Section 9

Section

Operational, Financial and Strategic Measures of Performance

9

Part A Suggested References When studying this topic you should refer to the following resources: Primary Reference th

Garrison, R.H., Noreen, E., and Brewer P. C., Managerial Accounting, 11 edition, Chapters 10, 16 and 17. Supplementary References th

Atkinson, A.A., Banker, R., Kaplan, R.S. and Young, D.W., Management Accounting, 4 edition, 2003, Chapter 9. th

Brigham, Eugene F., and Houston, Joel F., Fundamentals of Financial Management, 9 edition, 1999, Chapter3. Epstein, Marc and Wisner, Priscilla, “Using a Balanced Scorecard to Implement Sustainability”, Environmental quality Management, Winter 2001 pp. 1-10. th

Hansen, Don R., and Mowen, Maryanne M., Management Accounting (8 ed.), South Western Publishing Co., Cincinnati, Ohio, 2007, Chapter 10 and Chapter 13. Horngren, C.T., Datar S.M., and Foster, G., Ittner, C. and Rajan, M. Cost Accounting: A th Managerial Emphasis, 13 edition, 2008, Chapter 13. Hurle, Mike, “Are You Balanced?”, A Plus, September 2005, pp. 29-32 Kimmel, P.D., Carlon, S., Loftus, J., Mladenovic, R., Kieso D.E., and Weygandt J.J., Accounting: Building Business Skill, John Wiley and Sons, Ltd, Australia, 2003, Chapters 10 & 11. Robinson, Thomas R., Munter, Paul, Grant, Julia, Financial Statement Analysis: A Global Perspective, 2004 White, Gwendolen, “How to Report a Company’s Sustainability Activities”, Management Accounting Quarterly, Fall 2005, pp. 36 – 43. Bibliographic References Kaplan, R.S. and D.P. Norton (1992). The Balanced Scorecard - Measures that Drive Performance. Harvard Business Review, January-February, 71-79. Kaplan, R.S. and D.P. Norton (1996a). The Balanced Scorecard: Translating Strategy into Action. Harvard Business School Press, Boston. Kaplan, R.S. and D.P. Norton (1996b). Using the Balanced Scorecard as a Strategic Management System. Harvard Business Review, January-February, 71-79. Kaplan, R.S. and D.P. Norton (1996c). Linking the Balanced Scorecard to Strategy. California Management Review, Fall, 53-69. Kaplan, R.S and D.P. Norton (2001a). Transforming the Balanced Scorecard from Performance Measurement to Strategic Management: Part 1. Accounting Horizons, March, 87-104. Kaplan, R.S and D.P. Norton (2001b). Transforming the Balanced Scorecard from Performance Measurement to Strategic Management: Part 2. Accounting Horizons, June, 147-1

Hong Kong Institute of CPAs Financial Management Module

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9-1

Part B Topic

Learning Outcomes

Operational, financial and strategic measures of performance:

On completion of this module, you should be able to:

•

Overall performance measures

•

Financial measures

•

Profitability

•

Economic value added (EVA )

•

Cash flow

•

Growth

•

Financial and operating ratios

•

Non-financial measures

•

The balanced scorecard

•

The performance pyramid

•

Reporting and evaluating sustainability

•

Agency theory and managerial incentive schemes

i)

Calculate financial, strategic and operational performance measures and understand the relationships between them.

ii)

Describe the role of cash flow analysis in the evaluation of the organisation’s strategic and operational plan.

iii)

Describe the interrelationships between shareholder wealth creation and performance measures aligned to that objective, including agency theory and its relationship to managerial incentive schemes

iv)

Identify financial and non-financial measures of business profitability including cash flow measures.

v)

Describe measures of entity growth.

vi)

List the main steps in translating strategies and plans into goals, recognising their interrelationships.

vii)

List the limitations of benchmarking in facilitating organisational change.

®

viii) Describe the relationships between financial and operating ratios and be able to interpret trends over time and across time. ix)

Explain the key components of the balanced scorecard.

You may choose to complete this topic in a step-by-step way or skip ahead, depending on your knowledge and assessment of your own competency in relation to the above Learning Outcomes.

Part C Contents of this Section 9.1 9.2 9.3 9.4 9.5 9.6 9.7 9.8 9.9 9.10 9.11 9.12 9.13

Introduction ........................................................................................................................ 2 Overall performance measures ......................................................................................... 3 Financial measures............................................................................................................ 4 Profitability.......................................................................................................................... 4 ® Economic value added (EVA ) .......................................................................................... 5 Cash flow ........................................................................................................................... 5 Growth.............................................................................................................................. 10 Financial and operating ratios .......................................................................................... 12 Non-financial measures ................................................................................................... 18 The balanced scorecard .................................................................................................. 19 The performance pyramid................................................................................................ 20 Reporting and evaluating sustainability............................................................................ 21 Agency theory and managerial incentive schemes.......................................................... 22

9.1

Introduction

In Section 8 we looked at designing and tailoring performance measures to suit the structure of an organisation. In this section we look at applying performance measures to an organisation to evaluate its financial, strategic and operational performance. First we consider the differences in performance measures and how to calculate some of the main types. The links between different types of measures are also examined. Secondly, cash flow analysis is presented, with a focus on its relevance to strategic planning and operational planning. Shareholder valuation techniques, ® such as EVA , are shown to be consistent with shareholder value maximisation.


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9-2

In the last part we analyse ratios, both in isolation and in conjunction with other ratios.

9.2

Overall Performance Measures

9.2.1

Alignment with Strategic Goals

Most management accounting commentators agree that a mixture of financial and non-financial measures is the appropriate methodology to judge business or business unit performance. This is known as the Balanced Scorecard approach (BSC) (Kaplan & Norton 1992). The performance measures should be aligned with the strategic goals of the organisation, which may be growth, profitability or survival. Both financial and non-financial performance measures are very important. 9.2.2

Comparisons and Benchmarking

In order to measure performance, there must be comparisons made: •

To the organisations past performance or budget;

•

Between divisions of the organisation; and

•

With the organisation’s competitors.

Benchmarking is a continuous and systematic process of evaluating the products, services and work practices of an organisation against businesses that are considered to be the best performers in the practice or industry (competitors). It is a continuous process that allows an organisation to consider its financial and strategic position relative to world’s best practice. The steps in benchmarking are as follows: •

identify the functions to be benchmarked;

•

select benchmark partners;

•

collect data and perform analysis to identify performance gaps;

•

establish performance goals to narrow performance gap;

•

implement plans.

Benchmarking provides the opportunity to compare performance across sites and between companies to give an indication of current best practice. Potential sources for gathering data are: •

newspaper articles/ business magazines and journals;

•

market research;

•

inter-firm comparison reports (from government bodies);

•

brokers/bankers or market analysts reports;

•

exhibitions, trade fairs; and

•

hiring of ex-employees.

