PERFORMANCE MEASURES
Part 1 Financial
Part 2 Non Financial
Part 1: PERFORMANCE MEASURES – FINANCIAL
Performance measurement is defined as “the process of quantifying the efficiency and effectiveness of past actions. Performance measurement systems play a key role in developing strategy, evaluating the achievement of organizational objectives and compensating managers.
Two main types of performance measure analysis:
Trend analysis – comparing current ratios to past performance
Often the direction of the trend is more important than the magnitude. Prior 3 years analysis helps one gain insight into the development of the company and gain knowledge about financial strengths and weaknesses.
Industry level analysis (bench marking) – involves comparing a business’s performance to that of other similar businesses. Bench marking is a good tool to show “best practices” and identify areas that might need improvement.
In order to evaluate performance we need not only to measure it but also to know the context in which that performance has been achieved.
Note – a combination of both type of analyses will provide more relevant data. For example, a region’s sales could be up 5% this year against a posted performance of +4% in the prior year. On the face of this, it might be good news – but if the industry has posted a +10% gain, then this is not as good performance as initially expected. Conversely a company could be posting what initially appears to be mediocre performance, but when matched up against an even lower industry experience, it actually has done well. (Use of RPE performance evaluations is predicated on “leveling the playing field” for companies whose performance is impacted by the same factors as the industry itself).
Why are ratios important?
1) Purchase a business; expand a business
2) Invest in an asset
3) Improve operations
· Increase revenues
· Decrease expenses
4) Improve planning/forecasting
5) Use for contracting purposes (bonuses, restrictive debt covenants
Ratios can be used to assess the health of a business, the value of an investment, to measure success for initiatives that have taken place.
If there is an indication that the client’s accounting is incorrect (financial accounting competency) and adjustments are required, then the key ratios should be reassessed in light of the impact of these adjustments. Given the restrictive nature of debt covenants, for example, it is not unusual to find that the company could be close to breach once the accounting adjustments have been made.
Note: don’t forget to question the client’s information if there are hints that it might not be accurate (sales projections, expense reductions, WACC estimate). These could be overly optimistic (sales) or understated (expenses).
Student should know the answers to these questions:
What are the components used in a ratio?
What does a healthy ratio look like (or conversely, what is a bad number?)
What is the ratio number indicative of? (ex. High inventory turnover could mean stock out situation which indicates lost sales opportunities)
Is it the right ratio to be used in this situation? (ex. use of ROA when company has aging assets)
METRICS, KEY PERFORMANCE INDICATORS and SCORECARDS
(includes extracts from article by Tom Gonzalez , managing director of BrightPoint Consulting)
Metrics: When we use the term metric we are referring to a direct numerical measure that represents a piece of business data in the relationship of one or more dimensions
An example would be: “gross sales by week.” In this case, the measure would be dollars (gross sales) and the dimension would be time (week.) For a given measure, you may also want to see the values across different hierarchies within a dimension. For instance, seeing gross sales by day, week, or month would show you the measure dollars (gross sales) by different hierarchies (day, week, and month) within the time dimension.
Key Performance Indicators (KPI): A KPI is simply a metric that is tied to a target. Most often a KPI represents how far a metric is above or below a pre-determined target. However, a KPI could also be a key metric which shows the health of a business segment in a hard number (example, SPH, conversion, average sale, unit turn, GMROI)
Typically KPI’s are shown as a ratio of actual to target and are designed to instantly let a business user know if they are on or off their plan without the end user having to consciously focus on the metrics being represented. Ideally, one sees the measure for this year and the comparative period/plan and the % variance. Sometimes simply seeing a percentage is misleading since a small change on a small base could be a significant % variance. Conversely, the % variance could be low but the actual measure is of such magnitude that is it critical to see the underlying base.
Scorecards: start at the highest, most strategic level of the business decision making spectrum. Scorecards are primarily used to help align operational execution with business strategy. The goal of a scorecard is to keep the business focused on a common strategic plan by monitoring real world execution and mapping the results of that execution back to a specific strategy. The primary measurement used in a scorecard is the key performance indicator. These key performance indicators are often a composite of several metrics or other KPIs that measure the organizations ability to execute a strategic objective.
An example of a scorecard KPI would be an indicator named “Profitable Sales Growth” that combines several weighted measures such as: new customer acquisition, sales volume, and gross profitability into one final score.
