U2 Measuring Financial Performance Flashcards
(458 cards)
1
Q
A coach of a football team needs to know the running score of the game in order to assess whether he needs to make changes for the team to win. Additionally, the current position in the national league will likely affect the strategy employed. Managers of corporations need similar information to run the organization.
A
For business,
the running score are data such as profits, gains and losses, or the market share.
However, analyzing costs or other specific measures alone means little.
The context and position in relation to competitors-the ‘national league’ to draw on the football example-is equally important for the organization’s strategy.
2
Q
Measuring that running and contextual score and using it for better future performance in a business environment is the subject of performance measurement.
A
3
Q
Measuring that running and contextual score and using it for better future performance in a business environment is the subject of ———————-.
A
performance measurement.
4
Q
The approaches and concepts behind the practical implementation of performance measurement are numerous and diverse in nature. There is no—————————-or ———————————–which will work in every context and organization.
A
‘one-size-fits-all’
‘standard recipe’
5
Q
This means that performance measurement is often challenging and requires?
A
a good understanding of the organization and its core business processes.
6
Q
Complicating matters further is the fact that ?
We will define it here as “regular measurement of the results or outcomes and efficiency of services or programs”. One of the critical aspects of this definition is the regular measurement of results or outcomes.
A
performance measurement has many different meanings.
7
Q
Complicating matters further is the fact that ?
A
performance measurement has many different meanings.
8
Q
We will define it here as ?
A
“regular measurement of the results or outcomes and efficiency of services or programs”.
9
Q
One of the critical aspects of this definition is the regular measurement of ?
A
results or outcomes.
10
Q
Regular measurement is necessary in order to make progress towards ?
A
specified outcomes and it is a vital component of any customer-oriented process.
11
Q
Regular measurement is necessary in order to make progress towards ?
A
specified outcomes and it is a vital component of any customer-oriented process.
12
Q
Data quality is another essential requirement, because?
A
if things are not accurate, those using the information will be misled and bad decisions will likely ensue.
13
Q
The following statements, often used in the context of performance measurement, stress the importance of identifying the right metrics for a business:
A
=“You cannot manage what you cannot measure.
=“What gets measured gets done.”
=“Measurement influences behavior.”
14
Q
It is commonly believed that early performance measurement systems have their origin in
?
A
accounting systems.
15
Q
In this unit we will review some of the traditional models of performance measurement with a focus on financial key figures before we draw our attention to some of the more recent approaches to performance measurement.
Reviewing Traditional Models of Financial Performance Measurement
A
16
Q
In this unit we will review some of the traditional models of performance measurement with a focus on financial key figures before we draw our attention to some of the more recent approaches to performance measurement.
Reviewing Traditional Models of Financial Performance Measurement
A
16
Q
The more industrial organizations developed, the greater the need for?
A
17
Q
In this unit we will review some of the traditional models of performance measurement with a focus on financial key figures before we draw our attention to some of the more recent approaches to performance measurement.
Reviewing Traditional Models of Financial Performance Measurement
A
18
Q
The more industrial organizations developed, the greater the need for?
A
19
Q
The more industrial organizations developed, the greater the need for?
A
certain measures to determine their effectiveness.
20
Q
Current management accounting developed in the US between?
the 1850s and 1920s when industrial organizations moved from piece-work payment systems to wages, single efforts to multiple operations, individual production plants to vertical integrated businesses, and individual businesses to multi-divisional organizations.
A
the 1850s and 1920s
21
Q
Current management accounting developed in the US between the 1850s and 1920s when industrial organizations moved from ?
A
22
Q
Current management accounting developed in the US between?
A
the 1850s and 1920s
23
Q
Current management accounting developed in the US between the 1850s and 1920s when industrial organizations moved from ?
A
piece-work payment systems to wages,
single efforts to multiple operations,
individual production plants to vertical integrated businesses,
and individual businesses to multi-divisional organizations.
24
After World War I, companies such as du Pont, Sears Roebuck, and General Motors started to use sophisticated budgeting and management accounting techniques, such as?
standard costing, variance analysis, flexible budgets, return on investment, and other key management ratios. From these beginnings, the use of budgets spread widely.
24
In this unit we will review some of the traditional models of performance measurement with a focus on financial key figures before we draw our attention to some of the more recent approaches to performance measurement.
Reviewing Traditional Models of Financial Performance Measurement
25
Current management accounting developed in the US between the 1850s and 1920s when industrial organizations moved from ?
piece-work payment systems to wages,
single efforts to multiple operations,
individual production plants to vertical integrated businesses,
and individual businesses to multi-divisional organizations.
25
25
After World War I, companies such as du Pont, Sears Roebuck, and General Motors started to use sophisticated budgeting and management accounting techniques, such as?
standard costing,
variance analysis,
flexible budgets,
return on investment,
and other key management ratios.
From these beginnings, the use of budgets spread widely.
25
In this unit we will review some of the traditional models of performance measurement with a focus on financial key figures before we draw our attention to some of the more recent approaches to performance measurement.
Reviewing Traditional Models of Financial Performance Measurement
26
The period from 1925 to the 1980s was not characterized by?
inappropriate indicators for businesses effectiveness. The main criticism was focused on the dysfunctional actions of the traditional accounting-based performance measures, especially when used inappropriately.
significant changes in the development of management accounting.
27
However, beginning from the 1980s, traditional accounting measures were criticized as ?
28
The period from 1925 to the 1980s was not characterized by?
The main criticism was focused on the dysfunctional actions of the traditional accounting-based performance measures, especially when used inappropriately.
significant changes in the development of management accounting.
29
However, beginning from the 1980s, traditional accounting measures were criticized as ?
inappropriate indicators for businesses effectiveness.
30
The period from 1925 to the 1980s was not characterized by?
significant changes in the development of management accounting.
31
The main criticism was focused on ?
the dysfunctional actions of the traditional accounting-based performance measures, especially when used inappropriately.
32
In this unit we will review some of the traditional models of performance measurement with a focus on financial key figures before we draw our attention to some of the more recent approaches to performance measurement.
Reviewing Traditional Models of Financial Performance Measurement
32
They were also criticized for ?
encouraging short-term decision-making as well as for their inapplicability to modern manufacturing techniques.
32
Critics feared these criticisms had the potential to damage?
not only individual businesses,
but the entire economy.
33
After World War I, companies such as du Pont, Sears Roebuck, and General Motors started to use sophisticated budgeting and management accounting techniques, such as?
standard costing,
variance analysis,
flexible budgets,
return on investment,
and other key management ratios.
From these beginnings, the use of budgets spread widely.
33
The main criticism was focused on ?
the dysfunctional actions of the traditional accounting-based performance measures, especially when used inappropriately.
33
Current management accounting developed in the US between the 1850s and 1920s when industrial organizations moved from ?
piece-work payment systems to wages,
single efforts to multiple operations,
individual production plants to vertical integrated businesses,
and individual businesses to multi-divisional organizations.
34
Current management accounting developed in the US between the 1850s and 1920s when industrial organizations moved from ?
piece-work payment systems to wages,
single efforts to multiple operations,
individual production plants to vertical integrated businesses,
and individual businesses to multi-divisional organizations.
34
The main criticism was focused on ?
the dysfunctional actions of the traditional accounting-based performance measures, especially when used inappropriately.
35
In this unit we will review some of the traditional models of performance measurement with a focus on financial key figures before we draw our attention to some of the more recent approaches to performance measurement.
Reviewing Traditional Models of Financial Performance Measurement
35
Critics feared these criticisms had the potential to damage?
not only individual businesses,
but the entire economy.
35
After World War I, companies such as du Pont, Sears Roebuck, and General Motors started to use sophisticated budgeting and management accounting techniques, such as?
standard costing,
variance analysis,
flexible budgets,
return on investment,
and other key management ratios.
From these beginnings, the use of budgets spread widely.
36
They were also criticized for ?
encouraging short-term decision-making as well as for their inapplicability to modern manufacturing techniques.
36
Considering this historical context, it is not surprising that corporate performance has traditionally been understood in-------------------- terms. Still today, financial information is the most widely available information source on companies. One of the main reasons for this is the requirement imposed by regulators and supervisors on companies to disclose certain financial information.
financial
37
Considering this historical context, it is not surprising that corporate performance has traditionally been understood in-------------------- terms. Still today, financial information is the most widely ------------ information source on companies. One of the main reasons for this is the ------------------------------------------------------------------------------------------ on companies to disclose certain financial information.
financial
available
requirement imposed by regulators and supervisors
38
The extent to which financial information must be disclosed is dependent upon?
the public or private character of the company, its size, and whether the company is listed on a stock exchange or not.
