7- Performance appraisal Flashcards
Basis of performance appraisal
Performance appraisal is relative
To:
peers
performance over time
against market expectations
What is reviewed?
- Competitive environment
- Notes to accounts
How is the competitive environment reviewed?
- Porter’s 5 forces, PESTEL (Political, - Economic, Social, Technological, Environmental and Legal), SWOT etc.
- Industry growth prospects
- Market share
- Regulatory and legal issues
How is the notes to the accounts reviewed?
- Acquisitions and divestments
- Changes in accounting policies and estimates
- Changes in senior management
- Auditor qualifications
How are financial statements restated?
Reverse one-off gains
Restate financial statements into common form
Recalculate derived items (e.g. PBIT, PAT)
Move items if necessary
- Aim is comparability
What are metrics & why are they useful?
- Performance measures: ratios or percentages taken from Statement of Profit or Loss and Statement of Financial Position
- Simplify and structure the appraisal
Independent of size – comparison with other firms - Performance over time
- Earnings models, communications
Not defined under IFRS/US GAAP
Management of operating assets
- Inventory days
- Days-sales-outstanding
- Days-purchases-outstanding
- Non-current Asset turnover
Inventory Days
Inventory days shows how long it takes the firm to turn its inventory over once.
Average length of time inventory over once.
Inventory days equation
= (Inventory/Cost-of-sales) x 365
What does an increase in inventory days mean
- Stock build up
- Preparation for sales period, drop in demand
- Increased risk of wastage and obsolescence
- Has to be financed
What does a reduction in inventory days mean?
- Stock drawn down
- Better stock control, less financing needed
- After sales period, increase in demand
- Risks of lost customer sales and manufacturing disruption
Days-sales-outstanding
- Days-sales-outstanding shows how long on average it takes the firm’s customers to pay for the goods and services they have bought on credit.
- Only has meaning when most sales are on credit.
Days-sales-outstanding equation
= (Trade receivables/Revenue (from credit sales)) x 365
What does it mean if days-sales-outstanding increases?
- More generous payment terms
- Higher credit risk
- Easier to win sales
- Customers struggling to pay?
- Has to be financed
What does it mean if days-sales-outstanding decreases?
- Tightening payment terms
- Reduced credit sales
- Risk of lost sales
- Less financing required
Days-purchases-outstanding
- Days-purchasing-outstanding shows how long on average it takes the firm to pay its suppliers for goods and services they have bought on credit.
- Using cost of sales means this is an approximation
- Actual length of time likely to be longe
Days-purchasing-outstanding equation
= (Trade payables/ Cost-of-sales) x 365
What does an increase in days-purchases-outstanding mean?
- More generous payment terms
- Extracted better terms?
- Struggling to pay?
- Source of free financing
What does an decrease in days-purchases-outstanding mean?
- Tightening payment terms
- Imposed by supplier
- Reduction in free financing
Non-current Assets Turnover
- Shows how effective the firm is at generating revenue from its non-current assets.
- Gets rid of effects of changes in working capital
Non-current Assets Turnover equation
= Revenue / non-current assets
Financing of working capital
- Current ratio
- Days-free-financing, days-to-be financed
- Financing goals and operational constraints
Current ratio
= Current assets/ current liabilities
What does it mean if current ratio > 1?
- Shows the number of times current assets exceeds current liabilities
- The firm’s net current assets have to be funded by its equity and non-current liabilities
What does it mean if current ratio < 1?
- Shows the proportion of current liabilities used to finance the firm’s current assets.
- The net current liabilities are used to finance part of the firm’s non-current assets.
Current ratio meaning
- Value driven by nature of business
- Inventory, trade receivables, trade payables and unearned income
- Best seen as a financing measure – for a going concern
Liquidation measure (rather than liquidity) - Not useful as a liquidity measure
Liquidity is dynamic, current ratio is static
A CURRENT RATIO BELOW 1 DOES NOT MEAN A COMPANY IS INSOLVENT
Days-free-cash
Number of days between the firm receiving payment from the customer and having to then pay the supplier for the goods it sold.
Days-free-cash equation
= days-purchases-outstanding - inventory days - days-sales-outstanding
When: days-purchases > inventory days + days-sales-outstanding
Days-to-be-financed
Number of days between the firm pay the supplier for the goods it sold and receiving payment from the customer.
