Finanacial Accounting

Financial Statement Analysis And Valuation

- Dr. Pratapsinh L. Chauhan - Dr. Vishal G. Patidar

Preface Financial Statement Analysis and Valuation is an introduction to the concepts, tools, and applications of financial decisions. The purpose of this textbook is to communicate the fundamentals of financial management and financial decision analysis. This textbook is written in a way that will enable students understand financial decision-making and its role in the decision-making process of the entire firm. An important aspect of financial statement analysis is determining relevant relationships among specific items of information. Companies typically present financial information for more than one time period, which permits users of the information to make comparisons that help them understand changes over time. Rupee and percentage changes and trend percentages are tools for comparing information from successive time periods. Component percentages and ratios, on the other hand, are tools for establishing relationships and making comparisons within an accounting period. Both types of comparisons are important in understanding an enterprise's financial position, results of operations, and cash flows. Authors prudently compose the book in such a way that different groups of users of financial statements get detailed coverage on Financial Statement and its Valuation Techniques. In this book various techniques like, Profitability analysis, working capital analysis, activity analysis, analyzing financial performance of bank, economic value added, balance score card analysis and value based management has been explained with suitable illustrations.

Contents

1.

Financial Statement Analysis – An Introduction

2.

Working Capital Analysis

3.

Activity Analysis

4.

Profitability Analysis

5.

Productivity Analysis

6.

Analyzing Financial Performance of Banks

7.

Economic Value Added – A Tool for Performance Management

8.

Balance Score Card

9.

Value Based Management

Chapter – 1 Financial Statement Analysis – An Introduction

•

Concept of Financial Statements

•

Types of Financial Statements

•

Need of Financial Statements

•

Objectives of Financial Statements

•

Importance and Usefulness of Financial Statements

•

Tools of Financial Statement Analysis

•

Limitations of Financial Statements

•

Concept of Financial Analysis

•

Need and Aims of Financial Analysis

•

Illustration

•

References

Concepts of Financial Statements: Financial statements represent a summary of the financial information prepared in the required manner for the purpose of use by managers and external stakeholders. Financial reports are prepared basically to communicate to the external shareholders about the financial position of the company that they own. Financial statement analysis is useful both to help anticipate future conditions and, more important, as a starting point for planning actions that will improve the firm’s future performance. Financial statement analysis generally begins with a set of financial ratios designed to reveal a company’s strengths and weaknesses as compared with other companies in the same industry, and to show whether its financial position has been improving or deteriorating over time. Financial statements provide an overview of a business financial condition in both short and long term. In the words of Hampton, “A financial statement is an organized collection of data organized according to logical and consistent accounting procedures." Therefore, all the statements and accounting reports which the accountants prepare at the end of a period for a business enterprise may be taken as financial statements. But the principal financial statements are the `balance sheet’ and the `profit and loss account'. In the word of Howard and Upton, " Although any formal financial statements expressed in money values might be thought of as financial statements, the term has come to be limited by most accounting and business writers to mean the `balance sheet' and the `profit and loss statements'.” The balance sheet states the assets, liabilities and capital of the business and profit and loss statements shows the results of operations achieved during a certain period. These financial statements may be of various types, but according to Miller all the financial statements may be broadly classified in the following manner: 1. The audited statement 2. The interim statement 3. The un-audited year-end statement 4. The "estimated" statement

Accounting, which is the process of evolution, has three phases : (i) the recording of transaction in the books of original entry, (ii) the classification of these transaction in ledger, and (iii) the summarization of the records. The construction of the financial statement is a part of the third phase of accounting techniques.

Thus,

financial

statements summarized periodical reports of financial and operating data accumulated by an enterprise in its books of accounts. The accounting figures which are collected, tabulated and summarized by accounting methods are presented in financial statements. By nature, therefore, the financial statements are the end products of financial accounting or they are the final repositories of all accounting figures. Financial statements are periodical statements and the period for which they relate is known as accounting period, usually of one year's duration. Financial statement analysis is done to try and predict the future performance of a company. It is the process of examining relationships among financial statement elements and making comparisons with relevant information. It is a valuable tool used by investors and creditors, financial analysts, and others in their decision-making processes related to stocks, bonds, and other financial instruments. The goal in analyzing financial statements is to assess past performance and current financial position and to make predictions about the future performance of a company. Investors who buy stock are primarily interested in a company's profitability and their prospects for earning a return on their investment by receiving dividends and/or increasing the market value of their stock holdings. Creditors and investors who buy debt securities, such as bonds, are more interested in liquidity and solvency the company's short-and long-run ability to pay its debts. Financial analysts, who frequently specialize in following certain industries, routinely assess the profitability, liquidity, and solvency of companies in order to make recommendations about the purchase or sale of securities, such as stocks and bonds. Analysts can obtain useful information by comparing a company's most recent financial statements with its results in previous years and with the results of other companies in the same industry. Three primary types of financial statement analysis are commonly known as horizontal analysis, vertical analysis, and ratio analysis.

An important aspect of financial statement analysis is determining relevant relationships among specific items of information. Companies typically present financial information for more than one time period, which permits users of the information to make comparisons that help them understand changes over time. Financial statements based on absolute value and percentage changes and trend percentages are tools for comparing information from successive time periods. Component percentages and ratios, on the other hand, are tools for establishing relationships and making comparisons within an accounting period. Both types of comparisons are important in understanding an enterprise’s financial position, results of operations, and cash flows. Types of Financial Statements: The time is gone when leaflet or `dance card' type of annual report was considered sufficient as a folder in which the chairman and accountant `blessed' condensed financial summaries. But in the present time, the Annual Reports contain financial statements and the explanation of the various financial results. There are two major financial statements which are vital to financial analysis and financial management i.e., profit and loss account and balance sheet. These statements contain various information’s often needed by various persons interested in the enterprise such as shareholder, government, debenture holder, management etc. They convey the financial condition and results of operation of an enterprise for a given period and at a given date. In the annual report, together with these two statements, there may be statement or schedules of retained earnings, stockholders, equity statement, capital surplus fund , cash flow statement

etc. Accounting is a language of `Finance'

or

`Monetary'. A general search continues to be made for ways to improve readability of financial statements. A lay man who reds these statements is not able to understand the terminology used in these statements.

Balance Sheet: The balance sheet is a statement of assets and liabilities of a firm or what it owns and what it owes, as on a given date. In a balance sheet, the assets and liabilities are equal to each other. In the word of Pyle, White and Larson, "A balance sheet is so called because its two sides must always balance, the sum of the assets shown on the balance sheet must equal liabilities plus owner equity. According to Block and Hirt, "The balance sheet indicates hat the firm owns, and how these assets are financed in the form of liabilities or ownership interest. It is a statement of affairs of an organisation at a point of time and may be defined as a statement prepared with a view to measuring the financial position of a business enterprise at a certain fixed date. In reveals the financial position of a business as reflected by the accounting records and contains a list of assets, liability and capital items as on a given date. The balance sheet is designed to show the condition of the business in a form easily readable and more quickly comprehended than would be possible form a survey of the facts shown in the detailed records. The intention is to afford the shareholders who have placed their capital in an enterprise and the creditor who does business with it, an opportunity of estimating from time to time the financial stability. A balance sheet is a `status report' and as such it shows `what we have' and from `where' on the last date of the accounting year. In the word of Dennis, "The simplest way for a layman to understand this is to think of balance sheet as a statement of the `sources of funds' and a statement of the `deployment of funds'. It is always presented at a definite date highlighting the bird's eye-view of the financial statements. It is a statistical statement which shows the purpose of business at a certain moment of time. The balance sheet is also known as `Statement of Financial Condition', `Statement of Financial Position', `Statement of Assets

and

Liabilities',

`Statements

of

Resources and Liabilities', Statement of assets, Liabilities and Capital', `Statement of worth', and `Financial Statement'. It is an instantaneous photograph of assets, liabilities and net worth.

According to Hastings, "It reveals the property owned by the business, the assets and the debts owned by the company, the liabilities." Income Statements: The income statement, usually designated as profit and loss account for the relevant financial year, shows the net profit or net loss resulting from the operations of business during a special field period of time. The items appearing in it are in the nature of `revenue'. In the words of Walgenbach, Dittrich and Hanson, "To show the results of operations for a period, an income statement is prepared, which lists the revenues and expenses and presents the resulting net income amount." Foulke defines income statement as "the mathematical interpretation of the knowledge,

foresight,

and aggressiveness

policies,

experience,

of the management of a business

enterprise from the point of view of income, expenses, gross margin, operating profit, and net profit or loss." It provides a review of the factors directly concerned with the determination of the net income- the revenue realised from the sale of goods or services and the costs incurred in the process of producing the revenue. The income statement summarises the changes that have taken place since the date of preceding balance sheet and that have affected the owner's share in the business either by gain or loss. It is a performance report recording the changes in income, expenses, profit and loss as a result of business operations during the year between two balance sheet dates. According to Guthmann, "The balance sheet might be described as financial cross sections taken at certain intervals and earnings statements as condensed history of the growth or decay between the cross sections." The income statement suggests a long range view of a business and shows where it is going.

Statement of Retained Earnings: The statement of retained earnings indicates the magnitude and causes of changes in retained earnings of the enterprise due to year's activities. Retained earnings represent the sum of the earnings which have been kept by the enterprise over the years that is earnings not paid out in dividends. As defined by Walgenbach and Dittrich, "a retained earnings statement is an analysis of the retained earnings accounts for the accounting period and is usually presented with the other corporate financial statements." The statement of retained earnings serves as the link between the income statement and the balance sheet. Thus, changes in equity accounts between balance sheet dates are reported in the statement of retained earnings. The retained earnings shown in the statement of retained earnings are retained by the enterprise primarily to expand business. Statement of Changes in Financial Position: The statement of changes in financial position is a logical adjunct to the balance sheet and income statement. It has only recently become a required component of published corporate report, equal in status to the balance sheet and the income statement. According to Granof, "The statement of changes in financial position is most commonly used to indicate changes during the year in the companies' working capital position. The statement of changes in financial position indicates both the sources and application of working capital. Thus, it reveals the sources from which funds have been received during the year and these funds were used within the enterprise. According to Hampton, "This statement shows the movement of funds into the firm's current-asset accounts from external sources such as stockholders, creditors, and customers. It also shows the movement of funds to meet the firm’s obligations, retires stock, or pay dividends."

This statement is divided into two parts : I shows sources of working capital and part II shows application of working capital. The difference in the sources and application represents either net increase or decrease in working capital. Thus, it portrays the inflow and outflow of funds. It shows causes of net changes that occur in working capital between two balance sheet dates. In this way the variation in the flow of funds and their sources is measurable and usable for financial and operating analysis. Need of Financial Statements: During each business day, many transactions occur between a cooperative and its patrons, suppliers, employees, and customers. To understand and control the entire business operation, information must be brought together from all parts of the organization. Managers of individual operations or departments need information on physical units such as tons of fertilizer or number of auto batteries. However, to manage all operations, financial records are needed to control the total business. Financially, the performance of a business is judged as a single unit. Banks look at the total business when lending. Suppliers want to know about the strength of the total business before granting credit. Managers and directors use financial information for the entire organization in making many decisions, including if purchases of new facilities are possible or when member equity can be redeemed. Members and patrons also have an interest in understanding cooperative financial statements. Financial strength determines a cooperative’s ability to control its future and provide services for its members and patrons. Services provided by a local cooperative can be an important part of members’ operations. Members depend on financially strong organizations to serve their current and future needs. Members build an equity investment in their cooperative. Usually cooperatives do not pay dividends on this investment but redeem the equity upon the board of directors’ decisions. A financially secure cooperative is able to redeem equity regularly. A financially weak cooperative may delay equity redemption indefinitely.

Objectives of Financial Statements: The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions. Financial statements should be understandable, relevant, reliable and comparable. Reported assets, liabilities and equity are directly related to an organization's financial position. Reported income and expenses are directly related to an organization's financial performance. The Accounting Principles Board of America mentions the objectives of financial statements as follows: 1. To provide reliable financial information about economic resources and obligations of a business enterprise. 2. To provide reliable information about in net resources (resources less obligations) of an enterprise that results from its activities. 3. To provide financial information that assist in estimating the earning potentials of a business. 4.

To provide other needed information about changes in economic resources of obligation.

5.

To disclose, to the extent possible, other information related to the financial statements that is relevant to the needs of the users of these statements.

In order to meet the above objectives and to suit the needs of the varied users, the accountant entrusted with the task of compiling and presenting financial statements must follow a set of guidelines to ensure consistency, completeness, and fairness of the statements. These guidelines are called "generally accepted accounting principles". In absence of these `generally accepted accounting principles' the statements prepared may

be un-understandable and misleading for the various groups of users. In addition to this, the financial statements prepared must also be authenticated as to their accuracy and fairness so that the confidence of the users is invoked. For this purpose it is necessary that these statements be reviewed and certified by an independent reviewer, commonly known as auditor. Importance and Usefulness of Financial Statements:The importance and usefulness of financial statements, from the point of view of various interested parties, are as follows: 1.

Management:

Financial statements are of very great help to management in understanding the progress, position and prospects of business. Using analogy, it can be said that financial statements serve the business management as gauges and charts serve the engineer. In the absence of information’s which are included in the financial statements, management can neither plan nor fulfill easily the functions of operation and control. 2.

