Review questions - session 3 Flashcards
R1. “What gets measured gets managed.” Comment on the benefits of performance measurement.
- Measurement helps us to identify areas we should focus on. People in an organization will pay more attention to an activity or a project whose performance is tracked. We focus on things that we know somebody else (e.g. our boss) is keeping an eye on it, too.
- On the other hand, actions that are not monitored are ignored by most people.
- The consequence is that activities, processes, and projects which are tracked often improve in performance.
- Performance measurement includes collecting feedback by comparing own performance with historical performance or with competitors (external benchmarks).
- We get insight into the processes, we learn from mistakes and we are able to take corrective actions. As a result, performance improves.
So when we say “what gets measured gets managed,” actually we get to the heart of management control: to make sure that the goals that have been defined are achieved.
R2. Describe the different fields in a business organization that may be subject to performance measurement.
- Financial performance
- Process related performance
- Employee related performance
- Market and customer related performance
- Innovation related performance
R3. Describe the basic form of a balance sheet. Explain what is meant by the so-called balance sheet identity.
A balance sheet has two sides, a left side and a right side, commonly called debit and credit. On the debit side (left), the balance sheet lists all assets the company utilizes for conducting business. On the credit side (right), we find the liabilities (debt) and the equity of the company. These are the funds which have been raised from creditors and investors (owners).
The so-called balance sheet identity has to hold: Assets = Liabilities + Stockholders’ equity. This equation has to hold – always! If it does not balance, there is a mistake.
This leads us to the main message a balance sheet conveys. While the right side of the balance sheet tells us where the financing comes from (sources), the left side tells us what the company has done with the funds: they have been invested in assets.
R.4 What particular point distinguishes a balance sheet from the other financial statements? Explain its implications for analyzing the performance of a company.
A balance sheet is a static document which relates to one point of time. This means, the balance sheet gives a “snapshot” of the company’s assets used and the funds related to those assets at a specific point of time.
This has important implications for analyzing the performance of a company. Since it does not depict changes in assets, liabilities, or equity, a single balance sheet should be interpreted with care. By nature, a balance sheet only shows a specific status quo of a company. Yet, it might look completely different on the next day. For example, a major investment will change the asset structure on the left side substantially. Repayments of debt or raising new equity will change the structure on the right side, in addition to a change in totals on both sides of the balance sheet.
R5. Explain the criteria according to which the balance sheet elements are ordered on the debit and credit side of the balance sheet.
- On the left side, the assets are listed in the order of liquidity.
- Liquidity describes the ease and speed with which an asset can be liquidated, that is, turned into cash.
- Assets are then listed in an order ofleast liquid assets at the top and the most liquid assets at the bottom on the balance sheet. (order can also be upside down, starting from the most liquid assets at the top –> the choice is usually the preparer’s)
- On the right side, there is a similar logic in the order of the elements.
- You can either start with equity and then list noncurrent liabilities before current liabilities, or the other way around.
- On the right side of the balance sheet, the order refers to the maturity of the funds. The concept of maturity refers to the time horizon of repayment of the funds. Equity does not have a maturity at all, while non-current liabilities take a long time to mature and current liabilities are by nature to be repaid in the short term.
R6. What are the basic elements of a balance sheet? Give examples for each.
Non-current assets: Fixed (or non-current) assets are all long-term assets or long-term investments which are intended to serve the business for more than one year. Examples are land, buildings, machinery, equipment, and computers.
Current assets: These are short-term assets which are intended to be sold or used up within one year. Also cash and cash equivalents like checks belong to this category. Other typical examples are inventories and accounts receivable (also called trade receivables). Moreover, financial instruments if held for trading are often found here.
Non-current liabilities: Non-current liabilities are long-term debts with a repayment term of longer than one year. Examples are bonds issued with long-term maturities, mortgages, debentures, and term loans. Also pension liabilities are normally long-term.
Current liabilities: These are short-term liabilities with maturities or settlement dates of up to one year. Also, if liabilities are held for trading purposes, they are disclosed here. Examples are short- term bank loans, short-term provisions, notes payable, accounts payable, and any accrued liabilities if paid within the next 12 months.
Owners’ equity: In a corporation this is also called shareholders’ equity. It represents the claim of the owners to the assets of the firm. The equity section on a corporation’s balance sheet is typically divided into several accounts. Share capital, issued capital, or common stock represents the shares that have been sold to investors in an initial public offering or in any other secondary offerings. Capital reserve captures the additional paid in surplus when shares are sold above their nominal value. Retained earnings is a cumulative account which captures profit retained year by year in the company from normal business operations (what is not paid out as dividend).
R7. Explain why market values of assets are very often different to their book values.
- First and foremost, mainly non-current assets are recognized at historical cost. Historical cost is the original acquisition cost of an asset less depreciation. Some assets like land are not depreciated at all.
- It would be more than a coincidence if market and book values were close to each other.
