Chapter 11 - Performance Measurement And Control

Question 0

Net profit margin

Answer 0

Net profit margin = Net profit/ Turnover x 100

High net profit margin is desirable.
Indicates either sales prices are high or all costs are being kept well under control.

Question 1

Gross profit margin

Answer 1

Gross profit margin = Gross profit/ Turnover x 100%

High gross margin is desirable.
Indicates either sales prices are high or production costs are being kept well under control.

Question 2

Return on capital employed (ROCE)

Answer 2

ROCE = Net profit/ Capital employed x 100

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

Sometimes operating profit used instead of net profit.

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

1. Increasing net profit
2. Reducing capital employed.

ROCE = Net profit margin x Asset turnover

Question 3

Asset turnover

Answer 3

Asset turnover = Turnover/ Capital employed

High asset turnover is desirable. An increase could be achieved by:

1. Increasing turnover
2. Reducing capital employed.

Question 4

Current ratio

Answer 4

Current ratio = Current assets/ Current liabilities

A ratio in excess of 1 is desirable but depends on industry.

A decrease in the ratio below the average indicates the company has liquidity problems.

Question 5

Quick ratio (Acid test)

Answer 5

Current ratio = (Current assets - Inventory)/ Current liabilities

Question 6

Inventory holding period

Answer 6

Inventory holding period = Inventory/ Cost of Sales x 365

An increase indicates the company is having problems selling its products and could also indicate that there is an increased level of obsolete stock.

A decrease indicates the company’s ability to turn over inventory has improved and the company does not have excess cash tied up in inventory.
However any further reductions should be reviewed as the company may be struggling to manage its liquidity and may not have the cash available to hold the optimum level of inventory.

Question 7

Receivables (debtor) collection period

Answer 7

Receivables collection period = Receivables/ Turnover x 365

The average period for a company’s debtors to pay what they owe.

An increase indicates the company is struggling to manage its debts.
Possible steps to reduce the ratio are:
1. Credit checks on customers
2. Improve credit control.

A decrease indicates the company has improved its management of receivables.
However a collection period well below the industry average may make the company uncompetitive and profitability impacted.

Question 8

Payables (creditor) period

Answer 8

Payables period = Payables/ Purchases x 365

The average period for a company to pay for its purchases.

An increase indicates the company is struggling to pay it debts.
However it could also indicate the company is taking better advantage of any credit period offered to them.

A decrease indicates the company’s ability to pay for its purchases on time is improving.
However supplier finance is a useful source of finance.

Question 9

Financial gearing

Answer 9

Gearing = Debt/ Equity x 100

Gearing = Debt/ (Debt + Equity) x 100

High level indicates the company relies heavily on debt to finance its long term needs.

The ratio could be improved by reducing the level of long term debt and raising long term finance using equity.

Question 10

Interest cover

Answer 10

Interest cover = Operating profit/ Finance cost

A decrease indicates the company is not able to meet its finance payments as they fall due.

The ratio could be improved by increasing operating profit.

Question 11

Dividend cover.

Answer 11

Dividend cover = Net profit/ Dividend

A decrease indicates the company is not able to make its dividend payments to shareholders.

Question 12

Short-termism

Answer 12

Linking rewards to financial performance may tempt managers to improve short-term financial performance but may have a negative impact on long-term profitability e.g. Purchase cheaper but poorer materials.

Question 13

Manipulation of results

Answer 13

Accelerating revenue - Revenue in one year may be wrongly included in the previous year in order to improve the financial performance for the earlier year.

Delaying costs - Costs in one year may be wrongly recorded in the next year’ accounts to improve performance and meet targets for the earlier year.

Understating a provision or accrual - Improves financial performance and may result in the targets being achieved.

Manipulation of accounting policies - Closing inventory values may be overstated resulting in an increase in profits for the year.

Question 14

The balanced scorecard

Answer 14

Emphasises the need to provide management with a set of information which covers all relevant areas of performance.

Customer - What is it about us that new and existing customers value?

Internal - What processes must we excel at to achieve our financial and customer objectives?

Innovation and learning - how can we continue to improve and create future value?

Financial - how do we create value for our shareholders?

Question 15

Benefits and problems of the Balanced scorecard

Answer 15

Benefits:-

1. Focuses on factors which enable the company to succeed in the long-term.
2. Provides external and internal information.

Problems:-

1. Selection of measures can be difficult e.g. How to measure Innovation?
2. Obtaining information can be difficult e.g. Feedback from customers.
3. Information overload
4. Conflict between measures e.g. Profitability may increase in the short-term through a reduction in expenditure on staff training.

Question 16

The building block model

Answer 16

1. Dimensions are the goals for the business.

Profit
Competitiveness
Quality
Resource Utilisation
Flexibility
Innovation

2. Standards are the measures used.

Ownership
Achievability
Equity

3. Rewards to ensure employees are motivated to meet standards.

Clarity
Motivation
Controllability

Question 17

External considerations

Answer 17

1. Stakeholder - Any individual or group that has an interest in the business.

Shareholders
Employees
Loan providers
Government
Community
Customers
Environmental groups

2. Market conditions - Will impact business performance e.g. A downturn in the industry as a whole could have a negative impact on performance.
3. Competitors - Actions of competitors must be considered e.g. Company demand may decrease if a competitor reduces prices or launches a successful advertising campaign.