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