39
Performance measures focusing on financial aspects can be divided into two main types:
=Measures based on accounting data
=Market-based measures derived from stock or other financial market values
40
Current management accounting developed in the US between the 1850s and 1920s when industrial organizations moved from ?
piece-work payment systems to wages,
single efforts to multiple operations,
individual production plants to vertical integrated businesses,
and individual businesses to multi-divisional organizations.
40
After World War I, companies such as du Pont, Sears Roebuck, and General Motors started to use sophisticated budgeting and management accounting techniques, such as?
standard costing,
variance analysis,
flexible budgets,
return on investment,
and other key management ratios.
From these beginnings, the use of budgets spread widely.
40
Accounting-Based Performance Measures
Traditional accounting-based performance measures are characterized as being?
financially-based,
internally-focused,
retrospective,
and more concerned with local departmental performance rather than with the overall performance of the business.
40
40
They were also criticized for ?
encouraging short-term decision-making as well as for their inapplicability to modern manufacturing techniques.
41
The extent to which financial information must be disclosed is dependent upon?
the public or private character of the company, its size, and whether the company is listed on a stock exchange or not.
42
42
In this unit we will review some of the traditional models of performance measurement with a focus on financial key figures before we draw our attention to some of the more recent approaches to performance measurement.
Reviewing Traditional Models of Financial Performance Measurement
43
The validity of these measures has been extensively --------------------- and the main focus has been on --------------measures.
neoclassical economists and classical management, which ultimately sees the legitimate objective of any private organization as maximizing profits.
examined
profitability
44
The search for and interest in profitability measures is in line with ?
45
The extent to which financial information must be disclosed is dependent upon?
the public or private character of the company, its size, and whether the company is listed on a stock exchange or not.
45
In this unit we will review some of the traditional models of performance measurement with a focus on financial key figures before we draw our attention to some of the more recent approaches to performance measurement.
Reviewing Traditional Models of Financial Performance Measurement
46
Current management accounting developed in the US between the 1850s and 1920s when industrial organizations moved from ?
piece-work payment systems to wages,
single efforts to multiple operations,
individual production plants to vertical integrated businesses,
and individual businesses to multi-divisional organizations.
47
The validity of these measures has been extensively --------------------- and the main focus has been on --------------measures.
examined
profitability
48
The search for and interest in profitability measures is in line with ?
neoclassical economists and classical management, which ultimately sees the legitimate objective of any private organization as maximizing profits.
49
The minimum accounting-based financial information for any business is compiled in the form of ?
periodic financial statements which consist of (at least) a balance sheet and a profit and loss statement.
49
The financial statement is a public document which is targeted at the main user groups which include:
investors
shareholders
employees
lender
ssuppliers
customers
government
the public
50
The extent to which financial information must be disclosed is dependent upon?
the public or private character of the company, its size, and whether the company is listed on a stock exchange or not.
50
From a high-level perspective such performance comparisons and analysis may include:
=Comparison of current year’s results with the previous year to identify trends and performance drivers within the organization
=The current year’s results in comparison with the results of companies in the same line of business, in order to establish whether the organization is performing better or worse than its competitors
=Current performance against a standard or benchmark of performance
50
The minimum accounting-based financial information for any business is compiled in the form of ?
periodic financial statements which consist of (at least) a balance sheet and a profit and loss statement.
50
In this unit we will review some of the traditional models of performance measurement with a focus on financial key figures before we draw our attention to some of the more recent approaches to performance measurement.
Reviewing Traditional Models of Financial Performance Measurement
50
50
The various user groups have different interests in the business and consequently apply a series of accounting ratios to interpret and appraise financial performance based on?
their information needs.
50
After World War I, companies such as du Pont, Sears Roebuck, and General Motors started to use sophisticated budgeting and management accounting techniques, such as?
standard costing,
variance analysis,
flexible budgets,
return on investment,
and other key management ratios.
From these beginnings, the use of budgets spread widely.
51
Current management accounting developed in the US between the 1850s and 1920s when industrial organizations moved from ?
piece-work payment systems to wages,
single efforts to multiple operations,
individual production plants to vertical integrated businesses,
and individual businesses to multi-divisional organizations.
51
They were also criticized for ?
encouraging short-term decision-making as well as for their inapplicability to modern manufacturing techniques.
52
After World War I, companies such as du Pont, Sears Roebuck, and General Motors started to use sophisticated budgeting and management accounting techniques, such as?
standard costing,
variance analysis,
flexible budgets,
return on investment,
and other key management ratios.
From these beginnings, the use of budgets spread widely.
52
Current management accounting developed in the US between the 1850s and 1920s when industrial organizations moved from ?
piece-work payment systems to wages,
single efforts to multiple operations,
individual production plants to vertical integrated businesses,
and individual businesses to multi-divisional organizations.
52
They were also criticized for ?
encouraging short-term decision-making as well as for their inapplicability to modern manufacturing techniques.
53
53
The extent to which financial information must be disclosed is dependent upon?
the public or private character of the company, its size, and whether the company is listed on a stock exchange or not.
54
The minimum accounting-based financial information for any business is compiled in the form of ?
periodic financial statements which consist of (at least) a balance sheet and a profit and loss statement.
54
In this unit we will review some of the traditional models of performance measurement with a focus on financial key figures before we draw our attention to some of the more recent approaches to performance measurement.
Reviewing Traditional Models of Financial Performance Measurement
55
The various user groups have different interests in the business and consequently apply a series of accounting ratios to interpret and appraise financial performance based on?
their information needs.
55
From a high-level perspective such performance comparisons and analysis may include:
=Comparison of current year’s results with the previous year to identify trends and performance drivers within the organization
=The current year’s results in comparison with the results of companies in the same line of business, in order to establish whether the organization is performing better or worse than its competitors
=Current performance against a standard or benchmark of performance
=Comparisons of one segment or division of a business with others, so as to establish which parts of the business are achieving their goals
56
Financial performance indicators included in the financial statement can be presented in the form of?
ratios and cover a number of concepts.
57
Current management accounting developed in the US between the 1850s and 1920s when industrial organizations moved from ?
piece-work payment systems to wages,
single efforts to multiple operations,
individual production plants to vertical integrated businesses,
and individual businesses to multi-divisional organizations.
57
The minimum accounting-based financial information for any business is compiled in the form of ?
periodic financial statements which consist of (at least) a balance sheet and a profit and loss statement.
58
In this unit we will review some of the traditional models of performance measurement with a focus on financial key figures before we draw our attention to some of the more recent approaches to performance measurement.
Reviewing Traditional Models of Financial Performance Measurement
58
The extent to which financial information must be disclosed is dependent upon?
the public or private character of the company, its size, and whether the company is listed on a stock exchange or not.
58
These concepts can be grouped as follows:
profitability
liquidity
utilization
financial structur
einvestment–shareholder ratios
58
They were also criticized for ?
encouraging short-term decision-making as well as for their inapplicability to modern manufacturing techniques.
59
After World War I, companies such as du Pont, Sears Roebuck, and General Motors started to use sophisticated budgeting and management accounting techniques, such as?
standard costing,
variance analysis,
flexible budgets,
return on investment,
and other key management ratios.
From these beginnings, the use of budgets spread widely.
59
Financial performance indicators included in the financial statement can be presented in the form of?
ratios and cover a number of concepts.
60
Within each of these groups, there are numerous ratios which can be built and applied with?
basically no limit to the creativity of ‘inventing’ new ratios.
61
Within each of these groups, there are numerous ratios which can be built and applied with basically no limit to the creativity of ‘inventing’ new ratios. However, a guiding principle of building and analyzing performance ratios should be ?
Within each of these groups, there are numerous ratios which can be built and applied with?
basically no limit to the creativity of ‘inventing’ new ratios. However, a guiding principle of building and analyzing performance ratios should be
62
They were also criticized for ?
encouraging short-term decision-making as well as for their inapplicability to modern manufacturing techniques.
62
The extent to which financial information must be disclosed is dependent upon?
the public or private character of the company, its size, and whether the company is listed on a stock exchange or not.
62
62
These concepts can be grouped as follows:
profitability
liquidity
utilization
financial structur
einvestment–shareholder ratios
62
The minimum accounting-based financial information for any business is compiled in the form of ?
periodic financial statements which consist of (at least) a balance sheet and a profit and loss statement.
62
In this unit we will review some of the traditional models of performance measurement with a focus on financial key figures before we draw our attention to some of the more recent approaches to performance measurement.
Reviewing Traditional Models of Financial Performance Measurement
63
Current management accounting developed in the US between the 1850s and 1920s when industrial organizations moved from ?
piece-work payment systems to wages,
single efforts to multiple operations,
individual production plants to vertical integrated businesses,
and individual businesses to multi-divisional organizations.
