P5: Advanced Performance Management

Section D: Strategic performance measurement Designed to give you knowledge and application of: D1. Performance hierarchy D2. Strategic performance measures in private sector D3. Divisional performance and transfer pricing issues D4. Strategic performance measures in not-for-profit organisations D5. Non-financial performance indicators D6. The role quality in management information & performance management system. D7.Performance measurement & strategic human resources management issues D8. Performance measurement & the reward systems D9. Other behavioural aspects of performance measurement

 Demonstrate why the primary objective of financial performance should be primarily concerned with the benefits to shareholders. [2]  Justify the crucial objectives of survival and business growth. [2]  Discuss the appropriateness of, and apply different measures of performance, including: i. Return on Capital Employed (ROCE) ii. Return on Investment (ROI) iii. Earnings Per Share (EPS) iv. Earnings Before Interest, Tax and Depreciation Adjustment (EBITDA) v. Residual Income (RI) vi. Net Present Value (NPV) vii. Internal Rate of Return (IRR)  Discuss why indicators of liquidity and gearing need to considered in conjunction with profitability. [3]  Compare and contrast short and long run financial performance and the resulting management issues. [3]  Explore the traditional relationship between profits and share value with the long-term profit expectations of the stock market and recent financial performance of new technology companies. [3]  Assess the relative performance of the organisation compared to appropriate benchmarks. [3]  Discuss and apply Six Sigma measures of performance. [2] D2: Scope of strategic performance measures in private sector Learning outcomes

Demonstrate why the primary objective of financial performance should be primarily concerned with the benefits to shareholders Shareholders’ value perspective  emphasises profitability over responsibility  organisation is primarily the instrument of owners  society is best served if economic rationale is followed  maintaining market-based relationships Objective of a company To maximise shareholders’ value Key considerations for management - whether shareholders: prefer a steady income from dividends are concerned with long-term capital gains Shareholders Provide funds Expect valueAssume risk And Therefore affect market price of shares

Ability to survive & grow -- measure of success of a business Survival: Obvious objective Growth: supports survival Growth requires Growth ideas Growth processes Growth of people Survival depends on Growth perspective PESTEL conditions Ability to generate income Justify the crucial objectives of survival and business growth Survival & growth objectives: influence business strategies and operational decisions Refer to first example on page 221

Planning for survival Cutting the costs Increasing level of output of sales Raising revenue through price changes Carrying out regular SWOT analysis Threats to survival Fall in sales revenue Consumers moving away from the brand Rise in costs Incur cost of serving debts Refer to Example on page 222 Refer to Test Yourself 1 on page 222

Discuss appropriateness of different performance measures and apply them Measures of performance ROI EBITDA NPV RI EPS ROCE IRR Discussed in Paper F5 ROCE  Measures: profitability in relation to total assets  Indicates: how efficiently the company is using its capital to generate profits Continued…

ROI  Indicates: profit earned for each dollar invested in the operating assets  Use: for divisional / investment centre performance appraisal EPS  Indicates: company’s profit attributable to each share  single most variable in determining share’s price Continued…

EBITDA  Analyses company’s operating profitability before non-operating expenses and non-cash charges  Use: for comparison with other companies and stock analysis RI  Expressed in absolute terms  Indicates: net income after deducting a notional charge for the funds invested  NPV can be negative, positive or zero  Rule: accept the project if NPV is positive or accept the project with the highest NPV NPV Initial investment Sum of discounted cash flows to be generated in future Refer to Self Examination Question 1 on page D2.30 Continued…

Refer to Example on page D2.15 IRR When project cash inflows are not identical When the projects’ cash inflows are identical Table of cumulative present value factors can be used Interpolation method is used Refer to Example on page D2.16 Continued…

Discuss why indicators of liquidity and gearing need to be considered in conjunction with profitability Liquidity indicators- measure ability to meet short-term obligation Acid-test ratio Current ratio Net working capital Operating cash flow ratio Turnover ratios Inventory turnover Receivables turnover Payables turnover Gearing indicators- measure stability & ability to repay long- term debts Capital gearing ratio Interest cover ratio Discussed in Paper F5 & F9 Continued…

Higher capital gearing ratio: fine for a company with:  consistent profit  adequate asset base to offer as security  regular sales  more stability Financial health of the company depends on Profitability Long-term & short-term liquidity Companies with high profitability but poor liquidity / gearing measures Do not survive during depression / recession Better position of company in paying fixed charge of interest Indicates High interest cover ratio: More borrowed funds Indicates High capital gearing ratio: Vulnerability to shareholders’ position More difficult to borrow further

Formulae

Short-term performance should be assessed in the context of progress towards the long-term objectives Compare and contrast short and long term financial performance and the resulting management issues Short-term financial performance Focuses on immediate profitability Ignores long term objectives Rewards linked to short-term: managers focus on short term profitability at the cost of long term profitability Can cause manipulation Long-term financial performance Focuses on profitability in future Essential for the survival and growth Unavailability of required data

Price earning ratio Relationships between profits and share value with long-term profit expectations of stock market Increase in P/E ratio positive expectations about a firm’s earning performance and growth Indicates Dividend yield dividend as a % of operating profit  Retained earnings  Capital expenditure Share values are independent of  Investment behaviour  Corporate profits Share values are dependent on  Dividend pattern  Investment opportunities  Approach of the management  Expectations of investors Share values are a result of  Speculative activities of pension funds & insurance companies Firm’s share value Reflects Confidence in future profit

Recent financial performance of new technology / communications companies New dimension to Business: utiisation of cutting edge technology & human resources To create valueTo generate income Exclusive use of new technologies Decrease in costs Increase in productivity Rapid future growth of company High market price of shares Investor’s expectation of higher growth potential of technology companies Increase in the market prices of their shares

RECAP  Demonstrate why the primary objective of financial performance should be primarily concerned with the benefits to shareholders. [2]  Justify the crucial objectives of survival and business growth. [2]  Discuss the appropriateness of, and apply different measures of performance, including: i. Return on Capital Employed (ROCE) ii. Return on Investment (ROI) iii. Earnings Per Share (EPS) iv. Earnings Before Interest, Tax and Depreciation Adjustment (EBITDA) v. Residual Income (RI) vi. Net Present Value (NPV) vii. Internal Rate of Return (IRR)  Discuss why indicators of liquidity and gearing need to considered in conjunction with profitability. [3]  Compare and contrast short and long run financial performance and the resulting management issues. [3]  Explore the traditional relationship between profits and share value with the long-term profit expectations of the stock market and recent financial performance of new technology companies. [3]  Assess the relative performance of the organisation compared to appropriate benchmarks. [3]  Discuss and apply Six Sigma measures of performance. [2]