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Flashcards in Performance Measures Deck (45):

What four perspectives are included in Balanced Scorecard?

Financial / Customer / Internal Business Processes / Learning and Growth


Why was Balanced Scorecard created?

To measure Performance.


What are Strategy Maps?

Diagrams of Strategic Cause and Effect Relationships.


What is a Strategic Initiative?

A plan to achieve goals.


What measures are used under Value-Based Management?

Return on Investment
Residual Income
Economic Value Added
Free Cash Flow


How is Return on Investment (ROI) calculated?

ROI : Return / Investment

Example: You Invest $100 to buy a machine that generates $60 in Operating Income

$60 / $100 : 60% ROI


How is Residual Income calculated?

Operating Income - (Required Rate of Return x Invested Capital) : Residual Income


What is another name for Required Rate of Return (RROR)?

RROR is also called 'Cost of Capital'


What is Weighted Average Cost of Capital (WACC)? How is it calculated?

Cost of Capital is the weighted average of the interest rates you pay for your Capital.

Includes Debt and the Rate of Return your Equity Shareholders expect

Example: 45% of your Capital is supported by debt and has an interest rate of 9%. 55% of your Capital is supported by equity and shareholders expect a ROR of 12%

Your Cost of Capital is: (.45 x .09) + (.55 x .12) : 10.65%


How is Spread calculated?

Spread = ROI - Cost of Capital


What is the primary point of Economic Value Added? How is it calculated?

Investments should exceed costs- with an emphasis on stockholder value.

Economic Value Added : Operating Income After Tax - (Net Assets x WACC)

Economic Profit and EVA

Economic profit and economic value added measures stress the importance of making investments only when the return exceeds cost and, in the process, value to the stockholder is maximized. Economic profit is accounting profit minus the cost of capital. EVA is a variation of economic profit. EVA is net operating profit after taxes (NOPAT) minus the (after-tax) weighted average cost of capital (WACC) multiplied by total assets (TA) minus current liabilities (CL) (net assets).

EVA = Net operating profit after taxes (NOPAT) – [(TA – CL) × WACC]
Market value added is the difference between the market value of a company (both equity and debt) and the capital that lenders and shareholders have entrusted to it over the years in the form of loans, retained earnings, and paid-in capital. Market value added is a measure of the difference between “cash in” (what investors have contributed) and “cash out” (what they could get by selling at today’s prices)


How is Free Cash Flow calculated?

Operating Income After Tax
+ Depreciation & Amortization
- Capital Expenditures
- Change in Net Working Capital
= Free Cash Flow


What is measured by Six Sigma?

It measures a product versus its quality goal.


What is the Asset Turnover Ratio?

Sales / Average Assets


What does the Current Ratio tell us? How is it calculated?

Can the company pay their short-term liabilities?

Current Ratio = Current Assets / Current Liabilities


What does the Debt to Equity Ratio tell us? How is it calculated?

How is the company financing its capital?

Debt to Equity Ratio = Total Debt / Total Equity"


What does the Debt to Total Assets ratio tell us? How is it calculated?

What proportions of the company's assets are encumbered with debt?

Debt to Total Assets : Total Liabilities / Total Assets


What does Gross Margin % tell us? How is it calculated?

How profitable is the product after COGS?

Gross Margin = Gross Profit / Net Sales"


What does Operating Profit Margin tell us? How is it calculated?

How profitable is the product after all expenses (except interest and taxes)?

Operating Profit Margin = Operating Profit / Net Sales


How is Times Interest Earned calculated and what does it mean?

Can the company make their interest payments?

Times Interest Earned : Earnings Before Tax & Interest / Interest Expense


What does Return on Assets tell us? How is it calculated?

What % return are the assets generating?

Return on Assets = Net Income (net of interest & taxes) / Average Total Assets


How is Market/Book ratio calculated?

Market Value of Common Stock / Book Value of Common Stock


What is Inventory Turnover and how is it calculated?

"How quickly does inventory get sold?

Inventory Turnover = COGS / Average Inventory


What is the Quick Ratio and how is it calculated?

It measures short-term liquidity- and only includes assets that are quickly available (i.e. not inventory)

Quick Ratio : (Current Assets - Inventory) / Current Liabilities


What is Average Collection Period- and how is it calculated?

How many days does it take the company to collect payment on A/R?

Average Collection Period : Average AR / Average Sales Per Day


What is an Internal Failure?

Products have quality defects- but are caught BEFORE they leave the warehouse.


What is an External Failure?

Product reaches the customer- but they are not satisfied with the quality of the product.

This includes recalls.


What is Appraisal Cost?

Quality control- testing & inspection costs.


What are the two types of Levarage?

Operating Leverage and Financial Leverage


What is Operating leverage? and the equation?