Investors:

Financial statements are also significant for investor both present and prospective. However, the investor looks to the financial position of business concern from a different angle. Investors are interested in two things - firstly, they want to invest in such a situation where they feel the financial structure of a company is sound. Secondly, they want to invest only in such concern whose future is bright. Investor gives first attention to the profits after taxes in the profit and loss account. In case of prospective investors, financial statements serve as a mirror reflecting potential investment opportunity.

3.

Bankers:

A banker is primarily concerned with the ability of paying current debts and the current operation results. He wants not only the payment of advances but he also wants that such advance should be repaid at proper time also. 4.

Government:

Central and State Governments and Local Authorities are also interested in published financial statements in order to assess their revenues through various taxes to regulate capital issue and public utility regulation. 5.

Research Scholars:

The financial analysts and research workers are interested in published financial statements for guiding management or for establishing certain principles. A financial analyst can peep through these statements into the financial policies pursued by the management and offer constructive suggestions to over come the financial malady, if diagnosed. 6.

Trade Creditors:

From the creditor's point of view the Financial statements act as magic eye highlighting the credit worthiness, i.e., assurance whether the company will honour obligations as and when they mature.

7.

Labour Unions:

From social justice point of view in the present time, the labour unions may know if the labour is getting its fair share of business earnings. 8.

Public:

Financial statements are also valuable to the public who are interested in prospects of a concern, in one way or the other. It is the securities of the enterprise alone that are bought and sold on stock exchanges and the public is interested ,mostly in their financial standing and also to avoid hostile feelings of the public. Tools of Financial Statement Analysis: The commonly used tools for financial statement analysis are: •

Financial Ratio Analysis

•

Comparative financial statements analysis: –

Horizontal analysis/Trend analysis

–

Vertical analysis/Common size analysis/ Component Percentages

Financial Ratio Analysis •

Financial ratio analysis involves calculating and analysing ratios that use data from one, two or more financial statements.

•

Ratio analysis also expresses relationships between different financial statements.

•

Financial Ratios can be classified into 5 main categories: –

Profitability Ratios

–

Liquidity or Short-Term Solvency ratios

–

Asset Management or Activity Ratios

–

Financial Structure or Capitalisation Ratios

–

Market Test Ratios

Profitability Ratios 3 elements of the profitability analysis: •

Analysing on sales and trading margin –

•

Analysing on the control of expenses –

•

focus on gross profit focus on net profit

Assessing the return on assets and return on equity

Profitability Ratios •

Gross Profit % = Gross Profit * 100 Net Sales

•

Net Profit % = Net Profit after tax * 100 Net Sales

Or in some cases, firms use the net profit before tax figure. Firms have no control over tax expense as they would have over other expenses. ⇒ Net Profit % = Net Profit before tax *100 Net Sales •

Return on Assets =

Net Profit

* 100

Average Total Assets •

Return on Equity =

Net Profit

*100

Average Total Equity Liquidity or Short-Term Solvency ratios Short-term funds management •

Working capital management is important as it signals the firm’s ability to meet short term debt obligations.

For example: Current ratio •

The ideal benchmark for the current ratio is Rs. 2: Rs. 1 where there are two Rs. of current assets (CA) to cover Rs. 1 of current liabilities (CL). The acceptable benchmark is 1: 1 but a ratio below 1CA:1CL represents liquidity riskiness as there is insufficient current assets to cover 1 of current liabilities.

Liquidity or Short-Term Solvency ratios •

Working Capital = Current assets – Current Liabilities

•

Current Ratio =

Current Assets Current Liabilities

•

Quick Ratio = Current Assets – Inventory – Prepayments Current Liabilities – Bank Overdraft

Asset Management or Activity Ratios •

Efficiency of asset usage –

How well assets are used to generate revenues (income) will impact on the overall profitability of the business.

For example: Asset Turnover •

This ratio represents the efficiency of asset usage to generate sales revenue

•

Asset Turnover =

Net Sales Average Total Assets

•

Inventory Turnover = Cost of Goods Sold Average Ending Inventory

•

Average Collection Period = Average accounts Receivable Average daily net credit sales*

* Average daily net credit sales = net credit sales / 365 Financial Structure or Capitalisation Ratios Long term funds management •

Measures the riskiness of business in terms of debt gearing.

For example: Debt/Equity •

This ratio measures the relationship between debt and equity. A ratio of 1 indicates that debt and equity funding are equal (i.e. there is Rs.1 of debt to Rs.1 of equity) whereas a ratio of 1.5 indicates that there is higher debt gearing in the business (i.e. there is Rs. 1.5 of debt to Rs.1 of equity). This higher debt gearing is usually interpreted as bringing in more financial risk for the business particularly if the business has profitability or cash flow problems.

•

Debt/Equity ratio = Debt / Equity

•

Debt/Total Assets ratio =

Debt Total Assets

•

Equity ratio =

*100

•

Times Interest Earned = Earnings before Interest and Tax Interest

Equity Total Assets

*100

Market Test Ratios •

Based on the share market's perception of the company.

For example: Price/Earnings ratio •

The higher the ratio, the higher the perceived quality of the earnings by the share market.

•

Earnings per share =

Net Profit after tax Number of issued ordinary shares

•

Dividends per share =

•

Dividend payout ratio = Dividends per share *100 Earnings per share

•

Price Earnings ratio = Market price per share Earnings per share

Dividends Number of issued ordinary shares

Horizontal analysis/Trend analysis •

Trend percentage

•

Line-by-line item analysis

•

Items are expressed as a percentage of a base year

•

This is a time series analysis

•

For example, a line item could look at increase in sales turnover over a period of 5 years to identify what the growth in sales is over this period.

Vertical analysis/Common size analysis/ Component Percentages •

All items are expressed as a percentage of a common base item within a financial statement

•

e.g. Financial Performance – sales is the base

•

e.g. Financial Position – total assets is the base

•

Important analysis for comparative purposes –

Over time and

–

For different sized enterprises

Limitations of Financial Statements: Financial statements are basically representatives of a business' financial activates. These are: Balance sheet, Income Statement, Statement of retained earnings and Statement of cash flows. The nature of figures which are reported and the way in which they are reported tend to give the impression to the reader that financial statements are precise, exact and final. Financial Statements are not free from limitations. Following are their limitations to investors: •

Financial statements only reveal financial position of the company in a summarized manner. In case of balance sheet it shows the financial position of business on a particular day usually at the end of financial year.

•

Financial statements do not record non-monetary transaction.

•

Over time, conditions change and financial statements may not reflect current market values.

•

It is only the starting point of analysis, they do not show clearly the reasons behind a certain trend, the investors have to search and analyze by themselves.

•

Past financial performance does not signify what will happen with the investor in future

•

The financial statements are useless without the notes to the financial statements, which are complex.

•

Unless the statements are audited their authenticity is under doubt and they may be misleading and fraudulent.

•

Financial statements reflect the recorded facts and figures. Hence these are not useful for control purpose.

•

Valuation of inventories, method of depreciation, treatment of expenditure as capital or revenue etc., are based upon personal judgment.

•

These contain some estimated amounts such as provision for doubtful debts etc.

•

Balance sheet shows the deferred expenses

such

as preliminary expenses.

These are not really assets. •

Many a times, consistency is not followed and hence the profitability is not comparable from year to year.

•

Debt-equity ratio as prescribed by the Controller of Capital Issue is not mentioned in the financial statements.

Concept of Financial Analysis: Financial analysis is the process of identifying the financial strengths and weaknesses of the firm by property establishing relationships between the item of the balance sheet and the profit and loss account. Financial analysis helps to determine smooth operation of the project over its entire life cycle. The two major aspects of financial analysis are liquidity analysis and capital structure analysis for which ratios are employed. Liquidity ratios measure a project’s ability to meet its short-term obligations. Capital Structure analysis is done to see long term solvency i.e. the project’s ability to meet long-term commitments to creditors. Information contained in Balance Sheet and Profit and Loss Account are often in the form of raw data rather than as information useful for decision making. The process of converting the

raw data contained in the financial statements

into meaningful information for decision making is known as financial statement analysis. Profit and Loss Account is a dynamic statement which shows income and expenses between two balance sheet dates. Likewise Balance Sheet is a `static' statement that shows the financial position on a certain date. It is an instantaneous photograph of the assets and liabilities of an enterprise at a particular unit of time. It is some what similar to the view one gets when a motion picture projector is stopped and a single frame appears of the screen. Financial Analysis is a process of synthesis and intellectual activity. It is a technique of X-raying the financial position as well as the progress of a company. An analysis of both

these statements gives a comprehensive understanding of business operations and their impact on the financial health. If the business operations results in profits, the total investment is enhanced, bringing prosperity to shareholders, increase

in goodwill and

strengthening of credit. On the other hand, if these are looses, capital invested to the extent of loss is lost or dissipated ability to pay creditors and lenders is weakened and the business concern operates under a `handicap'. Users of Financial Analysis „ Trade creditors „ Lenders „ Investors „ Management Need and Aims of Financial Analysis: Need: Analysis of financial statements is an effort to find answers to a variety of practical and important questions such as prospects for future earnings, ability to pay interest, debt maturities-both current as well as long-term and probability of a sound dividend policy, etc. The main importance of financial

analysis is

the pin-pointing of the

strengths and weakness of a business enterprise by regrouping and analyzing the figures contained in financial statements i.e., Balance Sheet and Profit and Loss Account. An analysis of financial statements is more meaningful to the management and other interested in the concern. •

It helps in judging accounting quality by measuring overstatement/understatement of profits; auditors qualifications; method of income recognition; inventory valuation and depreciation policies; off balance sheet liabilities; etc.

•

Earnings protection (sources of future earnings growth; profitability ratios; earnings in relation to fixed income charges; etc.)

•

Adequacy of cash flows (in relation to debt and fixed and working capital needs; sustainability of cash flow; capital spending flexibility; working capital management etc.)

•

Financial flexibility (alternative financing plans in times of stress; ability to raise funds; asset redeployment potential; etc.)

Need for Management: Management of an enterprise use financial analysis for: (i)

Measuring the success or the failure of the operation, as

a whole,

(ii)

Making sound decisions relating to all the phase of operations,

(iii)

Controlling operations and

(iv)

Determining the relative efficiency of departments and process.

Need for outside parties: (i)

Creditors use analysis as a basis for granting credit.

(ii)

Investors use it to come to a decision of buying, selling

or holding shares in a

company, and (iii)

Government uses it for purposes of regulations and administration.

Aims: The main aims of financial analysis are listed as follows: 1.

To judge the financial health of the undertaking for management, creditors and bankers.

2.

To judge the earnings performance of the company and facility with which dividends can be paid from out of earned profits. Potential investors are primarily interested in this aspect.

3.

In case of institutional investors the analysis is carried over a long period with a view to identifying companies having growth potential and a sound financial base.

4.

To judge the ability of the company to pay the principal and interest, arrangements for amortization of debt and the security available for the loans extended.

5.

To judge the solvency of the undertaking. The trade creditors are mainly interested in assessing the liquidity position for which they look into the following: (a) Whether the current assets are sufficient to pay off the current liabilities, (b) The proportion of liquid assets to current assets, (c) Whether the debenture-holders are secured by a floating charge on the current assets and (d) The business prospects with reference to the future growth and earnings.

Case -1: Financial statement analysis •

The following financial statements of XYZ Ltd were prepared. XYZ Ltd is a diversified enterprise.

•

The financial statements of XYZ Ltd need to be analysed. An investor is considering purchasing shares in the company. Relevant ratios need to be selected and calculated and a report needs to be written for the investor. The report should evaluate the company’s performance and position

XYZ Ltd Statement of Financial Position as at 31 March 2007 000 Current Assets Bank Accounts receivable Inventory

2008

000

33.5 240.8 300.0

000

Horizontal Analysis

000

41.0 210.2 370.8 574.3

622.0 108

Non-current assets Fixtures & fittings (net) 64.6

63.2

381.2

376.2

Land & buildings (net) 445.8 1,020.1

Total assets Current Liabilities Accounts payable Income tax

261.6 60.2

Non-current liabilities Loan

Shareholders Funds Paid-up ordinary capital Retained profit Total liabilities & equity

439.4 99 1,061.4 104

288.8 76.0 321.8

364.8 113

200.0

60.0 30

300.0 198.3

334.1 302.5 498.3 1,020.1

636.6 128 1,061.4 104

XYZ Ltd Statement of Financial Performance for year ended 31 March 2007 000 Sales Less Cost of goods sold Gross profit Wages & salaries

000 2,240.8 1,745.4

2008 000

495.4 185.8

275.6

12.2

12.4

8.4

13.6

4.6

7.0

24.0

6.2

9.0

16.4

Horizontal Analysis

000 2,681.2 120 2,072.0 119 609.2 123

Rates Heat & light Insurance Interest expense Postage telephone Depreciation Buildings

&

Fixtures fittings

&

5.0

Net profit before tax Less Income tax Net profit after tax

5.0 276.0

27.0

369.0 32.8

134

219.4

240.2

60.2 159.2

109 76.0 126 164.2 103

XYZ Ltd Statement of Cash Flows for the year ended 31 March 2007 000

2008 000

000

000

Cash flow from operations Receipts from customers

2,281

2,711.8

(2,050)

(2,460.4)

Interest paid

(24)

(6.2)

Tax paid

46.4)

(60.2)

Payments to suppliers & employees

Net cash flow from operating activities

160.6

185

Investing activities Purchase of non-current assets

(121.2)

Net cash used in investing activities

(31.4) (121.2)

(31.4)

Financing activities Dividends paid

(32.0)

(40.2)

Issue of ordinary shares

20.0

34.1

Repayment of loan capital

-__

(140.0)

Net cash outflow from financing

(12)

(146.1)

activities Increase in cash & cash equivalents

27.4

7.5

Additional information: •

Credit purchases for the year 2008 were Rs. 2,142,800.