Accurate and relevant information is often difficult to obtain, as it is likely to be closely guarded by competitors, yet can be used as a comparative tool.


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9-3

9.3

Financial Measures

Financial measures of performance are covered under the following headings: •

Profitability (section 9.4)

•

Economic value added (EVA™) (section 9.5)

•

Cash flow (section 9.6)

•

Growth (section 9.7)

•

Financial and operating ratios (section 9.8).

9.4

Profitability

9.4.1

Return on Investment (ROI) and Residual Income (RI)

In section 8 individual divisions were evaluated using ROI and RI. These techniques can also be applied to the organisation as a whole. 9.4.2

Return on Equity (ROE)

ROE measures the performance of the firm’s management in respect of their ability to invest shareholder’s funds (equity). The usual calculation of ROE is: Operating profit Equity Example: Assume two firms Company A and Company B with Operating Profit and Equity balances of: Company A

Company B

$2,500,000

$9,600,000

1,880,000

6,560,000

Fixed Costs

300,000

2,400,000

Operating Profit

320,000

640,000

Total Assets

6,000,000

13,000,000

Total Liabilities

4,800,000

11,400,000

Equity

1,200,000

1,600,000

Revenue Variable Expenses

Company A has ROE of 26.67% ($320,000/$1,200,000) and Company B 40% ($640,000/$1,600,000). ROE would suggest Company B is more profitable but it is important to consider the level of debt as this affects both the profit and the equity balances. The Du Pont Formula, introduced by the Du Pont Company in the USA in the 1920s, can be used to further decompose the ROE into its component parts. For more details, see Section 8.3.2 or any good Finance Text, such as Brigham and Houston (1999), Chapter 3.


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9-4

®

9.5

Economic Value Added (EVA )

1

®

EVA has become widely used by profit-seeking organisations in recent years. calculation is as follows: ®

=

EVA

Net operating profit after tax (NOPAT)

–

[Total assets less current liabilities]

x

The basic

Weighted average cost of capital

The cost of capital is the required or minimum rate of return necessary to compensate the firm’s capital contributors (equity investors and debt issuers) for the risk of the investment. Consider the following example. Information

$

Sales

3,200,000

Operating expenses

2,000,000

Operating profit before tax

1,200,000

Income tax at 16% Operating profit after tax Total assets less current liabilities

192,000 1,008,000 10,000,000

Cost of capital

6%

®

The EVA for this period is HK$408,000 because over this period, HK$408,000 of value has been added to the company’s value. (The charge for the cost of capital was 6% of $10,000,000 or ® $600,000). There are some differences in application of the EVA number. Some commentators use average capital over the period while others use beginning of the period capital. ®

It should be noted that there are more sophisticated EVA models advocated by Stearns and Stewart, the initial advocates of the method. However these models tend to be variations on the basic calculations above, and also suffer from the major problem with the calculation i.e. the numbers are based on accounting book values and do not necessarily reflect “true” economic value.

9.6

Cash Flow

9.6.1

Overview

The management of cash flow is very important as cash balances must be maintained at a sufficient level to ensure that enough cash is available to meet the organisation’s short-term cash disbursement requirements and investment in idle cash balances is reduced to a minimum. The organisation must be able to maintain inventories or pay for purchases (Just in Time); offer competitive credit terms, and meet its short-term and long-term operating and financing costs as they fall due. Failure to meet maturing liabilities on time makes the organisation technically insolvent. Holding excess reserves of cash is also potentially dangerous as it can result in a loss in profitability and it may increase the attractiveness of the organisation as a potential takeover.

1

EVA is a registered trademark of the Stern Stewart Corporation.


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9-5

9.6.2

Factors Affecting Cash Flows

Organisations experience irregular increases in their cash holdings due to external and internal factors. External factors affecting cash inflows include sale of securities, such as ordinary shares, preference shares, bonds and debentures or non-marketable debt contracts, including loans from commercial banks. These cash flows tend to be irregular because there are usually large sums of money involved. Other sources of cash arise from internal operations and occur on a more regular basis. These usually comprise receipts from accounts receivable collections, cash sales and sales of fixed assets. Decreases in cash arise from the payment of preference and ordinary dividends, interest and principal repayments on debt, taxation liabilities; acquisition of fixed assets; and purchases of raw materials and inventories for production. If excess cash becomes temporarily available, the organisation purchases marketable securities or where a cash deficit is forecast, a portion of the organisation’s marketable securities portfolio is liquidated or short term borrowings can be made. 9.6.3

Reasons for Holding Cash

There are three reasons for holding cash: First to pay transactions arising in the ordinary course of business. Secondly, for precautionary reasons as a buffer to satisfy potential cash needs. Thirdly, for speculative purposes in order to take advantage of potential profit making situations. 9.6.4

Cash Flows and Performance

Managing the organisation’s cash flow involves simultaneous and interrelated decisions regarding investments in current and non-current assets and the use of current liabilities. Cash flow measures indicate the dividend or debt-paying ability of the firm, the ability of the firm to provide for future growth opportunities and the general solvency of the firm. a)

Marginal Cash Flow

Marginal cash flow shows the net of the variable cash inflows generated by operations after financing the variable working capital used by these operations. Marginal cash flow is the difference between the margin of a product and the marginal working capital required to support the sale of the product which includes trade debtors and inventory, less trade creditors required for the next unit of product or service. It helps to indicate what is likely to happen to cash flow in the future if these fundamental relationships are maintained. The marginal cash flow (MCF) calculation is: MCF = contribution margin - change in working capital where the change in working capital is an increase in working capital. b)

Operating Cash Flow

Operating cash flow measures the cash generated from operations, less the cash invested to fund operations and indicates whether the business’ ongoing ordinary operations are providing cash towards paying interest, tax, dividends, etc. If operating cash flow is negative there is not necessarily a problem. The business may be investing in fixed assets for future growth. Operating cash outflows are funded by increased borrowings or equity. The operating cash flow (OCF) calculation is: OCF = EBIT - change in net operating assets


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9-6

c)

Net Cash Flow

Net cash flow is the real cash flow, the change in borrowings for the year. Depreciation and other non-cash items are included in the determination of retained income and in the change in net assets. Net cash flow is the operating cash flow less interest, tax, dividends and extraordinary items (if applicable) and changes in equity, provision for tax and provision for dividend (if applicable). Example 1:

Cash Flows

The following information relates to Ling Industrial Ltd. Ling Industrial Limited: Balance Sheet as at 31 December 2009 Note

Current assets Accounts receivable Inventory Sundry debtors Non-current assets Fixed assets Total assets Current liabilities Bank overdraft Accounts payable Other current liabilities Non-current liabilities Commercial bill Total liabilities Net assets

