Financial Performance Management (MBA module 3 of 8)

Introduction

• Business: an organization (or economic system) where goods and services are exchanged for one another or for money
• Enhance the wealth of its owners
• Maximise sales and profit
• Achieve target market share
• Maximise long-term shareholder wealth
• Survival
• Shareholder theory
• The social responsibility of business is to increase its profits (Friedman, 1962)
• Emphasise profitability over responsibility and see the organization primarily as instrument of its owners
• Dividends
• Share price
• Profitability
• Stakeholder theory
• The purpose of the firm is to serve as a vehicle for coordinating stakeholders interests (Evan and Friedman, 1988)
• Emphasise responsibility over profitability and see the organization primarily as a coalition to serve all parties involved
• Customer satisfaction
• Employee satisfaction
• Customers
• Lenders
• Managers
• Regulators
• Suppliers
• Staff
• Owners
• Mission: a brief statement, typically one or two sentences, that defines why the organization exists, especially what it offers to its customers and clients
• Vision: a concise statement that defines the mid- to long- term (three- to 10-year) goals of the organization
• Values: the attitude, behaviour, and character of an organisation
• CFO or controller
• Supervising accounting personnel
• Preparation of information and reports, managerial and financial
• Analysis of accounting information
• Planning and decision making
• Treasurer
• Supervises relationships with financial institutions
• Work with investors and potential investors
• Manages investments
• Establishes credit policies
• Manages insurance coverage
• Internal auditor
• Expresses an opinion to top management regarding the effectiveness of the organization’s accounting system and its system of internal controls
• Accounting: the process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of the information
• Managerial accounting
• Internal parties: shareholders, management, employees, partners, etc.
• No external regulation: non mandatory
• Report on historical, current, and future performance
• Tailor-made to internal needs
• Timely and future-oriented
• Financial and operational performance measures
• Disaggregation to inform local decisions and actions.
• Financial accounting
• External parties: creditors, investors, suppliers, government, community, etc.
• Regulated by IFRS, GAAP, etc.: mandatory
• Report on past performance to external
• Delayed and historical
• Financial measures only
• Highly aggregate; report on the entire organisation
• Financial information: financial statement
• Any information that is expressed in monetary value and can be found in the financial statements
• Profitability
• Net income
• Dividend per share
• R&D investment
• Non-financial information: balanced scorecard, integrated reporting, ESG disclosure
• Any information that is not expressed in monetary value and cannot be found in the financial statements
• Suitability of stocks
• Environmental, social and governance information
• Relationship with customers
• There is an increasing trend for businesses to produce information on social, environmental and sustainable aspects of their operations
• The disclosure of such non-financial information usually takes place through Sustainability or Corporate Social Responsibility reports and Integrated Reports
• Companies may find it in their interest to disclose voluntarily certain non-financial information, particularly if it is designed as part of a package to improve their credibility and acceptance in key markets, or if it enables them to undertake business more successfully
• In sectors dominated by large multinational enterprises, disclosure of such information may be seen as an important business driver
• Increasing confidence in the company
• Improving the brand image
• Risk avoidance
• Internal staff relationships
• Performance Indicators
• Environmental: reduction of ecological footprint; energy consumption, (through conservation); Improvement of energy efficiency etc.
• Labour & employment: targets on gender and age distribution; Increase in number of women in management; Improvement of diversity representative of local communities etc.
• Human rights: measures taken to contribute to the elimination of child labour; code of conduct based on Universal Declaration on Human Rights etc.
• Society & community: cultivate more ecological and responsible partnerships; organising, contribution to local school programmes; Organising workshops for local hotels/caterers to make them more ecologically aware; Ensure responsible land use and limit closures; Reduce number of legal actions etc.