•

General prospects for the major industries in which XYZ is involved look good with a forecast glut of oil set to reduce the cost of production and world demand for product remaining strong.

Benchmarks: •

There are no exact benchmarks for Walker Ltd because it is a diversified company. The following are average indicators that relate to the retailing and manufacturing industries for the year 2008. –

Gross profit margin

25%

–

Net profit margin

7%

–

Inventory turnover

6 times

–

Debt/equity ratio

0.6 : 1

–

Return on Assets

12%

–

Return on Equity

20%

Solution: Relevant ratios Important note: The calculations of the ratios in this illustration did not use “averages” for total assets, equity and inventory. The 2007 and 2008 year end figures were used and this is a slight variation to the formulas provided. Profitability ratios:

Benchmarks

2005

2006

Gross Profit Margin

Industry 25%

22%

22.7%

Net Profit Margin

Industry 7%

7.1%

6.1%

Return on Assets

12%

15.6%

15.5%

Return on Equity

Industry 20%

32%

26%

Asset Management ratios:

Benchmarks

2007

2008

Inventory Turnover

Industry 6%

5.8 times

5.58 times

Asset Turnover

Not given

2.2

2.53

Liquidity ratios:

Benchmarks

2007

2008

Current Ratio

Ideal standard 2:1 Acceptable standard 1:1

1.78:1

1.70:1

Quick Ratio

Ideal standard 2:1 Acceptable standard 1:1

0.85:1

0.69:1

Days Payable

Standard 30 days

Credit purchases not available

49.19 days

Financial Benchmarks Structure ratios:

2005

2006

Debt/Equity

Industry 0.6:1 Standard benchmark 1:1

1.05: 1

0.67:1

TIE

Standard benchmark: Between 3 and 5. Below 3 risky. Above 5 very favourable

10.14 times

39.74 times

Report •

For the investor considering the purchase of shares in the company, the return they will earn is the key financial factor but an overall evaluation of the company’s performance and position is also important to get a better picture of how well the company is actually doing.

•

ROE in 2008 is 26%. Whether or not this is attractive depends on the perceived riskiness of this investment and other alternatives available but this return is certainly more attractive than current bank interest rates.

•

ROE has decreased by 4% but the company’s ROE at 26% is still better than the industry average of 20%

•

Riskiness of business is being reduced by the significant repayment of loan in 2008.

•

Profitability •

The NP% and ROA ratios show a small downward trend in % over the 2 year period. ROE% ratio shows a more significant decrease but is still better than the industry average.

•

Gross Profit Margin is slightly unfavourable at about 2.3% below the industry benchmark of 25%.

•

The horizontal analysis information show that Sales have increased by 20%. However operating costs have increased by 34%.

•

•

Asset Management •

IT has gone down slightly from 5.8 to 5.58 times.

•

IT is still close to the industry benchmark of 6 times.

•

AT has increased showing more sales being generated from asset usage

Liquidity •

Current ratios of 1.78:1 (2005) and 1.70: 1 are at above acceptable levels but below ideal level.

•

Quick ratios appear more of a concern being below acceptable levels in both years and even more so in 2008 (0.69:1).

•

Raises some concerns over the liquidity of the business and inventory management (although IT ratio only shows a slight decline in 2008).

•

Days Payable is a concern as there may be poor debt payment management.

•

Financial Structure •

Although slightly higher than D/E industry benchmark (0.67:1), business has become less risky due to the significant repayment of loan in 2008.

•

TIE is extremely good for the business at 39.74 times (well above 5 the standard benchmark).

•

Cash flow situation •

Strong cash flow from operating activities (increased from 160,600 to 185,000).

•

Spending under investing activities suggest more growth.

•

Repayment of debt under financing activities imply restructuring of business to have more equity funding rather than debt funding.

Recommendation Given: 1) The strong forecast for the industry (i.e. general prospects looking good and world demand for products remaining strong), 2) The sales growth in this business, 3) Acceptable ratios as they are quite close to the industry averages, 4) Good cash flows from operating activities and 5) Favourable ROE, although it has decreased, it is still better than the industry average ROE. =>

It is recommended that the investor purchase shares in the XYZ Ltd Company.

Case -2: Analysis the financial statement of Srujal-Mart Srujal-Mart Stores Balance Sheet For Fiscal Years 2007 and 2006 Period Ending

Assets Current Assets Cash and cash equivalents Net receivables Inventory Other current assets Total current assets Long-Term Assets Property plant and equipment Goodwill Other assets Total assets Current Liabilities Payables and accrued expenses Short-term and current long term debt Total current liabilities Long-Term Liabilities Long-term debt Deferred long-term liability charges Minority interest Total liabilities Stockholders Equity Common Stock Retained earnings Capital surplus Other stockholder equity Total stockholder equity Total liabilities and equity

March 31, 2007

March 31, 2006

Rs. 2,161 2,000 22,614 1,471 Rs. 28,246

Rs,2,054 1,768 21,442 1,291 Rs. 26,555

Rs. 45,750 8,595 860 Rs. 83,451

Rs. 40,934 9,059 1,582 Rs.78,130

Rs. 24,134 3,148 Rs.27,282

Rs. 22,288 6,661 Rs.28,949

Rs.18,732 1,128 1,207 Rs.48,349

Rs.15,655 1,043 1,140 Rs.46,787

Rs.445 34,441 1,484 (1,268) Rs.35,102 Rs.83,451

Rs.447 30,169 1,411 (684) Rs.31,343 Rs.78,130

Srujal-Mart Stores Income Statement for 2007 and 2006 March 31,2007

March 31, 2006

Rs. 219,812

Rs.193,295

171,562

150,255

Rs. 48,250

Rs.43,040

36,173

31,550

Rs .12,077

Rs.11,490

1,326

1,374

Rs.10,751

Rs.10,116

Income Tax Expense

3,897

3,692

Minority Interest

(183)

(129)

Rs.6,671

Rs.6,295

Total Revenue Cost of Revenue Gross Profit Selling General and Administrative Expenses Earnings Before Interest and Taxes Interest Expense Income Before Tax

Net Income Solution:

Selected Financial Ratios for Srujal-Mart Stores for 2007 and 2006 Ratio

2007

2006

Return Basic earning power

Rs.12,077/Rs.83,451 = 14.47%

Rs.16,490/Rs.78,130 = 21.11%

Return on assets

Rs.6,671/ Rs.83,451 = 7.9%

Rs.6,295/ Rs.78,130 = 8.06%

Return on equity

Rs.6,671/ Rs.35,102 = 19.00%

Rs.6,295/ Rs.31,343 = 20.03%

Current ratio

Rs.28,246/ Rs.27,282 = 1.04 times

Rs.26.555/ Rs.28,949 = 0.92 times

Quick ratio

Rs.5,628 / Rs.27,282 = 0.21 times

Rs.5,113/ Rs.28,949 =0.18 times

Liquidity

Profitability Gross profit margin

Rs.48,250/ Rs.219,812 = 21.95%

Rs.43,040/ Rs.193,295 = 22.27%

Operating profit margin Rs.12,877/ Rs.219,812 = 5.86%

Rs.11,490/ Rs.193,295 = 5.94%

Net profit margin

Rs.6,671/ Rs.219,812 = 3.03%

Rs.6,295/ Rs.193,295 = 3.26%

Inventory turnover

Rs.171,562/ Rs.22,618 = 7.59 times

Rs.150,255/ Rs.21,442 = 7.01 times

Total asset turnover

Rs.219,812/ Rs.83,451 = 2.63 times

Rs.193,295/ Rs.78,130 = 2.47 times

Total debt-to-assets

Rs.48,319/ Rs.83,451 = 58.90%

Rs.46,787/ Rs.78,130 = 59.88%

Total debt-to-equity

Rs.48,319/Rs.35,102 = 1.38 times

Rs.46,787/ Rs.31,343 = 1.49 times

Interest coverage

Rs.12,077/ Rs.1,326 = 9.11 times

Rs.11,490/ Rs.1,374 = 8.36 times

Activity

Financial leverage

References: •

Hampton, John J. Financial Decision Making - Concepts, Problems

and Cases,

Reston Pub. Co.,Inc., Virginia Ed.1976, p.62. •

Howard, Bion B. & Upton, Miller: Introduction to Business

Finance, McGraw-

Hill Book Co.Inc., New York, Ed.1953, p.61. •

Miller, Donald E.: The Meaningful Interpretation of Financial

Statements,

American Mgt. Asso., Inc., New York, Ed.1972, p.9. •

Pyle, William W.; White, John A. and Larson, Kermit D. : Accounting Principles, Richard D. Irwin, Inc.,

Fundamental

Homewood, Illinois, Ed.1978,

p.15. •

Block, Stanley

B. and Hirt, Geoffrey

A.

:

Foundation

Management, Richard D. Irwin, Inc.,Homewood •

of

Financial

Illinois, Ed. 1978, p.28.

Dennis, Lock : Financial Management of Production, Grower

Press Ltd.,

Epping-Essex, Ed. 1975, p.3. •

Guthmann,Harry G.: Analysis of Financial Statements, Prentice

Hall of India

Pvt. Ltd., New Delhi, Ed.1964, p.20. •

Hastings, Paul G.: The Management of Business Finance, D.Von

Nostrand

Co.Inc., New Jersey, Ed. 1966, p.16. •

Walgenbach, Paul H., Dittrich, Norman E. and Hanson, Earnest Accounting - An Introduction, Harcourt Brace Ed.1977, p.21.

I. : Financial

Jovanovich, Inc., New York,

•

Foulke, Roy A. : Practical Financial Statement Analysis, Tata

McGraw Hill

Publishing Co. Ltd., New Delhi, Ed. 1972, p.516. •

Walgenbach, Paul H. and Dittrich, Norman E.: Accounting - An Harcourt Brace Jovanovich, inc., New York, Ed.

•

Introduction,

1973, p.364.

Shuckett, Donald H. and Mock, Edward J. : Decision Strategies Management, Taraporevala Publishing Ind. Pvt.

in Financial

Ltd., Bombay, Ed. 1978,

p.112. •

Keneddy R.D. and McMullen S.Y., Financial Statements Analysis and Interpretation, Richard D. irwin, Inc., Illions, Ed. 1968 p.4.

Chapter – 2 Working Capital Analysis •

Introduction

•

Concept of Working Capital

•

Types of Working Capital

•

Working Capital Cycle

•

Working Capital Needs of a Business

•

Nature and Importance of Working Capital

•

Working Capital Management Concepts

•

Management of Working Capital

•

Measures of Working Capital Management Efficiency

•

Objective of Working Capital Management

•

Analysis of Working Capital 1. Working Capital Trend Analysis 2. Efficiency Analysis 3. Analysis of Liquidity Position

•

References

Introduction Every business needs adequate liquid resources in order to maintain day-to-day cash flow. It needs enough cash to pay wages and salaries as they fall due and to pay creditors if it is to keep its workforce and ensure its supplies. Maintaining adequate working capital is not just important in the short-term. Sufficient liquidity must be maintained in order to ensure the survival of the business in the long-term as well. Even a profitable business may fail if it does not have adequate cash flow to meet its liabilities as they fall due. Therefore, when businesses make investment decisions they must not only consider the financial outlay involved with acquiring the new machine or the new building, etc, but must also take account of the additional current assets that are usually involved with any expansion of activity. Increased production tends to engender a need to hold additional stocks of raw materials and work in progress. Increased sales usually means that the level of debtors will increase. A general increase in the firm’s scale of operations tends to imply a need for greater levels of cash. By minimizing the amount of funds tied up in current assets, firms are able to reduce financing costs and/or increase the funds available for expansion. The importance of efficient working capital management (WCM) is indisputable. Business viability relies on its ability to effectively manage receivables, inventory, and payables. By minimizing the amount of funds tied up in current assets, firms are able to reduce financing costs and/or increase the funds available for expansion. Much managerial effort is put into bringing non-optimal levels of current assets and liabilities back towards their optimal levels. The definition of working capital is fairly simple; it is the difference between an organization’s current assets and its current liabilities. Concept of Working Capital The core of the working capital concept has been subjected to considerable change over the years. A few decades ago the concept was viewed as a measure of the debtor’s ability to meet his obligations in case of liquidation. The prime concern was with whether or not

the current assets were immediately realizable and available to pay debts in case of liquidation. The Concept of working capital was, perhaps first evolved by Karl Marx though in a somewhat different form. Karl Marx used the term ‘Variable Capital’ meaning outlays for payrolls advanced to workers before the goods they worked on were complete. He contrasted this with ‘Constant Capital’ which according to him, is nothing but ‘dead labour’, i.e. outlays for raw materials and other instruments of production produced by labour in earlier stages which are now needed for the line labour to work within the present stage. This variable capital is nothing but wage fund which remains blocked in terms of financial management, in work0in-process along with other operating expenses until it is released through sale of finished goods. Although Marx did not mention that workers also gave credit to the firm by accepting periodical payment of wages which funded a portion of work-in-process, the concept of working capital, as we understood today, was embedded in his ‘variable capital’. Working capital is the difference between current assets and current liabilities: Working Capital Current Assets