- Some assets do not even appear on the balance sheet (e.g. reputation, customer base, workforce and know-how which are relevant to the company but don’t appear on balance sheet)
- These resources are generally included in what accountants call “goodwill.” Goodwill in turn is only capitalized in an arm’s length market transaction – a purchase of a company or a part of a company. Here, a purchased goodwill captures the excess purchase price over the assets which come along with the acquired business. In contrast, internally generated goodwill is never capitalized on a balance sheet.
R8. Explain the measure of total assets. How it is calculated?
Total assets is a measure for the total investments of a business. The number is useful when determining the resources a company utilizes to generate revenues, profits, and cash flows. It is often used as a basis for calculating returns on investment and comparing it with competitors.
R9. Explain financial debt. Why does it usually receive higher attention than total debt when analyzing a company’s liabilities?
Interest-bearing debts are called financial liabilities (or debts). Analysts often rather focus on financial debt, being a subset of total debts. This debt bears a cost that has to be earned by the operations of the business and makes it thus more “troublesome” for the business. When externals focus on this number, management also will want to understand how their company performs in this aspect.
What is meant by a company’s net debt? Explain how the measure can be derived from financial debt?
Net debt is a measure which is used in credit analysis and in valuation. Also when buying a company, not only do you want to know how much debt you have to shoulder, the liquidity that comes along with the purchased target is also important to take into account.
To calculate net debt, one has to simply subtract cash, cash equivalents (and depending on the degree of liquidity, also other liquid assets like short-term investments) from financial debt:
Net debt = Financial debt – Cash & cash equivalents
R11. How is net working capital calculated? Explain why it can be used both as a liquidity and efficiency measure.
In its most simple form, net working capital (NWC) is calculated by deducting current liabilities from current assets:
NWC = Current assets – current liabilities
Net working capital can be interpreted twofold. On the one hand, it can be used as a liquidity measure, indicating if liquid assets exceed current liabilities. On the other hand, above all, it is an efficiency measure indicating how much liquid capital is maintained to operate a business.
When looking at this formula, net working capital seems to be at first glance a measure of liquidity. Remember that current assets are those assets which are cash or converted to cash within one year. Current liabilities, on the hand, are the liabilities to be repaid within one year. So, a positive net working capital would indicate a surplus of liquid assets over short-term liabilities.
When current assets exceed current liabilities, NWC is positive. However, a positive net working capital brings a negative aspect along with it: it can be costly. As a result, current assets which exceed current liabilities (i.e. net working capital) have to be financed at a cost.
Managers, who have understood that net working capital is a necessary but expensive thing, try to keep it as low as possible. They try to optimize capital efficiency and limit net working capital to a minimum. They avoid holding excess cash, they try to minimize accounts receivable, and they try to keep inventory levels as low as possible.
R12. Explain the concept of capital employed. What is the purpose of this measure?
Capital employed (CE) is a concept which comprises the funds (debt and equity) of a company. However, capital employed has a different focus: it captures only those funds for which the providers require a return. Or when looked at from the company’s perspective, capital employed is a concept which considers only funds that bear a cost.
Consequently, capital employed is comprised of all equity plus financial liabilities:
Capital employed = Owners’ equity + financial debt
Capital employed is an important concept widespread in value-based performance measurement. The measure is used for computing return ratios and for determining the capital charge when considering cost of debt and cost of equity.
R13. Explain the structure and function of an income statement.
The income statement – also called profit and loss statement – is the central report on a company’s profitability. Its function is to identify total revenue earned and total expenses incurred over a particular period.
An income statement starts with revenues. An adjustment is made for any changes in inventory. Then, step by step, expenses (net of income) are gradually subtracted.
R14. Compare the nature-of-expense with the function-of-expense method of an income statement. What are the advantages and disadvantages of the respective methods?
An income statement structured by nature of expense lists expenses such as material, personnel, depreciation, and rent expense. It normally follows a single-step approach with no or only few subtotals being calculated.
The strength of this method lies in its simplicity. However, it lacks the detail of the function-of- expense method.
In an income statement following the function-of-expense method, expenses are listed by functions, such as cost of goods sold, selling, R&D, and administration. Expenses such as cost of material, labor, and depreciation are allocated to different functions.
An advantage of this method is that it allows for calculating a gross profit and other profit numbers in a multi-step approach. After each step, a subtotal can be calculated which represents a certain profit figure (such as gross profit, operating profit). A disadvantage is that it does not disclose a number for depreciation.
R15. “The income statement serves as a bridge between a balance sheet at the beginning of a period and at the end.” Comment.
As outlined earlier, a balance sheet represents only the perspective of a certain point in time. Net income as the ultimate profit number at the end of an income statement serves as a bridge for the equity between two balance sheet dates. Companies pay dividends from net income. The remaining amounts which are not distributed to shareholders are retained in the business and increase the book equity on the balance sheet. The account which captures these increases is called retained earnings. In modern accounting schemes such as IFRS, this link is a bit more complicated as there are more transactions which can affect equity that are not necessarily included in net income.