63
After World War I, companies such as du Pont, Sears Roebuck, and General Motors started to use sophisticated budgeting and management accounting techniques, such as?
standard costing,
variance analysis,
flexible budgets,
return on investment,
and other key management ratios.
From these beginnings, the use of budgets spread widely.
63
Within each of these groups, there are numerous ratios which can be built and applied with basically no limit to the creativity of ‘inventing’ new ratios. However, a guiding principle of building and analyzing performance ratios should be ?
the objective that these figures are supposed to accomplish, which highly depends on the context.
63
64
Current management accounting developed in the US between the 1850s and 1920s when industrial organizations moved from ?
piece-work payment systems to wages,
single efforts to multiple operations,
individual production plants to vertical integrated businesses,
and individual businesses to multi-divisional organizations.
64
In this unit we will review some of the traditional models of performance measurement with a focus on financial key figures before we draw our attention to some of the more recent approaches to performance measurement.
Reviewing Traditional Models of Financial Performance Measurement
64
64
After World War I, companies such as du Pont, Sears Roebuck, and General Motors started to use sophisticated budgeting and management accounting techniques, such as?
standard costing,
variance analysis,
flexible budgets,
return on investment,
and other key management ratios.
From these beginnings, the use of budgets spread widely.
65
The extent to which financial information must be disclosed is dependent upon?
the public or private character of the company, its size, and whether the company is listed on a stock exchange or not.
65
The minimum accounting-based financial information for any business is compiled in the form of ?
periodic financial statements which consist of (at least) a balance sheet and a profit and loss statement.
65
For example, organizations which provide credit to their customers have a need to?
control their debtors through debtors’ balances, presented on a monthly basis.
Those who have a significant investment in stock should implement controls through perpetual inventory records.
Regular debtor and inventory reports will help prevent too much capital being tied up in these areas and allow for prompt follow up action.
Such actions can include changing inventory ordering patterns and allowing for immediate follow-up on debtors to prevent ‘bad’ debts.
65
Within each of these groups, there are numerous ratios which can be built and applied with basically no limit to the creativity of ‘inventing’ new ratios. However, a guiding principle of building and analyzing performance ratios should be ?
the objective that these figures are supposed to accomplish, which highly depends on the context.
65
They were also criticized for ?
encouraging short-term decision-making as well as for their inapplicability to modern manufacturing techniques.
66
These concepts can be grouped as follows:
profitability
liquidity
utilization
financial structur
einvestment–shareholder ratios
67
In this unit we will review some of the traditional models of performance measurement with a focus on financial key figures before we draw our attention to some of the more recent approaches to performance measurement.
Reviewing Traditional Models of Financial Performance Measurement
67
Current management accounting developed in the US between the 1850s and 1920s when industrial organizations moved from ?
piece-work payment systems to wages,
single efforts to multiple operations,
individual production plants to vertical integrated businesses,
and individual businesses to multi-divisional organizations.
67
For example, organizations which provide credit to their customers have a need to control their debtors through?
debtors’ balances, presented on a monthly basis.
Those who have a significant investment in stock should implement controls through perpetual inventory records.
Regular debtor and inventory reports will help prevent too much capital being tied up in these areas and allow for prompt follow up action.
Such actions can include changing inventory ordering patterns and allowing for immediate follow-up on debtors to prevent ‘bad’ debts.
67
These concepts can be grouped as follows:
profitability
liquidity
utilization
financial structur
einvestment–shareholder ratios
67
Although the use of specific accounting-based performance figures depends very much on the objective and specific context, some performance measures have gained prominence and are frequently used.
67
Within each of these groups, there are numerous ratios which can be built and applied with basically no limit to the creativity of ‘inventing’ new ratios. However, a guiding principle of building and analyzing performance ratios should be?
the objective that these figures are supposed to accomplish, which highly depends on the context.
67
After World War I, companies such as du Pont, Sears Roebuck, and General Motors started to use sophisticated budgeting and management accounting techniques, such as?
standard costing,
variance analysis,
flexible budgets,
return on investment,
and other key management ratios.
From these beginnings, the use of budgets spread widely.
67
They were also criticized for ?
encouraging short-term decision-making as well as for their inapplicability to modern manufacturing techniques.
67
The minimum accounting-based financial information for any business is compiled in the form of ?
periodic financial statements which consist of (at least) a balance sheet and a profit and loss statement.
68
The extent to which financial information must be disclosed is dependent upon?
the public or private character of the company, its size, and whether the company is listed on a stock exchange or not.
69
Although the use of specific accounting-based performance figures depends very much on the objective and specific context, some performance measures have gained prominence and are frequently used.
69
These concepts can be grouped as follows:
profitability
liquidity
utilization
financial structur
einvestment–shareholder ratios
69
For example, organizations which provide credit to their customers have a need to control their debtors through?
debtors’ balances, presented on a monthly basis.
Those who have a significant investment in stock should implement controls through perpetual inventory records.
69
The extent to which financial information must be disclosed is dependent upon?
the public or private character of the company, its size, and whether the company is listed on a stock exchange or not.
69
The minimum accounting-based financial information for any business is compiled in the form of ?
periodic financial statements which consist of (at least) a balance sheet and a profit and loss statement.
69
Within each of these groups, there are numerous ratios which can be built and applied with basically no limit to the creativity of ‘inventing’ new ratios. However, a guiding principle of building and analyzing performance ratios should be?
the objective that these figures are supposed to accomplish, which highly depends on the context.
70
After World War I, companies such as du Pont, Sears Roebuck, and General Motors started to use sophisticated budgeting and management accounting techniques, such as?
standard costing,
variance analysis,
flexible budgets,
return on investment,
and other key management ratios.
From these beginnings, the use of budgets spread widely.
70
Current management accounting developed in the US between the 1850s and 1920s when industrial organizations moved from ?
piece-work payment systems to wages,
single efforts to multiple operations,
individual production plants to vertical integrated businesses,
and individual businesses to multi-divisional organizations.
70
In this unit we will review some of the traditional models of performance measurement with a focus on financial key figures before we draw our attention to some of the more recent approaches to performance measurement.
Reviewing Traditional Models of Financial Performance Measurement
70
They were also criticized for ?
encouraging short-term decision-making as well as for their inapplicability to modern manufacturing techniques.
71
After World War I, companies such as du Pont, Sears Roebuck, and General Motors started to use sophisticated budgeting and management accounting techniques, such as?
standard costing,
variance analysis,
flexible budgets,
return on investment,
and other key management ratios.
From these beginnings, the use of budgets spread widely.
71
Current management accounting developed in the US between the 1850s and 1920s when industrial organizations moved from ?
piece-work payment systems to wages,
single efforts to multiple operations,
individual production plants to vertical integrated businesses,
and individual businesses to multi-divisional organizations.
71
In this unit we will review some of the traditional models of performance measurement with a focus on financial key figures before we draw our attention to some of the more recent approaches to performance measurement.
Reviewing Traditional Models of Financial Performance Measurement
71
Within each of these groups, there are numerous ratios which can be built and applied with basically no limit to the creativity of ‘inventing’ new ratios. However, a guiding principle of building and analyzing performance ratios should be?
the objective that these figures are supposed to accomplish, which highly depends on the context.
71
These concepts can be grouped as follows:
profitability
liquidity
utilization
financial structur
einvestment–shareholder ratios
71
The minimum accounting-based financial information for any business is compiled in the form of ?
periodic financial statements which consist of (at least) a balance sheet and a profit and loss statement.
71
For example, organizations which provide credit to their customers have a need to control their debtors through?
debtors’ balances, presented on a monthly basis.
Those who have a significant investment in stock should implement controls through perpetual inventory records.
72
They were also criticized for ?
encouraging short-term decision-making as well as for their inapplicability to modern manufacturing techniques.
72
The extent to which financial information must be disclosed is dependent upon?
the public or private character of the company, its size, and whether the company is listed on a stock exchange or not.
72
Regular debtor and inventory reports will help prevent too much capital being tied up in these areas and allow for prompt follow up action.
Such actions can include changing inventory ordering patterns and allowing for immediate follow-up on debtors to prevent ‘bad’ debts.
72
Although the use of specific accounting-based performance figures depends very much on the objective and specific context, some performance measures have gained prominence and are frequently used.
73
Although the use of specific accounting-based performance figures depends very much on?
the objective and specific context, some performance measures have gained prominence and are frequently used.
74
Return on equity (ROE):
Calculates the earnings over a shareholder’s equity.
It measures a corporation’s profitability by revealing how much profit a company generates with the money shareholders have invested.