Shareholders equity Share capital Retained profits

Note 1: Inventory Raw materials WIP Finished goods


1

2009

2008

2007

$

$

$

2,732,315 1,412,935 189,700 4,334,950

2,442,357 1,256,225 170,540 3,869,122

1,833,349 1,107,726 102,300 3,043,375

4,599,772 8,934,722

4,385,123 8,254,245

3,980,421 7,023,796

2,224,053 684,426 133,900 3,042,379

2,075,421 1,261,348 62,500 3,399,269

1,567,820 897,931 39,420 2,505,171

3,500,000 6,542,379 2,392,343

2,500,000 5,899,269 2,354,976

2,000,000 4,505,171 2,518,625

1,000,000 1,392,343 2,392,343

1,000,000 1,354,976 2,354,976

1,000,000 1,518,625 2,518,625

320,649 274,943 817,343 1,412,935

298,851 173,752 783,622 1,256,225

270,511 120,344 716,871 1,107,726

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9-7

Ling Industrial Limited: Profit and Loss Account for the year ended 31 December 2009

Sales Cost of sales Direct materials Direct labour Production o/heads variable Production o/heads fixed Gross profit Overhead expenses Admin salaries Overhead expenses Profit before interest and tax Interest expense Tax Net profit after tax

2009 $

2008 $

10,259,006

10,456,640

3,276,495 1,919,093 404,258 1,063,775 6,663,621 3,595,385

3,439,624 2,051,656 424,150 1,131,185 7,046,615 3,410,025

838,572 2,160,977 2,999,549 595,836 551,429 7,040 37,367

881,010 2,225,549 3,106,559 303,466 467,115 (163,649)

Ling Industrial Limited: Statement of Cash Flows for the year ended 31 December 2009 Note

Cash flows from operating activities Receipts from customers Payments to suppliers and employees Interest paid Net cash used in operating activities

2

Cash flows from investing activities Payment for property, plant and equipment Net cash used in investing activities Cash flows from financing activities Proceeds from borrowings Net cash provided by financing activities

2009 $000 inflows (outflows)

2008 $000 inflows (outflows)

9,950 (9,887) (551) (488)

9,779 (9,516) (467) (204)

(669) (669)

(803) (803)

1,000 1,000

Net increase (decrease) in cash held Cash at beginning of period Cash at end of period

(157) (2,075) (2,232)

500 500 (507) (1,568) (2,075)

Note 2: Reconciliation of net cash used in operating activities to operating profit after tax


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9-8

Operating profit after tax Depreciation Increase in tax payable Changes in assets and liabilities Increase in trade debtors Increase in inventories Increase in sundry debtors Decrease in trade creditors Increase in other current liabilities Net cash used in operating activities

2009 $ 38 454 7

2008 $ (164) 399

(290) (157) (19) (577) 56 (488)

(609) (148) (68) 363 23 (204)

Required Calculate and analyse the marginal, operating and net cash flows for Ling Industrial Limited for 2008 and 2009. Suggested Solution Example 1 Cash Flows i.

Marginal cash flow Contribution margin Less/(add) inventory increase/(decrease) debtors increase/(decrease) Add/(less) trade creditors decrease/(increase)

2009 $ 4,659,160 (156,710) (289,958) ( 576,922) 3,635,570

2008 $ 4,541,210 (148,499) (609,008) 363,417 4,147,120

Marginal cash flow has declined dramatically from 2008 to 2009 (a decrease of $511,550 or 12.3% on 2006 figures). This decline is largely due to an increase in debtors of approximately $300,000 and a decrease in creditors of almost $600,000. ii.

Operating cash flow Profit before interest and tax 2 Less increase in net operating assets

2009 595,836 1,185,999 (590,163)

2008 303,466 843,952 (540,486)

Ling Industrial Limited’s operating cash flow is negative in both years under review, underlining the increase in net debt over the period. The increase in net operating assets of $1,186,000 in 2008 is largely due to an increase in debtors of approximately $300,000, fixed assets of $200,000 and a reduction in creditors of $600,000. iii.

2

Net cash flow Opening net operating debt* Less: closing net operating debt**

2009 4,575,421 5,724,053 (1,148,632)

2008 3,567,820 4,575,421 (1,007,601)

Net operating assets equals increase in current assets plus increase in non-current assets less increase in current liabilities less increase in cash-on-hand plus increase in bank overdraft. 2009 = $214,649 + 465,828 + 349,276 + 156,246 (Note: current liabilities have decreased therefore the difference is added rather than subtracted. 2008 = 825,747 + 404,702 – 894,098 + 507,601)


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9-9

*Opening net debt Total liabilities less a/c payable less other liabilities net debt

2009 5,899,269 1,261,348 62,500 4,575,421

2008 4,505,171 897,931 39,420 3,567,820

**Closing net debt Total liabilities less a/c payable less other liabilities net debt

2009 6,542,379 684,426 133,900 5,724,053

2008 5,899,269 1,261,348 62,500 4,575,421

Net Cash Flow The cash flow or change in net debt can also be calculated for 2009 as follows: Net profit after tax for the year ended 31 December 2009

37,367

Less: Increase in net operating assets

1,185,999

Net cash outflow

(1,148,632)

Net cash flow can be reconciled to operating cash flow in 2009 as follows: Operating cash flow

(590,163)

Less: interest

(551,429)

Less: tax

(7,040)

Net cash outflow

9.7

Growth

9.7.1

Overview

(1,148,632)

Short term financial growth measures include percentage changes in: gross sales revenue, net profit and earnings per share. 9.7.2

Percentage Change in Gross Sales Revenue

This is used to indicate growth at either the strategic level (i.e. organisation-wide) or at the business unit (operational) level. Reasons for changes should be carefully scrutinised relying on trends and comparisons with competitors. 9.7.3

Percentage Change in Net Profit

Net profit can also change for a number of reasons, including changes to cost structures, changes to selling prices and external changes such as new accounting standards. 9.7.4

Percentage Change in Earnings Per Share

Brokers, analysts and other capital market participants frequently use EPS and EPS changes in determining firm performance and growth prospects. The specific changes in EPS should be determined because many “non-operating change type” factors influence changes in EPS such as, non-payment of dividends, buying back ordinary shares, increasing debt level, and acquisitions and divestitures of companies with different price-to-earnings ratios and/or different capital structures.


