15 Financial Performance Measurement 2

Question 1

What is the basic formula for a residual term

Answer 1

A – B = C

Question 2

What is the basic formula for a ratio term

Answer 2

A / B = C%

Question 3

What is the purpose of financial performance metrics

Answer 3

• Promote goal congruence
• Through compatibility and accountability
• Can lead to sub optimisation
  o Myopic behaviour
   Not investing in good customer service as it would hurt short term profit

Question 4

What is residual income

Answer 4

• Residual income is the income remaining after charging for the cost of capital
  Residual income = Net income before tax - (Net asset × Risk adjusted cost of capital)
• Better than accounting profit as recognised cost of equity
  o Costs of debt are recognised in accounting profit (loan repayments)
  o Residual income considers both
• As it is a residual term the residual income is not very comparable
• Residual income can be used to mitigate suboptimal decisions about selecting projects as creates alignment with company’s overall objectives

Question 5

How can residual income lead to sub optimisation

Answer 5

• Residual income makes performance targets uniform
• Business units will be induced to invest when RI is positive

Question 6

How can residual income lead to myopia

Answer 6

• As the calculation of residual income is based on accounting profits the issue of myopia still exists
• Accounting profit is prudent, costs recognised sooner than profits
  o As accounting measures are for external individuals

Question 7

How can you overcome myopia

Answer 7

• Improve accounting profit measures, for both denominator and numerator of ROI
  o Net income and Cost of investment
• A more representative view can be made by
  o Capitalising R&D
  o Adopting current value depreciation for older assets
  o Impute cost of equity to balance sheet
• Improvements for accounting measures usually require deviations from accounting standards
  o Therefore, performance reports for management purposes differ significantly from information used for financial reporting to external parties
  o Involves additional costs of processing and reconciliation
• Despite the over emphasis on one financial measure, ROI, being problematic, a new measure was created
  o This is Economic Value Added (EVA)

Question 8

What is Economic Value Add (EVA)

Answer 8

Economic Value Added = Modified after tax operating profit - (Total Capital × Weighted average cost of capital)
* WACC = weighted average of debt and equity
o Also based on industry and risk characteristics of individual decisions
o Based on CAPM
* Suggest 164 modifications, including
o Capitalising R&D expenses and amortising them
o Capitalise goodwill to reflect future economic value
o Don’t treating differed tax as a liability

Question 9

What are the main differences between residual income and economic value add

Answer 9

• RI looks at removing sub optimal decisions
• EVA looks at risks of running a business

Question 10

How does return on investment relate to economic value add

Answer 10

• Like ROI, EVA evaluates income relative to the level of investment required to earn an income
• Unlike ROI, EVA does not motivate managers to turn down investments that ar expected to earn more than their cost of capital
• It is possible to compute EVA for every major product or product line to evaluate its contribution to creating shareholder wealth
  o The intent is to develop an income number that better reflects the organisations long run earnings potential
  o Eliminates potential for accounting profit manipulation

Question 11

What information is provided by economic value added

Answer 11

• Finds the real economic value added by a business units behaviour
  o Which is lead by management
• A positive EVA indicates that the earnings generated by managers are large enough to cover operating costs and cost of capital funds

Question 12

How does financial control enhance shareholder value

Answer 12

• Financial result control is important as it enhances shareholders value
  o If used properly, financial results provide help in assessing am organisations long term viability and identify processes for improvement
• They mostly tell you about the future by looking at the past
• Also financial control does not try to measure other performance criteria that may be critical to the organisations stakeholders and therefore long term success
  o Such as customer service, quality, employee skills
  o Therefore, despite the wide practice of financial controls many people question its true effectiveness

Question 13

What are the critics of financial control

Answer 13

• That it is delayed and highly aggregated information about how well the organisation is doing in meeting its commitments to its shareholders
• This information measures neither the drivers of the financial results or how well the organisation is doing in eating other stakeholders requirements
  o These stakeholders are key for long term success

Question 14

What is the financial control scorecard

Answer 14

• Financial control may be an ineffective control scorecard for three reasons
  1. It focuses on financial measures that do not measure the organisations other important attributes
  2. Financial control measures the financial effect of the overall level of performance achieved on the critical success factor, and it ignores the performance achieved on the individual critical success factors
  3. Financial control is usually oriented to short term profit performance, rarely focusing on long term improvement or trend analysis, instead considering how well the organisation or one of its responsibility centres has performed in the period
  a. This is the result of the misuse of financial control rather than a fault of the financial system
  This has lead to the balanced scorecard

Question 15

How can myopia be overcome

Answer 15

• Use more future orientated measures of performance
  o Lead indicators
• Supplement accounting measures with non – financial measures of performance which can provide better signals of future performance
• Value drivers such as innovation, marketing initiatives and staff development provide leading indicators of future possible cash flows and profits
  o Leads managers to make trade offs between short term profits and drivers of long term change
  o Holding managers accountable for a combination of lead indicators gives a stronger presence to long term possibilities
  o Better feed forward control will provide a better means to alter managers to potential problems and give them time to prepare or address the problem before it occurs