Current Liabilities

Cash

Short-term Debt

Marketable Securities

Current Portion of Long-term Debt

Accounts Receivable

Accounts Payable

Inventory

Accrued Liabilities

Prepaid Expenses A firm is required to maintain a balance between liquidity and profitability while conducting its day to day operations. Liquidity is a precondition to ensure that firms are able to meet its short-term obligations and its continued flow can be guaranteed from a profitable venture. The importance of cash as an indicator of continuing financial health should not be surprising in view of its crucial role within the business. This requires that

business must be run both efficiently and profitably. In the process, an asset-liability mismatch may occur which may increase firm’s profitability in the short run but at a risk of its insolvency. On the other hand, too much focus on liquidity will be at the expense of profitability. Thus, the manager of a business entity is in a dilemma of achieving desired tradeoff between liquidity and profitability in order to maximize the value of a firm. Working capital management (WCM) is of particular importance to the small business. With limited access to the long-term capital markets, these firms tend to rely more heavily on owner financing, trade credit and short-term bank loans to finance their needed investment in cash, accounts receivable and inventory (Chittenden et al, 1998; Saccurato, 1994). TYPES OF WORKING CAPITAL

WORKING CAPITAL BASIS OF TIME

Low

Gross Working Capital

Permanent / Fixed WC

Net Working Capital

Temporary / Variable WC

Seasonal WC Regular WC

Reserve WC

Special WC

Working capital cycle The working capital cycle can be defined as: The period of time which elapses between the point at which cash begins to be expended on the production of a product and the collection of cash from a customer The diagram below illustrates the working capital cycle for a manufacturing firm

The upper portion of the diagram above shows in a simplified form the chain of events in a manufacturing firm. Each of the boxes in the upper part of the diagram can be seen as a tank through which funds flow. These tanks, which are concerned with day-to-day activities, have funds constantly flowing into and out of them. •

The chain starts with the firm buying raw materials on credit.

•

In due course this stock will be used in production, work will be carried out on the stock, and it will become part of the firm’s work in progress (WIP)

•

Work will continue on the WIP until it eventually emerges as the finished product

•

As production progresses, labour costs and overheads will need to be met

•

Of course at some stage trade creditors will need to be paid

•

When the finished goods are sold on credit, debtors are increased

•

They will eventually pay, so that cash will be injected into the firm

Each of the areas – stocks (raw materials, work in progress and finished goods), trade debtors, cash (positive or negative) and trade creditors – can be viewed as tanks into and from which funds flow. Working capital is clearly not the only aspect of a business that affects the amount of cash: •

The business will have to make payments to government for taxation

•

Fixed assets will be purchased and sold

•

Lessors of fixed assets will be paid their rent

•

Shareholders (existing or new) may provide new funds in the form of cash

•

Some shares may be redeemed for cash

•

Dividends may be paid

•

Long-term loan creditors (existing or new) may provide loan finance, loans will need to be repaid from time to time, and

•

Interest obligations will have to be met by the business.

Unlike movements in the working capital items, most of these ‘non-working capital’ cash transactions are not everyday events. Some of them are annual events (e.g. tax payments,

lease payments, dividends, interest and, possibly, fixed asset purchases and sales). Others (e.g. new equity and loan finance and redemption of old equity and loan finance) would typically be rarer events. Working Capital Needs of a Business Different industries have different optimum working capital profiles, reflecting their methods of doing business and what they are selling. •

Businesses with a lot of cash sales and few credit sales should have minimal trade debtors. Supermarkets are good examples of such businesses;

•

Businesses that exist to trade in completed products will only have finished goods in stock. Compare this with manufacturers who will also have to maintain stocks of raw materials and work-in-progress.

•

Some finished goods, notably foodstuffs, have to be sold within a limited period because of their perishable nature.

•

Larger companies may be able to use their bargaining strength as customers to obtain more favourable, extended credit terms from suppliers. By contrast, smaller companies, particularly those that have recently started trading (and do not have a track record of credit worthiness) may be required to pay their suppliers immediately.

•

Some businesses will receive their monies at certain times of the year, although they may incur expenses throughout the year at a fairly consistent level. This is often known as “seasonality” of cash flow.

Nature and Importance of Working Capital The working capital meets the short-term financial requirements of a business enterprise. It is a trading capital, not retained in the business in a particular form for longer than a year. By minimizing the amount of funds tied up in current assets, firms are able to reduce financing costs and/or increase the funds available for expansion. The money

invested in it changes form and substance during the normal course of business operations. The need for maintaining an adequate working capital can hardly be questioned. Just as circulation of blood is very necessary in the human body to maintain life, the flow of funds is very necessary to maintain business. If it becomes weak, the business can hardly prosper and survive. Working capital starvation is generally credited as a major cause if not the major cause of small business failure in many developed and developing countries (Rafuse, 1996). The success of a firm depends ultimately, on its ability to generate cash receipts in excess of disbursements. The cash flow problems of many small businesses are exacerbated by poor financial management and in particular the lack of planning cash requirements (Jarvis et al, 1996). Working Capital Management Concepts The working capital meets the short-term financial requirements of a business enterprise. It is the investment required for running day-to-day business. It is the result of the time lag between the expenditure for the purchase of raw materials and the collection for the sales of finished products. The components of working capital are inventories, accounts to be paid to suppliers, and payments to be received from customers after sales. Financing is needed for receivables and inventories net of payables. The proportions of these components in the working capital change from time to time during the trade cycle. The working capital requirements decide the liquidity and profitability of a firm and hence affect the financing and investing decisions. Lesser requirement of working capital leads to less need for financing and less cost of capital and hence availability of more cash for shareholders. However the lesser working capital may lead to lost sales and thus may affect the profitability. The management of working capital by managing the proportions of the WCM components is important to the financial health of businesses from all industries. To reduce accounts receivable, a firm may have strict collections policies and limited sales credits to its customers. This would increase cash inflow. However the strict collection policies and lesser sales credits would lead to lost sales thus reducing the profits.

Maximizing account payables by having longer credits from the suppliers also has the chance of getting poor quality materials from supplier that would ultimately affect the profitability. Minimizing inventory may lead to lost sales by stock-outs. The working capital management should aim at having balanced; optimal proportions of the WCM components to achieve maximum profit and cash flow. Management of Working Capital While the performance levels of small businesses have traditionally been attributed to general managerial factors such as manufacturing, marketing and operations, working capital management may have a consequent impact on small business survival and growth (Kargar and Blumenthal, 1994). The management of working capital is important to the financial health of businesses of all sizes. The amounts invested in working capital are often high in proportion to the total assets employed and so it is vital that these amounts are used in an efficient and effective way. However, there is evidence that small businesses are not very good at managing their working capital. Given that many small businesses suffer from under capitalisation, the importance of exerting tight control over working capital investment is difficult to overstate. A firm can be very profitable, but if this is not translated into cash from operations within the same operating cycle, the firm would need to borrow to support its continued working capital needs. Thus, the twin objectives of profitability and liquidity must be synchronized and one should not impinge on the other for long. Investments in current assets are inevitable to ensure delivery of goods or services to the ultimate customers and a proper management of same should give the desired impact on either profitability or liquidity. If resources are blocked at the different stage of the supply chain, this will prolong the cash operating cycle. Although this might increase profitability (due to increase sales), it may also adversely affect the profitability if the costs tied up in working capital exceed the benefits of holding more inventory and/or granting more trade credit to customers. Another component of working capital is accounts payable, but it is different in the sense that it does not consume resources; instead it is often used as a short term source of

finance. Thus it helps firms to reduce its cash operating cycle, but it has an implicit cost where discount is offered for early settlement of invoices. Working capital management (WCM) is the management of short-term financing requirements of a firm. This includes maintaining optimum balance of working capital components – receivables, inventory and payables – and using the cash efficiently for day-to-day operations. Optimization of working capital balance means minimizing the working capital requirements and realizing maximum possible revenues. Efficient WCM increases firms’ free cash flow, which in turn increases the firms’ growth opportunities and return to shareholders. Even though firms traditionally are focused on long term capital budgeting and capital structure, the recent trend is that many companies across different industries focus on WCM efficiency. Measures of Working Capital Management Efficiency The form and amount of working capital components vary over the operating cycle. It would be hard to get the amounts of the components used in operations for an operating cycle. Hence the working capital management efficiency is measured in terms of the “days of working capital” (DWC). DWC value is based on the Rupee amount in each of equally weighted receivable, inventory and payable accounts. The DWC represents the time period between purchases of materials on account from suppliers until the sale of finished product to the customer, the collection of the receivables, and payment receipts. Thus it reflects the company’s ability to finance its core operations with vendor credit. The firm’s profitability is measured using the operating income plus depreciation related to total assets (IA). This measure is indicator of the raw earning power of the firm’s assets. Another profitability measure used for this analysis is the operating income plus depreciation related to the sales (IS). This indicates the profit margin on sales. To measure the liquidity of the firm the cash conversion efficiency (CCE) and current ratio (CR) are used. The CCE is the cash flow generated from operating activities related to the sales

Objective of Working Capital Management „ To run the firm efficiently with as little money as possible tied up in Working Capital „ Involves trade-offs between easier operation and the cost of carrying short-term assets •

Benefit of low working capital •

Able to funnel money into accounts that generate a higher payoff

•

Cost of low working capital •

Risky Inventory

High Levels

Low Levels

Benefit:

Cost:

„ Happy customers

„ Shortages

„ Few production delays (always have

„ Dissatisfied customers Benefit:

needed parts on hand)

„ Low storage costs

Cost:

„ Less risk of

„ Expensive „ High storage costs

obsolescence

„ Risk of obsolescence Cash High Levels

Low Levels

Benefit:

Benefit:

„ Reduces risk

„ Reduces financing

Cost: „ Increases financing costs

costs Cost: „ Increases risk

Accounts Receivable High Levels (favorable credit terms)

Low Levels (unfavorable terms)

Benefit:

Cost:

„ Happy customers

„ Dissatisfied customers

„ High sales

„ Lower Sales

Cost:

Benefit:

„ Expensive

„ Less expensive

„ High collection costs „ Increases financing costs Payables and Accruals High Levels

Low Levels

Benefit:

Benefit:

„ Reduces need for external finance--

„ Happy

using a spontaneous financing source Cost: „ Unhappy suppliers

suppliers/employees Cost: „ Not using a spontaneous financing source

Analysis of Liquidity Position Liquidity Liquidity reflects the ability of a firm to meet its short-term obligations using those assets that are most readily converted into cash. Assets that may be converted into cash in a short period of time are referred to as liquid assets; they are listed in financial statements as current assets. Current assets are often referred to as working capital, since they represent the resources needed for the day-to-day operations of the firm’s long-term capital investments. Current assets are used to satisfy short-term obligations, or current

liabilities. The amount by which current assets exceed current liabilities is referred to as the net working capital. The Operating Cycle How much liquidity a firm needs depends on its operating cycle. The operating cycle is the duration from the time cash is invested in goods and services to the time that investment produces cash. For example, a .rm that produces and sells goods has an operating cycle comprising four phases: 1.

Purchase raw materials and produce goods, investing in inventory.

2.

Sell goods, generating sales, which may or may not be for cash.

3.

Extend credit, creating accounts receivable.

4.

Collect accounts receivable, generating cash.

The four phases make up the cycle of cash use and generation. The operating cycle would be somewhat different for companies that produce services rather than goods, but the idea is the same—the operating cycle is the length of time it takes to generate cash through the investment of cash. What does the operating cycle have to do with liquidity? The longer the operating cycle, the more current assets are needed (relative to current liabilities) since it takes longer to convert inventories and receivables into cash. In other words, the longer the operating cycle, the greater the amount of net working capital required. To measure the length of an operating cycle we need to know: 1.

The time it takes to convert the investment in inventory into sales (that is, cash inventory

2.

sales

accounts receivable).

The time it takes to collect sales on credit (that is, accounts receivable

cash).

Liquidity and Working Capital Analysis

Liquidity and

Operating

Working Capital

Activity

Additional Liquidity Measures

Current Assets

Receivables Liquidity

Asset Composition

Current Liabilities

Inventory Turnover

Liquidity Index

Working Capital

Liquidity of Current

Acid-test Ratio

Current Ratio

Liabilities

Cash Flow Measures

Cash-based Ratio

Financial Flexibility What if analysis

Liquidity Ratios Liquidity ratios (or solvency ratios) include the current ratio, the quick ratio, and net working capital. Current Ratio The current ratio compares current assets to current liabilities. It measures the margin of safety a company has for paying short-term debts in the event of a reduction in current assets. It also gives an idea of a company’s ability to meet day-to-day payment obligations. Generally, a higher ratio is better. This is the standard measure of any business’s financial health. Current ratio

=

Current assets Current liabilities

Current assets include cash, accounts receivable, marketable securities, inventory, and any prepaid expenses like insurance or taxes. Current liabilities include accounts payable, current interest due on long-term debt, like taxes payable and salaries payable.