Financial statement

• The balance sheet (or statement of financial position)
• Assets: Cash, inventory, property, plant, equipment, and other investments
• Current assets
• Cash
• Marketable securities
• Accounts receivable
• Inventories
• Other current assets
• Non-current assets
• Net property
• Plant & equipment
• Goodwill and intangible assets
• Other non-current assets
• Liabilities: Obligations to creditors
• Current liabilities
• Accounts payable
• Short-term debt/notes payable
• Current maturities of non-current (long-term) debt
• Other current liabilities
• Non-current liabilities
• Long-term debt
• Capital leases
• Deferred taxes
• Equity: assets minus liabilities, firm’s net worth
• Book value of equity: difference between the firm's assets and liabilities
• Assets = liabilities + shareholders’ equity
• Net working capital = current assets - current liabilities
• Market value of equity = shares outstanding x market price per share
• Market to book ratio = market capitalisation ÷ book value of equity
• Enterprise value = market value of equity + debt - cash
• Shows how the business is financed and how funds are deployed
• Can provide a basis for assessing the value of the business
• Relationships between assets, liabilities and equity can be assessed
• To measure performance of the business
• Most assets and liabilities are recorded at their historical costs
• Most items are calculated based on estimation
• Subject to ‘window-dressing’ and potential fraud because managers may want to provide good results to gain benefits
• The income statement (profit and loss)
• Total sales/revenues - cost of sales = gross profit
• - operating expenses = operating income
• +/- other income/other expenses = earnings before interest and taxes (ebit)
• +/- interest income/interest expense = pre-tax income
• - taxes = net income
• It shows how effective the business has been in generating wealth
• It provides information on how the profit was derived
• Accounting information is based on assumption which can be inaccurate
• Creative accounting – managers may use methods involving unorthodox practices for reporting (e.g. revenue, expenditure, assets and liabilities) to arrive at the desired result
• Profit and cash provide different information
• The statement of cash flows
• Operating activity
• Investing activity
• Financing activity
• The statement of shareholders’ equity

Financial ratio analysis

• Efficiency: the economic use of scarce resource. Measure of efficiency takes the input to the process and access how economically they are used to produce a given output and tends to focus on cost
• Effectiveness: the production of the results or effect. The value of output produced from a given set of resources
• Efficacy: The production of result intended. The measure of efficacy access the degree to which inputs produced the result intended and thereby contributed to the true achievement of the enterprise
• Compare the firm with itself
• Compare the firm to other similar firms
• Liquidity ratios: ratios designed to measure the ability of the firm to meet its short term liabilities as they come due
• Current ratio = current assets ÷ current liabilities
• Quick ratio = (current assets - inventories) ÷ current liabilities
• Cash ratio = cash / current liabilities
• Profitability ratios: ratios designed to measure the earning power of the firm
• Account receivable days = accounts receivable ÷ sales x 365
• Inventory days = inventory ÷ cost of sales x 365
• Account payable days = accounts payable ÷ cost of sales x 365
• Leverage ratios (or solvency/capital structure ratios): refer to the extend to which a firm employs debt capital to finance its operations
• Gross margin = gross profit ÷ sales
• Operating margin = operating income ÷ sales
• Return on equity = net income ÷ equity
• Return on assets = net income ÷ total assets
• EBIT margin = EBIT ÷ sales
• Net profit margin = net income ÷ sales
• Working capital ratios (or asset management ratios): ratios designed to measure the relation between annual sales and investments in various classes of asset accounts
• D/E ratio = total debt ÷ total equity
• D/C ratio = total debt ÷ (total equity + total debt)
• Equity multiplier = total assets ÷ total equity
• Interest coverage ratio = EBIT ÷ interest expense
• Interest coverage ratio
• EBIT/Interest coverage = EBIT ÷ interest expense
• EBITDA/Interest coverate = EBITDA ÷ interest expense
• Valuation ratios: used (by current and potential investors) to evaluate the current share price of a publicly-held company's stock
• P/E ratio = market price ÷ earnings per share
• Earnings per share = earnings ÷ total shares outstanding
• Book value per share = total equity ÷ total shares outstanding
• Dividend yield = total dividends ÷ market price
• Assumptions
• Accounting policies are consistent with previous year/budget/forecast
• Accounting policies are broadly similar with that used in the industry generally, e.g. methods of stock valuation, depreciation, etc.
• Company aims to maximise profits
• Inflation, tax is considered constant
• Limitations
• Lack of detail in financial statements
• Variations of accounting policies
• Asset values: historic cost or revalued
• Is prudence built into figures?
• Possible management bias