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9 - 10

9.7.5 Sustainable Growth Organisational growth is normally a strategic objective yet a firm must be able to fund its growth. Future expansion requires the generation of funds sufficient to maintain the current or required capital structure. The sustainable growth concept is used by businesses to manage the financial performance of their organisation so that the longer-term growth requirements can be achieved. The level of growth depends on such factors as market size, demand, and ability to deliver the quantity of products/services necessary to achieve the desired growth rate. Sustainable growth is measured by the relationship between retained income and opening funding, as follows: Sustainable growth %

=

Retained income Opening equity

x (1 - dividend payout ratio)

3

where dividend payout ratio is Divided payout ratio

=

Cash dividends Net profit

The sustainable growth rate highlights the level of growth capable of being funded from retained income and existing debt. The measure helps management plan future expansion by highlighting the fact that while growth opportunities are unlimited, the resources to fund growth are not. Using the data from the previous example, we can calculate the sustainable growth rate for Ling Industrial Limited for 2008 and 2009. Sustainable growth = retained income/opening equity as follows: 2008 $ (163,649) 2,518,625 =( 6.50%)


2009 $ 37,367 2,354,976 = 1.58%

A negative ratio cannot be compared with a positive ratio value. The measure must be compared to sales growth projections, after taking into account changes in the operating structure of the business. Examples of changes in operating structure could be changes in the debt to equity structure; changes in gross profit percentage; purchases or sales of fixed assets, etc.

3

When the entity pays no cash dividends for the period this calculation reduces to: Sustainable growth %


=


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9 - 11

9.8

Financial and Operating Ratios

9.8.1

Financial Ratios

i)

Liquidity Ratios – Short Term

The current ratio and quick ratio are used to assess liquidity and the formulae should be familiar. The current ratio is calculated by dividing current assets by current liabilities. The quick ratio is calculated by dividing current assets (except for inventory) by current liabilities. As they become larger, these ratios indicate better liquidity but it is important to analyse trends, industry comparisons and the mix of current assets. Consider the following simple example. 2009

2008

Trend

$

$

$

5,800,000

1,000,000

Cash

100,000

1,000,000

Bank accepted bills

100,000

1,000,000

Total current assets

6,000,000

3,000,000

Current liabilities

3,000,000

3,000,000

Current ratio

2.00

1.00

Improving

Quick ratio

0.06

0.67

Worsening

Inventory

The working capital turnover ratio is calculated by dividing sales by working capital. Working capital is defined as total current assets less total current liabilities. Year-end, beginning-of-theyear or average-for-the-year working capital numbers can be used. This ratio provides a number that indicates the length of the firm’s operating cycle, i.e. the time from purchase of inventory to receipt of cash from sale of that inventory. This can also be calculated by dividing 365 (days) by the working capital turnover ratio. Consider the following example: Chang Ltd has the following information for the past four years: Year

2008

2007

3,500

2,800

1,950

1,500

Current assets ($000)

500

490

400

320

Current liabilities ($000)

200

200

190

150

Working capital (average working capital)

11.9 4 (3,500/295 )

11.2 (2,800/250)

10.3 (1,950/190)

Working capital (ending working capital)

11.7 (3,500/300)

9.7 (2,800/290)

9.3 (1,950/210)

8.8 (1,500/170)

Days working capital turned over (ending working capital ratio)

31.1 days (365/11.7)

37.6 days (365/9.7)

39.3 days (365/9.3)

41.4 days (365/8.8)

Sales ($000)

4

2009

2006

(Opening balance + closing balance)/2 = (290+300)/2 = 295


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9 - 12

The trend in these ratios is favourable, indicating that working capital is turning over more quickly each year. The usual reason would be that sales are increasing at a faster rate than the inventory, but other factors can increase this ratio. For instance, increases in creditors (ceteris paribus) lower the denominator, increasing the working capital ratio and reducing the days working capital turned over, yet this may also indicate liquidity problems for the firm (paying creditors late). ii)

Liquidity Ratios – Long Term

The debt to total funds ratio total debt divided by total funds (total debt plus total equity). The debt to equity ratio is calculated as total debt divided by total equity. Both ratios provide an indication of the financial viability of an organisation, the lower the ratio, the better the financial viability. Changes occur to the ratio when the financial structure of the entity is altered. The long-term debt to equity ratio indicates the solvency for the long term. Future expectations about a downturn in the economy, for example, might suggest that firms with high numbers for this ratio will suffer solvency problems and/or incur higher interest rates. The interest coverage ratio is calculated by dividing (net profit before income tax plus interest expense) by interest expense. This ratio is called interest coverage because the resulting number shows how many times the interest expense for a period is covered by the profit before interest and tax. Higher coverage numbers are better. The number can change due to changes in the debt structure and poor sales, increasing operating expenses, or both. Non-current Assets to Equity: A high level for this ratio might indicate that investment in non-current assets is too great. It should be compared with industry averages or with a number of competitors. A lower ratio suggests that some working capital is funded by equity, which is expected because a firm cannot operate with non-current assets alone. 9.8.2

Operating Ratios

Net profit to net sales indicates the amount of net profit that one dollar of sales generates. Gross profit to net sales indicates the ability of the organisation to cover other operating and non-operating expenses. Factors affecting both these ratios include increased competition, changes to sales revenue due to quantity and/or price changes. 9.8.3

Financial and Operating Ratio Relationships

Sales to accounts receivable is also called the debtors or accounts receivable turnover ratio because it indicates the number of times that the amount of money equal to current debtors has been received during the period. Low ratios can be due to inadequate credit collection policies and procedures, bad debt write-offs, or credit terms for poor-paying customers. It is also possible to calculate the average number of days that debtors have been outstanding by dividing 365 (days) by the accounts receivable turnover ratio. The ratios should be compared with prior periods and industry averages. Industry averages are important because the nature of the business will affect this ratio.


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9 - 13

9.8.4

Stock (Inventory) Ratios

The stock turnover ratio is calculated as cost of goods sold divided by average stock. The ratio should be as high as possible. Possible reasons for changes include having too much or too little stock in anticipation of a price rise or fall respectively. The cost of sales to sales ratio indicates the number of dollars of cost of goods sold to each dollar of sales revenue for the period. The lower the ratio the better. It can also be expressed as days inventory held by dividing 365 days by the stock turnover ratio. A lowering trend is desirable. Increasing days inventory held numbers usually indicates stock is becoming obsolete and is becoming more difficult to sell. Take the following example. XZY Ltd has the following information for the past six years: Sales ($000’s) Cost of sales ($000’s) Average stock ($000’s) Stock turnover (times)

Days Inventory held

2009 7,800 3,900 1,600 2.4 (3,900/ 1,600) 5 152

2008 7,900 5,100 2,100 2.4 (5,100/ 2,100) 152

2007 8,000 5,000 2,000 2.5 (5,000/ 2,000) 146

2006 5,000 3,200 1,200 2.7 (3,200/ 1,200) 135

2005 2,500 1,700 600 2.8 (1,700/ 600) 130

2004 1,000 600 150 4.0 (600/ 150) 91

Both the declining turnover ratio and the days’ inventory held indicate that inventory is moving more slowly. Further investigation would be needed to identify the specific cause. Additionally, there may be other inter-related effects of lower inventory turnover. For example, there may be an adverse effect on profitability.

5

= 365/2.4 To calculate the percentages in the table above we divide each number by the total sales for the company. E.g. the gross profit percentage for Company C is: $200,000 / $800,000 x 100 = 25%.