Generally, the higher the current ratio, the greater the safety margin between current obligations and the ability to pay them. The benchmark current ratio is 2:1. Hypothetical Example: Table: Current Ratios March-2003

March-2004

March-2005

March-2006

March-2007

Company

2.2

2.1

3.7

1.9

2.0

Industry

1.4

1.3

1.5

1.5

1.4

The Company’s current ratio was consistently above the industry average over the period, as shown in Table. The Company’s ratio is higher than the industry due to lower current liabilities. Quick Ratio: “Acid Test” The quick ratio is similar to the current ratio, but it’s a tougher measure of liquidity than the current ratio, because it excludes inventories. Inventories typically take time to convert to ready cash. Thus, most analysts find them illiquid, not a cash equivalent. Generally a higher ratio is better. Quick ratio

=

(Current assets – Inventory) Current liabilities

Generally, the quick ratio should be lower than the current ratio, because the inventory figure drops from the calculation. A higher ratio correlates to a higher level of liquidity. This usually corresponds to better financial health. The quick ratio also indicates whether a business could pay off its debts quickly, if necessary. The desired quick ratio is at least 1:1. A lower ratio flags questions about whether the firm can continue to meet its outstanding obligations.

Hypothetical Example: Table: Quick Ratios March-2003

March-2004

March-2005

March-2006

March-2007

Company

1.8

1.6

2.4

0.9

1.7

Industry

1.1

1.0

1.1

1.2

1.4

As shown in Table, the Company’s quick ratios fluctuated over the period. The basic difference between the current and quick ratio is that the quick ratio includes only cash and receivables as the numerator. Thus, inventory is not included. As can be seen from the table, the industry averages contained a larger inventory base due to the lower ratio. The Company carried a minimal inventory of materials and supplies. In 2006, the Company’s ratio was lower than the industry average due to a large increase in current liabilities in that year. Other than that year, the Company has been very liquid and could easily cover its current maturities. Liquidity is a matter of degree Lack of liquidity can limit: •

Advantages of favorable discounts

•

Profitable opportunities

•

Management actions

•

Coverage of current obligations

Severe illiquidity often proceeds: •

Lower profitability

•

Restricted opportunities

•

Loss of owner control

•

Loss of capital investment

•

Insolvency and bankruptcy

References: •

Chiou, J. R., Cheng, L. and Wu, H.W. (2006). “The determinants of working capital management”, The Journal of American Academy of Business, Vol. 10, No. 1, pp. 149-155.

•

Deloof, M. (2003). “Does working capital management affect profitability of Belgian firms?” Journal of Business Finance and Accounting, 30(3) & (4), pp. 573-587.

•

Filbeck, G. and Krueger, T. M. (2005). “An analysis of working capital management results across industries”, American Journal of Business, Vol. 20, Issue 2, pp. 11-18.

•

Kuchhal, S.C., 1985. Financial Management, Chaitanya Publishing

•

Kulkarni, P.V., 1985. Financial Management, Himalaya Publishing

•

Shin, H. H. and Soenen, L. (1998). “Efficiency of working capital management and corporate profitability”, Financial Practice and Education, Vol. 8, No. 2, pp. 37-45.

•

Solomon, Eraz and Pringle John, 1978. An Introduction to Financial Management, Prentice-Hall of India

•

Van Horne, James C., 1985. Fundamentals of Financial Management, PrenticeHall of India.

Chapter - 3 Analysis of Activity

•

Concept of Activity

•

Activity in Relation to Total Resources 1. Total Assets Turnover Ratio 2. Fixed Assets Turnover Ratio 3. Current Assets Turnover Ratio

•

Sales Trend and Cost Structure Analysis

•

Analysis of Sales Trend

•

Analysis of Cost Structure

•

(a)

Raw Materials and Stores Consumed

(b)

Salaries and Wages

(c)

Indirect Taxes

(d)

Power and Fuel

(e)

Depreciation

(f)

Administrative, Selling, Distribution and Other Expenses

(g)

Financial Charges

References

Concept of Activity Analysis: Sale of product is the primary object of any business enterprise. It is pivot around which all business operations cluster. The increase or decrease of the business profits depend upon the magnitude of sale because it is the key figure in the business enterprise. Income from net sales is the life blood of every commercial and industrial business. Sales support life of business. More sales more profit and or less sales less profit or even there may be loss. Thus re-sales, are to a business enterprise what oxygen is to the human being, a very Material increase in the volume of net sales has the same effect upon the business organism as an increase in the quantity of inhaled oxygen has upon the human organism.1 The quantity quality and regularity

of flow of sales revenue

govern the physical appearance and the internal conditions of the business organism. In fact, with the higher volume of sales, the business operates with greater profits and effectiveness and operations are speeded up. It is apparent, therefore, that the significance of any business activity can be measured in terms of its contribution towards sales. Activity ratios are turnover ratios where the significance of financial figures is measured in terms of sales of business enterprise. The approach to the activity analysis in Cement Industry in India is as follows: 1. The growth of activity and its measurement in terms of investment 2. Activity in relation to total resources 3. The conduct of activity and 4. The impact of activity.

Activity in Relation to Total Resources: Sale is the major factor of judging the activity of an enterprise and it is affected by the total resources available in the business. The term 'Sales' indicates the efficiency with which investment in the asset is rotated in the process of doing business. Efficient rotation of capital or total resources would lead to higher profitability therefore profitability depends up the sales or turnover ratio. Sales ratio is calculated usually by comparing the net sales with the total investment (total assets or total resources) As the management of the concern is responsible for making proper use of resources, it is necessary to clarify the word `Total

Resources'.

The total resources available in the

enterprise are characterised by total assets which are made up of fixed assets and current assets. Since the assets of a business are use for the purpose of producing revenue, hence, efficient utilization of the assets is a must for business activity. Activity is judged in relation to total investment as represented by total assets. This is ascertained by the sales to total sales assets ratio or `an activity index'. Some of the principal ratios which have been used in the study are as under. Total Assets Turnover Ratio This ratio is also termed as capital turnover ratio. The total assets turnover measures as how many rupees of sales are supported by each rupee in total assets .A high ratio suggests management’s ability to make a good use of its tangible assets but low ratio may be caused due to large outlays on fixed assets.

Table No.1 Total Assets Turnover Ratio 1999- 2000- 2001- 2002- 2003- 2004- 2005COMPANY 2000

01

02

03

04

05

06

AVE. S.D. C.V.

Min Max

RELAINCE 1.46

1.44

1.44

1.16

1.11

1.05

1

1.24

0.2

ESSAR

0.08

0.07

0.07

0.06

0.06

0.06

0.06

0.07

0.01 11.97 0.06 0.08

HPCL

4.28

3.84

3.66

3.65

3.45

3.36

3.32

3.65

0.33 9.125 3.32 4.28

BPCL

6.87

6.52

6.01

5.7

5.42

5.25

4.99

5.82

0.69 11.77 4.99 6.87

IOC

2.84

2.61

2.46

2.4

2.35

2.28

2.13

2.44

0.23 9.48

2.13 2.84

CPCL

2.85

3.69

3.67

3.6

3.19

2.99

2.68

3.24

0.42 12.9

2.68 3.69

Ave.

3.06

3.028 2.89

2.76

2.6

2.5

2.36

2.7

0.31 11.9

2.36 3.2

16.35 1

In Reliance the ratio ranged between 1.00 times in 2005-06 to 1.46 times in 1999-2000 with an average of 1.24. The standard deviation was 0.20 and coefficient of variation is 16.35. In Essar the ratio was less than 1 times and its average was 0.07 times. It indicates the management of units was unsuccessful in the utilization of fixed assets. Where as the ratio fixed assets turnover was fluctuated between 3.32 times to 4.28 times in HPCL and 4.99 times to 6.87 times in BPCL and 2.13 times to 2.84 times in IOC. The average ratio CPCL was 3.24 which were more than the industry’s average. The BPCL has the highest ratio which has indicated good efficiency in assets utilization. Fixed Assets Turnover Ratio The fixed assets turnover ratio measures the efficiency with the firm is utilizing its investment in fixed assets. It also indicates the adequacy of sales in relation to the investment in fixed assets. The fixed assets turnover ratio is sales divided by fixed assets less depreciation. The greater the ratio more will be efficiency of assets usage.

1.46

Table No.2 Fixed Assets turnover ratio 1999- 2000- 2001- 2002- 2003- 2004- 2005COMPANY 2000

01

02

03

04

05

06

AVE. S.D. C.V.

RPL

0.85

1.04

1.36

1.09

1.14

1.42

1.34

1.18

0.21 17.47 0.85 1.42

ESSAR

0.5

0.44

0.32

0.35

0.35

3.71

2.48

1.16

1.37 117.4 0.32 3.71

HPCL

4.79

5.53

4.6

5.19

5.22

5.52

5.99

5.26

0.47 8.967 4.6

BPCL

4.23

5.25

5.99

4.56

5.04

5.06

5.36

5.07

0.57 11.19 4.23 5.99

IOC

4.76

4.88

4.05

3.88

3.8

4.03

4.62

4.29

0.45 10.48 3.8

CPCL

3.14

3.5

3.02

3.95

3.14

3.82

5.31

3.7

0.8

Average

3.05

3.44

3.22

3.17

3.12

3.93

4.18

3.4

0.64 31.2

5.99 4.88

21.52 3.02 5.31

It is evident from table No.2 that the fixed assets turnover ratio of HPCL was the highest among all companies. The average turnover was at 1.18 times, 1.16 times 5.07 times, 4.29 times and 3.70 times in RPL, ESSAR, BPCL, IOC and CPCL respectively. The S.D. of these companies is 0.21, 1.37, 0.47, 0.57, 0.45 and 0.80 respectively.

Current Assets Turnover Ratio This ratio applied to measure the turnover and profitability of total current assets applied to conduct the operation of firm. The ratio is calculated by dividing the amount of sales by the amount of current assets. The ideal behind the current assets turnover ratio is to give an over-all impression of how rapidly the total investment in current assets is being turned and is thought of by some as an index of ‘efficiency’. The lower the turnover of the current assets worse is the utilization of current assets. The higher the turnover, the better is the use of current assets.

Min Max

2.8

4.55

Table No.3 Current Assets turnover ratio 1999- 2000COMPANY 2000

01

2001- 2002- 2003- 2004- 200502

03

04

05

06

AVE. S.D. C.V.

Min

Max

RPL

1.749 2.2758 2.094 2.127 2.22

2.269 3.361 2.3

0.5

21.8

1.749 3.36

ESSAR

0.245 0.2744 0.217 0.366 0.21

0.939 0.553 0.4

0.27 66.4

0.209 0.94

HPCL

4.947 5.5643 6.414 5.781 5.47

6.306 6.569 5.87

0.59 10.05 4.947 6.57

BPCL

6.035 5.7904 6.488 6.139 5.27

5.565 5.673 5.85

0.4

IOC

3.731 4.0362 4.503 3.847 3.8

3.779 4.184 3.98

0.28 7.05

CPCL

3.137 3.8355 3.726 3.688 3.8

3.62

0.29 7.913 3.137 4.1

Average

3.307 3.6294 3.907 3.658 3.46

3.746 4.074 3.68

4.102 3.7

6.913 5.266 6.49 3.731 4.5

0.39 20.02 3.173 4.33

The current assets turnover ratio of refinery industry registered an increasing trend during the research period. It is ranged between 3.307 times in 1999-2000 to 4.074 times in 2005-06. The average ratio of RPL and Essar was lower than the industry’s average which indicates lower utilization of current assets in these units. But the same ratio was good in HPCL, BPCL, IOC and CPCL which showed proper utilization of current assets. As whole it can be concluded that the performance of HPCL and BPCL was satisfactory.

Sales Trend and Cost Structure Analysis Trend analysis examines the tendencies by (a) selecting a representative year as the base and (b) expressing the figures of the year.

remaining years in relation to the base

The significance of the choice of base lies in the fact that the values of the

items in the base year are assumed to be 100 and the index numbers are calculated for other years based on the amount of that item in those years. It is not necessary that a year should be chosen as the base. If there is no year which qualifies to be the base, for whatever reason, and then an `average concept' can be employed.

In India, the financial analysis made by the Stock Exchange Authorities follows the `average concept' in presenting trend data. According to the stock exchange official directory, "A trend analysis has been made showing the percentage of major items in the balance sheet and profit and loss statement compared to a base value ...., for the purpose of calculation the base value has been taken as the average for each item over the last ten years or as many years for which the data is available." Trend analysis is effective only when relevant and related items are studied together. Thus, the results which are shown are an enterprise has to be viewed in conjunction with the resources employed. For instances, sales trend have to be studied alongwith debtors, inventory and even fixed assets, because it would be unhealthy

development

if a

downward trend in sales is accompanied by an upward trend in inventories and trend debts or by a marked increase in plant and equipment, especially if financed by borrowed funds. In present paper an attempt has been made to study the cost component of cement units under study. For the purpose of analysis of cost component the all components cost has been calculated as percentage of sales. While to analyze the sales position of units trend analysis is made.

ANALYSIS OF SALES TREND: `Sales' is the value of the output supplied to

the customers. It is the life blood of a

business enterprise. Without which the business can not survive. Further, `Sales' is the indicator of the operational efficiency of management in

to how

efficiently

the

management has used the assets of the business. The higher the volume of sales, the more efficient the management. Sales is also related to profitability of an enterprise, if other things remain constant. The higher the amount of sales, the more profitable the business is and vice versa. The matching of costs incurred during a certain period with sales generated during that period reveals the net income or net loss.