Integrated reporting

• A new form of corporate reporting aimed primarily at providers of capital
• It tells a organisation’s value creation story
• It is much more than bringing together financial and sustainability reporting
• It does not replace either financial or sustainability reporting – both need to be in place for integrated reporting
• The importance
• Influences decisions and actions of management
• An essential element of corporate governance
• Influences decisions and actions of shareholders and other stakeholders
• Affects resource allocation (financial, natural and human resources) in society
• Critical for investor confidence
• Influences perceptions of the company’s customers, vendors, and employees
• Shapes how a company sees itself
• Corporate reporting has undergone various transformations to adapt to a changing landscape of economic, technological, social, and political drivers and to the information needs of different stakeholders
• Beyond the basic financial statements: such as management commentary, governance disclosures, and footnotes to the financial statement, external auditing, so that stakeholders could have a better understanding of the value-creation process
• Users of corporate reporting still find the information to be incomplete and inadequate in explaining the value-creation process of an organization and material nonfinancial risks
• The International Integrated Reporting Council (IIRC) defines integrated reporting as ‘a process founded on integrated thinking that results in a periodic integrated report by an organization about value creation over time and related communications regarding aspects of value creation’ (IIRC, 2013)
• The concept of integrated reporting was introduced in South Africa in 2009 through King III, the code of corporate governance. The Johannesburg Stock Exchange adopted King III, and all listed companies are now required to “apply or explain” the King III principles, of which IR is one
• The IIRC, set up at the end of 2010, aims to create the globally accepted integrated reporting framework
• Challenges
• Complexity
• Meaningful narrative information
• Reporting on risk, executive compensation and corporate governance
• Auditing for fraud
• Lack of standards
• Lack of common terminology
• Underdeveloped audit methodologies
• Controversial role of the Global Reporting Initiative
• Natural capital
• Basis and glue for the entire economic and social system
• Resources that often cannot be replaced
• Essential for the functioning of the economy as a whole
• Includes water, land, minerals, and forests; and biodiversity and eco-system health
• Financial capital
• Funds obtained through financing or generated by means of organization’s productivity
• The pool of funds available to the organisation
• Intellectual capital
• Intangibles associated with brand and reputation, critical to the organization
• Includes patents, copyrights, intellectual property and organisational systems, procedures and protocols
• Provide significant competitive advantages
• Intangibles that provide competitive advantage
• Social and relationship capital
• The stock of resources created by the relationships between an organization and all its stakeholders
• The institutions and relationships established within and between each community, group of stakeholders and other networks to enhance individual and collective well-being. Includes an organization’s social license to operate
• Human capital
• Skills and know-how of an organisation’s professionals as well as their commitment and motivation and their ability to lead, cooperate or innovate
• People’s skills and experience, and their motivations to innovate
• Manufactured capital
• Mainly comprises physical infrastructure such as buildings or technology equipment and tools
• Manufactured physical objects, as distinct from natural physical objects
• Benefits
• Greater clarity about the relationship between financial and non-financial performance and how this affects value creation
• Better inernal decision making for a sustainable strategy
• Deeper engagement and improved relationships with shareholders and stakeholders
• Lower reputation risk
• Improved measurement and control systems for non-financial information
• Greater employee engagement
• More committed customers who care about sustainability
• Reporting against KPIs which align to the corporate strategy cooperation and collaboration across the business
• Telling the story about what the core business does
• Risk assessment focused on material risks
• Wider knowledge of non-financial business drivers
• Discussing the future considering finance and sustainability
• Knowledge across the business and sharing best practice
• Costs
• Preparation costs related to the collection and analysis of new data
• Infrastructure investments in new information systems and data sets
• New processes and control systems
• People with analytics skills
• Assurance from third parties
• Potential proprietary disclosure costs and revelation of competitive information
• A sustainability report is a report published by a company or organization  about the economic, environmental and social impacts caused by its  everyday activities. A sustainability report also presents the organization's  values and governance model, and demonstrates the link between its  strategy and its commitment to a sustainable global economy
• Reporting not a PR exercise
• Interaction with stakeholders
• Transparency
• Brand Management
• Guiding principles
• Strategic focus and future orientation: the institutions and relationships established within and between each community, group of stakeholders and other networks to enhance individual and collective well-being. Includes an organization’s social license to operate
• Connectivity of information: an Integrated Report shows the connections between the different components of the organization’s business model, external factors that affect the organization, and the various resources and relationships on which the organization and its overall performance depend
• Stakeholder responsiveness: an Integrated Report provides insight into the organization’s relationships with its key stakeholders and how and to what extent the organization understands, takes into account and responds to their needs
• Materiality and conciseness: an Integrated Report provides concise, reliable information that is material to assessing the organization’s ability to create and sustain value in the short, medium and long term
• Reliability and completeness
• Consistency and comparability
• Future orientation: an Integrated Report includes management’s expectations about the future, as well as other information to help report users understand and assess the organization’s prospects and the uncertainties it faces
• IR vs traditional
• Thinking: integrated
• Stewardship: all forms of capital
• Focus: past and future, connected, strategic
• Timeframe: short, medium and long term
• Trust: greater transparency
• Adaptive: responsive to individual circumstances
• Concise: concise and material
• Technology enabled: technology enabled
• Content element
• Organisational overview and business model: what does the organization do and how does it create and sustain value in the short, medium and long term?
• Operating context, including risks and opportunities: what are the circumstances under which the organization operates, including the key resources and relationships on which it depends and the key risks and opportunities that it faces?
• Strategic objectives and strategies to achieve those objectives: where does the organization want to go and how is it going to get there?
• Governance and remuneration: what is the organization’s governance structure, and how does governance support the strategic objectives of the organization and relate to the organization’s approach to remuneration?
• Performance: how has the organization performed against its strategic objectives and related strategies?
• Future outlook: what opportunities, challenges and uncertainties is the organization likely to encounter in achieving its strategic objectives and what are the resulting implications for its strategies and future performance?
• Stakeholder expectations
• The company has not profited at the expense of the environment, human rights, a lack of integrity or society
• There are adequate controls in place to monitor and manage material risks and opportunities
• Remuneration is linked to overall performance which includes social, environmental and financial aspects
• There is an interactive communication with the stakeholders who are strategic to the company’s business
• The company is conducting a sustainable business