75
image
76
performance measures
=Return on equity (ROE):
=Return on assets (ROA):
=Return on investment (ROI):
=Earning per share (EPS):
=Dividend payout-ratio:
=Cash flow:
=Stock turnover-days:
=Receivables turnover ratio:
=Receivables turnover ratio:
=Debt\/equity ratio:
=Interest coverage ratio:
=Gross profit margin:
=Breakeven sales:
=Price-to-book ratio (P\/B ratio):
=Price-to-earnings ratio (P\/E ratio):
=Dividend yield:
=Net present value (NPV):
=Internal rate of return (IRR):
77
Return on assets (ROA):
This is an indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. This ratio is calculated by dividing a company’s annual earnings by its total assets.
78
image
79
Return on investment (ROI):
Represents the after-tax return which owners are receiving on their investment and should be compared with alternative forms of investment.
80
The extent to which financial information must be disclosed is dependent upon?
the public or private character of the company, its size, and whether the company is listed on a stock exchange or not.
80
In this unit we will review some of the traditional models of performance measurement with a focus on financial key figures before we draw our attention to some of the more recent approaches to performance measurement.
Reviewing Traditional Models of Financial Performance Measurement
81
Current management accounting developed in the US between the 1850s and 1920s when industrial organizations moved from ?
piece-work payment systems to wages,
single efforts to multiple operations,
individual production plants to vertical integrated businesses,
and individual businesses to multi-divisional organizations.
81
Return on investment (ROI):
Represents the after-tax return which owners are receiving on their investment and should be compared with alternative forms of investment.
81
The minimum accounting-based financial information for any business is compiled in the form of ?
periodic financial statements which consist of (at least) a balance sheet and a profit and loss statement.
82
image
83
Earning per share (EPS):
The portion of a company’s profit allocated to weighted outstanding shares. EPS serves as an indicator of a company’s profitability.
84
image
85
Dividend payout-ratio:
Calculates the percentage of earnings paid to shareholders in dividends in a specific period. A stable dividend payout ratio indicates a solid dividend policy by the company’s board of directors.
86
image
87
Cash flow:
There are different definitions for cash flows and different types of cash flows (e.g. free cash flow, operational cash flows, etc.). For practical purposes earnings plus depreciations can be used as a simple approximation.
88
In this unit we will review some of the traditional models of performance measurement with a focus on financial key figures before we draw our attention to some of the more recent approaches to performance measurement.
Reviewing Traditional Models of Financial Performance Measurement
88
The extent to which financial information must be disclosed is dependent upon?
the public or private character of the company, its size, and whether the company is listed on a stock exchange or not.
89
The minimum accounting-based financial information for any business is compiled in the form of ?
periodic financial statements which consist of (at least) a balance sheet and a profit and loss statement.
90
Current management accounting developed in the US between the 1850s and 1920s when industrial organizations moved from ?
piece-work payment systems to wages,
single efforts to multiple operations,
individual production plants to vertical integrated businesses,
and individual businesses to multi-divisional organizations.
91
After World War I, companies such as du Pont, Sears Roebuck, and General Motors started to use sophisticated budgeting and management accounting techniques, such as?
standard costing,
variance analysis,
flexible budgets,
return on investment,
and other key management ratios.
From these beginnings, the use of budgets spread widely.
91
image
91
Cash flow:
There are different definitions for cash flows and different types of cash flows (e.g. free cash flow, operational cash flows, etc.). For practical purposes earnings plus depreciations can be used as a simple approximation.
91
The minimum accounting-based financial information for any business is compiled in the form of ?
periodic financial statements which consist of (at least) a balance sheet and a profit and loss statement.
91
image
91
Although the use of specific accounting-based performance figures depends very much on the objective and specific context, some performance measures have gained prominence and are frequently used.
91
Current management accounting developed in the US between the 1850s and 1920s when industrial organizations moved from ?
piece-work payment systems to wages,
single efforts to multiple operations,
individual production plants to vertical integrated businesses,
and individual businesses to multi-divisional organizations.
92
They were also criticized for ?
encouraging short-term decision-making as well as for their inapplicability to modern manufacturing techniques.
92
These concepts can be grouped as follows:
profitability
liquidity
utilization
financial structur
einvestment–shareholder ratios
92
Return on equity (ROE):
Calculates the earnings over a shareholder’s equity.
It measures a corporation’s profitability by revealing how much profit a company generates with the money shareholders have invested.
92
The extent to which financial information must be disclosed is dependent upon?
the public or private character of the company, its size, and whether the company is listed on a stock exchange or not.
93
Return on investment (ROI):
Represents the after-tax return which owners are receiving on their investment and should be compared with alternative forms of investment.
93
Although the use of specific accounting-based performance figures depends very much on?
the objective and specific context, some performance measures have gained prominence and are frequently used.
94
In this unit we will review some of the traditional models of performance measurement with a focus on financial key figures before we draw our attention to some of the more recent approaches to performance measurement.
Reviewing Traditional Models of Financial Performance Measurement
95
From this list of traditional performance measures, many analysts and investors tend to focus on ?
ROE as a primary measure of company performance. As a result, many executives also strongly focus on this metric, recognizing that it is the one that seems to get most attention from the investor community. On the other hand, ROE can obscure a lot of potential problems.
96
If investors are not careful, it can divert attention from?
business fundamentals.
97
The minimum accounting-based financial information for any business is compiled in the form of ?
periodic financial statements which consist of (at least) a balance sheet and a profit and loss statement.
97
In this unit we will review some of the traditional models of performance measurement with a focus on financial key figures before we draw our attention to some of the more recent approaches to performance measurement.
Reviewing Traditional Models of Financial Performance Measurement
97
The extent to which financial information must be disclosed is dependent upon?
the public or private character of the company, its size, and whether the company is listed on a stock exchange or not.
97
If investors are not careful, it can divert attention from?
Growing debt leverage and stock buybacks, funded through accumulated cash, can help to maintain a company’s ROE even if operational profitability is eroding. Mounting competitive pressure combined with artificially low interest rates, characteristic of the last decades, creates a potent incentive to engage in these strategies in order to keep investors happy.
business fundamentals.
97
Current management accounting developed in the US between the 1850s and 1920s when industrial organizations moved from ?
piece-work payment systems to wages,
single efforts to multiple operations,
individual production plants to vertical integrated businesses,
and individual businesses to multi-divisional organizations.
98
Organizations can resort to financial strategies and therefore artificially maintain a healthy ROE temporarily while?
hiding deteriorating performance in business fundamentals.
99
Mounting competitive pressure combined with ?
artificially low interest rates,
characteristic of the last decades,
creates a potent incentive to engage in these strategies in order to keep investors happy.
99
Return on investment (ROI):
Represents the after-tax return which owners are receiving on their investment and should be compared with alternative forms of investment.
99
Organizations can resort to financial strategies and therefore artificially maintain a healthy ROE temporarily while?
hiding deteriorating performance in business fundamentals.
99
The extent to which financial information must be disclosed is dependent upon?
the public or private character of the company, its size, and whether the company is listed on a stock exchange or not.
99
These concepts can be grouped as follows:
profitability
liquidity
utilization
financial structur
einvestment–shareholder ratios
100
The minimum accounting-based financial information for any business is compiled in the form of ?
periodic financial statements which consist of (at least) a balance sheet and a profit and loss statement.
100
They were also criticized for ?
encouraging short-term decision-making as well as for their inapplicability to modern manufacturing techniques.
100
After World War I, companies such as du Pont, Sears Roebuck, and General Motors started to use sophisticated budgeting and management accounting techniques, such as?
standard costing,
variance analysis,
flexible budgets,
return on investment,
and other key management ratios.
From these beginnings, the use of budgets spread widely.
100
Although the use of specific accounting-based performance figures depends very much on the objective and specific context, some performance measures have gained prominence and are frequently used.
100
100
Return on equity (ROE):
Calculates the earnings over a shareholder’s equity.
It measures a corporation’s profitability by revealing how much profit a company generates with the money shareholders have invested.
100
Growing debt leverage and stock buybacks, funded through/
accumulated cash, can help to maintain a company’s ROE even if operational profitability is eroding.
100
Current management accounting developed in the US between the 1850s and 1920s when industrial organizations moved from ?
piece-work payment systems to wages,
single efforts to multiple operations,
individual production plants to vertical integrated businesses,
and individual businesses to multi-divisional organizations.
100
Cash flow:
There are different definitions for cash flows and different types of cash flows (e.g. free cash flow, operational cash flows, etc.). For practical purposes earnings plus depreciations can be used as a simple approximation.
100
Although the use of specific accounting-based performance figures depends very much on?
the objective and specific context, some performance measures have gained prominence and are frequently used.
100
image
101
From this list of traditional performance measures, many analysts and investors tend to focus on?
ROE as a primary measure of company performance. ?
102
As a result, many executives also strongly focus on?
this metric, recognizing that it is the one that seems to get most attention from the investor community.
