14 Financial Performance Measurements 1

Question 1

What is the purpose of financial performance measurements

Answer 1

• Whole objective of this is to ensure systems are in place to aide goal congruency with the organisations overall objectives
• Provide a single number aggregate of bottom line financial measures of performance
  o Also give insights to multiple performance areas

Question 2

What are market measures

Answer 2

• Reflect changes in stock prices or shareholder returns
  o Dividend yield
  o Capital appreciation and dividends
• Mainly based on the market value of the firm
• Market value of a publicly traded firm is regarded as the closest measure of the firms intrinsic/economic value

Question 3

What are the advantages of market measures

Answer 3

• Timely – measured in short time periods
• Precise – in well-functioning capital markets
• Objective – not (easily) manipulable by the managers whose performances are being evaluated
• Cost effective – do not require any company measurement expense
• Understandable – in terms of what the measures represent (changes in market value of the firm)
• Congruent – the most direct manifestation, or closest proxy, of the theoretical notion of firm value

Question 4

What are the problems with market measures

Answer 4

• As all performance measures are meant to ensure goal congruency
• This might not work that well in larger firms when managers will have very little power over the company’s stock price or be able to make decisions affecting it
• Therefore, might be demotivating to use as a way of assessing performance
• Also, market measures are not available either for privately-held firms or wholly-owned subsidiaries or divisions, and they are not applicable to not-for-profit organizations
• And market values do not always reflect realized performance. They represent mainly expectations

Question 5

What are accounting measures

Answer 5

• The limitations of market measures cause organizations to look for surrogate measures of performance.
• Accounting measures, especially accounting profits and returns, are the most important surrogates used, particularly at management levels below the very top of the firm
• Defined in residual terms
  o Net oncome after taxes, operating profit, economic value add
• Or ratio terms
  o Return on investment, return on equity

Question 6

What are the advantages of accounting measures

Answer 6

• Timeliness
  o Measured in short time periods.
• Precision
  o Accounting rules and standards
• Objectivity
  o Independent auditors.
• Congruence
  o In for-profit firms, accounting profits or returns are relatively congruent with the true firm goal of maximizing shareholder value.
  o Positive correlations between accounting profits and changes in stock prices.
• Understandable
• Inexpensive
  o Financial reporting requirements

Question 7

What are the problems with accounting measures

Answer 7

• Is only based on what has happened and transactions that have taken place
• Accounts are prepared in a prudent manor
  o Potential costs recognised at lower thresholds than potential profits
• Are dependent on the choice of measurement method
  o Judgements are required which could lead to window dressing
• Ignore intangible assets (e.g. brand value, goodwill, reputation).
• Ignore the cost of investments in working capital
• Ignore the cost of equity capital which is usually more expensive than borrowed capital
• Ignore risk- reduced risk in cash flows increases economic value but this is not reflected in accounting profit

Question 8

What are the implications of the drawbacks of accounting measures

Answer 8

• The use of accounting income measures which emphasise the past, and thus may not be a reliable measure of future economic income and performance, may motivate managers to make decisions that will give a better accounting measure at the expense of economic income.
• The result is behavioural displacement problems, most especially myopia

Question 9

What is the two types of myopia

Answer 9

• Two types
  o Investment myopia
  o Operational myopia

Question 10

What is investment myopia

Answer 10

• Managers more concerned with the accounting profits in the short term- monthly, yearly profits, rather than long term value creation
• They might reduce or postpone investments that promise payoffs in future measurement periods
  o As the books would show the costs but as the revenues hadn’t been generated yet profits would be down
  o Due to accountings prudent nature
• Managers may be induced to ignore intangible assets which have mainly longer term future payoffs which manager may not benefit from

Question 11

What is operational myopia

Answer 11

Focusing on costs can sacrifice quality, goodwill with customers, and society at large

Question 12

What is return on investment

Answer 12

• Used in decentralized organizations which have multiple (investment) responsibility centers
• ROI is a ratio of the accounting profits earned by the business unit divided by the investment it should control
  ROI=Profits/(Investment Base)
• ROI is the most commonly used measure
  o ROI is easy to calculate, easy to understand,
  o Provides a single, comprehensive measure that reflects the tradeoffs that managers must make between revenues, costs and investments
  o Provides a means to compare results of businesses operating in different areas of the market

Question 13

How can you decide to invest based on ROI

Answer 13

• If the ROI of a project is greater than the cost of capital it should be accepted.
• However, focusing on ROI maximisation will not encourage this
• If cost of capital is 10% and manager averages 20% a potential project providing 15% should be accepted but it will hurt the managers performance metrics
  o Creating a suboptimal decision
• Or could be the inverse and making decisions that boost ROI for the department but the net affect on the whole company is negative
• Profit-seeking organizations should make investments in order of declining profitability until the marginal cost of capital of the last dollar invested equals the marginal return generated by that dollar

Question 14

What are the problems with ROI

Answer 14

• Numerator …
  o Accounting profits, hence, …
  o ROI contains all problems associated with these accounting measures (i.e. myopia).
• Denominator …
  o How to measure the fixed assets portion (e.g. book value vs. economic value)?
• Suboptimisation
  o ROI-measures can lead division managers to make decisions
  that improve division ROI even though the decisions are not in
  the corporation’s best interest.
  o Tension between division desired performance and overall organization performance

Question 15

When using ROI should you use net book value or cost

Answer 15

• Have to decision to value the investment at cost or book value
• To use book value would lead to increasing ROI as the asset deprecates
• But original cost does not represent what the asset is worth today to the business

Question 16

What is the dupont system

Answer 16

• Dupont, as a multiproduct firm, pioneered the systematic use of ROI to evaluate the profitability of its different lines of business
• The Dupont system of financial control focuses on ROI and breaks that measure into two components:
  o A return measure that assesses efficiency
  o A turnover measure that assesses productivity
• The Dupont approach to financial control develops increasingly more detailed subcomponents for the efficiency and productivity measures by focusing on more detailed calculations of costs and different groups of assets
• It is possible to compare these individual and group efficiency measures with those of similar organisation units or competitors
• Comparisons of these turnover ratios with those of similar units or those of competitors suggest where improvements are required

Question 17

What is return on equity

Answer 17

ROE=(Net profit)/Equity
This does pose the risk of promoting managers to finance on debt or lease assets

Question 18

What is return on capital employed

Answer 18

ROCE=EBIT/(Total Assets-Current Liabilities)

Question 19

What is return on assets

Answer 19

RONA=(Net Income)/(Fixed Assets+Working Capital)

Question 20

How can performance metrics give misleading performance signals

Answer 20

• SBU-managers are encouraged to retain assets beyond their optimal life and not to invest in new assets.
• Corporate managers are induced to over-allocate resources to business units with older assets.
• Combined with the suboptimization issues discussed above, manager of units with older assets, and, hence, a higher ROI, are likely to be more reluctant to invest in “desirable” projects with an IRR higher than the corporate cost of capital.
• Gross Book Value (GBV)?
  o However, in periods of inflation, old assets valued at GBV are still expressed at lower values than new assets, so ROI is still overstated