Reports: Probably the most prevalent analytical tool seen in business today is the traditional report. Reports can be very simple and static in nature, such as a list of sales transaction for a given time period, to more sophisticated cross-tab reports with nested grouping, rolling summaries, and dynamic drill-through or linking. Reports are best used when the user needs to look at raw data in an easy to read format. When combined with scorecards and dashboards *, reports offer a tremendous way to allow users to analyze the specific data underlying their metrics and key performance indicators.
* Dashboards: less focused on a strategic objective and more tied to specific operational goals. An operational goal may directly contribute to one or more higher level strategic objectives. A dashboard is typically a pictorial representation of progress towards a stated goal.
PA2 COMPETENCIES related to PERFORMANCE MEASURES
Financial accounting and reporting (Professional knowledge)
Develops, prepares, analyzes, and interprets relevant financial and non-financial performance measures (comparative financial results, trend/ ratio/industry analysis, key performance indicators (PK:FA:9)
Finance and financial planning (Professional knowledge)
Develops financial plans and monitors forecasts in alignment with strategic and operational plans
of organizations and/or individuals (financial plans, projections, proposals, and trend analyses;
pro forma and projected financial statements; translates operational plans into cash requirement plans) (PK:FN:6)
Develops and assesses financial KPIs (determines an appropriate cost of capital for an organization, determines economic value added [EVA]) (PK:FN9)
Management accounting (Professional knowledge)
Designs, evaluates, and advises on the organization’s performance measures to ensure alignment with corporate strategy, and recommends changes as required (KPIs and balanced scorecards) (PK:MA:1)
Develops, analyzes, and monitors operational plans and budgets, and recommends corrective action as needed (annual budgets, special project budgets, budget variance analysis) (PK:MA:2)
Identifies, assesses, and advises on information required for management decision making (cost-volume-profit relationships, cost classifications and flows, market or industry data, non-financial factors) (PK:MA:3)
Designs, evaluates, and advises on the organization’s management accounting systems to ensure that information is relevant, accurate, and timely (costing models, non-financial reporting, planning and forecasting, activity-based cost models, KPIs and balanced scorecards, responsibility accounting (PK:MA:4)
Implements, monitors, and updates management accounting systems (costing models, non-financial reporting, planning and forecasting, activity-based cost models, KPIs and balanced scorecards, responsibility accounting) (PK:MA:5)
Analyzes and evaluates information from management accounting systems, and makes decisions (pricing and costing decisions, transfer pricing decisions, make or buy decisions, performance-based compensation plans) (PK:MA:6)
Organizational Effectiveness (Leadership)
Analyzes and evaluates results and information from business activities and processes against objectives and benchmarks, and advises on further action (conducts and reports on gap analysis) (LD:OE:1)
Strategic and organizational leadership (Leadership)
Evaluates the organization’s strengths, weaknesses, opportunities, and threats (reputation, process,
finances, human resources, location, brand recognition, competition) (LD:SO:2)
Problem solving (Professionalism)
Collects, selects, verifies, and evaluates information relevant to the defined problem (PR:PS:2)
Integrates and analyzes data for patterns, relationships, and trends (PR:PS:3)
EXHIBIT 1 TOP TEN FINANCIAL RATIOS
Extract from Fastcompany.com
Corresponding to figures from your financial statements, ratios make relationships in your business more understandable. A ratio is only a shorthand note: It shows you what's going on according to your books. If your books are accurate portrayals of your business, here are 10 checkpoints to think about.
Acid Test = Cash and Near Cash ÷ Current Liabilities (also known as quick ratio)
Measures ability to meet current debt, a stringent test since it discounts the value of inventories. The rule of thumb is 1-to-1. A lower ratio indicates illiquidity. A higher ratio may imply unused funds.
Current Ratio = Current Assets ÷ Current Liabilities
Another measure of ability to meet current obligations. Less accurate than the acid test for very near term, but probably better a measure for six months to a year out, since it contains receivables and inventories as well as cash and near cash. The rule of thumb is 2-to-1, though this will be affected by seasonality.
Receivables Turnover = Sales ÷ Average Receivables
Measures the effectiveness of credit and collection policies. If your ratio is going down, collection efforts may be improving, sales may be rising, or receivables are being reduced. If your ratio is going up, sales credit policies may be changing, collection efforts may be flagging, or sales may have taken a nosedive.