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9 - 14

9.8.5

Trends

Analysing ratios over time can give valuable insights into a firm’s performance. Common size analysis can be used to compare or benchmark financial performance against other firms within the same industry; and to get a different picture about trends for one firm. Using this approach each line item in the Profit and Loss Account (or Balance Sheet) is expressed as a percentage of sales (or total assets). Consider the following Profit and Loss Accounts and common size Profit and Loss Accounts for 6 three firms in the electronics industry . Company A $(000’s) Sales

%

Company B $(000’s)

%

Company C $(000’s)

%

900.0

100.0%

600.0

100.00%

800.0

100.0%

Cost of sales

579.6

64.4%

319.8

53.3%

600.0

75.0%

Gross profit

320.4

35.6%

280.2

46.7%

200.0

25.0%

53.1

5.9%

48.0

8.0%

15.2

1.9%

162.0

18.0%

114.0

19.0%

79.2

9.9%

R&D Sales & admin. Other expenses

1.8

0.2%

9.6

1.6%

7.2

0.9%

Total expenses

216.9

24.1%

171.6

28.6%

101.6

12.7%

Profit before tax

103.5

11.5%

108.6

18.1%

98.4

12.3%

Income tax

16.5

1.8%

17.4

2.9%

15.7

2.0%

Net profit

87.0

9.7%

91.2

15.2%

82.7

10.3%

Company B has the highest gross and net profit percentages of the three companies indicating better profitability. To see if these percentages are due to better efficiency, better strategy, some other reason or a combination of these, further investigation is necessary. To establish a starting point to answer these questions more fully, we could review the notes in the published financial reports. Often, such reports can be obtained from the Internet in spreadsheet format so that analyses can be carried out easily.

6

To calculate the percentages in the table we divide each number by the total sales for the company. E.g. the gross profit percentage for Company C is: $200,000 / $800,000 x 100 = 25%.


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Common size analysis can also be used for within-company comparisons as shown in the table below: Zhou Company Inc 2007 2008 Amount % Amount % ($000’s) ($000’s) Cash Debtors Stock Other Total current assets

45 1,515 1,655 145 3,360

0.88% 29.65% 32.38% 2.84% 65.75%

Plant and equipment Other Total non-current assets Total assets

1,600 150 1,750 5,110

Creditors Short-term loan Other Total current liabilities

7

2009 Amount % ($000’s)

115 1,700 1,819 138 3,772

1.94% 28.66% 30.67% 2.33% 63.60%

310 2,315 2,267 141 5,033

4.08% 30.49% 29.85% 1.86% 66.28%

31.31% 2.94% 34.25% 100.00%

2,000 159 2,159 5,931

33.72% 2.68% 36.40% 100.00%

2,400 161 2,561 7,594

31.60% 2.12% 33.72% 100.00%

750 500 200 1,450

14.68% 9.79% 3.91% 28.38%

1,265 420 210 1,895

21.33% 7.08% 3.54% 31.95%

1,505 420 215 2,140

19.82% 5.53% 2.83% 28.18%

Long-term loan Total non-current liabilities

1,000 1,000

19.57% 19.57%

1,100 1,100

18.55% 18.55%

1,300 1,300

17.12% 17.12%

Paid up capital Retained profits Total equity

2,360 300 2,660

46.18% 5.87% 52.05%

2,560 376 2,936

43.16% 6.34% 49.50%

3,693 461 4,154

48.63% 6.07% 54.70%

Total liabilities & equity

5,110

100.00%

5,931

100.00%

7,594

100.00%

The best way to start this analysis is to look at the trends in the subtotals and the totals. For example, we see that non-current assets percentages have decreased from 2008 to 2009 and we see that current assets percentages have increased. We would then look to the individual accounts to determine the main reasons for this pattern. Cash has increased over the three-year period, and debtors fell for the first year and then increased. A decline in accounts receivable may be good news unless it has been caused by writing off bad debts or a decline in currentperiod sales or some combination of these. Stock also decreased slightly relative to total assets - good news as stock earns no return sitting in a warehouse, yet some stock levels need to be maintained in order to satisfy customer demand (unless the firm uses a JIT system and are very confident that our suppliers can deliver but this is not always the case, especially in Hong Kong). Other current assets have remained relatively stable over the three-year period, while investment in non-current assets has decreased relative to total assets from 2008 to 2009. This may be due to accounting or to real economic reasons or both. Further investigation is required.

7

To calculate the common size balance sheet numbers we just divide each number by total assets. So, for example, the percentage for plant and equipment for 2008 is 33.72% (2,000/5,931 × 100 = 33.72%).


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The mix of how the assets are funded can be seen in the total liabilities and equity section. Total debt (short and long-term debt) has fallen as a percentage of total assets, with some of this being taken up by paid up capital. This means less of a future cash burden on the company because paid up capital represents funding which does not attract a requirement to pay a regular cash payment. This is because dividends are paid at the discretion of the directors. Debt, on the other hand means the company must pay interest (and principal) each period regardless of how the company is performing. Zhou Company also seems to be making much better use of its accounts payable funding. Accounts payable is (usually), interest free so the longer the payment can be deferred the better. However, relationships with suppliers are very important and they must be nurtured and maintained at a good level so the company can carry out its operations and satisfy its own customers. A balance needs to be achieved. Index Analysis We can also perform an index analysis when looking at trends. Index analysis expresses the amounts of a particular profit and loss or balance sheet item as a percentage of the amounts of that same item in the base year. The base year is selected by the analyst as the starting point for the trend analysis. With index analysis we see how an item has changed over time relative to itself. For example it may be seen from the index analysis below, that the cash balance in 2009 is 6.89 times the balance of cash in 2007 i.e. 310 / 45.