Days-to-be-financed equation
= inventory days + days-sales-outstanding - purchases-outstanding
When: inventory days + days-sales-outstanding > days-purchases-outstanding
Actions to meet financing goals
- Cash- Keep only as much cash as needed for short-term liquidity purposes.
- Inventory- Keep as low as possible and turnover as high as possible
- Trade receivables- Give customers as little credit as possible to keep trade receivables as low as possible
- Trade payables- Extract as much credit as possible to keep trade payables as high as possible.
- Unearned income- Get customers to pay for goods and services in advance.
SUBJECT TO OPERATIONAL CONSTRAINTS
Operational Constraints and Risks
- Cash- Runs risks that it fails to meet all of its contractual payments, has to get expensive overdrafts or is unable to borrow at all.
- Inventory- Risks from running out of stock causing expensive disruption to manufacturing or lost sales.
Leave firm more exposed to supply disruptions and less likely to get purchasing volume discounts - Trade receivables- Risk that it loses sales and customers to competitors willing to offer better payment terms.
- Trade payables- Risk that suppliers refuse to deal with they or suppliers forced out of business or become less cooperative in the future.
- Unearned income- Difficult to persuade customers to pay for goods in advance (unless it is already the norm for the industry).
Why revenue needs to be analysed?
- Headline figures tell one story
- Need to look at lowest level of breakdown from notes.
Why market share need to be analysed?
Look for external data on revenue growth for sector and/or market share
Revenue, margins and operating profitability- metrics
- Gross margin.
- Operating margin
- Asset turnover
- Return on Capital Employed (ROCE)
Gross Margin
The gross margin tells us the difference in % terms between how much a firm can sell its goods for and how much it costs to produce and deliver the goods to its customers.
Gross Margin equation
= Gross profit/ revenue
Cost-income ratio
The cost income ratio shows how much of a company’s gross profits go on paying for the costs of running the business.
Cost-income ratio equation
= other operating expenses/ gross profit
Operating margin
The operating margin tell us how many cents from each dollar of revenue is left over after paying for the costs of goods sold, taking account of other income and the costs of running the business.
May vary with business model
Operating margin equation
= Profit before interest and tax/ revenue
Asset turnover
Asset turnover shows how many dollars of revenue has been generated from each dollar invested in a firm’s operating assets each year.
Asset turnover equation
= Revenue/ (Non-current assets + working capital)
What does asset turnover show?
Shows how “hard a firm is working its assets”.
Return on Capital Employed
- Return on firm’s operating assets
- Independent of financing structure of firm
Return on Capital Employed
= PBIT/ Non-current assets + working capital
What is ROCE Decomposition for?
- Method for identifying causes of changes in ROCE.
- Shows that increase in ROCE caused by widening of operating margin and increased asset turnover.
ROCE decomposition equation
??
Cause of increase ROCE
Widening of operating margin and increased asset turnover.
Nine possible combinations
??
Metrics to analyse investor returns
- Net profit margin
- Financial leverage multiplier
- Return on Equity (ROE)
- Interest cover
- Analysis of ROE
Net profit margin
The net profit margin tells us how much of operating profits after debtholders and tax have been paid goes to the owners of the firm, expressed as a % of revenue.
How many cents of each dollar of revenue is left over for the owners.
Net profit margin
= profit after tax/ revenue
Financial Leverage Multiplier
- The financial leverage multiplier is a common measure of debt gearing.
- Debt usually increases returns to investors at expense of greater risk.
Financial Leverage Multiplier equation
= Capital Employed/Equity
= Non current liabilities + equity/equity
What accounts for capital employed?
- Non-current liabilities
- Owners’ equity
Return on equity
- Return on equity shows the annual accounting return to the owners of the firm.
- Key investor return
Return on equity (ROE) equation
= Profit after tax/ equity
Interest Cover
- Interest cover shows the number of times that finance expense is covered by PBIT.
- Indication of ability to service debt – PBIT based on accrual concepts, not cash
- Adjustments to finance expense
Interest cover equation
= PBIT/ Finance expenses
ROE decomposition equation
??
Cause of increasing in ROE
Due to the widening of the net profit margin, assisted by higher asset turnover and was despite a slight fall in leverage.
How does gearing affect ROE?
??
What factors affect ROE?
- Operating profitability (ROCE)
- Level of debt gearing (D/E)
- Cost of debt rD
- Marginal tax rate tr
