Chapter 8 - Financial performance measures in the private sector

Question 1

What are three reasons that companies are under increasing pressure to look at the long-term value of the business?

Answer 1

• 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

Question 2

Give four reasons why a business uses gross profit and operating profit even though there is a poor correlation between them and shareholder value?

Answer 2

• 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

Question 3

What is the formula for Gross profit?

Answer 3

Gross profit margin = (Gross profit ÷ Sales) × 100%

Question 4

What is the formula for Operating profit?

Answer 4

Operating profit margin = (Operating profit ÷ Sales) × 100%

Question 5

What are two advantages of Gross profit?

Answer 5

• 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

Question 6

What are two advantages of Operating profit?

Answer 6

• Indicates whether gross profit is sufficient to cover wider costs.
• Useful for highlighting wider cost efficiency issues

Question 7

For short-term decision making, what could be argued that would be a more useful metric than gross and operating profit?

Answer 7

Contribution

Question 8

What is the formula for ROCE?

Answer 8

ROCE = Operating profit / Capital employed × 100

Question 9

What is capital employed?

Answer 9

Capital employed = total assets less current liabilities; or

Capital employed = total equity plus long-term debt.

Question 10

What are two ways to achieve a higher ROCE?

Answer 10

• 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.

Question 11

What are four advantages of ROCE?

Answer 11

• 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.

Question 12

What are four disadvantages of ROCE?

Answer 12

• 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.

Question 13

What is the formula for EPS?

Answer 13

EPS = (Profit after tax less preference dividends) ÷ (Weighted average number of ordinary shares in issue)

Question 14

What are four advantages of EPS?

Answer 14

• Easily understood
• Calculation precisely defined by accounting standards
• Figures are readily available
• Often used to compare similar companies

Question 15

What are two disadvantages of EPS?

Answer 15

• Research shows a poor correlation between EPS and shareholder value
• Accounting treatment may cause ratio to be distorted

Question 16

What is EBITDA?

Answer 16

Earnings before interest tax depreciation and amortisation (and write offs such as goodwill)

Question 17

What are five advantages of EBITDA?

Answer 17

• 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

Question 18

What are five disadvantages of EBITDA?

Answer 18

• 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

Question 19

What is the formula for asset turnover?

Answer 19

Sales ÷ Capital employed

Question 20

What is the formula for Dividend cover?

Answer 20

PAT ÷ Dividends paid during the year

Question 21

What is the formula for Dividend yield?

Answer 21

(Dividend per share ÷ Current share price) × 100%

Question 22

What is the formula for P/E ratio?

Answer 22

Share price ÷ EPS

Question 23

What is the formula for Earnings yield?

Answer 23

(EPS ÷ Share price) × 100%

Question 24

What is the formula for Return on equity?

Answer 24

Net profit after tax ÷ Average shareholders’ equity

Question 25

What is the formula for the current ratio?

Answer 25

Current assets ÷ Current liabilities

Question 26

What is the formula for the acid test or quick ratio?

Answer 26

(Current assets – inventories) ÷ Current liabilities

Question 27

What is the formula for the Inventory period?

Answer 27

(Ave. value of inventory ÷ Cost of sales) × 365

Question 28

What is the formula for the Raw material period?

Answer 28

(Ave. value of raw materials ÷ Purchases) × 365

Question 29

What is the formula for the WIP period?

Answer 29

(Ave. value of WIP ÷ Cost of sales) × 365

Question 30

What is the formula for the Finished goods period?

Answer 30

(Ave. value of finished goods ÷ Cost of sales) × 365

Question 31

What is the formula for the Receivables period?

Answer 31

(Ave. receivables ÷ Sales) × 365

Question 32

What is the formula for the Payables period?

Answer 32

(Ave. payables ÷ Purchases) × 365

Question 33

What is the formula for financial gearing?

Answer 33

(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))

Question 34

What does operational gearing measure?

Answer 34

The level of business risk relating to how fluctuations in sales volume might lead to falling profits.

Question 35

What is the formula for Operational gearing?

Answer 35

Operational gearing = (Contribution/PBIT)

Question 36

What is contribution?

Answer 36

The amount of earnings remaining after all direct costs have been subtracted from revenue.

Question 37

What is the formula for interest cover?

Answer 37

Interest cover = (PBIT/Interest charges)

Question 38

What are three techniques to appraise individual projects?

Answer 38

• Net present value (NPV)
• Internal rate of return (IRR)
• Modified internal rate of return (MIRR).

Question 39

What are five advantages of NPV?

Answer 39

• 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

Question 40

What are four disadvantages of NPV?

Answer 40

• 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

Question 41

What is the formula for sensitivity?

Answer 41

Sensitivity = NPV ÷ PV of flows under consideration x 100

Question 42

What is one drawback of IRR?

Answer 42

It is possible to get multiple rates of return. MIRR fixes this.

Question 43

What does MIRR represent?

Answer 43

The actual return generated by a project.

Question 44

What does MIRR assume?

Answer 44

That funds will be reinvested at the investor’s required return (cost of capital).

Question 45

What is the calculation for MIRR?

Answer 45

((PV of inflows ÷ PV of outflows)^1/n × (1 + cost of capital)) – 1

Question 46

What are 7 ways of reducing short terminism?

Answer 46

• Use both financial and non-financial measures
• Switch from budget constrained style
• Share options
• Bonuses
• NPV/IRR
• Reduce decentralisation
• Value based techniques

Question 47

When might a short term approach be taken?

Answer 47

When an organisation is in survival mode.