Index Analysis

Cash Debtors Stock Other Total current assets

2007 Amount Index (HK$000) 45 1.00 1,515 1.00 1,655 1.00 145 1.00 3,360 1.00

2008 Amount (HK$000) 115 1,700 1,819 138 3,772

Index 2.56 1.12 1.10 0.95 1.12

2009 Amount (HK$000) 310 2,315 2,267 141 5,033

Index 6.89 1.53 1.37 0.97 1.50

Plant & equipment Other Total non-current assets

1,600 150 1,750

1.00 1.00 1.00

2,000 159 2,159

1.25 1.06 1.23

2,400 161 2,561

1.50 1.07 1.46

Total assets

5,110

1.00

5,931

1.16

7,594

1.49

Creditors Short-term loan Other Total current liabilities

750 500 200 1,450

1.00 1.00 1.00 1.00

1,265 420 210 1,895

1.69 0.84 1.05 1.31

1,505 420 215 2,140

2.01 0.84 1.08 1.48

Long-term loan Total non-current liabilities

1,000 1,000

1.00 1.00

1,100 1,100

1.10 1.10

1,300 1,300

1.30 1.30

Paid up capital Retained profits Total equity

2,360 300 2,660

1.00 1.00 1.00

2,560 376 2,936

1.08 1.25 1.10

3,693 461 4,154

1.56 1.54 1.56

Total liabilities & equity

5,110

1.00

5931

1.16

7,594

1.49


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While the cash balance has increased significantly relative to itself over the three-year period, its amount is not material when compared with total current assets. Of more interest are the index changes for debtors and for stock. Based on the common size analysis percentages in the previous table, the trends in these accounts did not appear to stand out (both remained at around 30% of total assets). The 2009 balance for debtors is about 1.5 times the balance in 2007 and for stock it is about 1.4 times. Further analysis of debtors could include inspection of an aged trial balance (if possible), to determine if the build up is due to an increase in cash collection times or changes in credit sales over the period. The stock change is consistent with sales growth explaining the change because stock would be expected to increase if sales and accounts receivable are also increasing, yet other factors need to be considered. The increase in plant and equipment seems to have been funded mainly from the increase in retained profits and paid up capital (total equity). Common size and index analysis complement one another yet the presentation of the information in different ways makes certain relationships easier to see.

9.9

Non-financial Measures

9.9.1

Common Non-financial Measures

It is now commonly recognised that a balanced scorecard (BSC) should be used to measure performance. The BSC requires the use of both financial and non-financial measures. Common non-financial measures include: •

customer satisfaction;

•

percentage of on-time deliveries;

•

delivery response time;

•

internal efficiency;

•

cycle time;

•

good output per employee;

•

sales per employee;

•

creativity;

•

time for product to reach market from initial idea;

•

time between new product and a competitor’s new product; and

•

percentage of new products reaching the market before competitors’ products.


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9.10

The Balanced Scorecard

9.10.1 Description “The BSC provides an organisation with a comprehensive framework that translates the organisation's vision and strategy into a coherent set of performance measures” (Kaplan and Norton, 1996a, p.24). Kaplan and Norton (1992) brought the BSC into prominence and it has evolved from a performance measurement system to a core management system that is now widely used across many sectors, including service, government, not for profit and for profit. The performance measures in the BSC are organised under four perspectives: financial, customer, internal business processes and learning and growth. Each perspective has a short term goal with one or more critical success factors identified with that goal. The general BSC model is illustrated in Figure One. Financial Perspective Return on Investment Operating Income Return on Equity Cash flow

Customer Perspective Customer Satisfaction Surveys Customer Retention Market Share New Customer Acquisition

Internal Business Perspective Organisation’s Vision and Strategy

Production Flexibility % of Sales for New Products Product Quality After Sales Service

Learning and Growth Perspective Employee Training Employee Satisfaction Strategic Investment Decisions Figure 1: The Balanced Scorecard (Examples of Measures) Adapted from Kaplan and Norton (1992). 9.10.2 Benefits of the Balanced Scorecard The balanced scorecard approach can lead to consensus on organisational priorities, clear specification of goals, rigorous planning and improvement processes, alignment of strategic goals with shorter term actions, clearer communication, team working and knowledge sharing and clearer accountability for results.


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9.10.3 Potential Problems Although the method may assist in highlighting organisational issues, it cannot always resolve them easily. For example, some measures in the scorecard will conflict and difficult choices must be made to resolve these issues (e.g. R & D investment versus short term profitability); organisational culture may over-emphasise some measures and ignore others (e.g. an organisation with a strong sales culture may ignore underlying profitability). Top management commitment to the balanced scorecard approach is necessary for it to succeed. The BSC leads to a better basis for managers’ performance bonuses. However, all performance measures are open to manipulation by managers.

9.11

The Performance Pyramid

The Vision

Corporate level

SBU level Operational

Market satisfaction

Customer satisfaction Quality

Delivery

Financial measures

Flexibility

Productivity

Process time

Cost

Operation

External effectiveness

Internal efficiency

The performance pyramid shows how goals are set within a BSC. At the top of the pyramid is the firms’ vision. All goals are set in line with this vision. At the corporate level, the goals are concerned with market satisfaction (external) and financial performance (internal). At the Strategic Business Unit level, the strategic goals are customer satisfaction, flexibility (responsiveness of the SBU to changing demands) and productivity (efficient use of resources). At the operational level, the criteria are quality (fitness for purpose); efficiency of delivery; efficiency of processes resulting in fast process times; and elimination of non value added activities, resulting in leaner costs.


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9.12

Reporting and Evaluating Sustainability

Many firms are recognising the benefits of operating in a sustainable manner. These benefits include; keeping the environment clean, treating people with respect and operating profitably. Firms that implement a BSC can extend this to monitor and measure their sustainability efforts and link corporate sustainability objectives with appropriate corporate actions and performance outcomes. When appropriate strategic measures are included in a firm’s BSC, sustainability can be improved. For example toxic emissions are a lag measure of a firm’s process efficiency and also a lead indicator of future environmental costs. When choosing sustainability measures consideration should be given to ensuring the measures are: •

quantifiable, either in absolute or percentage terms

•

complete, in that the measure sums up in one number multiple measures of performance e.g. profit is a summary measure of revenue generation and cost control.

•

Controllable, in that employees can influence improvement

Some firms choose to integrate sustainability measures into the existing perspective of the BSC. Sustainability is typically included in the Internal business process perspective, however research shows that sustainability measures can be incorporated into any of the four perspectives of the BSC. Incorporation into an existing BSC can help to show the interrelationships between the measures and other areas of the firm to fulfil corporate strategy. Other firms add a fifth perspective to the BSC. By including social and environmental performance indicators that link the other four perspectives the importance of social and environmental responsibilities is highlighted as a corporate objective. Benefits of firms including sustainability measures into a BSC include: •