Caution: This ratio depends on when receivables are measured and the seasonality of the business. Careful bookkeeping is also essential. The same applies to inventory turnover: Make sure that the measures are comparable from month to month. Use average receivables (inventories) if you can.
Days Receivables = 30 ÷ Receivables Turnover
Another way of looking at receivables. Particularly useful in explaining graphically what changes in credit and collection operations do to a business. (Note: collection period is calculated as 365/receivables turnover)
Inventory Turnover = Cost of Goods Sold ÷ Average Inventory
A measure of how well inventory is managed. Most businesses have a steady inventory turn. Compare your figures from year to year, asking yourself what causes the inevitable fluctuations. Small fluctuations are probably due to the flow of work. If you produce one jumbo jet a year, your inventory picture will be very different from that of a dealer of ripe tomatoes.
Days Inventory = 30 ÷ Inventory Turnover
Another way of monitoring inventory. This is controlled by your inventory ordering patterns (among other considerations), so be careful how you interpret it.
Gross Margin Rate = Gross Margin ÷ Sales
Permits comparison of margins over months with dissimilar sales. Ideally, this holds pretty steady in good months and bad -- but it depends on your business. It can distort fluctuations if sales are erratic.
Net Profit Rate = Net Profit ÷ Sales
An overall batting average: The aim is consistency over the long haul, not just short-term stardom.
Return on Investment (ROI) = Net Profit ÷ Net Worth
(Note: Net worth might show up on your financial statements as shareholder's equity.) Another profitability ratio, best looked at occasionally, because it tends to magnify short-term shifts in thinly capitalized companies.
Return on Assets (ROA)= Net Profit ÷ Total Assets
A better profitability measure than ROI. ROA shows how well you're using your assets. However, since profits are a volatile short-term measure, this should also be taken with a grain of salt. The long-term trend is what matters. A large investment in fixed assets to handle growth will seriously alter this ratio.
All ratios must be taken in context. The reason to look at them on a monthly basis is to make sure that you spot trends as they develop, not afterward. If you are doing something exceedingly well, you need to know it. And if something is wrong, it's better to find out sooner than later. (fastcompany.com)
EXHIBIT 2
Widely Used
Through Thesiness
KEY FINANCIAL RATIOS used by Retailers
The table that follows shows the key metrics used by most retailers to track and manage their performance. In particular, The Finance Function is very concerned with Return on Capital Employed or Return on Net Assets, Inventory Turn, Gross Margin Percent, Expenses Percent To Sales and expenses measured by line item and expressed as a percent to sales. They may also be concerned with other measures such as the Quick Ratio, Acid Ratio, Gearing and Interest Cover. This latter set tends to be examined infrequently, perhaps quarterly, half yearly or annually.
S
Widely UsedThrough The
Business / Buying &
Merchandisiing / Store
Operations / Finance / Marketing
Sales
• Sales vs. Last
year
• Sales vs. Plan/
Budget
• Like for like Sales
• Sales per Square
Foot/Meter
Inventory
•Stock Turn
•Availabilty/In-Stock %
Margins
• Gross Margins %
• Markdown %
Profi t
• Pre-Tax Profi t % / Sales
• Sell Through
Inventory
• GMROI
• Fresh Stock %
• Average Stock
• Weeks of Supply
Margins
• Markup %
• GMROF / Sales
• Average Sale (Money)
• Average Sale (Items)
• Conversion Rate
• Transaction Count
Inventory
• Shrinkage
Margins
•Local Markdown %
Labor
• Labor % Sales
• Sales per FTE
• Sales per Labor Hour
• GMROL / • Return on capital
Employed
• Return on Net Asset
• Interest Cover %
• Expense Lines %
Corporate and Shareholders
Corporate &
Shareholders
• Share Price
• Earnings per
Share / • Market Share
• Share of the Purse/
Wallet
Human Resources
•Employee/Associate
Turnover
• Training Cost per
Associate
• Absentee
EXHIBIT 3 FINANCIAL STATEMENT RATIOS
Refer to ratios on Blackboard (shock wave file) and use this to test your knowledge. This file will provide you with the specific ratio formulas, rules of thumb and some tips/guidelines.