The trend of sales indicates the direction in which a concern is going on and on the basis of which forecast for further can be made. The trend analysis of sales makes to understand the growth of a business enterprise. For proper trend analysis, the trend should be studied at least over period of 5 or more years. To study the trend of sales in cement companies under study, the year 1998-99 has been chosen as the base year and figure of sales in the base year have been taken equal to 100. Index numbers have been calculated for the remaining years based on the amount of sales for the base year. The following table shows the trend of sales in the companies under study. Table - 1 Sales Trend Year

1998-99

1999-2000 2000-01

2001-02

2002-03

Average

S.D.

DCL

100

113.530

127.721

129.559

136.527

121.467

14.622

GACL

100

105.335

119.571

130.485

163.557

123.790

25.252

ICL

100

103.301

108.669

88.107

73.623

94.740

14.008

MCL

100

98.693

118.577

135.602

120.253

114.625

15.452

SCL

100

98.191

95.828

112.345

107.338

102.740

6.881

Average 100

103.81

114.073

119.22

120.26

111.4725

Sales trend of units under study showed a fluctuating trend. DCL and GACL trend indicates an increasing trend thought the study period. Where ICL, MCL and SCL trend indicated a fluctuating trend. The average trend of units under study was 111.47. While the average trend of DCL and GACL were higher than this on other hand ICL, MCL, and SCL trend were lower than the average of units under study. The standard deviation figure shows a high fluctuation in trend value of all the units under study.

Analysis of Cost Structure: The data of total cost in various cement companies under study have been rearranged and classified under the coming heads: (a)

Raw Materials and Stores Consumed:

Raw materials consumed consists of the amount spend on various types of raw materials and components consumed during the course of manufacturing. Further the figure has been arrived at by adding the cost of opening stock of raw materials to the purchases of raw material and deducting the cost of closing stock. It also includes the amount spent on octroi, carriage inwards as well stores consumed etc. Table - 2 Raw Materials and Stores Cost as Percentage of Sales Year

1998-99

1999-2000 2000-01

2001-02

2002-03

Average

S.D.

DCL

29.7

34.11

32.09

32.73

28.8

31.486

2.191

GACL

13.29

11.39

13.34

15.46

15.05

13.706

1.624

ICL

15.03

16.35

14.1

13.64

17.73

15.37

1.677

MCL

19.33

20.01

22.21

19.52

22.13

20.64

1.419

SCL

15.58

13.8

15.95

13.06

17.54

15.186

1.783

19.132

19.538

18.882

20.25

19.2776

Average 18.586

Table – 2 indicates the percentage of raw materials and stores cost to sales. The cost showed a fluctuating trend in all units under study. The average raw material cost of the entire study was 19.277 per cent, where as the average raw material cost of DCL was 31.486 per cent, which was highest among all units under study. While the raw material cost of GACL was 13.706 per cent, which is lowest among all units under study. The average raw material cost of ICL, MCL and SCL were 15.37 per cent, 20.64 per cent and

15.186 per cent respectively. The standard deviation of DCL indicates high fluctuation in cost. Raw Materials and Stores Consumed Cost and ANOVA Test: Ho = There is no any significant difference in percentage of Raw Materials and Stores Consumed cost in companies. Table - 3 ANOVA Source

of

Variation

SS

df

MS

F

F crit

Between Groups

8.346896 4

2.086724 0.037157 2.866081

Within Groups

1123.206 20

56.1603

Total

1131.553 24

It is evident from table - 3 that there is no any difference in Raw Materials and Stores Consumed among the units under study because calculated value of F (0.037) is lower than table vale of 2.86. (b) Salaries and Wages: The amount paid to employees by way of salaries, wages, bonus, gratuties and contribution towards the provident funds, superannuation funds, family pension scheme, gratuity funds have been classified as `Salaries and Wages' in the present study.

Table - 4 Wages & Salaries Cost as Percentage of Sales Year

1998-99

1999-2000 2000-01

2001-02

2002-03

Average

S.D.

DCL

7.37

6.87

5.57

5.4

5.07

6.056

1.003

GACL

2.68

3.4

3.2

3.36

3.4

3.208

0.306

ICL

5.63

4.97

5.35

7.51

9.09

6.51

1.743

MCL

4.6

5.47

5.58

4.54

4.73

4.984

0.500

SCL

3.31

3.03

2.99

3.41

4.14

3.376

0.463

4.748

4.538

4.844

5.286

4.8268

Average 4.718

Wages and salaries cost as percentage of sales has been presented in table – 4. The portion of this cost in total cost is very low. It ranged between 3 to 6 per cent. The average wages and salaries cost of study was 4.82 per cent; while the GACL cost is lowest (3.20 per cent) among all units under study. The standard deviation of GACL also indicates that very low fluctuation in cost. Wages and Salaries Cost and ANOVA test: Ho = There is no any significant difference in percentage of Salaries and Wages cost in companies. Table - 5 ANOVA Source

of

Variation

SS

df

MS

F

F crit

Between Groups

1.563064 4

0.390766 0.125411 2.866081

Within Groups

62.31768 20

3.115884

Total

63.88074 24

It is clear from table – 5 that there is no any difference in wages and salaries cost in all units under study. Because of table value of F is higher than calculated value of F. Standard deviation also indicates very low fluctuations in cost. (c) Indirect Taxes: The indirect taxes includes excise duty charged at the time of production by the Central Government has been consider under this head. Table - 6 Indirect Taxes as Percentage of Sales Year

1998-99

1999-2000

2000-01

2001-02

2002-03

Average

S.D.

DCL

13.4

15.03

12.98

12.89

13.51

13.562

0.862

GACL

15.43

14.38

12.43

12.71

14.46

13.882

1.271

ICL

16.07

16.92

14.54

16.15

18.46

16.428

1.427

MCL

2.07

2.45

1.93

15.11

17.85

7.882

7.911

SCL

15.77

15.59

15.95

16.22

17.01

16.108

0.555

12.874

11.566

14.616

16.258

13.5724

Average 12.548

Table – 6 showed a portion of indirect taxes as percentage of sales in cement industry. The data showed fluctuating trends in all units under study. The average ratio of units under study was 13.57 per cent. Out of five units under study the average cost of two units were below the study average. MCL indirect cost was lowest (7.88 per cent) among all units under study. The result of standard deviation also indicates very low fluctuation in all units under study except MCL. Indirect Cost and ANOVA test: Ho = There is no any significant difference in percentage of Indirect Cost in companies.

Table - 7 ANOVA Source

of

Variation

SS

df

MS

F

F crit

Between Groups

69.32174 4

17.33043 0.796606 2.866081

Within Groups

435.1065 20

21.75533

Total

504.4283 24

From the above table, it is clear that there is no any difference in indirect cost of all units. Because the calculated value of F is lower than table value of F. (d) Power and Fuel: Electricity expenses in cement industry played a vital role. For the purpose of analysis any expenses related to electricity and for other fuel have been considered under this head. Table – 8 Power and Fuel Cost as Percentage of Sales Year

1998-99

1999-2000

2000-01

2001-02

2002-03

Average

S.D.

DCL

17.72

16.4

15.72

15.44

16.34

16.324

0.880

GACL

19.2

21.38

20.46

20.45

21.18

20.534

0.855

ICL

24.74

26.11

24.34

25.46

30.22

26.174

2.361

MCL

22.85

24.88

23.16

20.17

21.99

22.61

1.721

SCL

25.31

28.63

23.59

22.74

20.5

24.154

3.043

23.48

21.454

20.852

22.046

21.9592

Average 21.964

Power and fuel cost as percentages of sales presented in table – 8. The range of power and fuel cost in selected units was between 16.324 to 26.174 per cent. The average power and fuel cost of the study was 21.959 per cent; while the average power and fuel cost of

DCL (16.32 per cent) and GACL (20.534 per cent) were lower than the average of study. The standard deviation of SCL indicates high fluctuation in cost, while standard deviation of DCL (0.88) indicates a low fluctuation in cost. Power and Fuel Cost and ANOVA test: Ho = There is no any significant difference in percentage of Power and Fuel cost in companies. Table -9 ANOVA Source

of

Variation

SS

df

MS

F

F crit

Between Groups

19.00754 4

4.751886 0.277747 2.866081

Within Groups

342.1732 20

17.10866

Total

361.1808 24

Anova table indicates there is no any significance difference in power and fuel cost among all the units under study because calculated value of F is lower than table value of F at 5% level of significance. (e) Depreciation: In the cost structure of Indian cement industry the absolute figure of depreciation is very high. So the amount of depreciation of all fixed assets is considered under this head in present study.

Table - 10 Depreciation Cost as Percentage of Sales Year

1998-99

1999-2000

2000-01

2001-02

2002-03

Average

S.D.

DCL

5.95

5.41

4.77

4.83

4.73

5.138

0.532

GACL

9.82

9.51

8.93

8.7

8.44

9.08

0.572

ICL

5.17

5.25

5.76

7.36

7.93

6.294

1.270

MCL

8.33

8.95

8.51

7.45

8.53

8.354

0.554

SCL

5.67

5.09

4.62

10.86

10.37

7.322

3.034

6.842

6.518

7.84

8

7.2376

Average 6.988

Depreciation cost as percentage of sales presented in table – 10. The average depreciation cost of DCL, GACL, ICL, MCL and SCL were 5.13 per cent, 9.08 per cent, 6.29 per cent, 8.35 per cent and 7.32 per cent respectively. The table data and standard deviation indicates a low fluctuation in the cost in all units under study. Depreciation Cost and ANOVA test: Ho = There is no any significant difference in percentage of Depreciation cost in companies. Table - 11 ANOVA Source

of

Variation

SS

df

MS

F

F crit

Between Groups

8.403816 4

2.100954 0.476043 2.866081

Within Groups

88.26744 20

4.413372

Total

96.67126 24

Table – 11 indicates that calculated value of F is lower than table value so, null hypothesis is accepted. It means there is no any significance difference in the depreciation cost among all units under study. (f) Administrative, Selling, Distribution and Other Expenses: The expenses relating to office and general

administration of

companies like the

director's fees, auditor's remuneration, legal expenses, rent, rates, taxes and depreciation of office building and equipments have been groped as administrative and other expenses. Selling and Distribution expenses include the amount spent during the course of sales, boosting the sales and delivery of goods sold has been termed as selling and distribution expenses. The expenses relating to advertisement , commission to selling agents and other

incentive

and

service

charge,

delivery

charges, freight and

transportation etc. are covered under the above head. Table - 12 Administrative, Selling, Distribution & Other Expenses as Percentage of Sales Year

1998-99

1999-2000 2000-01

2001-02

2002-03

Average

S.D.

DCL

11.48

12.28

11.98

10.97

9.95

11.332

0.919

GACL

18.65

17.03

16.31

16.12

18.31

17.284

1.150

ICL

16.3

16.44

16.4

17.85

15.02

16.402

1.002

MCL

17.18

17.41

16.5

16.45

11.04

15.716

2.647

SCL

21.09

21.28

22.98

23.57

22.54

22.292

1.077

16.888

16.834

16.992

15.372

16.6052

Average 16.94

Table – 12 reveals administrative, selling, distribution and miscellaneous expenses as percentage of sales. The average ratio of DCL, MCL and ICL were 11.33 per cent, 15.71 per cent and 16.402 per cent which were lower than the average ratio of industry. While SCL ratio was 22.29 per cent highest among all units under study.

Administrative, Selling, Distribution and Other Expenses ages and Salaries Cost and ANOVA test: Ho = There is no any significant difference in percentage of Administrative, Selling, Distribution and Other Expenses cost in companies. Table - 13 ANOVA Source

of

Variation

SS

df

MS

F

F crit

Between Groups

8.403816 4

2.100954 0.476043 2.866081

Within Groups

88.26744 20

4.413372

Total

96.67126 24

Table shows that there is no any significance difference in Administrative, Selling, and Distribution & Other Expenses of units under study because of the acceptance of null hypothesis. (g) Financial Charges In Indian cement industry structure indicates that most of the companies satisfied their financial need through Equity, Preference, Loans and Debentures. So the portion of Financial Charges in the cost structure of industry has played vital role in the performance of the companies. Expenses related to interest and other financial charges have been considered under this head for the purpose of the study.

Table - 14 Financial Charges Cost as Percentage of Sales Year

1998-99

1999-2000 2000-01

2001-02

2002-03

Average

S.D.

DCL

9.56

8.35

7.84

7.12

6.33

7.84

1.226

GACL

10.35

9.63

9.78

7.31

6.45

8.704

1.714

ICL

11.51

12.17

13.2

17.32

25.18

15.876

5.670

MCL

13.71

12.06

10.85

9.68

9.03

11.066

1.877

SCL

10.91

10.31

8.74

8.44

5.99

8.878

1.919

10.504

10.082

9.974

10.596

10.4728

Average 11.208

Table – 14 reveals that the ratio of financial charges to total sales in cement industry of India. The ratio showed a fluctuating trend. The average ratio of study was 10.47 per cent where as the ratio of ICL and MCL were higher than average ratio of study. The standard deviation of ICL indicates high fluctuations. Financial Charges Cost and ANOVA test: Ho = There is no any significant difference in percentage of Financial Charges cost in companies. Table - 15 ANOVA Source

of

Variation

SS

df

MS

F

F crit

Between Groups

4.790984 4

1.197746 0.062848 2.866081

Within Groups

381.1547 20

19.05774

Total

385.9457 24

Table – 15 indicates that critical value of F is higher than calculated value of F means null hypothesis accepted and alternative hypothesis is accepted. Result of Anova indicates there is no any significance difference in financial charges cost among all units under study. References •

Chowdhry S.B. Analysis of Company Financial Statement, Asia Publishing House, 1964, p.71

•

Foulke A. Roy, Practical Financial Statement Analsis, Tata McGraw Hill Ed. VI, p.155.