Budget

• Establish mission 
• Set strategic plans and objectives
• Break long term strategic plan into series of detailed short term operational plans 
• Budgets are how the business converts strategic objectives into immediate deliverables and targets
• Budgeting is the most widely used accounting tool for planning and controlling organisations
• A budget is a quantitative expression of a proposed plan for a future time period and an aid to the coordination and implementation of the plan
• Budget provides targets and directions: increase income or decrease expenses
• It can cover both financial and non-financial aspects
• Budgeting cycle
• Planning the performance of the organisation (whole and subunits)
• Providing a set of expectations (to compare with actual results)
• Investigating variations from plans (and corrective actions)
• Planning again, considering feedback and changed conditions
• Types of budget
• Master budget: a comprehensive expression of management’s operating and financial plans for a future time period (usually one year)
• Operating budget: part of the master budget that comprises the budgeted profit statement
• Operating decisions centre on the use of scarce resources
• Sales budget
• Production budget
• Direct material usage
• Direct material purchases
• Direct labour budget
• Factory overhead budget
• Selling & distribution budget
• Administration budget
• Financial budget: part of the master budget that comprises capital budget, cash budget, budgeted balance sheet and budgeted statement of cash flows
• Financing decisions centre on how to obtain the funds to acquire those resources
• Fixed asset budget
• Working capital budget
• Cash budget
• Operating and Financial Budget: operational budget deals with cost for merchandise and services produced. Financial budget examines expected asset liability and equity
• Cash budget: cash planning and Control. Aims to avoid idle cash and possible cash shortage
• Static (fixed) budget: appropriate for departments whose work load does not have a direct current relationship to sales
• Flexible (expense) budget: dynamic and most commonly used
• Activity based budgeting: budgets for individual activity
• Capital expenditure budget: budgeting for long-term projects to be undertaken and capital to be acquired
• Rolling budget: a budget or plan that is always available for a specified future period by adding a month, quarter or year in the future as the month, quarter or year just ended is dropped
• Main benefits 
• Promote forward thinking and identification of short-term problems 
• Motivate managers to better performance 
• Provide a basis for a system of control 
• Help coordinate the various sections of the business 
• Provide a system of authorisation
• Functions
• Planning and setting objectives: budgets are a key planning and forecasting tool
• Controlling and monitoring: managers obtain regular information about results which can be compared to the plan 
• Communicating: budgets help identify priorities and indicate what is expected of people
• Coordinating: budgets coordinate departments that depend on one another  
• Motivating: in setting clear expectations of staff (targets) budgets can be an important influence on their motivation
• Planning and control process
1. Establish mission, vision and objectives
2. Undertake a position analysis
3. Identify and assess strategic options
4. Select strategic options and formulate long-term (strategic) plans
5. Prepare budgets 
6. Perform and collect information on actual performance
7. Identify variances between planned (budgeted) and actual performance
8. Respond to variances and exercise control
9. Revise plans (and budgets) if necessary 
• Steps in the budget-setting process
1. Establish responsibility for the budget-setting process
2. Communicate budget guidelines to relevant managers
3. Identify the key, or limiting, factor
4. Prepare the budget for the area of the limiting factor
5. Prepare draft budgets for all other areas 
6. Review and co-ordinate budgets
7. Prepare the master budgets
8. Communicate the budgets to all interested parties
9. Monitor actual performance relative to the budget 
• Limitations
• Cannot deal with rapid change
• Focus on short-term targets, rather than value creation
• Encourage a ‘top-down’ management style