Increased employee satisfaction

•

Lower operational and administrative costs

•

Improved productivity

•

Enhanced image and reputation

•

Increased market opportunities

•

Improved shareholder relationships

•

Share market premiums


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9.13

Agency Theory and Managerial Incentive Schemes

An agency relationship exists whenever one party (the principal) hires another party (the agent) to perform some service, and this service requires the principal to delegate some decision making authority to the agent. Two types of principal-agent relationships arise in connection with managerial incentive schemes. First, the organization’s owners or shareholders, acting as the principal (usually through the board of directors), hire the chief executive group to be their agents in managing the firm in their best interests. In the second principal - agent relationship, the firm’s chief executive group acts as the principal and hires division managers as agents to manage subunits of the organization. Agency theory assumes that all individuals - principals and agents - care not only about financial compensation but also about such properties as attractive working conditions and flexibility in hours worked. Managers are assumed to prefer leisure to hard or routine work, although for some top management an aversion to work may not be a realistic assumption. Nevertheless, the argument goes that agents require incentives to minimize the net costs of the divergence of interests between them and the principal. Among other things, the agency model argues that if top executives of the company are compensated only by straight salary, they may not be motivated to take actions that increase the value of the firm to the shareholders. They may overconsume in such areas as leisure, attractive working conditions, and company perquisites, or will not spend enough time and effort to increase shareholder wealth. If the firm’s owners knew what actions were optimal for the firm and could observe without cost the actions of the top managers, they could direct the managers to implement these optimal actions, with the threat of withholding compensation or dismissal if these actions were not carried out. However, a dispersed group of owners will probably have inadequate information and will find monitoring costly. Accordingly, the owners are unlikely either to know what the optimal actions should be or to be able to direct and monitor the actions of the top executives. Therefore, to encourage managers to take actions that are in the firm’s best interests, the owners may introduce incentive compensation plans that enable the managers to share in the firm’s increased wealth. These schemes can take a variety of forms, including merit raises, bonuses based on reported performance, and various types of share ownership plans. Executive incentive compensation bonus plans are designed to create a commonality of interest between the owners (principal) and the executives (agents). However, some divergence of interest will always exist between the principal and the agents. This is due to differences in risk attitudes, the existence of private information (managers always know more about the firm than shareholders), and limited or costly observability. The principal will usually attempt to limit this divergence by establishing appropriate incentives for the agents, and by incurring monitoring costs designed to limit actions that increase the agents’ welfare at the expense of the principal. Annual audited financial statements are an excellent example of costly monitoring of managerial behaviour.


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Part D Practice Question 1

[30 Marks]

Financial information for Chang Inc is provided below for 2009 and 2010:

Chang Inc Corporation Income Statement and Statement of Retained Earnings For the Year Ended June 30, 2010 (in thousands) Revenue: Net sales

$480,000

Other

36,000

Total revenue

516,000

Expenses: Cost of goods sold

324,000

Selling and administrative

93,000

Depreciation

15,000

Interest

12,000

Total expenses

444,000

Income before income taxes

72,000

Income taxes (assumed 15%)

10,800

Net income

61,200

Less: Dividends

15,300

Net income added to retained earnings

45,900

Retained earnings, 1/7/2008

68,400

Retained earnings, 30/06/2009


$114,300

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Chang Inc Comparative Balance Sheets June 30, 2010 and 2009 ($ thousands) Assets Current assets: Cash and marketable securities Net Receivables Inventories Other current assets Total current assets Investments Property, plant, and equipment: Land Buildings and equipment Total property, plant, and equipment. Total assets Liabilities and Shareholders' Equity Current liabilities: Bank Overdraft Accounts payable Salaries payable Total current liabilities Long-term debt. Total liabilities Shareholders' equity: Share capital Retained earnings Total shareholders' equity Total liabilities and shareholders' equity

2010

2009

$28,700 $28,800 $39,000 $3,000 $99,500 $79,600

$12,600 $30,000 $37,200 $1,800 $81,600 $68,400

$7,200 $160,800 $168,000 $347,100 2010

$7,200 $148,800 $156,000 $306,000 2009

$13,200 $43,200 $15,600 $72,000 $96,000 $168,000

$14,400 $42,600 $16,200 $73,200 $102,600 $175,800

$64,800 $114,300 $179,100 $347,100

$61,800 $68,400 $130,200 $306,000

The following industry ratios apply: 1. 2. 3. 4. 5. 6. 7. 8.

Net profit as a percentage of sales Return on assets Return on equity Current ratio Quick ratio Debt-equity ratio Interest coverage Dividend payout ratio

10% 15% 22% 1.7 .75 1.35 6.75 35%

Required a)

b)

Calculate the ratios listed below for Chang Inc for 2010: 1. Net profit as a percentage of sales. 2.

Return on assets.

3.

Return on equity.

4.

Current ratio.

5.

Quick ratio.

6.

Debt-equity ratio.

7.

Interest coverage.

8.

Dividend payout ratio.

Analyse Chang Inc’s performance using two years of data where appropriate and the industry ratios provided.


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9 - 24

Suggested Solution Practice Question 1 Timing (minutes)

[30 Marks] Part a)

30 minutes

b)

15 minutes

Total time spent on this question a)

45 minutes

The financial ratios are calculated as follows: 1.

2.

3.

4.

4.

Net profit as a percentage of sales

Return on assets

Return on equity

(i) Current ratio (2010)

(ii) Current ratio (2009)


=

net profit net sales

=

$61,200 $480,000

=

12.75%

=

net income before interest (net of taxes) average total assets

=

$61,200 + ($12,000 x .85) (347,100 + $306,000)/2

=

22% (rounded)

=

Operating Profit Equity

=

$61,200 ($179,100 + $130,200)/2

=

40% rounded

=

current assets current liabilities

=

$99,500 $72,000

=

1.38

=

current assets current liabilities

=

$81,600 $73,200

=

1.11

(printed May 2010)

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5.

(i) Quick ratio (2010)

=

quick assets current liabilities

=

$28,700 + $28,800 72,000

5.

(ii) Quick ratio (2009)

=

0.80 (rounded)

=

quick assets current liabilities

=

$12,600 + $30,000 73,200

= 6.

6.

7.

(i) Debt/equity ratio 2010

(ii) Debt/equity ratio 2009

Interest coverage

=

0.58 (rounded) total liabilities* total shareholders equity

=

$168,000 $179,100

=

0.94

=

total liabilities* total shareholders equity

=

$175,800 $130,200

=

1.35

=

operating income interest expense

=

($72,000 + $12,000)* $12,000

=

7 times

*Income before taxes + Interest expense 8.

Dividend payout ratio

=

cash dividends net profit

=

15,300/61,200

=

25%

* Some literature uses total interest-bearing debt for these ratios. In that case, both accounts payable and salaries payable would be excluded.


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b)

Comparing the key balance sheet ratios from 2000 to 2010, Chang Inc has improved its liquidity in both the short and the long term. A comparison of Chang Inc with industry ratios indicates that the firm has an above average profit margin, and generates a healthy return on both assets and equity. However, the company's liquidity (although showing improvement from last year) is still below the industry average for the current ratio but ahead on the quick ratio. Times interest earned is in line with industry averages, but the dividend payout ratio is lower than industry which may be of concern to some shareholders. Specific comparisons: •

Net profit as a percentage of sales is 3% percent above the industry average, indicating that its sales revenue generates larger than average profits and, as a result, Chang Inc may be able to decrease the sales price to gain competitive advantage. Such a competitive advantage will only occur if the product has an appropriate degree of price sensitivity.

•

The return on assets is 6 percent greater than the industry average, indicating a stronger than industry ability to use assets to generate profits.

•

The 40 percent return on equity is almost twice the industry average, indicating that profitability is sufficient to absorb reductions in profit.

•

The current ratio of 1.38 is below the industry average, indicating that the firm's short-term debt paying ability is not as strong as it should be however there has been a distinct improvement since last year when it was 1.11.

