customers since low inventory means an increased risk of goods being out of stock.

 

The low cash balance means that unexpected expenditures cannot be paid for out of cash. Specific funds would have to be organised.

 

The high trade payables will upset the suppliers; they may even stop supply until the balance outstanding is paid.

 

Test your understanding 8

 

 

 

Report on the comparative financial performance of WSS and EA.

 

  • Summary of financial ratios

 

WSS EA
Profitability (W1) 20X9 20X8 20X9 20X8
ROCE 8.4% 12.7% 3.2% 40.0%
Profit margin 45.2% 56.7% 5.0% 34.3%
Asset utilisation 18.6% 22.4% 64.5% 116.7%
Liquidity
Current ratio 1.7 1.0 3.25 3.0
Risk
Gearing (W2) 39.2 54.0 0 0
Growth
Turnover 3.3% (42.9%)
Profit (25%) (91.7%)
Capital employed 24.6% 3.3%

 

  • Comments on ratios

 

Both companies have shown a significant fall in profits. The ratios show that this is due to both a reduction in margins and falling asset utilisation. Capital employed has grown (especially for WSS) and it may be that this extra investment needs more time to generate additional profit.

 

EA has witnessed a dramatic reduction in sales. Costs seem to be largely fixed as these have only fallen by 17%. Turnover for the regulated monopoly appears to be more stable.

 

Financial risk (gearing) is high in WSS (although no comparisons with similar companies are available), but the gearing ratio has fallen in the year. High gearing magnifies the effect of volatile turnover on profit. Although it would seem EA has high operating gearing (fixed to total costs), this is somewhat compensated by the fact that it has no financial gearing.

 

Liquidity for both companies has improved, although no benchmarks against respective industry averages are available.

 

 

  • Limitations

 

Accuracy of the figures – are the two years under review representative?

 

Short versus long term – longer-term trends would be useful. Certain events in 20X9 (i.e. expenditure on fixed assets) will reduce short-term performance but fuel longer-term growth (and profit). The two companies cannot really be compared – one is a regulated monopoly, the other has to compete in a competitive market based on the perception of its products, quality and value for money. As such, comparison may be better carried out using industry benchmarks.

 

Profitability can only be fully appraised when compared against required returns of the shareholders. This, in turn, reflects the perceived risks they take when investing in each company. This may be lower for a regulated monopoly, and thus ROCEs lower, although the monopoly does have a higher level of gearing.

 

Workings

 

(W1) Profitability ratios (20X9 shown)

 

WSS                                             EA

 

ROCE*                         14/167 × 100 = 8.4%        1/31 × 100 = 3.2%

 

Profit margin             14/31 × 100 = 45.2%         1/20 × 100 = 5.0%

 

Asset utilisation     31/167 × 100 = 18.6%      20/31 × 100 = 64.5%

 

*Note: profit before interest used as the objective is to measure internal efficiency rather than return to external shareholders.

 

(W2) Gearing ratios (20X9 shown)

 

                                         WSS                                       EA

 

Debt/Equity                         47/120 = 39.2                   0

 

 

 

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