• Time consuming
• Based around traditional business functions; do not cross boundaries
• Encourage incremental thinking (last year’s figure plus x percent)
• Protect rather than lower costs
• Promote ‘sharp’ practice among managers (budgetary ploys)
• Lack of influence: if managers cannot influence many of the figures in their budgets, they may find it easy not to take responsibility for achieving budget targets
• Building in slack: managers may be tempted to exaggerate their expenditure and   underestimate revenue and play “budget games” 
• Fear: if staff feel budgets are being set to test them, they may avoid involvement in the process
• Lack of understanding: some managers are ignorant of budgets or finance in general. They may avoid involvement in such areas
• Self-interest: ‘empire building’, or other opportunistic behaviour to keep higher resources occurs
• Atrill and McLaney identify the following criticisms of budgets
• Cannot deal with rapid change
• Focus on short term financial targets rather than value creation
• Encourage a top-down management style
• Are time consuming
• Encourage incremental thinking
• Protect rather than lower costs
• Promote sharp practice among managers
• Elements to consider when preparing for budget
• Past sales patterns
• Results of market research
• Competition
• Changing customer taste (value for money)
• New legislation (e.g. health & safety)
• Pricing policies and discounts offered
• Environmental factors
• Forecasting availability of resources
• Expected inflation should be included in calculations
• Tendency by management to introduce budgetary slack
• Interdepartmental rivalries: dysfunctional behaviour
• Resistance by employees: don’t like change
• Static budget
• A static budget is a budget that is based on one level of output
• It is based on the level of output planned at the start of the budget period
• It is not adjusted or altered after it is set
• It is prepared at the start of the period when the actual output is known
• Performance evaluation is difficult when actual activities differ from the planned
• level of activity
• The master budget is an example of a static budget
• Static-budget variance is the difference between the actual result and the corresponding static budget amount
• Favourable variance (F) is a variance that increases operating income relative to the budget amount
• It increases operating profit relative to the budgeted amount
• In revenue items means that actual revenues exceeded budgeted revenues
• In cost items means that actual costs were less than budgeted costs
• Unfavourable variance (U) is a variance that decreases operating income relative to the budget amount
• A variance that decreases operating profit relative to the budgeted amount
• Flexible budgets
• A flexible budget shows revenues and expenses that should have occurred at the actual level of activity
• A flexible budget is adjusted in accordance with changes in actual output
• A flexible budget is prepared at the end of the period when the actual output is known
• Flexible budget is used for both better planning and control
• Improve performance evaluation
• A key difference between a flexible budget and a static budget is the use of the actual output level in the flexible budget
• Flexible-budget variance is the difference between the actual results and the flexible-budget amount for the actual levels of revenue and cost drivers
• Flexible budget variances = actual results – flexible budget
• Sales-volume variance is the difference between the flexible-budget amount and the static-budget amount; unit selling prices, unit variable costs and fixed costs are held constant
• Sales-volume variances = flexible budget – static budget
• Variance analysis for performance evaluation
• Effectiveness: the degree to which a predetermined objective or target is met
• Efficiency: the relative amount of inputs used to achieve a given level of output
• Variance analysis allows to understand the causes of a variance
• Purchasing manager bargained effectively with suppliers
• Purchasing manager accepted lower-quality materials at a lower price
• Purchasing manager secured a discount for buying in bulk. However, he bought higher quantities than necessary, which resulted in excessive level of stock

