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Financial Performance Analysis

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Published in: Financial Management
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Financial Performance Analysis

Meera's C / Mumbai

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  1. Financial Performance Analysis
  2. Decentralization I I Strategy of delegating decision-making responsibility from senior management to employees at lower levels of the organization Effective in organizations whose: Environments, technologies, and customer requirements are changing Employees have the skills and knowledge to accept decision making Employees understand the organization's objectives so that they can make decisions that are consistent with those objectives
  3. I I I I Centralization Control moves from task control to results control The focus is on motivating people to use their skill, knowledge, and creativity to improve operating results Occurs when decision making is reserved for senior managers Works effectively in organizations that face stable demand, technologies, and where customer requirements are well understood
  4. I I Responsibility Centres Cost Centre Employees control costs but do not control revenues or investments Revenue Centre Employees control revenue but do not control cost or the level of investment. Revenue managers are often at the mercy of others who determine costs of their goods
  5. I I Responsibility Centres Profit Centre Employees control revenue and costs but not the level of investment (i.e. fast food chains) Investment Centre Employees control revenue, costs, and level of investment (i.e. an independent business)
  6. Responsibility Centres Investment Centres Superior Foods Corporation Corporate Headquarters President and CEO Personnel Vice President Salty Snacks Operations Vice President Beverages Product Manger Product Manager Bottling Plant Manager Warehouse Manager Finance Chief Flnancial Officer Confections Product Manager Distribution Manager Legal General Counsel Cost Centres
  7. Responsibility Centres Superior Foods Corporation Corporate Headquarters Personnel Vice President Salty Snacks Operations Vice President Beverages Product Manger Product Manager Bottling Plant Manager Warehouse Manager President and CEO Finance Chief Flnancial Officer Confections Product Manager Distribution Manager Legal General Counsel Profit Centres
  8. Decentralization and Segment Reporting segment is any part or activity of an organization about which a manager seeks cost, revenue, or profit data, A segment can An Individual Store A Sales Territory A Service Centre
  9. Levels of Segmented Statements Income Statement Sales Variable costs CM Traceable FC Division margin Common costs Net operating income Company $ 500,000 230,000 270,000 170,000 100,000 25,000 75,000 Television $ 300,000 150,000 150,000 90,000 $ 60,000 Computer $ 200,000 80,000 120,000 80,000 $ 40,000 Common costs should not be allocated to the divisions, These costs would remain even if one of the divisions were eliminated,
  10. Evaluating Responsibility Centres I Controllability People should only be held accountable for results that they can control One major difficulty in applying this occurs when revenue and costs are jointly earned or incurred Separating these components can involve detailed (or even arbitrary) accounting procedures
  11. I I Evaluating Responsibility Centres Segment margins v The level of controllable profit reported by an organizational unit or product line Interpreting segment margins should be done carefully They can represent highly aggregated summaries Other critical success factors should be used to assess performance Allocations can be misleading
  12. How to assess the performance of a Responsibility Centre Is the RC being effective-doing the right things- qualitative Is the RC being efficient-doing things rightly- comparison between inputs and outputs- measurement of variance etc For Financial Performance Assessment, how should RC's be assessed by both effectiveness and efficiency criteria since the profit objective of a business organization demands both
  13. Measuring the Performance of Cost Centre s Comparing Actual Costs with Budgeted Cost levels Comparing Actual Costs with Previous Period Production mix and Production levels Other issues: quality, response time, customer service, employee safety, environmental care
  14. Measuring the Performance of Revenue Centers Actual Revenue Earned vs. Budget What costs are controllable? Ego Labor in gas station Staff rewarded solely on sales: Wide product lines — excessive inventory Excessive customized service — additional costs
  15. Measuring the Performance of Profit Centers Responsibility for pricing, product selection, purchasing, promotion, but not investments Are they really profit centers or is the corporate office controlling many facets of their operations? Burger Poor performance my reflect (l) an unfavorable condition that no one in the organization can control; (2) poor corporate decisions; (3) poor local decisions
  16. Measuring the Performance of Investment Centers Return on Investment (ROI) Residual Income (RI) Economic Value Added (EVA)
  17. Components of ROI Operating income ROI Average operating assets Sales Operating income x Average operating Sales assets Operating income Operating asset margin x turnover
  18. Components of ROI expresses the portion of sales that is -Margin available for interest, income taxes, and profit. a Turnover shows how productively assets are being used to generate sales.
  19. Com arison of ROI Year 1: Sales Operating income Average operating assets ROI Year 2: Sales Operating income Average operating assets ROI Snack Foods Division 180/0 $40,000,000 Appliance Division 1800 150/0
  20. Margin and Turnover Comparison Snack Foods Division Appliance Division Margin Turnover ROI Year 1 x3.0 18.0% Year 2 x4.0 20.0% Year 1 x6.0 18.0% Year 2 2.5% x6.0 15.0%