Operating leverage measures the degree to which a firm builds fixed costs into its operations. If fixed costs are high a significant decrease in sales can be devastating. Therefore, all other things being equal, the greater a firm’s fixed costs the greater its business risk. On the other hand, if sales increase for a firm with a high degree of operating leverage, there will be a larger increase in return on equity. The degree of operating leverage (DOL) may be computed using the following formula:

DOL = Percent change in operating income
Percent change in unit volume

Highly leveraged firms, such as Ford Motor Company, enjoy substantial increases in income when sales volume increases. Less leveraged firms enjoy only modest increases in income as sales volume increases.


What is Financial Leverage? and the equation?

Financial leverage measures the extent to which the firm uses debt financing. While the use of debt can produce high returns to stockholders, it also increases their risk. Since debt generally is a less costly form of financing, a firm will generally attempt to use as much debt for financing as possible. However, as more and more debt is issued, the firm becomes more leveraged and the risk of its debt increases, causing the interest rate on additional debt to rise. Therefore, the optimal capital structure for a firm involves a mixture of debt and equity. The degree of financial leverage (DFL) for a firm may be computed using the following formula:

DFL = Percent change in EPS
Percent change in EBIT

EPS = Earnings per share
EBIT = Earnings before interest and taxes
EXAMPLE: Let’s examine two different leverage strategies. Under Plan 1 (the leveraged plan) management borrows $400,000 and sells 20,000 shares of common stock at $10 per share. Under Plan 2 (the conservative plan) the firm borrows $100,000 and issues 50,000 shares of stock at $10 per share. The debt bears interest at 10% and the firm has a 40% tax rate. These alternatives are illustrated below.

Plan 1 Plan 2
Debt (10% interest) $400,000 $100,000
Common stock 200,000 500,000
Total financing $600,000 $600,000
Common stock 20,000 shares 50,000 shares

Now let’s examine two sets of financial results. First, assume that the firm loses $200,000 before interest and taxes (EBIT). The financial results under the two different financing scenarios are shown below.

Plan 1 Plan 2
EBIT ($200,000) ($200,000)
Interest (10% × principal) (40,000) (10,000)
Earnings before taxes ($240,000) ($210,000)
Tax benefit (40% × EBT) 96,000 84,000
Net loss ($144,000) ($126,000)
Loss per share ($7.20) ($2.52)

Next, assume that the firm earns $200,000 before interest and taxes. Again, the financial results under the two different financing scenarios is shown below.

Plan 1 Plan 2
EBIT $200,000 $200,000
Interest (10% × principal) 40,000 (10,000)
Earnings before taxes $160,000 $190,000
Tax benefit (40% × EBT) 64,000 76,000
Net earnings $96,000 $114,000
Loss per share $4.80 $2.28

As you can see from the tables, the more leveraged strategy results in much more earnings for common stockholders when the firm performs well. However, it results in much more loss per share when the firm performs poorly. These examples clearly illustrate the major advantages and disadvantages of financial leverage.


In computing the reorder point for an item of inventory, which of the following is used?

I. Cost
II. Usage per day
III. Lead time

I and II.
II and III. this is the correct answer.
I and III.
I, II, and III.

The answer is Usage per day and Lead time COST IS NOT USED. However cost is used for EOQ but not for reorder point computation.

The lead time multiplied by the usage per day expected during lead time yields the reorder point. The most common approach to setting the optimum safety-stock level is to examine previous lead time periods to determine the probabilities of running out of stock (a stockout) for different assessed levels of safety stock. Cost is used to determine the amount to be ordered, known as the economic order quantity, not when to reorder.

When to Reorder? The objective is to order at a point in time so as to avoid stockouts but not so early that an excessive safety stock is maintained. Safety stocks may be used to guard against stockouts; they are maintained by increasing the lead time (the time that elapses from order placement until order arrival). Thus, safety stocks decrease stockout costs but increase carrying costs. Examples of these costs include

Carrying costs of safety stock
(and inventory in general) Stockout costs
1. Storage 1. Profit on lost sales
2. Interest 2. Customer ill will
3. Spoilage 3. Idle equipment
4. Insurance 4. Work stoppages
5. Property taxes


ABC Co. had debt with a market value of $1 million and an after-tax cost of financing of 8%. ABC also had equity with a market value of $2 million and a cost of equity capital of 9%. ABC’s weighted-average cost of capital would be

Cost of capital Weight Weighted-average
Debt 8% 33 1/3% 2.667%
Equity 9% 66 2/3% 6.000%

The weights allocation is off of the $3 million, however another way to weight this can be to extend the 1mx.08 and 2m x .09 and then weight these results you will come up with the same answer.


What are disadvantages of NPV?

1. is calculated using sensitivity analysis
2. computes the true interest rate
3 does not provide the true return on investment - only compute whether is exceeds or fails desired ROR.