Costs

• Classification
• Direct material
• Direct labour
• Manufacturing overhead
• Prime cost
• Conversion cost
• Historic cost: what has been paid
• Opportunity cost: next best alternative, the value of an opportunity forgone
• Relevant cost: use in decisions
• Relate to business objectives
• Must be a future cost
• Must vary with decision
• Irrelevant cost: don’t use for decisions
• Does not relate to the objective of the business
• Does not related to the future
• Does not vary with decision
• Fixed costs: do not vary with changes in the volume of activity
• Variable costs: vary with the volume of activity
• Semi-Fixed (semi-variable) cost
• The margin of safety: the extent to which the planned volume of output or sales lies above the breakeven point (BEP),  measure of risk
• Operating gearing: the relationship between contribution and fixed cost
• Full cost information
• Pricing and output decisions
• Control
• Assessing efficiency
• Assessing performance
• Direct cost: identify with cost unit
• Indirect cost (overheads): cannot measure in respect of a specific unit 
• Out-of-Pocket Costs
• Those costs that require the payment of cash or other assets as a result of its incurrence
• These costs should be considered when making decisions
• Sunk cost
• All costs incurred in the past that cannot be changed by any decision made now or in the future are sunk costs
• Absorption costing: cost units will absorb overheads this leads to full costing also being called absorption costing
• Managers aware of total costs
• Provides full costings so that selling prices can be set using full cost plus a mark up
• The overhead absorption rate can be useful in budgeting future expenditure
• Apportionment of overheads may be arbitrary
• Unrealistic total costs may lead to unrealistic setting of selling prices where full cost plus pricing is used
• In reality costs and activity levels are estimates and there will be under or over absorption of costs
• Ignores the distinction between variable and fixed costs (unlike marginal costing)
• Traditional costing
• Overheads are first assigned to product cost centres
• Overheads are then allocated to cost units using an overhead recovery rate
• Activity-based costing (ABC)
• Overheads are first assigned to cost pools
• Overheads are then assigned to cost units using cost drive rates
• More accurate cost hence better pricing and product mix decisions
• Time consuming hence costly. Question relevance if product processes are similar. Measurement and tracing issues
• Cost drivers could be the key stages in a manufacturing process e.g. setting up machines, or quality control
• Each cost driver would be used as the basis for overhead absorption 
• An overhead cost pool would be established for each cost driver which would collect all the costs associated with this activity 
• Total costs in the pool would be allocated to output according to the extent to which each unit of output drove those costs, using the cost driver identified

Balanced scorecard (BSC)

• Performance management system is to monitor, measure and report on the current and future critical factors that support strategy execution
• May encourage short term actions not in company’s long-term interests (i.e. managerial myopia)
• May encourage “cooking the books”, gaming, budgetary ploys
• May discourage long term actions (i.e., training; investment; R&D) to maximise short term profits
• Outcome (lagging) & driver (leading) measures
• GM% declining may be caused by too many unique parts in design
• Quantitative (financial & non-financial) and qualitative measures
• Both need to be included in management incentive programs
•  Internal & external measures
• The Balanced Scorecard approach was promoted by Robert Kaplan and David Norton in various articles (1992 and 1993) and their 1996 book ‘The Balanced Scorecard’.  The BSC is seen as a tool for monitoring the strategic decisions taken by the company based on indicators previously established and that should permeate through at four perspectives
• Financial
• ROI 
• EVA
• Return on capital employed (ROCE)
• Revenue growth
• Cost reductions
• ROS
• Return on capital employed
• ROCE
• Grow revenue
• Total Revenue
• Return on sales
• Volume in target segments
• Minimise cost
• Total cost vs. plan
• Customer
• Market share growth
• Customer acquisition rate
• Customer retention rate
• Customer satisfaction scores
• Product return rate
• Defect rate
• On-time delivery rate
• provide superior brand image 
• Price premium vs. competition in key segments
• Deliver on our promises
• Revenue from new products
• Customer retention in target segments
• Build distributor partnership
• % perfect orders
• Customer/distributor survey
• Internal processes
• Product-development cycle time
• Order-to-delivery response time
• Six sigma 
• New product/service introduction rate
• Lead product innovation 
• Product development cycle time
• # of product development projects in pipeline
• Manage supplier relationship
• # of long-term partnership agreements
• Upgrade and utilise equipment 
• Cost per unit (by product)/ % of equipment upgraded
• Increase maintenance effectiveness
• % of maintenance time spent on prevention/downtime
• Streamline order fulfilment process
• Cost of delivery per order/time to deliver each order
• Learning & growth
• Employee retention/turnover rate
• Salaries/wage index
• Training/development hours per employee
• Value-added per employee dollar
• Align the organisation through technology 
• % of employees using information technology
• Develop change culture
• Culture survey
• Train world class workforce
• Skills gaps closed
• Hours of training
• Cause-and-effect relationship in BSC components
• Learning and growth: investment in staff development
• Internal business process: improvement in level of after-sales service 
• Customer: increase in customer satisfaction
• Financial: increase in sales and profit