•

The quick ratio has improved dramatically in 2010 and is now above the industry average.

•

The debt/equity ratio improved dramatically this year taking it from the industry average in 2009 of 1.35 to 0.94 in 2010. Therefore, a lower proportion of the firm's resources are provided by debt indicating that Chang Inc is a safer investment.

•

The interest coverage of 7 times is just above the industry average.

•

The dividend payout ratio of 25% is well below the industry average of 35%. Although this decision has improved cash flow, investors may be disappointed and Chang Inc will have to revisit this decision in 2011.


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Practice Question 2

[20 Marks]

Condensed financial data of Wong Manufacturing appear below: WONG MANUFACTURING Comparative Balance Sheets 30 June

Cash Accounts receivable Inventories Prepaid expenses Investments Plant assets Accumulated depreciation Total Liabilities and Shareholders' Equity Accounts payable Accrued expenses payable Notes payable Ordinary shares Retained earnings Total

2010 (000s) $144,000 $170,000 $240,000 $38,000 $180,000 $620,000 ($130,000) $1,262,000

2009 (000s) $70,000 $106,000 $264,000 $50,000 $150,000 $500,000 ($120,000) $1,020,000

$186,000 $58,000 $260,000 $490,000 $268,000 $1,262,000

$150,000 $48,000 $320,000 $340,000 $162,000 $1,020,000

WONG MANUFACTURING Income Statement for the year ended 30 June 2010 ($ 000s) Sales Less: Cost of goods sold Operating expenses (excluding depreciation) Depreciation expense Income taxes Interest expense Loss on sale of plant assets Net income

$960,000 $580,000 $120,000 $34,000 $30,000 $36,000 $6,000

806,000 $154,000

Additional information: 1.

New plant assets costing $170,000,000 were purchased for cash in 2010.

2.

Old plant assets costing $50,000,000 were sold for $20,000,000 cash when book value was $26,000,000.

3.

Notes with a face value of $60,000,000 were converted into $60,000,000 of ordinary shares.

4.

A cash dividend of $48,000,000 was declared and paid during the year.

5.

Accounts payable pertain to merchandise purchases.

Required a)

Prepare a cash flow statement for the year ended 30 June 2010.

b)

Reconcile operating profit to net cash from operating activities.


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Suggested Solution Practice Question 2

[20 Marks]

Timing (minutes)

Part a) 20 minutes b) 10 minutes

Total time spent on this question a)

30 minutes

Cash flow statement WONG MANUFACTURING Cash Flow Statement for the year ended 30 June 2010 ($ 000s)

Cash flows from operating activities Cash receipts from customers ($960,000 - $64,000) Cash payments: To suppliers For operating expenses For income taxes For interest Net cash provided by operating activities Cash flows from investing activities Purchase of investments Purchase of plant assets Sale of plant assets Net cash used by investing activities Cash flows from financing activities Issue of ordinary shares Payment of cash dividends Net cash provided by financing activities Net increase in cash Cash at beginning of period Cash at end of period

$896,000 $520,000 (1) 98,000 (2) 30,000 36,000

(30,000) (170,000) 20,000 (180,000) 90,000 (48,000) 42,000 74,000 70,000 $ 144,000

Non-cash investing and financing activities Conversion of notes payable into ordinary shares

$ 60,000

(1)

Cost of goods sold Deduct: Decrease in inventory Purchases Deduct: Increase in accounts payable Cash payments to suppliers

$580,000 (24,000) 556,000 (36,000) $520,000

(2)

Operating expenses Deduct: Decrease in prepaid expenses Deduct: Increase in accrued expenses payable Cash payments for operating expenses

$120,000 (12,000) (10,000) $98,000


(printed May 2010)

684,000 212,000

9 - 29

b) Reconciliation of net profit after tax with cash flows from operating activities NOPAT $154,000 Non-cash items: Depreciation $34,000 Loss on sale $6,000 Deferrals & Accruals: Increase in accounts receivable (64,000) Decrease in Inventory 24,000 Decrease in Prepaid expenses 12,000 Increase in Accounts Payable 36,000 Increase in Accrued expenses 10,000 Net cash from operating activities 212,000 Practice Question 3

[15 Marks]

The Balanced Scorecard (BSC) encourages firms to develop performance measures along four perspectives. These are introduced above and are also discussed in detail in the readings. Required: a)

Give a brief description of the four components of the balance scorecard.

b)

Below is a list of performance measures for Ling Electronics Ltd. Produce a balanced scorecard by placing these measures in the appropriate perspectives. •

Employee effectiveness

•

Delivery time

•

Number of new products

•

Number of repairs under warranty

•

Sales $

•

Profit

•

Throughput

•

Return on Investment

•

Sales to new customers

•

Manufacturing cycle time

•

Employee empowerment

•

Customer satisfaction

•

EVA™

•

Employee turnover

•

Number of new patents

•

Customer retention

•

Cost of scrap

•

Lost sales

•

Employee efficiency.


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Suggested Solution Practice Question 3 Timing (minutes)

[15 Marks] Part a)

7 minutes

b) 13 minutes Total time spent on this question

20 minutes

a)

The four components of the BSC include financial, customer, internal business process and learning and growth. The financial perspective guides the firm on value creation for stakeholders. The customer perspective ensures that the company understands how its customers view the firm. In the internal business process perspective, the firm focuses on improving efficiency across all aspects of the firms’ value chain. Finally the learning and growth perspective focuses on three aspects: the efficiency and effectiveness of employees; increasing information systems capabilities and product innovation.

b)

Balanced Scorecard for Ling Electronics Limited. Perspective Financial

Measures Sales $ Profit Return on Investment EVA™

Customer

Lost sales Sales to new customers Customer retention Customer satisfaction *

Delivery time

Number of repairs under warranty Internal Business Process

Throughput Manufacturing cycle time Cost of scrap

Learning and Growth

Employee efficiency Employee turnover Employee empowerment Employee effectiveness Number of new patents Number of new products

*

Delivery time might also be classified as an Internal Business Process


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Part E How do I know I have succeeded in this topic?

Should I do more research

After my examination preparation

After talking to my Workshop Facilitator

After my Workshop

After working through this Section

Can I:

Calculate financial, strategic and operational performance measures and understand the relationships between them. Describe the role of cash flow analysis in the evaluation of the organisation’s strategic and operational plan. Describe the interrelationships between shareholder wealth creation and performance measures aligned to that objective, including agency theory and its relationship to managerial incentive schemes. Identify financial and non-financial measures of business profitability including cash flow measures. Describe measures of entity growth. List the main steps in translating strategies and plans into goals, recognising their interrelationships. List the limitations of benchmarking in facilitating organisational change. Describe the relationships between financial and operating ratios and be able to interpret trends over time and across time. Explain the key components of the balanced scorecard.


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