Chapter – 4 Profitability Analysis •

Introduction

•

Concept of Profitability

•

Measurement of Profitability

•

Profitability from the view point of Financial Management (i) Gross Profit Ratio (ii) Operating Profit Ratio (iii) Return on Capital Employed

•

Analysis of the profitability from the view of shareholder's (i) Net Profit Ratio (ii) Return on Owners' Equity (iii) Return on Equity Capital (vi) Earning Per Share (v) Dividend Pay-out Ratio

•

Case Study of Profitability Analysis

•

References

Introduction: The financial manager has to take rational decisions from time to time keeping in view the objectives of his company. Always the decisions must be based on the analytical tools. Financial analysis is the most useful techniques in this regard. Financial analysis relies on the comparisons or relationships of the data that enhances the utility or the practical value of the accounting information. This analysis consists in applying various analytical tools and techniques to the financial data.

Concept of Profitability:The Word ‘profitability’ is composed of two words ‘profit’ and ‘ability’. Therefore, profitability means the profit-making ability of the enterprise. Profits are the soul of the business without which it is lifeless. For accounting purpose the profit is the difference between total revenue and total expenditure over a period of time. The term ability is also referred to as ‘earning power’ or ‘operating performance’ of the concerned investment. Profitability indicates the capacity of management to generate surplus in the process of business operations.

Sometimes the terms ‘profitability’ and ‘profit’ are used

synonymously but there is difference between the two. Profitability has a sense of relativity, where as the term profit is used in absolute sense.

Measurement of Profitability:Profitability is the result of financial as well as operational efficiency. It is the outcome of all business activities. Measurement of profitability is a multi-stage concept. A measure of ‘profitability’ is the overall measure of efficiency.” Profitability is a concept based on profits but since it is a relative concept, profits are to be expressed in relation to some other variables. Several ratios can be computed to measure the extent of profitability in quantitative terms. Profitability ratios are calculated to measure the operating efficiency of an enterprise. Profits can be related mainly to sales and investment to determine profitability. An enterprise should be able to produce

adequate profit on each rupee of sales. If sufficient profits are not generated through sales, it becomes problematic for an enterprise to cover its operating costs and the interest burden. An appraisal of the financial position of any enterprise is incomplete unless its overall profitability is measured in relation to the sales, assets, capital employed, net worth and the earning per share.

Profitability from the view point of Financial Management A financial manager is very much interested to locate and pin-point the causes which are responsible

for

low

or

high profitability. The Financial Manager should

continuously evaluate the efficiency of its company in terms of profit. In analysing the profitability of cement industry in India, from the point of view

of Financial

Management, the following ratios are considered: (i) Gross Profit Ratio (ii) Operating Profit Ratio (iii) Return on Capital Employed 1.

Gross Profit Ratio:

This ratio expresses the relationship of gross profit to net sales, in term of percentage. The determinants of this ratio are the gross profit and sales, which means net sales, obtained after deducting the value of goods returned by the customers from total sales. This ratio is of vital importance for gauging business results. A low gross profit ratio will suggests decline in business which may be to insufficient sales, higher cost of production with the existing or reduced selling price or the all-round inefficient management. The financial Manager must be able to detect the causes of a falling gross profit ratio and initiate action to improve the situation.

A high gross profit is a sign of good and efficient management. It is calculated as follows: Gross Profit Gross Profit Ratio = --------------- * 100 Net Sales 2.

Operating Profit Ratio:

This ratio indicates the relationship between operating profit and net sales in the form of percentage. Operating profit arrived at by adjusting all non-operating expenses and incomes in net profit in the other words, we can say profits before depreciation and taxes. A consistently high ratio tells us the effective and efficient operation of the business. It is calculated as below; Operating Profit Operating profit ratio = ------------------ * 100 Net Sales 3.

Return on Net Capital Employed:

In the words of Anthony, "Return on net capital employed looks at income in relation to the permanent funds invested in the enterprise.

The permanent funds

consist

of

shareholders' equity plus non-current liabilities or the same figure may be found by subtracting current liabilities from total assets thus, net capital employed consists of total assets in the enterprise less its current liabilities. The term `return' signifies operating profit before interest and taxes. The ratio is more appropriate for evaluating the efficiency of internal management. It enables the management to show whether the funds entrusted to enterprise have been properly used or not. A high ratio is a test of better performance and low ratio is an indication of poor performance. This ratio is the most important for studying the management efficiency of

the enterprise. It is used to study the operational efficiency of the enterprise. It shows the earning capacity of the capital. The formula for derivation of this ratio is: Operating profit before Interest and Tax Return on Net Capital = --------------------------------------Employed Net Capital Employed

Analysis of the Profitability from the view of Shareholder's The owners- the shareholders- have permanent stake in the enterprise and as such they have to share the prosperity marked by higher profitability and adversity marked by losses. The financial welfare of the owners increases when net profit after tax has increases and also when they receive larger share of dividend. For this analysis, following ratio are calculated: (i) Net Profit Ratio (ii) Return on Owners' Equity (iii) Return on Equity Capital (vi) Earning Per Share (v) Dividend Pay-out Ratio

1.

Net Profit Ratio:

Net profit margin is a good indicator of the efficiency of a firm. As pointed out by Van Horne this ratio "tells us the relative efficiency of the firm after taking into account all expenses and income-taxes, but not extraordinary charges." Net profit margin ratio is determined by relating net income after taxes to net sales.

Net profit margin ratio(in percentages) is calculated by dividing the amount of net surplus by the amount of operating revenue(sales) multiplying by 100. The formula for calculating the ratio is: Net Profit Net Profit Ratio = -------------- * 100 Sales 2.

Return on Owner's Equity (Net Worth):

The ratio of return on owner’s equity is a valuable measure for judging the profitability of an organisation. This ratio helps the shareholders of a company to know the return on investment in terms of profits. Shareholders are always interested in knowing as to what return they earned on their invested capital. Anthony and Reece opine that this ratio "reflects that how much the firm has earned on the funds invested by the shareholders (either directly or through retained earnings). They further point out that the ratio of return on owner's equity is most significant when the book value of net worth is close to the market value of the stock since new capital is raised at market prices rather than at book value and firms are usually judged on their earnings performance relative to the market price of their stock. This ratio is expressed in the percentage from of net profit earned to the owners' equity. The formula for the derivation of this ratio is: Net Profit(after int. & tax) Return on Owner's Equity = ----------------------------- * 100 Owners' Equity

3.

Return on Equity Capital:

The net surplus after tax expressed as a percentage to the equity capital shows the degree of availability of current profits to the equity shareholders. According to Bierman and Drebin, "The stock equity earning ratio gives an indication of how effectively the investment of stockholders is being used". A high stock equity earnings rate may be obtained by using a large amount of debt if the rate of earnings on assets exceeds the interest rate on the debt. This is called trading on equity. The formula for calculating return on equity capital ratio can be expressed as: Net Profit (after int. & tax) Return on Equity Capital = ------------------------------ * 100 Equity Capital (Paid-up) 4.

Earning Per Share (EPS):

In the word of A. Tom Neslon, "Investment circles often quote earning per share as a measure of profitableness of the ordinary shareholders' investment. It has become one of the most important measure by which outsiders evaluate performance of management." Earning per share is considered one of the most important indicator of profitability because it can easily be compared with previous EPS figures and with those of other companies and investors find it convenient to compare the amount earned for a single share of stock. Hampton, John, J. observes that, "Earning per share is arrived at by dividing the earning available to the equity or common shareholders by the number of outstanding shares. However, the shares authorised but not used or authorised, issue and repurchased are omitted from the calculation." To interpret, this ratio properly requires a good understanding of how primary and fully diluted EPS are calculated. It is expressed by the formula given below:

Net profit Earning Per Share = ---------------------Total number of shares 5.

Dividend Pay-out Ratio:

This ratio indicates what percentage of the firms earnings, after tax less preference dividend is being paid to equity shareholders in the form of dividends. The percentage not paid out is retained in the business for ploughing back. Thus, the pay-out ratio is a major aspects of the dividend policy of a firm, because it measures the relationship between the earnings belonging to equity shareholders and the cash dividend paid to them. If the dividend pay-out ratio is subtracted from 100, it will give the percentage share of the net profits retained in the business. If the pay-out ratio is more than 100, it means dividend has been paid from the previous reserves. Equity Dividend Dividend Pay-out Ratio = ---------------------------- * 100 Profit after tax & Pref. Div.

Case Study of Profitability Analysis: Profitability is the overall measure of the companies with regard to efficient and effective utilization of the resources at their command. It indicates in a nutshell the effectiveness of the decisions taken by the management from time to time. The profitability is also known as the “Return on the Total Assets” (ROI). It can be calculated by using the following formula: Return on Investment (ROI) = Net Profit/Total Capital Employed.

Table –1 Profitability Ratios of the Companies Return on Investment Ratio GACL DCL MCL Net Profit Ratio GACL DCL MCL Total Assets Turnover Ratio GACL DCL MCL Return on Net Worth Ratio GACL DCL MCL

1997-98 1998-99 6.07 6.42 5.86 3.7 3.93 4.55

19992000 5.47 3.77 4.28

200001 5.72 4.81 4.24

2001- 2002Average 02 03 5.07 5.44 5.698 4.33 0.96 3.905 2.03 1.1 3.355

S.D. C.V. 0.484 8.500 1.647 42.164 1.431 42.651

12.72 10.16 6.79

13.13 6.31 7.61

12.16 6.15 7.76

14.25 13.38 7.52 7.11 7.82 3.69

12.13 1.56 2.28

12.962 6.468 5.992

0.807 6.226 2.806 43.378 2.400 40.056

0.478 0.595 0.599

0.481 0.621 0.58

0.454 0.663 0.568

0.404 0.376 0.674 0.623 0.546 0.549

0.45 0.554 0.483

0.441 0.622 0.554

0.042 0.044 0.040

12.62 14.27 10.78

12.51 8.87 11.95

10.22 9.08 11.12

11.93 11.85 11.47 11.26 12.3 7.68

13.13 2.73 5.33

12.043 9.613 9.860

1.011 8.391 3.900 40.571 2.758 27.970

It is evident from table –1 that the highest ROI among all units was at 6.42 percent in 1998-99, 5.68 percent in 1997-98 and 4.55 percent in 1998-99 for GACL, DCL and MCL respectively. In DCL and MCL the ROI in 2002-03 was 0.96 percent and 0.11 percent respectively, which was lowest ROI among all units under study. The average rate of return was at 5.698 percent in GACL, 3.905 percent in DCL and 3.355 per cent in MCL. The standard deviation (0.484) and C.V. (8.50) of GACL shows consistency in the ratio as compared to DCL and MCL.

9.530 7.099 7.230

ROI (%)

Return On Investment 8 6 4 2 0 1997- 1998- 1999- 2000- 2001- 200298 99 2000 01 02 03

GACL DCL MCL

Year

Return on Investment and ANOVA Test: Null Hypothesis: The profitability of all three units is uniform. Table – 2 Source of Variation Between Companies With in Companies Total

ANOVA Table Sum of Degree of Mean ‘F’ Ratio Squares Freedom Square 18.02 2 9.01 5.41 24.97 15 1.66 42.99 17

5% F Limit From Table F F(2,15) 3.68

It is evident from the table - 2 that the difference between in Return on Investment of companies was significant because the calculated value of ‘F’ (5.41) was higher than that of table value (3.68) at 5% level of significance. Hence the null hypothesis is rejected and the alternative hypothesis is accepted. The difference in between was significant because of variation in return on investment ratio of the companies. Analysis of Sales and Assets Efficiency: Sales and assets efficiency ratios are components of the ROI. Sales efficiency can be measured with the help of net profit margin; whereas the assets efficiency is presented by assets turn over ratio. Efficiency of Sales: This ratio explains per rupee profit generating capacity of the sales. If the cost of goods sold is lower, then the profit will be higher and then we divide it with the net sales the

result is the high sales efficiency. If lower is the net profit per rupee of sales, lower will be the sales efficiency. The companies must try for achieving greater sales efficiency for maximizing the ROI. Sales efficiency ratio = Net Profit/Net Sales. Efficiency of Assets: This ratio measures the efficiency of the assets use. The efficient use of assets will generate greater sales per rupee invested in all the assets of the company. The inefficient use of the assets will result in low sales volume coupled with higher overhead charges and under utilization of the available capacity. Hence, the management must strive for using of total resources at optimum level, to achieve higher ROI. Assets Efficiency Ratio = Net Sales/Total Net Assets Analysis of Sales Efficiency Profit margin ratio of GACL shows fluctuating trend, the average ratio of GACL was 12.962 percent, which was highest among all the units of study. The net profit margin of DCL and MCL was 1.56 percent and 2.28 percent in 2002-03, which was lowest in entire study. It shows the sales efficiency of these units were poor. The S.D. of GACL was 0.807, which indicates consistency in net profit margin. The sales efficiency ratios have been showing a significant feature of higher rates with greater reliability and uniformity in GACL than the DCL and MCL during the entire period under the study. Analysis of Assets Efficiency The analysis of the assets efficiency ratios indicates that in 2002-03 these were at 0.45, 0.554 and 0.483 times in GACL, DCL and MCL respectively. The average ratio of DCL was highest among all the units. The S. D. of all units was near 0.04 indicates consistency in this ratio.