103
On the other hand, ROE can obscure a lot of potential problems. If investors are not careful?
it can divert attention from business fundamentals. Organizations can resort to financial strategies and therefore artificially maintain a healthy ROE temporarily
while hiding deteriorating performance in business fundamentals. Growing debt leverage and stock buybacks, funded through accumulated cash, can help to maintain a company’s ROE even if operational profitability is eroding.
104
Mounting competitive pressure combined with artificially low interest rates, characteristic of the last decades, creates?
a potent incentive to engage in these strategies in order to keep investors happy.
105
If underlying profitability continues to deteriorate, ---------------------------------------------------------------------------------will be necessary to maintain an attractive return on equity.
more stock buybacks or debt leverage
106
Therefore, the company is increasingly vulnerable to?
unanticipated downturns in consumer demand or financial market crises.
107
But allowing ROE to decline is often too ----------------------------to contemplate, since the impact on stock performance can be --------------------. The ----------on the other side are less immediate and less quantifiable, so there is an understandable temptation to avoid -------------------------------- in this way.
painful
immediate
risks
immediate pain
108
These issues with ROE led some companies to?
pick a different bottom-line metric for corporate financial performance.
109
This is return on assets (ROA) which receives far less attention from?
executives and investors alike when seeking to analyze long-term profitability trends across all public organizations.
110
Return on assets avoids the potential distortions created by?
financial strategies such as those mentioned above.
111
At the same time, ROA is a better metric of financial performance than?
income statement profitability measures such as return on sales. ROA explicitly considers the assets used to support business activities.
112
It determines whether the organization is able to?
generate an adequate return on these assets, rather than simply showing robust return on sales.
113
Asset-heavy business organizations need a higher level of?
net income to support the business, whereas asset-light organizations can generate a very healthy return on assets on thin margins.
114
Many organizations outsource asset intensive manufacturing and logistics operations to more?
specialized providers in an effort to create ‘asset-light’ businesses.
115
Those assets have not gone away-they have simply shifted from one organization to another. Someone has to earn a reasonable return on those asset investments. Even intrinsically ‘asset-light’ businesses have some limited current and fixed assets required to?
support the business.
116
Using ROA as a key performance metric quickly focuses management attention on?
the assets required to run the business.
117
The key question is who is in the best position to earn the highest return on those assets?
This question helps executive teams to focus their own operations more intently on the activities and assets they are best qualified to manage and to branch out other activities and assets to more specialized organizations.
118
This is a powerful alternative form of leverage, namely -------------------------------------. Excessive f
capability leverage.
119
inancial leverage can become a ?
large and inescapable burden in an economic downturn.
120
Capability leverage, in contrast, supports?
a business through all phases of the economic cycle.
121
Due to the scale and diversity of their operations, specialized outsourcing providers can supply?
key assets and capabilities quickly and more profitably to help companies ramp up their production rapidly during an economic upturn.
122
Variable cost outsourcing arrangements support scaling back during ------------------------. That said, readily available financial leverage often helps to -------------------------------------------------, leading many companies to neglect the potential of-----------------------------------------------.
downturns
increase returns for shareholders
capability leverage
123
In addition to the abovementioned ‘traditional’ accounting-based performance measures?
(in particular ROE and ROA), other key financial performance indicators are used and monitored widely.
124
Stock turnover-days:
Reflects the number of times inventory is sold or used in a
time period. The lower the ratio, the quicker the stock is sold.
125
image
126
This ratio can be used to calculate the average days it takes to sell the inventory:
image
127
Receivables turnover ratio:
Reflect average length of time from sale to cash collection. The lower the ratio, the quicker an account is paid. From a cash flow perspective, it is important to keep the time lag to a minimum.
128
image
129
The average days to collect receivables can be calculated as:
image
130
Current assets\/liability ratio:
Indicates the extent to which current assets cover current liabilities and is a way to measure the ability to meet short-term obligations. The rough rule of thumb is a ratio of 2:1. That is for every €1 of liabilities (within 12 months), there should be at least €2 in current assets to meet such liabilities.
131
image
132
Debt\/equity ratio:
This is a way to measure the extent to which a business relies on external borrowings to fund its ongoing operations. The higher the ratio, the more heavily debt financing is used. In order to provide a reliable measure, assets should be valued at market value.
133
image
134
image
135
Interest coverage ratio:
Provides a way to measure the ability of the business to meet its interest commitments through profits and is linked to the debt\/equity ratio. The rough rule of thumb used by banks is a ratio of 3:1. That is earnings before interest and taxes (EBIT) exceeding interest expense threefold.
136
Gross profit margin:
An indication of the profitability of the business and a reflection of control over cost of goods sold (COGS) and pricing policies. This ratio should be compared to prior periods and to any available industry data.
137
image
138
Breakeven sales:
Reflects the sales which need to be generated in order to cover expenses. In other words, this is the level of activity at which neither profit nor losses are incurred, or where total costs equate with total revenue. This is a very important ratio which every business should monitor on a monthly basis.
139
In addition to these metrics which are mainly based on ?
historical annual totals, one of the key financial performance indicators an organization should prepare on a monthly basis is a profit and loss budget for at least a 12-month period.
140
It is vitally important to assess the impact that these projections have on?
the future cash flow of the business.
141
Budgets should be compared to ?
actual results and variances acted upon on a timely basis.
142
The following table shows an example of a profit and loss budget.
143
table Example of Profit and Loss Budget
144
table
145
table
146
Excepting this budget, all of the different accounting-based financial measures are?
retrospective and depict the company’s performance over the past year or several previous years.
147
This is one of the most criticized aspects of accounting-based performance measures:
-they only reflect a company’s former achievements which are not always indicative of future developments.
-These measures show the results of the business after events have occurred and as such are ‘lagging’ indicators.
148
In addition, accounting-based measures have further weakness. Since some accounting rules are not static and leave room for interpretation, accounting measures can be?
misleading, if they have been ‘massaged’ or ‘window dressed’ in such a way that they do not provide a true reflection of the company’s results.
Especially when it comes to the comparison of performance figures between companies from different countries, accounting-based measures reveal another weakness.
149
Accounting principles (e.g. US-GAAP and IFRS) can differ significantly from country to country with respect to?
goodwill, taxation, valuation of inventories, and capitalization of losses.
150
This inevitably leads to different performance figures. As a result, it could be possible that
the same company reports a loss based on one country’s accounting principles and a gain based on another set of accounting principles.
151
To overcome the weaknesses of accounting-based measures, there is a need for ?
more frequent reporting periods and to gather more essential data as well as making use of other financial and non-financial indicators.
152
simple examples of alternative indicators could be?
number of enquiries, number of customers per day, average sales value, number of quoted jobs lost, customer satisfaction, etc.
153
Thus, for more accurate results, financial statements and other key performance indicators (KPIs) should be?
prepared on a regular and consistent basis and compared with earlier periods.
154
Monitoring performance via using successive monthly or quarterly accounts can show?
trends that otherwise might not be apparent.
155
Knowing the financial position becomes?
even more important as the business grows.
156
Lack of precise and timely knowledge of the current financial position can lead to?
business failure and have other consequences for the owners, stakeholders, and employees.
157
Performance Measures
158
Market-Based Performance
MeasuresMarket-based measures of financial performance are completely different from?
accounting-based metrics.
159
While accounting-based performance measures focus on?
the companies past performance, market-based measures reflect the present value of future streams of income.
160
These figures fluctuate daily and incorporate?
internal as well as external factors and developments in the valuation.
161
Market Value Added and Total Market Value
image
162
A central concept of market-based performance figures is ?
market capitalization, which is defined as the total market value of all shares of a company.
163
The current market capitalization can be calculated by ?
multiplying the number of shares of a company with the current price per share on the stock market.
164
If the market capitalization plus the market value of debt (i.e. -------------------------------------------------) is higher than the capital contributed by investors (------------------------------------------), the management of the company has created value and this additional value is called ------------------------------------------------------(MVA).
total market value of a company
both equity and debt
market value added
165
(MVA) is simply calculated as?
the difference between the company’s market capitalization and the shareholders’ equity plus debt.
166
The shareholders’ equity is made up of?
the share capital and any retained profits of the organization.
167
Both figures are important information, but as we will learn in the next section, the idea of market capitalization and market value added has laid the foundation for?
other more recent non-accounting-based performance concepts.
168
However, before we introduce these concepts, we will focus on some of the traditional market-based performance measures. The most common measures are as follows:
-Price-to-book ratio (P\/B ratio):
-Price-to-earnings ratio (P\/E ratio):
-Dividend yield:
169
Price-to-book ratio (P\/B ratio):
This ratio is used to compare a stock’s market value with its book value. It is calculated by dividing the current market capitalization by the latest quarter‘s book value of the shareholders’ equity.