Shareholder valuation

• Gordon’s dividend growth model
• D0: latest dividend paid (interim + final)
• g: annualised expected growth over time
• K: cost of capital
• Ve: value of equity ie, current share price
• The downside to this strategy is that funds used to pay the dividend could be used to reinvest and grow the business
• By reducing dividend payments Jack Welch grew GE by over 400%. The value of the firm increased if shareholders wanted more cash they could sell shares (NY 1981)
• Shareholder value
• Cash flow from operations
• Business strategy
• Sales growth
• Margin
• Planning horizon
• Investment strategy
• Capital investment
• Working capital
• Acquisitions
• Cost of capital
• Financing strategy
• Credit rating
• Tax rate
• Capital structure
• Dividend policy

Investment appraisal

• Companies need to invest in new wealth creating assets in order to continue in business or to grow
• Typically, capital investment projects require large cash outflows at the beginning then produce cash inflows over a number of years
• To maximise return to shareholders companies must select the best projects, often from a range of competing options, and avoid those with negative strategic or financial consequences
• Today’s capital spending is the way in which a company achieves its long term strategy
• In order to perform an investment appraisal we need to determine the costs and benefits of the project
• We are only interested in relevant costs and benefits i.e. those that result from undertaking the project and not those which will be incurred even if the project is rejected
• Irrelevant costs include “sunk costs” (i.e. those already incurred or to which we are committed) and apportioned fixed overheads. Such costs are irrelevant as they will be incurred anyway
• Additional overheads taken on as a result of a project, such as a new project manager, are relevant costs
• Opportunity costs, cash or otherwise, are relevant costs
• Evaluation methods
• Payback period (PP)
• The payback period is the number of years it will take to recover the original investment. The disadvantage is that it ignores the time value of money and the cash flows received after the payback period
• The discounted payback period is similar to the payback period except that the cash flows are discounted by the project's cost of capital. It still ignores cash flows received after payback
• Simple and easy to use (and very popular)
• Calculated using cash flows so not open to manipulation by creative accounting
• If we assume a shorter PP is preferable then the method takes account of risk in that we prefer earlier, more certain cash flows over those which are more distant and therefore less certain
• Cash flows after the payback period are ignored
• Ignores the time value of money. This is sufficiently serious for it to be rejected as an indicator of whether a project increases the value of a company
• Accounting rate of return (ARR)
• Also called ROCE and ROI
• Relates accounting profit (operating cash flows adjusted for depreciation) generated by an investment project to the capital it uses
• Average annual accounting profit ÷ average investment x 100
• Average investment must take account of any scrap value therefore average investment (assuming straight line depreciation over the life of the investment) = (initial investment + scrap value) ÷ 2
• ARR is calculated using accounting profits which are operating cash flows  adjusted for depreciation. Accounting profits are not cash flows; depreciation is an accounting adjustment which does not involve the movement of cash
• Using ARR we  accept a project if its return is above the company’s target or hurdle rate for investment
• If there are two mutually exclusive projects then the one with the higher ARR is accepted
• Easy to use as it gives a value in % terms which can be compared with a hurdle rate or with the company’s existing ROCE and to compare mutually exclusive projects
• Considers all cash flows over the life of a project (unlike PP)
• Uses accounting profit not cash. Accounting profit can be manipulated (e.g. by changing assumptions about scrap value and hence annual depreciation charges). Cash is used to pay dividends to shareholders and to acquire new resources
• Uses average profits therefore does not take into account the timing of profits (earlier profits may be preferred to later ones – see PP method)
• It is a relative measure (expressed as a %) and ignores the absolute size of the investment
• Net present value (NPV)
• The net present value (NPV) method finds the present value of the cash flows. For independent projects, if NPV > 0, accept the project. For mutually exclusive projects, choose the project with the highest NPV
• In theory, a positive NPV project should cause a proportionate increase in the company’s stock price. In reality, changes in the stock price will result more from changes in expectations about a project’s profitability
• Note that machine 1 has a higher IRR but machine 2 has a higher NPV. In this situation the NPV method is preferred as it will achieve the objective of maximising shareholder wealth
• IRR is a measure of relative returns whereas NPV measures the absolute increase in shareholder value
• Where an investment has both cash inflows and cash outflows over its life (rather than a single cash outflow at the start) it may have more than one IRR. The NPV method can accommodate such irregular cash flows and will lead to the correct investment decision.
• The NPV method assumes that project cash flows can be reinvested at the cost of capital whereas the IRR method assumes reinvestment at  the project’s IRR.
• Internal rate of return (IRR)
• The internal rate of return (IRR) is the rate of return that equates the present value of the project's expected cash inflows with the present value of the project's cost. For independent projects, accept if IRR > WACC
• For independent projects, the IRR and NPV will result in the same accept / reject decisions
• When evaluating mutually exclusive projects, the IRR and NPV methods can give conflicting results. NPV assumes that the rate of return on the project can be reinvested at the firm’s cost of capital.
• IRR assumes the firm can reinvest at the IRR rate