4. is difficult to adapt to risk


What is the purpose of the Cash Budget?
And what are the main sections of it?

Projects sources and uses of funds for a specified period of time.

Since all of the operating budgets affect sources of cash they must be prepared first.

After the projected cash inflows and outflows are determined and the scheduled outflows for repayments for the prior financing and interest payments are accounted for, and a cash balance target is determined, then the future necessary financing needs can be projected.

Divided into four main sections: For Beginning and Ending Balance sheets:
1. Cash Receipts both cash and credit sales (for the project portion thereof). In order to project must know beginning A/R balance and Sales projection for the time period. And A/R aging and the collection methodologies for A/R.
2. Cash Disbursements
3. Cash Surplus or Deficit
4. Cash Financing


Cash Flow from two or more alternatives from an after-tax cash flow?

Project.. Compute
Add Inflow income +
Less Outflow expenses
Less depr

Compute EBT which are the two above numbers less depreciation and multiply this EBT result by the tax rate..


Explain Benchmarking and Best Practices

Benchmarking and Best Practices

Benchmarking is the continuous process of comparing the levels of performance in producing products and services and executing activities against the best levels of performance. It is the search for and implementation of “best practices.” There are different types of benchmarking including

• Internal benchmarking compares similar operations within different units of the same organization.
• Competitive benchmarking targets processes and methods used by an organization’s direct competitors.
• Functional or industry benchmarking compares similar functions within the same broad industry.
• Generic benchmarking compares processes that are independent of industry.

Best practices are the best ways to perform a process. Best practices represent the means by which world-class organizations have achieved superior performance. However, no practice can be considered a “best practice” for all organizations or in all situations. The advice of Dr. W. Edwards Deming applies to benchmarking: “Adapt, don’t adopt.”
Benchmarks are the performance metrics used in benchmarking.


What are the four perspectives of the balanced scorecard?

1. Financial
2. Customer
3. Internal Business Processes
4. Learning and Growth


What does the internal business processes perspective include?

Measures cost, quality, and time performance.


Value-Based Management (VBM)

VBM involves the use of value-based metrics (performance measures) in a strategic management system and as such could be viewed as a financial scorecard. The spectrum of value-based metrics include performance measures such as: return on investment (ROI), economic profit, economic value added, cash flow ROI, and residual income.



Return on investment is the ratio of a measure of “return” divided by a measure of “investment.” There are various ways to measure ROI including: return on assets (ROA), return on net assets (RONA), and return on equity (ROE). ROI is most often computed using net income (income after interest and taxes) but it also may be computed using operating income or operating income after taxes. and DuPont ROI Analysis.


DuPont ROI Analysis two computational factors

1st compute (ROS) Return on Sales (net income/sales)
2nd compute Asset turnover (sales/total assets)
then calculate DuPont ROI:

= NI/sales x Sales/TAs
= ROS x Asset turnover ratio

E.g. The following selected data pertain to the Amy Division of Cara Products, Inc. for 2003:

Sales $20,000,000
Average invested capital (Total assets) 5,000,000
Net operating income 1,250,000
Cost of capital 10 %

Compute ROI: $1,250,000/$5,000,000 = .25
$1,250,000/$20,000,000 x $20,000,000/$500,000
= 25%
or ROS 6.25% x asset turnover 4.0 = 25% ROI.


Residual income

Residual income is net income (or operating income after taxes) minus a cost of capital based on capital invested in a division or project.

Residual income
Net income–Interest on investment

Net income–(Required rate of return × Invested capital)

EXAMPLE: Using the data from the previous example for Amy Division

Sales $20,000,000
Average invested capital 5,000,000
Operating income 1,250,000
Required rate of return 10 %

Residual income
$1,250,000 – (10% × $5,000,000)

$1,250,000 – 500,000


Remember that the ROI was 25% for this company and the required interest rate is 10%. The difference between the ROI and the required interest rate (cost of capital) is sometimes called the spread. In this case the spread can be computed as follows:

ROI – Cost of capital

25% – 10%


Notice that the residual income of $750,000 divided by the invested capital of $5,000,000 equals the spread of 15%.


Performance costs for costs of Quality define the components

Conformance costs are prevention and appraisal costs

Nonconformance costs are internal failure and external failure costs.


The Real Risk-free rate of return (Rf)

1+I then subtract 1 to get Rf

The real risk-free rate of return (Rf) is the minimum return an investor requires. This rate does not take into account expected inflation and the capital market environment. Determine the real risk-free rate if the nominal risk-free rate is 8% and the inflation rate is 3%.

(Rf) = (1 + nominal risk-free rate)
______________________ -1 =
(1 + inflation rate)

or same
Rf = ((1 +.nominal risk-free rate)/(1+.03)) - 1