Performance evaluation Primary objective of financial performance Maximise shareholder value Shareholder provide funds, assume risks and expect value. Theories of performance evaluation The shareholder value perspective Emphasis profitability over responsibility and sees the organisation as instruments of owners. Proponents believe that an organisation’s success can be measured by factors such as share price, dividends and economic profit and see shareholder management as a means to an end rather

They believe social responsibility is not a matter for organisations and claim society is best served by organisations aiming to achieve self interest which include economic efficiency. The responsibility of creating employment , improving local communities, protecting the environment, consumer welfare and social developments are not organisational matters but are left to individuals and Government.

They believe that paying attention to enlightened self interest and maintaining market- based relationships between the company and all stakeholders, maximising value for shareholders will result in the maximisation of societal wealth. Measures of financial performance Profitability is widely used as a measure of the performance of a unit. However, organisations cannot use profit alone to compare one division to the other divisions (or to compare their performance with their competitors).

The reasons are other divisions or alternative investments may have different size or have different operating characteristics. Return on capital employed (ROCE) Most popular ratio for measuring general management performance in relation to the capital invested in business. Roce defines capital invested in the business as total assets less current liabilities which measures profitability in relation to assets.

ROCE= earnings before interest and tax(ebit)*100 capital employed(shareholder’ funds +medium and long term debt. ROCE is influenced by two ratios: 1.Operating profit margin- this illustrates what proportion of sales revenue was retained in the form of profits before deduction of interest and tax. Operating profit margin=operating profit(ebit)*100 sales revenue 2.Asset turnover Ratio = illustrates how efficiently assets are being used to generate sales.

Asset turnover ratio =sales revenue *100 average capital employed Thus ROCE=operating profit*sales revenue*100 sales revenue average capital emplo Example Makano ltd provides the following details. Financial goal of the company for 2013: Roce of 10% minimum. The actual figures are as follows: EBIT ----------- $ 480 000 Sales revenue ------$ 800 000 Average capital employed-----$5 647 000

Previous year’s 2012 ratios were: Roce -----------------------9% Operating margin---------5% Asset turnover -ratio------1.8. Calculate ROCE and comment on the results.

RETURN ON INVESTMENT Is the ratio of profit to investment in operating assets. Normally expressed as a percentage ,the larger the percentage the better the ROI. ROI is normally used for divisional performance or appraising investment centre performance appraisal. ROI =return on assets*operating asset turnover = EBIT * sales sales operating asset turnover

ROI indicates profit earned per $ invested in operating assets of a business ROIs for successful firms range from 10% to more than 50% although it depends on industry and economic factors facing the particular entity or SBU. Example Makomo provides you with information from his two independent projects: project A project B Sales 30 000 39 000 Cost of sales 20 000 29 000

Investment 115 000 125 000 Calculate ROI and comment. When using ROI for divisional performance measurement ,in order to achieve better results only capital traceable to the division and controllable by the manager should be taken into consideration. Thus ROI = divisional profit division’ capital employed Advantages -Versatility (can use, revenues, costs &investment) comparability, flexibility

Disadvantage Ignore time value of money. Ignore risk associated with the project Flexibility- results can be manipulated Inconsistency- income at times taken before interest and tax. Earnings per share (EPS) The amount of profits attributable to each ordinary share or what each share has generated in profits. Saves as an indicator of a company’s profitability

EPS = profit attributable to ordinary shareholders weighed average number of ordinary shares Example Makomo gives you the following profit attributable to ordinary shares 3million Weighted no/ of ordinary outstanding 1,5 million Industry average $1.5 Previous year’s EPS = $1.7 and the target for current year was $1,9 Calculate EPS for the company

Residual Income Is the operating income that an investment centre is able to earn above a particular minimum return on its assets. Or It is the net income earned after deducting a charge for the funds invested in the division or investment unit. RI= income- charge on investment (charge on investment =investment *desired rate of return)

Using example of Makomo investments, assume a rate of return of 5% Using example of Makomo investments, assume a rate of return of 5%. Calculate RI Limitations The major limitations of this method is that because residual income is not expressed as a percentage. It is not useful for comparing units of significantly different sizes. If favours larger units that would be expected to have large residual income , even with relatively poor performance.