Chapter 8 - Financial performance measures in the private sector Flashcards
What are three reasons that companies are under increasing pressure to look at the long-term value of the business?
- Research suggests a poor correlation between short term profitability and shareholder return
- Investors look for long term value
- Reported profits may not be comparable between companies
Give four reasons why a business uses gross profit and operating profit even though there is a poor correlation between them and shareholder value?
- Information is readily available as prepared for statutory reporting
- Comparable between companies
- Most managers understand it
- Does not include figures like tax which managers cant control
What is the formula for Gross profit?
Gross profit margin = (Gross profit ÷ Sales) × 100%
What is the formula for Operating profit?
Operating profit margin = (Operating profit ÷ Sales) × 100%
What are two advantages of Gross profit?
- Focusses purely on whether the process of making and selling products is profitable
- Useful for highlighting product profitability issues – for example, if gross profit has fallen, is this due to cost rises
What are two advantages of Operating profit?
- Indicates whether gross profit is sufficient to cover wider costs.
- Useful for highlighting wider cost efficiency issues
For short-term decision making, what could be argued that would be a more useful metric than gross and operating profit?
Contribution
What is the formula for ROCE?
ROCE = Operating profit / Capital employed × 100
What is capital employed?
Capital employed = total assets less current liabilities; or
Capital employed = total equity plus long-term debt.
What are two ways to achieve a higher ROCE?
- 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.
What are four advantages of ROCE?
- Easy to calculate.
- Figures are readily available.
- Measures how well a business is utilising the funds invested in it.
- Often used by external analysts/investors.
What are four disadvantages of ROCE?
- Research shows a poor correlation between ROCE and shareholder value.
- ROCE can be improved by cutting back investment – this may not be in the company’s long-term best interest.
- Differences between the companies being compared may make comparison less meaningful.
- Can be distorted by accounting policies.
What is the formula for EPS?
EPS = (Profit after tax less preference dividends) ÷ (Weighted average number of ordinary shares in issue)
What are four advantages of EPS?
- Easily understood
- Calculation precisely defined by accounting standards
- Figures are readily available
- Often used to compare similar companies
What are two disadvantages of EPS?
- Research shows a poor correlation between EPS and shareholder value
- Accounting treatment may cause ratio to be distorted
What is EBITDA?
Earnings before interest tax depreciation and amortisation (and write offs such as goodwill)
What are five advantages of EBITDA?
- Shows cashflow generated from operating profit
- Tax excluded (does not show performance)
- Depn and amortisation do not effect performance of a particular year
- Easy to calclate
- Easy to understand
What are five disadvantages of EBITDA?
- Poor corelation with shareholder wealth
- Comparison is difficult due to accounting policies
- Ignores changes in working capital and impact of cashflow
- Doesnt consider NCA replacements needed by business
- Easily manipulated by accounting policies
What is the formula for asset turnover?
Sales ÷ Capital employed
What is the formula for Dividend cover?
PAT ÷ Dividends paid during the year
What is the formula for Dividend yield?
(Dividend per share ÷ Current share price) × 100%
What is the formula for P/E ratio?
Share price ÷ EPS
What is the formula for Earnings yield?
(EPS ÷ Share price) × 100%
What is the formula for Return on equity?
Net profit after tax ÷ Average shareholders’ equity
What is the formula for the current ratio?
Current assets ÷ Current liabilities
What is the formula for the acid test or quick ratio?
(Current assets – inventories) ÷ Current liabilities
What is the formula for the Inventory period?
(Ave. value of inventory ÷ Cost of sales) × 365
What is the formula for the Raw material period?
(Ave. value of raw materials ÷ Purchases) × 365
What is the formula for the WIP period?
(Ave. value of WIP ÷ Cost of sales) × 365
What is the formula for the Finished goods period?
(Ave. value of finished goods ÷ Cost of sales) × 365
What is the formula for the Receivables period?
(Ave. receivables ÷ Sales) × 365
What is the formula for the Payables period?
(Ave. payables ÷ Purchases) × 365
What is the formula for financial gearing?
(Long-term debt + Preference share capital/Shareholder funds) × 100%
(D/E)
or
(Long-term debt + Preference share capital/ Long-term debt + Preference share capital + Shareholder funds)
(D/(D+E))
What does operational gearing measure?
The level of business risk relating to how fluctuations in sales volume might lead to falling profits.
What is the formula for Operational gearing?
Operational gearing = (Contribution/PBIT)
What is contribution?
The amount of earnings remaining after all direct costs have been subtracted from revenue.
What is the formula for interest cover?
Interest cover = (PBIT/Interest charges)
What are three techniques to appraise individual projects?
- Net present value (NPV)
- Internal rate of return (IRR)
- Modified internal rate of return (MIRR).
What are five advantages of NPV?
- Strong correlation with shareholder value
- It considers time value of money
- Risk can be allowed by adjusting cost of capital
- Cashflows are less subjective and subject to manipulation
- Considers all project cashflows
What are four disadvantages of NPV?
- Hard to calc and understand
- Hard to compare projects of different sizes
- Based on assumption’s that could be wrong
- May have to switch to profit measures to motivate managers
What is the formula for sensitivity?
Sensitivity = NPV ÷ PV of flows under consideration x 100
What is one drawback of IRR?
It is possible to get multiple rates of return. MIRR fixes this.
What does MIRR represent?
The actual return generated by a project.
What does MIRR assume?
That funds will be reinvested at the investor’s required return (cost of capital).
What is the calculation for MIRR?
((PV of inflows ÷ PV of outflows)^1/n × (1 + cost of capital)) – 1
What are 7 ways of reducing short terminism?
- Use both financial and non-financial measures
- Switch from budget constrained style
- Share options
- Bonuses
- NPV/IRR
- Reduce decentralisation
- Value based techniques
When might a short term approach be taken?
When an organisation is in survival mode.