170
image
171
Price-to-earnings ratio (P\/E ratio):
A valuation ratio of a company’s market capitalization to its earnings.
172
image
173
Alternatively, this ratio can also be calculated as the current share price divided by?
the per-share earnings (EPS).
174
The P\/E ratio is sometimes referred to as the ‘multiple’, because it shows?
how much investors are willing to pay per dollar of earnings.
175
If a company were for example :
trading at a multiple (P\/E) of 20, the interpretation is that an investor is willing to pay €20 for €1 of current earnings.
176
Dividend yield:
This figure shows how much a company pays out in dividends each year relative to its share price. In the absence of any capital gains, the dividend yield is the return on investment for a stock.
177
image
178
In general, high measures indicate well-performing companies. But this is not always the case and depends very much on?
the circumstances and on the sector a company is operating in.
179
For example, :
a high P\/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P\/E and it can be a sign of the quality of the management.
However, it also might reflect the poor quality of present performance.
180
Usually, it is better to consider market-based performance measures in relation to?
the entire stock market (national or international), against an industry average, or a subset of organizations in a particular industry.
181
The comparison with the company’s industry is also referred to as?
peer group analysis.
182
To conclude this section there are in addition to the typical market-based measures mentioned above other measures which are not necessarily limited to performance measurement, but are worth mentioning in this context as well. They mainly focus on the performance of ?
individual projects or investments which will ultimately influence the overall performance of an organization.
183
Both measures are based on?
discounted cash flows and to some extent use market-based values.
184
-Net present value (NPV):
-Internal rate of return (IRR):
185
Net present value (NPV):
This metric calculates the difference between the present value of cash inflows and cash outflows (Ct) over a period of time (t). It is primarily used in capital budgeting to analyze the profitability of a specific investment or project and is sensitive to the reliability of future cash inflows that an investment or project will yield and the expected rate of return (r).
186
image
187
If the net present value of a potential project or investment is positive, it should be?
accepted.
188
On the other hand, if the net present value is negative, the project should be?
rejected because it does not create value for the organization.
189
Internal rate of return (IRR):
The internal rate of return is often used in capital budgeting. It is the exact interest rate (r) which makes the net present value (NPV) of all cash flows from a particular project equal to zero.
190
Generally speaking, the higher a project’s or an investment’s internal rate of return, the more?
desirable it is to undertake the project or investment.
191
In this context, the IRR can be used to?
prioritize several potential projects a company is considering.
192
Assuming all other factors are equal among the various projects, the project with the highest internal rate of return would probably be?
considered the best and undertaken first.
193
Seen from a different angle,----can be viewed as the rate of growth a project is expected to generate. Although, in many cases, the actual rate of return that a given project or investment ends up ------------------------------, will often differ from its---------------------.
IRR
generating
estimated IRR
194
However, it can be expected that a project with a substantially higher IRR value than other available options would?
still provide a much better chance of strong growth.
195
To illustrate the application, the following table shows an example of net present value and internal rate of return calculation for a potential project or investment.
Example of Internal Rate of Return and Net Present Value
196
The table shows the estimated cash flows for years one to five. For ----------------------,
both projects
197
the calculation of the NPV is based on?
an interest rate (r) of 10 %.
198
Since the IRR of is higher than 10 % in both cases, the NPV is ?
positive.
199
Current Trends and Drivers for Performance Measures
Since the introduction of performance measurement as its own discipline, more and more organizations have been taking steps to?
improve their performance measurement capabilities in the light of altered economic and market conditions and new management needs.
200
For example,
new regulatory constraints such as those related to payment-card issuing and processing are affecting the underlying economics of businesses.
201
Capital requirements are increasing for?
most financial and banking businesses.
202
New channels such as mobile phones are becoming more important. Revenue growth continues to be?
difficult to achieve due to weak economic conditions, low interest rates, and regulatory restrictions.
203
Organizations are trying to improve their management of the cost-effectiveness ratio, deepen relationships with?
customers and enhance product mix and pricing decisions.
204
These and other factors are causing organizations to ?
re-examine and improve the ways in which they measure and recount business performance.
205
The following key areas of performance management are emphasized and marked as central trends which are emerging across the business world:
=reviewing and enhancing organizational management profitability and the methodologies of recounting them
=emphasizing the use of business-unit key performance indicators
=refining customer- and channel-profitability measurement and analytics
=improving alignment of the components of the performance management process
=improving systems support and automation of the performance management process
=improving data quality and consistency
206
As these trends and needs indicate, traditional performance measures are not able to cover all of these requirements. The following sections will introduce
some of the more recent performance measurement concepts addressing these needs.
207
The Economic Value Added (EVA) Metric
As highlighted in the previous section, traditional performance measures have been subject to?
growing criticism and have been largely outgrown by current management needs.
208
Especially in the 1980s, researchers found empirical evidence that?
there is little correlation between historical accounting earning and shareholder value.
209
This highlights that accounting measures are not the only driving force for?
stock market performance of a company.
210
In order to address this critique, analysts, consultants, and researchers have been searching for?
performance measures which are more aligned with the corporate strategy and the long-term value creation.
211
One of the solutions discussed is the shareholder value concept, which is based on ?
the simple idea of measuring the value a company creates or destroys by subtracting a capital charge from the cash returns generated on the capital invested.
212
This is supposed to give an incentive to decision-makers when?
evaluating new projects or business opportunities to view them from an economic profit perspective.
213
Economic profit focuses on?
the returns generated and is different from accounting-based profit,
since it takes into account opportunity costs of the capital employed in the enterprise.
214
The concept of-------------------------------------------------expands this approach and additionally builds on the ---------------------------- concept.
economic value added (EVA)
residual income
215
Residual income measures how much?
profit reamains for investment in the business or distribution to the owners after subtracting expected returns on investment.
216
It is generally defined as the accounting profit minus a charge for capital used to generate?
returns (this is more a conceptual than precise definition of residual income and we will come back to it later in this section):
217
image
218
It is expected that a positive residual income should help to ?
increase the total market value of an organization because a positive residual income indicates that a company is accumulating profits at a greater rate then it needs to accummulate in order to satisty the providers of capital.
219
Consequently, the residual income concept has shifted focus from a total profit perspective to?
a ‘net’ profit view that takes into account expected capital returns.
220
The EVA model expands the---------------------------concept further and tries to measure the difference between the---------------------- made during a period and the ------------------of all resources valued in economic terms consumed in the same period.
residual income
revenue
costs
221
Discounting the stream of all the expected future improvements in EVA helps to?
explain the difference between the total market value of an organization and its debt plus equity capital. In other words, the market value added (MVA) is the present value of all future EVA.
222
Market Value Added and Economic Value Added
image
223
In order to get to a true economic view, adjustments to the -------------------------------------------------------------- need to be done.
values from the accounting world
224
Stern Stewart has identified?
164 adjustments which can be applied to both the profits and capital employed before arriving at the EVA.
225
Since the adjustments proposed are very specific and focus on?
typical accounting issues, we will not go into details
but instead present the main idea of EVA and how it differs from traditional approaches.
226
Since the adjustments proposed are very specific and focus on?
typical accounting issues, we will not go into details
but instead present the main idea of EVA and how it differs from traditional approaches.
226
The two main differences are:
1-Inclusion of capital costs:
2-Post-tax profits:
3-Interest is not deducted:
227
Inclusion of capital costs:
One of the key features of the EVA model is that it brings balance sheets and therefore cash flow variables into the profit and loss account by charging the organization’s cost of capital as a percentage of the assets employed in the business before the bottom-line profit is calculated.
228
Post-tax profits:
Another main feature of EVA is its focus on post-tax profits rather than operational profit. This incentivizes management to actively take this part into consideration when managing the profit and loss account. Althoug this sounds like a simple modification, for the practical implemention the tax issues add a significant layer of complexity to the EVA model. The resulting number is usually called net profit after tax (NOPAT).
229
Interest is not deducted:
In order to avoid double accounting interest, paid for capital is not deducted from the revenues but it is included in the capital charge for both equity and debt (net working capital).
230
The following table shows the calculation of?
EVA-based profit in comparison with the traditional calculation.
231
Comparison of Traditional and EVA-Based Profit Calculation
image
232
Calculating the Economic Value Added and Other Related Measures
In the previous section we have discussed the main ideas and basics of the economic value added (EVA) model. Earnings before interest and taxes (EBIT), as well as the net operating profit after taxes (NOPAT), are two important measures on the way to EVA calculation.
However, there are other related figures worth mentioning in the context of EVA since they are commonly used. These figures provide an additional and somewhat more precise ‘route’ to arrive at the EVA and highlight the dependence on, yet difference from accounting-based measures.
233
To explore the relationships between various non-traditional measures, one should commence by?
defining a concept of earnings before extraordinary items (EBEI) and then discuss all the additional components required to calculate the measures which lead to the EVA.