  21. Advantages of the ROI Measure Q It encourages managers to pay careful attention to the relationships among sales, expenses, and investments, as should be the case for a manager of an investment center. Q It encourages cost efficiency. Q It focuses on operating assets efficiency
  22. Disadvantages of the ROI Measure It discourages managers from investing in projects Q that would decrease the divisional ROI but would increase the profitability of the company as a whole. Q It can encourage myopic behavior, in that managers may focus on the short run at the expense of the long run. Q Actions in myopic behavior QLay off high salaried people QCut advertising budget QDelay all promotions QReduce preventive maintenance QUse cheaper raw materials in the short run
  23. Residua/ Income Residua/ income is the difference between operating income and the minimum dollar return required on a company's operating assets: Residual Income Project 1: Operating (Minimum rate of return x income - Operating assets) RI = - (0.10 x = $300,000 Project 11: RI = $640,000 - (0.10 x = $240,000
  24. Residua/ Income--Examp/e In thousands Operating assets Operating income Minimum return Residual income Desired return = Prejectl $60,000 $ 8,800 6 000 $ 2,800 100/0 Prejectll $54,000 5 400 $ 2,740 Add Both Prqjects $64,000 $ 9,440 6 400 $ 3,040 Preferred alternative Maintain Status Quo $50,000 $ 7,500 5 000 $ 2,500
  25. Disadvantages of Residual Income l, 2. It is an absolute measure of return which make it difficult to directly compare the performance of divisions. It does not discourage myopic behavior.
  26. Disadvantages of Residual Income Minimum requirement is 8% Average operating assets Operating income Minimum return Residual income Residual return Division A 1 200 000 $ 300,000 Division B $ 300,000 200 000 $ 100,000
  27. Economic Value Added -Economic value added (EVA) is after-tax operating profit minus the total annual cost of capital. EVA = After-tax operating income (Weighted average cost of capital) x (Total capital employed)
  28. I I I I Economic Value Added is income less the economic cost of the investment used to generate the income, EVA = Income — Cost of Capital CWofCåp ais the required interest or dividend expectations of the debt or contributed capital, Shareholders receive value when the return from the capital employed in the business operations is greater than the cost of that capital
  29. EVA Example Three sources of revenue were used by Furman, Inc.: $2 million of mortgage bonds paying 8 percent interest, $3 million of unsecured bonds paying 10 percent interest, and $10 million in common stock. Govt Bond rates are 6% and stockholders have recd. an avg return 6 percentage points higher than Govt Bonds Furman pays a tax rate of 40 percent. Compute the WACC
  30. EVA Example After-Tax Percent x Cost Mortgage bonds Unsecured bonds Common stock Total Amount 10 000 000 0.133 0.200 0.667 0.048 0.060 0.120 Weighted Cost 0.006 0.012 0.080 0.098 Weighted average cost of capital X .098 -
  31. EVA Example Furman earned an after tax profit of $ 1,583,000 Compute its EVA
  32. EVA Example Furman's EVA is calculated as follows: After-tax profit Less: Weighted average cost of capital EVA 1 470 000 $ 113,000 The positive EVA means that Furman, Inc., earned operating profit over and above the cost of the capital used.
  33. Behavioral Aspect of EVA Supertech, Inc., has two divisions.Operating income statements for the divisions are shown below: Sales Cost of goods sold Gross profit Divisional selling and administrative expenses Operating income Hardware Division 2 000 000 2 000 000 Software Division 1 100 000 $ 900,000 400 000 $ 500,000 Which Division is doing better?
  34. Behavioral Aspect of EVA V Supertech's weighted average cost of capital is I I percent. V Hardware, a buildup of inventories, use of warehouses, etc. uses capital amounting to $10 million. V The cost of capital for Hardware Division is (0.11 x V The dollar cost of capital for the Software Division is $220,000 (0.11 x
  35. Behavioral Aspect of EVA The EVA for each division can be calculated as follows: Operating income Less: Cost of capital EVA Hardware Division 1 100 000 -$ 100 000 Software Division $500,000 220 000 $280 000
  36. 1 1 Adjustments to EVA In reality, EVA is a bit more complex: Often ircn.ois adjusted for "conservative nature of the Accounting Standards."For example: v v v v v Research and Development expenses are capitalized. Advertising expense is capitalized. The increase in the allowance for bad debt is added to income. The increase in the LIFO reserve is added to income. Effect of the change in deferred taxes is netted from income. Operating leases are assumed to be capital leases. Coar,tejis reduced by "non interest bearing current liabilities" such as: Customer advances Accounts payable Accrued liabilities
  37. ROI versus EVA Majority of companies use ROI , Benefits of ROI — Is a comprehensive measure-anything that affects financials is reflected in ROI — It can be applied to any organizational unit regardless of type — Different units can be compared — Can be compared with ROI data of competitors
  38. ROI versus EVA Cons of EVA Absolute amount-hence cannot be compared with competitors Benefits of EVA (1) All business units have the same profit objective-a unit earning 30% ROI may be reluctant to invest in a project with 25% ROI but if EVA is positive ,PAT is more than capital charge ie wealth of business increases then unit may invest; vice versa if a unit earning 5% ROI wants to invest in a project earning 10% ROI but if WACC is 12%, the project will not create wealth for company hence even if unit wants corporate HO may drop project by EVA criterion
  39. Benefits of EVA (2) decisions that increase ROI may decrease absolute profits-eg Investment center whose ROI is 30% may by disposing off assets earning 25% ROI, actually decrease profits but under EVA this is taken care of (3) EVA hasa stronger positive correlation with shareholder value which apart from other things is important for: • reducing risk of take over • reduces cost of capital and promotes faster investment for growth

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