P5: Advanced Performance Management

Section E: Performance Evaluation and Corporate failure E1. Alternative views of performance measurement E2. Non-financial performance indicators E3. Predicting and preventing corporate failure E1. Alternative views of performance measurement E2. Non-financial performance indicators E3. Predicting and preventing corporate failure Designed to give you knowledge and application of:

 Assess the potential likelihood of corporate failure, utilising quantitative and qualitative performance measures. [3]  Assess and critique quantitative and qualitative corporate failure prediction models. [3]  Identify and discuss performance improvement strategies that may be adopted in order to prevent corporate failure. [3]  Discuss how long-term survival necessitates consideration of life-cycle issues. [3]  Identify and discuss operational changes to performance management system required to implement the performance improvement strategies. [3] E3. Predicting and preventing corporate failure Learning Outcomes

Assess the potential likelihood of corporate failure and assess and critique quantitative & qualitative corporate failure prediction models Corporate failure Meaning  Unable to achieve satisfactory ROCE  Unable to settle due liabilities  Unable to convert assets into cash  Unable to adopt environmental change  Unable to cope with fierce competition  Unable to raise and utilise funds Causes Internal  High level debts  Inefficient management  Defective credit policies  Lack of internal controls External  Rigid govt. regulations  Pressing demands of labour union & natural disasters According to Argenti  Leadership traps  Monolithic cultures & skills  Power & politics  Structural memories

RatiosExamples Performance ratios: indicate the performance of the organisation  Gross margin, operating margin, ROCE Efficiency ratios: convey the efficiency levels at which the organisation is functioning  Labour turnover ratio & labour efficiency ratio Risk-related ratios: indicate the obligation fulfilling capacity of a borrowing organisation  Gearing ratios, debt service coverage ratios (DSCR) & Beaver’s failure ratio Liquidity ratios: indicate capability to meet short-term obligations  Current ratio, & cash exhaustion ratio, debtor days, creditor days and stock days Market share ratios: help equity shareholders to evaluate their investments and assess the returns from them  PE ratio, EPS and dividend yield ratio 1. Financial ratios Quantitative models Continued…

2. Beaver’s univariate model (developed by William Beaver in 1967) Features  Based on belief that organisations about to experience financial distress exhibits different characteristics from those that are not going to experience financial distress  Developed using single financial ratio  Ratio < 0.3 indicates failure  Ratio & failure status is linear  On ratio may conflicts with other  Cut off point may not give true results Disadvantages Refer to Example in paragraph 1.2 Continued…

3. Altman’s multivariate model (Z-score) (1968) Based on following financial ratios  Liquidity  Profitability  Activity / efficiency  Leverage  Solvency Z = 1.2X X X X X 5 Where, Z is the overall index and X 1-5 are as follows: RatioSignificance X1X1 Working capital/Total assetsTo measure liquidity X2X2 Retained earnings/Total assetsTo measure cumulative profitability X3X3 Earnings before interest & tax/Total assets To measure productivity of assets (activity / efficiency) X4X4 Market value of equity (including preference shares)/Book value of total debt To measure gearing levels (leverage) X5X5 Sales/Total assetsTo measure revenue-generating capacity (solvency) Continued…

Assessment of Z-score Z-scorePrediction Less than 1.80  High probability of corporate failure 1.81 to 3  Needs further investigation Above 3  Financially sound company Refer to Example in paragraph Zeta model (1977) (Improved version of Z-score model) Based on following variables:  Return on assets  Gearing  Cumulative profitability  Liquidity  Market capitalisation  Stability of earning  Size of the organisation Two more variables added to Z-score model

5. Ohlson analysis (1980) Based on 9 measures of organisation’s size, leverage, liquidity and performance Y = Y Y Y Y Y Y 6 +.3Y Y 8 -.5Y 9 (2) Where, Y 1 = Log (total assets/GNP price-level index) Y 2 = Total liabilities/Total assets Y 3 = Working capital/Total assets Y 4 = Current liabilities/Current assets Y 5 = One if total liabilities exceed total assets, zero otherwise Y 6 = Net income/Total assets; Y 7 = Funds provided by operations/Total liabilities Y 8 = One if net income was negative for the last two years, zero otherwise Y 9 = Measure of change in net income Y = Overall index i.e. the probability of bankruptcy for a firm

6. Zmijewski (probit analysis) (1984) Measures performance, leverage, and liquidity of an organisation using financial ratios Steps in Zmijewski model 1. Take the following equation 2. Multiply by a constant to the constants in the formula & each parameter in this equation, to calculate adjusted parameter 4. To this adjusted score, apply the following formula to translate into a measure of probability Probability bankruptcy = 1/1 + [Exp (-Adjusted score) ] 3. Multiply these adjusted parameters by the respective financial ratios to give the adjusted score X = X X X 3 (1) Where: X 1 = Net income/Total assets X 2 = Total debt/Total assets X 3 = Current assets/Current liabilities X = Overall index i.e. adjusted score Assessment of Zmijewski’s model ProbabilityAssessment ≥ 0.5  Classify as bankrupt < 0.5  Do not classify as bankrupt

1.Argenti’s A score (developed by John Argenti in 1976) Predicts corporate failure on the basis of defects in management and accounting structure ProbabilityAssessment  High pass – no clear for concern  Pass  Cause for concern (pass)  Grey zone – warning sign >35  Company is at risk Qualitative models Groups Group A Group B Group Divided into management & accounting defects with scores 19 & 24 Avoidable mistakes with score 45 Symptoms of failure with score 12

1.Other information Other:  Non-compliance with capital or other statutory requirement  Pending legal or regulatory proceeding against entity  Changes in legislation or government policy expected to adversely affect entity Other Operating:  Loss of key management without replacement  Loss of a major market, franchise, license or principal supplier  Technological obsolescence  Shortage of resources Operating

Identify and discuss performance improvement strategies that may be adopted in order to prevent corporate failure Three Ms and corporate failure Increase in liquidity Decrease in profitability Leads to Increase in profitability Decrease in liquidity Leads to Management has to strike a balance ProfitabilityLiquidity 1. Money Balance between profitability and liquidity 2. Management Should consist of efficient & experienced people 3. Market Strategies for increasing demand of the product

Increase product demand by cost-cutting & reducing selling price Become more flexible by accepting challenges & taking quick decisions Become innovative & undertake SWOT analysis Adopt modern management tools to improve performance in order to survive growth Achieve sustainable competitive advantage Employ help of turn- around experts Strategies to avoid corporate failure

Discuss how organisational survival in the long term necessitates consideration of life cycle issues Costs involved at different stages of the life cycle Manufacturing Planning and design Service & abandonment  Research & development costs  Costs of product design  Manufacturing  Marketing  Selling & distribution costs  Costs relating to after-sales services Life cycle costing: system that tracks & accumulates every individual cost which is incurred during the life cycle of a product

Time frame of a typical product life cycle cost Life cycle costing  provides input for pricing across life cycle  identifies areas in which cost cutting will be most effective  highlights committed costs of a product  forms input to evaluation processes  emphasises on time management  provides long-term picture of product  provides premises for decision making regarding product introduction, product mix & discontinuation of products

RECAP  Assess the potential likelihood of corporate failure, utilising quantitative and qualitative performance measures. [3]  Assess and critique quantitative and qualitative corporate failure prediction models. [3]  Identify and discuss performance improvement strategies that may be adopted in order to prevent corporate failure. [3]  Discuss how long-term survival necessitates consideration of life-cycle issues. [3]  Identify and discuss operational changes to performance management system required to implement the performance improvement strategies. [3]