234
An organization’s EBEI could be defined as follows:
image
235
where:
CHECK THE WEBSITE
EBEIt is the earnings before extraordinary items and tax for period
t,CFOt is the net cash from operating activities, and
accrual stands for the total operating accruals of the organization.
236
The difference between EBEI and the net operating profit after tax (NOPAT) is that?
NOPAT does not take the after-tax interest expense into account, while EBEI does.
237
Therefore:
image
238
where:
ATIntt is the interest expense after provision for tax.
239
While EBEI makes provision for the cost of debt by?
subtracting the interest expense, residual income (RI) is calculated by deducting the cost of the total (i.e. debt and equity) capital.
240
Organizations which achieve positive RI values are able to generate?
profits in excess of their total cost of capital and consequently shareholder value should be created.
241
Negative RI values are an indication that ?
insufficient profits are generated, and as a result, shareholder value could be destroyed.
242
Finally, EVA is calculated in?
a similar way as RI.
243
The major difference between the two measures relates to?
a number of adjustments to NOPAT and IC.
244
These adjustments are included in the calculation of EVA.
image
245
where
AcctAdjop;t is adjustments to remove the accounting distortions from operating profit, and
AcctAdjc;t is adjustments to remove the accounting distortions from invested capital.
246
Alternative Value-Based Financial Performance Measures
In addition to the EVA concept, a number of value-based financial performance measures have been developed in?
an attempt to guide management actions towards achieving the maximization of shareholder value and ensure that all activities generate positive net present values.
247
All of these value-based measures attempt to include ?
an organization’s cost of capital and to adjust financial statement information in order to remove some of the accounting distortions contained in traditional financial performance measures.
248
Performance exceeding the cost of capital is certain to produce value, while the failure to achieve this will result in?
the destruction of shareholder value.
249
Advocates of value-based financial performance measures present those theories as?
a major improvement over the traditional performance measures.
250
Most importantly, by including an organization’s cost of capital in their calculation, they can be applied to assess?
the value creating potential of an organization.
251
If the returns generated by an organization’s projects are in excess of ?
the cost of capital, these projects will generate positive net present values and consequently shareholder value is increased.
252
These value-based management approaches also attempt to overcome?
some of the problems associated with traditional measures.
253
Accounting distortions contained in?
the financial statements are being removed.
254
Cash value added (CVA) is ?
another well-known performance measure and serves as an alternative to economic value added.
255
Cash value added is considered to be?
another form of residual income.
256
This measure calculates the difference between an organizations’ operating cash flow and?
a capital charge based on the gross amount of invested capital.
257
One of the major differences between CVA and EVA is?
that depreciations and accruals are added when calculating the operating cash flow values in CVA.
258
Furthermore, accumulated depreciation is included in ?
the invested capital amount when the gross invested capital is determined.
259
The calculation of CVA is less complex than?
the calculation of EVA since no accounting adjustments are required.
260
Since depreciation is added back during the calculation of?
the CVA, the measure is not influenced by an organization’s depreciation policy.
261
This characteristic of CVA can be seen as?
an advantage over EVA where different depreciation policies can result in large variations in the value of the measure.
262
At the same time, there are a number of limitations with regard to CVA:
=some researchers are of the opinion that EVA can be considered a better financial measure than CVA.
= They also argue that the problem of different depreciation policies in the case of EVA can be solved by including an accounting adjustment.
263
Furthermore, there is an indication that if accruals and depreciation are removed from the calculation of CVA, the measure may lose ?
important information required by the market when evaluating an enterprise.
264
The process of removing the effects of accounting accruals in the calculation of CVA could also be?
relatively complex.
265
Moreover, the incorporation of CVA values into valuation models should be undertaken with special care, since CVA is based on?
historical accounting figures which do not represent the expected future cash flow generated by the enterprise.
266
Cash flow return on investment (CFROI) has been presented by its proponents as?
an improvement over some of the other traditional and value-based measures.
267
It is calculated by considering the inflation-adjusted investment in assets, the inflation-adjusted cash flow generated by?
employing these assets in the organization, and determines the yield generated over the estimated lifetime of the assets.
268
The calculation of CFROI is based on ?
basic discounted cash flow principles.
269
The four inputs required to calculate the measure are as follows:
=the average life of the depreciating assets
=the total amount of assets (includes both depreciating as well as non-depreciating assets) adjusted for inflation
=the inflation-adjusted cash flows generated by the assets over their lifetime
=the final inflation-adjusted residual value of the non-depreciating assets at the end of the asset lifetime
270
The company’s cash flow return on investment (CFROI) value is calculated as?
the discount rate which would ensure that the present value of all the future cash flows (i.e. the equal annual inflation-adjusted gross cash flows, as well as the terminal non-depreciating assets amount),
is equal to the initial investment (i.e. total non-depreciating and depreciating assets).
271
As such, the CFROI may be viewed as a return on investment (ROI). However, it is not ?
calculated for individual projects, but rather for the firm as a whole.
272
The cash flow return on investment is compared to the organization’s ---------------------------------- (real) cost of capital. If an organization is able to generate------------------------ values in excess of its ------------------------------ cost of capital, it should increase its shareholder’s value. CFROI values below the-----------------------------------will result in the destruction of shareholders’ value.
inflation-adjusted
CFROI
inflation-adjusted
real cost of capital
273
One of the characteristics of this measure is that it focuses on?
the return offered to all the capital providers of the organization and not only to shareholders.
274
On the other hand, relatively little empirical research has been conducted on?
the performance of CFROI in comparison to other financial performance measures.
275
Basic Shared Elements of Value-Based Management
In addition to the main conceptual foundations that value-based performance measures share,?
some common operational elements can be identified.
276
This includes the organization’s management, which can be thought of as a three-stage-process:
--gain understanding of value creation in each business
--transform the company to align it with the ultimate goal of shareholder value maximization
--communicate results internally and externally
277
It is understood that value creation is the central theme of value-based management and shareholder value is created when?
future cash flows with a positive net present value exceed expectations.
278
From a management perspective, the main focus is on?
value drivers which ultimately increase shareholder value.
279
In many cases these drivers are thought of in ------------------------terms. All aspects and activities of the organization need to be brought in line with -----------------------------------------------------.
financial
shareholder value maximization
280
After an initial analysis, phase actions must be untertaken to create and preserve?
shareholder value and allign the company with its overall goal.
281
This is clearly the management component of the----------------------------------------------- process.
value-based management
282
For the practical implementation of this process, several techniques such as ---------------------------------------------------------------------------------------------------are used. In many cases, specific reward and compensation plans are also developed to
---------------this process.
portfolio management and competitive advantage frameworks
back
283
A traditional managerial bonus plan awards a target bonus for meeting expectations. These expectations can be linked to share price or any other metric. The size of the bonus to be earned by exceeding expectations is ?
capped.
284
The cap controls costs, but it provides no?
incentive to improve performance above a certain level.
285
Sub-par performance is punished by ?
reducing the bonus with no further disincentive once the bonus bottoms out at zero.
286
A value-based bonus plan can also include?
a target bonus plus a fixed percentage of excess value added improvement (since value-based metrics are measured in currency and can be positive or negative).
287
The fixed percentage component results in an uncapped bonus level on ?
the upside or the downside.
288
Removal of the upside cap creates ?
an unlimited incentive for improvement.
289
The removal of the downside cap could theoretically result in ?
a negative bonus, but the bonus bank eliminates that possibility.
290
With a bonus bank, a portion of any bonus exceeding the target bonus is banked for?
payout in future years.
291
Therefore, managers can still get a bonus in years when?
value added metrics decline more than expected, which lessens retention risk.
292
For any given year, no bonus is paid if the bonus bank balance is negative due to ?
long-term decreases in value added performance.
293
Although such a bonus model has advantages over traditional measures, it still has three major limitations:
==The bonus plan can backfire if the corporate or national culture spurns strong wealth incentives. Older managers near retirement may see strong wealth leverage as too risky.
==In highly cyclical industries, it is difficult to create strong wealth leverage while avoiding large negative bonus bank balances in downtimes. This can only be achieved by setting compensation above market levels which results in a high cost to shareholders.
==In start-up companies or emerging markets, EVA is not the best performance metric.
294
Communication is:
the third and last step in value-based management.
While specific to various aspects of internal and external communication, good, clear communication is sort of a holistic approach which especially stresses the question of how everybody in the company can contribute to the overall goal of the organization.
295
Comminication efforts outside the company need to be?
very well coordinated and are part of the value realization process.
296
Good and clear communication to the------------------------------------- is crucial.
financial markets
297
In addition to these practical and more operational steps, value-based management is generally embedded in ?
an ethical framework for achievement in business.
