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Introduction to Accounting > 7- Performance appraisal > Flashcards

7- Performance appraisal Flashcards

1
Q

Basis of performance appraisal

A

Performance appraisal is relative
To:
peers
performance over time
against market expectations

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2
Q

What is reviewed?

A
  • Competitive environment
  • Notes to accounts
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3
Q

How is the competitive environment reviewed?

A
  • Porter’s 5 forces, PESTEL (Political, - Economic, Social, Technological, Environmental and Legal), SWOT etc.
  • Industry growth prospects
  • Market share
  • Regulatory and legal issues
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4
Q

How is the notes to the accounts reviewed?

A
  • Acquisitions and divestments
  • Changes in accounting policies and estimates
  • Changes in senior management
  • Auditor qualifications
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5
Q

How are financial statements restated?

A

Reverse one-off gains
Restate financial statements into common form
Recalculate derived items (e.g. PBIT, PAT)
Move items if necessary
- Aim is comparability

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6
Q

What are metrics & why are they useful?

A
  • 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
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7
Q

Management of operating assets

A
  • Inventory days
  • Days-sales-outstanding
  • Days-purchases-outstanding
  • Non-current Asset turnover
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8
Q

Inventory Days

A

Inventory days shows how long it takes the firm to turn its inventory over once.
Average length of time inventory over once.

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9
Q

Inventory days equation

A

= (Inventory/Cost-of-sales) x 365

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10
Q

What does an increase in inventory days mean

A
  • Stock build up
  • Preparation for sales period, drop in demand
  • Increased risk of wastage and obsolescence
  • Has to be financed
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11
Q

What does a reduction in inventory days mean?

A
  • Stock drawn down
  • Better stock control, less financing needed
  • After sales period, increase in demand
  • Risks of lost customer sales and manufacturing disruption
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12
Q

Days-sales-outstanding

A
  • 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.
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13
Q

Days-sales-outstanding equation

A

= (Trade receivables/Revenue (from credit sales)) x 365

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14
Q

What does it mean if days-sales-outstanding increases?

A
  • More generous payment terms
  • Higher credit risk
  • Easier to win sales
  • Customers struggling to pay?
  • Has to be financed
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15
Q

What does it mean if days-sales-outstanding decreases?

A
  • Tightening payment terms
  • Reduced credit sales
  • Risk of lost sales
  • Less financing required
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16
Q

Days-purchases-outstanding

A
  • 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
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17
Q

Days-purchasing-outstanding equation

A

= (Trade payables/ Cost-of-sales) x 365

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18
Q

What does an increase in days-purchases-outstanding mean?

A
  • More generous payment terms
  • Extracted better terms?
  • Struggling to pay?
  • Source of free financing
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19
Q

What does an decrease in days-purchases-outstanding mean?

A
  • Tightening payment terms
  • Imposed by supplier
  • Reduction in free financing
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20
Q

Non-current Assets Turnover

A
  • Shows how effective the firm is at generating revenue from its non-current assets.
  • Gets rid of effects of changes in working capital
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21
Q

Non-current Assets Turnover equation

A

= Revenue / non-current assets

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22
Q

Financing of working capital

A
  • Current ratio
  • Days-free-financing, days-to-be financed
  • Financing goals and operational constraints
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23
Q

Current ratio

A

= Current assets/ current liabilities

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24
Q

What does it mean if current ratio > 1?

A
  • 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
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25
Q

What does it mean if current ratio < 1?

A
  • 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.
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26
Q

Current ratio meaning

A
  • 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
27
Q

Days-free-cash

A

Number of days between the firm receiving payment from the customer and having to then pay the supplier for the goods it sold.

28
Q

Days-free-cash equation

A

= days-purchases-outstanding - inventory days - days-sales-outstanding
When: days-purchases > inventory days + days-sales-outstanding

29
Q

Days-to-be-financed

A

Number of days between the firm pay the supplier for the goods it sold and receiving payment from the customer.

30
Q

Days-to-be-financed equation

A

= inventory days + days-sales-outstanding - purchases-outstanding
When: inventory days + days-sales-outstanding > days-purchases-outstanding

31
Q

Actions to meet financing goals

A
  • 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

32
Q

Operational Constraints and Risks

A
  • 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).
33
Q

Why revenue needs to be analysed?

A
  • Headline figures tell one story
  • Need to look at lowest level of breakdown from notes.
34
Q

Why market share need to be analysed?

A

Look for external data on revenue growth for sector and/or market share

35
Q

Revenue, margins and operating profitability- metrics

A
  • Gross margin.
  • Operating margin
  • Asset turnover
  • Return on Capital Employed (ROCE)
36
Q

Gross Margin

A

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.

37
Q

Gross Margin equation

A

= Gross profit/ revenue

38
Q

Cost-income ratio

A

The cost income ratio shows how much of a company’s gross profits go on paying for the costs of running the business.

39
Q

Cost-income ratio equation

A

= other operating expenses/ gross profit

40
Q

Operating margin

A

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

41
Q

Operating margin equation

A

= Profit before interest and tax/ revenue

42
Q

Asset turnover

A

Asset turnover shows how many dollars of revenue has been generated from each dollar invested in a firm’s operating assets each year.

43
Q

Asset turnover equation

A

= Revenue/ (Non-current assets + working capital)

44
Q

What does asset turnover show?

A

Shows how “hard a firm is working its assets”.

45
Q

Return on Capital Employed

A
  • Return on firm’s operating assets
  • Independent of financing structure of firm
46
Q

Return on Capital Employed

A

= PBIT/ Non-current assets + working capital

47
Q

What is ROCE Decomposition for?

A
  • Method for identifying causes of changes in ROCE.
  • Shows that increase in ROCE caused by widening of operating margin and increased asset turnover.
48
Q

ROCE decomposition equation

A

??

49
Q

Cause of increase ROCE

A

Widening of operating margin and increased asset turnover.

50
Q

Nine possible combinations

A

??

51
Q

Metrics to analyse investor returns

A
  • Net profit margin
  • Financial leverage multiplier
  • Return on Equity (ROE)
  • Interest cover
  • Analysis of ROE
52
Q

Net profit margin

A

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.

53
Q

Net profit margin

A

= profit after tax/ revenue

54
Q

Financial Leverage Multiplier

A
  • The financial leverage multiplier is a common measure of debt gearing.
  • Debt usually increases returns to investors at expense of greater risk.
55
Q

Financial Leverage Multiplier equation

A

= Capital Employed/Equity
= Non current liabilities + equity/equity

56
Q

What accounts for capital employed?

A
  • Non-current liabilities
  • Owners’ equity
57
Q

Return on equity

A
  • Return on equity shows the annual accounting return to the owners of the firm.
  • Key investor return
58
Q

Return on equity (ROE) equation

A

= Profit after tax/ equity

59
Q

Interest Cover

A
  • 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
60
Q

Interest cover equation

A

= PBIT/ Finance expenses

61
Q

ROE decomposition equation

A

??

62
Q

Cause of increasing in ROE

A

Due to the widening of the net profit margin, assisted by higher asset turnover and was despite a slight fall in leverage.

63
Q

How does gearing affect ROE?

A

??

64
Q

What factors affect ROE?

A
  • Operating profitability (ROCE)
  • Level of debt gearing (D/E)
  • Cost of debt rD
  • Marginal tax rate tr

Introduction to Accounting (7 decks)

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