Corporate Governance

• The focus on shareholder wealth has brought much criticism one such critic was Sumantra Goshal who argued that there should be a greater focus on stakeholder value as opposed to shareholder value
• He also argued for a greater focus on business sustainability as opposed to short term gain.  The increased emphasis on Corporate Governance has echoed this theme
• Corporate governance covers a wide range of issues and disciplines from company secretarial and legal through business strategy, executive and non-executive management and investor relations to accounting and information management systems. Look at the amount of CG information now in Financial Statements.  (Financial reporting Council –UK. Sarbanes Oxley –US.)
• Financial reporting (Monsanto, Tesco, Parmalat)
• Corporate scandals (Enron, World com)
• Excessive  director’s remuneration (Stan O’Neal)
• The system by which organisations are directed and controlled
• The set of processes, customs, policies, laws and institutions affecting the way in which an entity is directed, administered or controlled.  CG serves the needs of shareholders, and other stakeholders, by directing and controlling management activities towards good business practices, objectivity and integrity in order to satisfy the objectives of the entity
• Management and reduction of risk
• Distribution rights and responsibilities of different participants in organisation
• Rules and responsibilities for decision making 
• Structures through which objectives are set
• Means of attaining the objectives and monitoring performance
• Provides an ethical framework and safeguards
• Can attract new investment
• Underpins capital market confidence 
• New management model
1. To satisfy shareholders by achieving sustained competitive success
2. To find and keep the best people
3. To be innovative
4. To operate with low costs
5. To satisfy customers profitably
6. To maintain effective governance and promote ethical reporting
• Key principles of adaptive processes
1. Base goals on external benchmarks
2. Base evaluation and rewards on relative improvement contracts with hindsight
3. Make action planning a continuous and inclusive process 
4. Make resources available as required under KPI accountability
5. Coordinate cross company actions to meet customer demand
6. Base controls on effective governance and on a range of relative performance indicators rather than on fixed reviews against annual plans and budgets

Key terms

• PMS: Performance Management System
• BSC: Balanced Scorecard
• IR: Integrated Reporting
• R&D: Research and Development
• EVA: Economic Value Added
• ROE: Return on Equity
• ROI: Return on Investment
• ROCE: Return On Capital Employed
• ROS: Return On Sales
• VOC: Voice Of the Customer
• CTQs: Critical To Quality outputs.
• KPIs: Key Performance Indicators
• Six-sigma: tools and techniques for process improvement – Bill Smith at Motorola (1986) Jack Welch at General Electric (1995)
• TQM: Total Quality Management
• Kaizen: Philosophy of continuous improvement – Japan post WW2 ‘The Toyota Way’