As such, this management system balances individual values with economic values.
298
Three notions of value according to value-based management are:
==a foundation of shared ethical values-starting with a belief in the intrinsic value of each person (each employee, customer, and supplier).
==success in the marketplace based on delivering maximum value (higher quality at lower prices) to the customer.
==rewards based on the value people contribute to the organization; as individuals and as a team, as employees and as owners.
299
The ethical and material aspects of value can be realized in a business by?
creating structures of corporate governance and management based on shared organizational values,
300
as expressed in a written set of:
-organizational core values (i.e. ethical principles which define the culture and clarify the social purposes of the organization);
-a code of ethics (i.e. a set of encouraged habits to guide individual behavior toward strengthening the organization’s culture and interpersonal harmony).
301
Ideally these core values and codes of ethics are agreed upon by ?
every person in the organization and are subject to periodic review and improvement.
302
These values serve as the ‘------------------------- for guiding corporate objectives, ---------------------, and other decisions.
They also provide a basis for judging ---------------------------------------.
compass’
policies
people’s behavior
303
Another aspect is maximizing value for ?
the stakeholders and customers by increasing quality and\/or decreasing price.
304
Within a value-based culture, everyone in the organization recognizes ‘service to the customer’ as?
a primary goal.
305
This simple formula becomes the core strategic task for any business that desires to succeed in ?
the competitive marketplace.
306
As mentioned, structuring the company’s compensation and reward system therefore enables each person in the organization to be?
This theory states that a person’s returns are based on performance and contribution, not charity.
rewarded for the value of their contributions and inputs.
307
This is one of the fundamental aspects of
----------------------. It reflects the ‘correct’ principle of ------------------------------- and is contained within the------------------------- theory of economic justice.
ownership
distributive justice
Kelso-Adler
308
This theory states that a person’s returns are based on?
performance and contribution, not charity.
309
Basic value-based management compensation and reward systems might include:
--monthly, bimonthly, or quarterly bonuses linked to each worker’s profit centre within the company
--annual, corporate-wide performance bonuses based on formulas tying each worker’s contributions to overall organizational profits
--a structured, profit-based program of shared ownership (i.e. annual ESOP contributions) supplemented by cash dividend payouts to reinforce ownership awareness
310
Value based management is designed to ?
‘institutionalize’ shared responsibility and shared risks as well as shared rewards within the organization’s ongoing structures and processes.
311
The key management areas affected by the value based management transformation process include:
1corporate values and vision
2leadership style and skills
3corporate governance
4‘open book’ management
5operations (policies and procedures)
6communications and information sharing
7training and education
8payment and rewards
9grievances and adjudication
10collective bargaining with labor unions
11employee shareholder education and participation
12future planning
312
Experiences from a growing number of organizations indicate that?
the more people’s self-interests are unified within a management system which is reflecting the principles of value-based management, the greater customer and employee satisfaction will be.
313
This can lead to?
a flow of increased cost savings, increased sales, and increased profits.
314
Summary and Pros and Cons of the Economic Value Added Model
After broadening the idea of value-based management, we want to return to the economic value added (EVA) model at the end of this section by summarizing the main advantages and limitations of this concept.
315
Considered alongside similar value-based measures metrics, the EVA metric can overcome some significant shortcomings of other approaches such as:
==Traditional income measures, including net income and earnings per share, can be easily manipulated and they do not account for the cost of equity.
==Market-based measures, including market value added (MVA), excess return, and future growth value (FGV) can only be calculated for publicly-traded entities.
==Cash flow measures, including cash flow from operations (CFO) and cash flow return on investment (CFROI) include neither the cost of equity nor the cost of debt.
316
Additionally, calculating economic value added for private entities or for divisions within companies can also be used as?
a motivational tool on several levels of hierarchy within an organization.
317
Traditional managers understand that their organizations need to control ----------------------------------------------------------------------. However, many organizations must compete in the capital markets by keeping their cost of capital --------.
operating costs and succeed in commercial markets
low
318
Paying managers for performance is a ------------------------------------ practice, since the -------------------------------------------assign value on a forward-looking basis. Therefore, organizations which pay their managers for past performance may
-----------------------pay to undermine value creation.
backward-looking
capital markets
unwittingly
319
An organization willing to implement EVA-related performance measurement throughout its business has to?
recognize the importance of all affected employees understanding the common goal as well as how their actions contribute to meeting it.
320
In this respect, the EVAs’ popularity corresponds with ?
the trend of ‘total quality management’,
which was established in the 1980s.
321
Like quality, value is every employee’s responsibility. Therefore, management and employee training programs are?
crucial components of any EVA plan.
322
The shareholder value approach has-----------------in importance over the last years. Academics and practitioners, mention several benefits of the ------------------------------ in the context of shareholder value management. As a ------------------------------------measure, it allows for an annual measurement of ------------------------------------------------------------------------------- performance.
increased
EVA concept
single-period
actual, non-estimated or forecasted value-created
323
The EVA corresponds more closely to?
economic profit than accounting measures do, and as a result, it is consistent with shareholder interests.
324
Claims have also been made that the introduction of EVA measures can drive behavioral change by?
providing an incentive to promote shareholder interests as the main objective.
325
Going back to the observation that traditional performance measures do not correlate with?
stock prices, several studies have attempted to empirically prove the relationship between EVA performance measures and stock performance (i.e. shareholder value increase).
326
While some studies find support for this hypothesis, others have contradicted this conclusion, pointing out that EVA does not --------------------------------------------------. As such, there are indicators that EVA does not overcome all ---------------------------------------------------- measures.
influence stock market returns
limitations of traditional performance
327
Moreover, it can be said that EVA as a single period measure does not address the problem of?
the time period over which profits are to be maximized and it does not provide a strong enough incentive to avoid ‘short-termism’.
328
An additional critique stems from the fact that EVA is still tied to accounting derived figures such as?
the capital charge being based on the economic book value and thus strategic and market based aspects are neglected.
329
A final drawback of EVA is the -------------------focus of the model. It fails to consider the industry and ----------------------------------------- in which each organization operates and it does not give clear direction on how businesses can create sustainable value from a strategic -------------------------------------.
financial
competitive context
long-term view
330
We will return later to this aspect and explore how other performance measures, in particular the balanced?
scorecard, tackles these issues.
331
Additionally, it is worth mentioning that implementing EVA is a ----------------------- and very much ----------------------- process. Its practical application goes beyond pure account and
-------------- measures.
complex
company-specific
financial
332
Facets of Economic Value Added-Based Management
image
333
Companies are more likely to benefit from economic value added (EVA) if they adopt the following characteristics:
==The corporate structure consists of relatively autonomous business units, rather than one large unit or a matrix organization with substantially shared resources.
==Strong managerial wealth incentives are tied to business unit performance, rather than to corporate-wide goals (as with stock or stock options) or the discretion of the compensation committee.
==The CEO is an enthusiastic advocate. They go along with something that they fully understand and support. Economic value added implementation should begin at the top.
==Business unit heads are personally involved with the well-being of the organization and are thus motivated by long-term incentives.
334
Ultimately, it can be said that EVA-based management is a?
customer-focused system built upon shared principles and core values.
335
It is designed to?
instill an ownership culture in an organization.
336
Following on from the market-oriented theory of economic justice, this management system is?
triggered by ‘authentic leaders’ who actively seek to empower others; it is developed and sustained from the bottom up.
337
Furthermore, value-based management offers employees an opportunity to participate as?
first-class shareholders in the company’s equity growth.
338
This is achieved by monthly and annual profits on?
a profit centre basis.
339
Experience has shown that the encouragement of people, reinforced by?
a value based management culture, leads to an empowered workforce which makes better decisions, disciplines its own behavior, and works together more effectively.
340
Since each person contributes and therefore carries risks and shares as an owner as well as?
a worker, the value-based management helps unite everyone’s self-interest around the organization’s bottom-line and corporate values.
341
A well-designed EVA-based management system can sharpen ?
a new market philosophy around a set of universal business principles.
342
Through a participatory, company-wide process, the foundation is laid for ?
an on-going ownership sharing culture within an organization.
343
Such culture typically incorporates an?
employee stock ownership plan, individual and team performance feedback (i.e. formula-based cash profit sharing), ownership education, and sharing of financial information.
344
Furthermore, it contributes to ?
structured participatory management and governance.
345
EVA-based management builds checks-and-balances in the governance and accountability system to allow?
executives flexibility to make traditional executive decisions, while avoiding unworkable ‘management by committee’.
346
EVA is one of the basic factors of?
value-based management.
347
Value-based management goes beyond quantitative approaches and can be seen as?
an ethical framework for succeeding in business.
348
Value-based management is also related to?
the cash value added (CVA) metric as well as the cash flow return on investment (CFROI) metric.