Impact of sales and assets efficiency on ROI

The analysis revealed that the sales efficiency was more uniform and significantly higher in GACL followed by DCL. The assets efficiency was more consistent in DCL and MCL as compared to GCAL. Thus, this indicates that the sales efficiency was maximum in GACL, while assets efficiency was maximum in DCL. However to pinpoint the possible influencing factor, contributing for the fluctuations in ROI, we analyze the highest/lowest years of ROI with reference to sales and assets efficiency ratios we observe the following: •

The highest ROI in 1998-99 at 6.42 percent in GACL was influenced by the increase in the assets efficiency and sales efficiency.

•

The low rate of ROI in 2001-02 in GACL was attributed to low rate of assets efficiency rather than the sales efficiency.

•

In DCL the highest ROI in 1997-98 at 5.86 per cent was the reasons of higher sales efficiency and in MCL ROI was highest in 1998-99 at 4.55 per cent was also the reason of higher sales efficiency.

•

The reason for lower ROI in DCL and MCL was the lower the efficiency of sales and assets.

Tables and analysis indicates that the sales efficiency was the major contribution factor for the fluctuation in the rates of ROI in all the companies. Return on Net Worth: The return on net worth in GACL was highest in 2002-03 at 13.13 percent and its average return was 12.043 where as the average return on net worth of DCL and MCL was 9.613 per cent and 9.860 percent respectively. In the year 2002-03 the return of both these companies was lower during the study. The reason behind on this was lower ROI in these years. The ratio of GACL also shows a steady return on net worth. Analysis of Liquidity Position: Next, it is decided to make an attempt to study the liquidity position of the companies, in order to highlight the relative strength of the companies in meeting their current

obligations to maintain sound liquidity and to pinpoint the difficulties if any in it. Using the following two liquidity ratios makes the analysis of the liquidity position: 1. Current Ratio = Current Assets/Current Liabilities 2. Quick Ratio = Quick Assets/Current Liabilities Table –3

Liquidity Ratios of the Companies (Times) Current Ratio 1997-98 1998-99 1999-2000 2000-01 2001-02 2002-03 Average S.D. C.V. GACL 1.717 1.264 0.564 0.976 1.465 0.709 1.116 0.446 39.976 DCL 2.362 2.622 1.875 2.189 1.533 1.239 1.970 0.522 26.484 MCL 1.688 1.411 1.283 1.85 1.341 1.234 1.468 0.246 16.762 Quick Ratio GACL 0.84 0.44 0.14 0.19 0.34 0.14 0.348 0.269 77.255 DCL 0.74 0.87 0.56 0.62 0.27 0.22 0.547 0.257 47.047 MCL 0.78 0.53 0.36 0.58 0.41 0.39 0.508 0.158 31.115 Current Ratio: A close examination of the data pertaining to the current ratios reveals that these ratios are significantly lower in all the companies as compared to standard norms of 2:1. The average ratios are at 1.11 in GACL, 1.97 in DCL and 1.46 in MCL. This ratio indicates that the liquidity position of DCL was sound as compared to GACL and MCL. In 200203 the ratio of GACL was 0.709 indicate the scarcity of liquidity. Where the ratio of MCL shows consistency in liquidity position of the company because of its S.D. is 0.24 lower among all companies.

C.R. (Times)

Current Ratio 3 2 1 0 1997- 1998- 1999- 2000- 2001- 200298 99 2000 01 02 03

GACL DCL MCL

Year

Current Ratio and ANOVA Test: Null Hypothesis: The liquidity position of all three units is satisfactory. Table – 4 Source of Variation Between Companies With in Companies Total

ANOVA Table Sum of Degree of Mean ‘F’ Ratio Squares Freedom Square 2.21 2 1.11 6.24 2.66 15 0.18 4.87 17

5% F Limit From Table F F(2,15) 3.68

It is clear from table- 4 that the difference in between companies was significant because the calculated value of F was higher than table value. So, null hypothesis is rejected and alternative hypothesis is accepted. The difference is due to working capital policy of companies. Quick Ratio: The quick ratio was of GACL, DCL and MCL were at 0.14, 0.22 and 0.39 times in 200203 respectively as compared to standard norms of 1:1. It signals that companies have been suffering from the problem of liquidity. During the study period average ratio of DCL was higher as compared to GACL and MCL, but the consistency was maintain by MCL because its S.D. was lower as compared to GACL and DCL. The analysis of both current and quick ratio revels that the companies were not able to maintain sound liquidity position. Hence, it is advise that the companies maintain the sound liquidity position by reducing the burden of excessive current liquidities or by

increasing the investing in components of current assets depending upon the requirement of the companies. Analysis of Leverage Position: The leverage ratios explain the extent to which, the debt is employed in capital structure of the companies. Always companies use debt fund along with equity funds, in order to maximize the after tax profits, thereby optimizing earning available to equity shareholders. The basic facility of debt funds is that after tax cost of them will be significantly lower, and which can be paid back depending upon their terms of issue. Further, debt funds will not dilute the equity holders control position. However, the debts funds are used very carefully by considering the liquidity and risk factors. The debts will increase the risk of the company. Now, let us analyze the leverage position of the companies. For this purpose we have made using the following ratios: 1. Capital Gearing Ratio = Loan Capital + Preference Capital/Equity Capital 2. Debt Equity Ratio = Long-term Debt/Equity 3. Time Interest Earned = EBIT/Interest Table -5 Leverage Ratios of the Companies (Times) Capital Gearing Ratio 1997-98 1998-99 1999-2000 2000-01 2001-02 2002-03 Average S.D. C.V. GACL 1.088 0.779 0.851 1.083 1.114 1.086 1.000 0.146 14.562 DCL 1.222 1.16 1.174 1.06 1.285 1.223 1.187 0.076 6.431 MCL 1.563 1.284 1.5 1.795 2.808 2.661 1.935 0.642 33.171 Debt Equity Ratio GACL 0.995 0.692 0.784 1.083 1.114 1.086 0.959 0.178 18.580 DCL 1.222 1.16 1.174 1.06 1.285 1.223 1.187 0.076 6.431 MCL 1.563 1.284 1.5 1.795 2.808 2.661 1.935 0.642 33.171 Interest Coverage Ratio GACL 2.06 2.16 4.64 2.46 2.94 2.94 2.867 0.946 32.987 DCL 2.08 1.72 1.74 2.11 2.19 1.91 1.958 0.199 10.169 MCL 1.45 1.5 1.69 1.83 1.51 1.34 1.553 0.177 11.376

Capital Gearing: The average capital gearing of GACL was 1.00 indicates there is no gearing. While in MCL ratio was 1.935 times indicates high gearing, it discloses that companies are more dependants on fixed interest bearing securities. While in DCL the average ratio (1.187 times) indicates low gearing. Debt Equity Ratio: It measures the extent of equity covering the debt. It is computed by dividing debt by equity. Normally 2:1 debt equity ratio is considered to be standard. The range of debt equity ratio in GACL was 0.692 to 1.114 times in 1998-99 and 2001-02 respectively. Where as the average ratio of DCL and MCL were 1.187 and 1.935 times respectively. The ratio indicates that MCL is highly dependent on debt. While GACL’s debt is less that its equity indicated conservatives approach of financial management. The DCL ratio shows moderate approach of financing of organization need.

D.E.R. (Times)

Debt Equity Ratio 3 2 1 0 1997- 1998- 1999- 2000- 2001- 200298 99 2000 01 02 03

GACL DCL MCL

Year

Debt Equity Ratio and ANOVA Test: Null Hypothesis: The capital structure of all three units is uniform. Table – 6 Source of Variation Between Companies With in Companies Total

ANOVA Table Sum of Degree of Mean ‘F’ Ratio Squares Freedom Square 3.13 2 1.56 10.44 2.25 15 0.15 5.38 17

5% F Limit From Table F F(2,15) 3.68

From above table it is clear that calculated value of ‘F’ is higher than table value so, null hypothesis is rejected and alternative hypothesis is rejected. The difference is due to un uniform debt equity proportion of companies. Interest Coverage Ratio: It really measures the ability of the companies to service the debt. The ratio of GACL was highest among all the companies under study. The average ratio of GACL, DCL and MCL were 2.86 percent, 1.958 percent and 1.553 percent respectively. In 2002-03 the ratio of GACL was highest between all the year and all the companies. It indicates sound position of companies to pay the interest to its creditors. The DCL shows consistency Analysis of Activity Ratio: These ratios are also called as turnover ratios. These will indicate position of the assets usage. In order to compute these ratios sales are divided by various types of assets such as inventory, debtors and net fixed assets. The ratios are expressed in number of times. The greater the ratio more will be efficiency of assets usage. The lower ratio will reflect the under utilization of the resources available at the command of the companies. Always the companies must plan for efficient use of the assets to increase the overall efficiency. In this analysis we will be covering the following ratios: 1. Inventory Turnover Ratio = Sales/Average Inventory 2. Debtors Turnover Ratio = Sales/Average Debtors 3. Net Fixed Assets Turnover Ratio = Sales/Net Fixed Assets

Table – 7 Activity Ratios of the Companies (Times) Inventory Turnover Ratio 1997-98 1998-99 1999-2000 2000-01 2001-02 2002-03 Average S.D. C.V. GACL 14.26 17.47 22.12 20.86 20.15 25.16 20.003 3.774 18.869 DCL 10.38 9.74 8.67 6.62 4.91 4.21 7.422 2.567 34.590 MCL 15.17 16.71 17.19 15.67 20.45 25.87 18.510 4.053 21.897 Debtors Turnover Ratio GACL 58.13 50.49 42.46 42.7 43.72 47.87 47.562 6.079 12.782 DCL 13.51 13.62 12.85 12.07 12.83 16.6 13.580 1.581 11.644 MCL 26.62 15.79 13.48 13.78 16.29 14.25 16.702 4.986 29.853 Fixed Assets Turnover Ratio GACL 0.739 0.723 0.818 0.912 0.79 0.885 0.811 0.076 9.404 DCL 1.239 1.179 1.29 1.37 1.32 1.235 1.272 0.068 5.370 MCL 0.83 0.776 0.768 0.77 0.746 0.625 0.753 0.068 9.092 Inventory Turnover Ratio: Table – 5 indicates that inventory turnover was 25.16, 4.21 and 25.87 time in GACL, DCL and MCL respectively in 2002-03. This went to explain that rupee invested in inventory was able to generate 7 to 20 times of sales in the companies. The ratio indicates there was much distinctive difference in the inventory turnover, but with regards to the stability of the ratio, it was more uniform in DCL. Debtors Turnover: In GACL highest debtors turnover was at 58.13 times in 1997-98, while it was lowest 42.7 times in 2001. The trend of ratio shows fluctuating, with an average ratio of 47.562 times. As compared to GACL the ratio of DCL and MCL was lower in all the years of study period. The average ratio of DCL and MCL was 13.580 times and 16.702 times respectively. The DCL ratio was more stable as compared to GACL and MCL. The ratio of GACL indicates effective management of debtors. Net Fixed Assets Turnovers: It is evident from the Table – 5 that the fixed assets turnover ratio of DCL was higher among all companies. The average turnover was at 0.811, 1.272 and 0.753 times in

GACL, DCL and MCL respectively. The S.D. of DCL and MCL was shown same consistency in both companies. Summary of Findings and Suggestions: ¾ Return on the investment in 2002-03 was at 5.44, 0.96, and 1.1 in GACL, DCL and MCL respectively, reflecting very low return in DCL and MCL. The average return of all companies is also very low. The ROI of GACL was consistent and higher than DCL and MCL. ¾ F test suggest that there is no uniformity in return on investment of all companies. ¾ The sales efficiency of GACL was significantly higher than DCL and MCL. While no feature of assets efficiency was shown in GACL. ¾ The study of impact of sales and assets efficiency on the ROI shows that sales efficiency was major contributing factor more than the assets efficiency for the variation in the rates of ROI of the companies. It is suggested that the management of GACL has to pursue the policy of maximizing assets efficiency, while DCL and MCL has to strive for the maximizing the sales efficiency by generating maximum profit by introducing cost minimization and cost efficiency techniques. ¾ The return on net worth of GACL was higher among all companies. While DCL and MCL return was mostly equal. ¾ The liquidity position of GACL was quite alarming since they are facing chronic liquidity problems. While DCL and MCL liquidity position also not quite good. Therefore, it is suggested that the companies improve the liquidity position wither by reducing excessive burden of current liabilities or increasing the level of current assets depending upon the requirements. ¾ The leverage position of the companies reveals that GACL has no any gearing while gearing in MCL is higher. In MCL debt equity ratio is higher and in GACL it is lower. The GACL are not using high debt even though its ROI is higher. While MCL is not succeed in taking the benefits of trading on equity. ¾ The result of F test indicates that the un uniform proportion of debt and equity in the companies under study.

¾ In activity analysis inventory turnover of GACL and MCL are satisfactory while inn DCL it is poor. The debtor’s turnover of GACL is very high but its fixed assets turnover is low. The debtors and fixed assets turnover of DCL and MCL should improve for generating higher profits. References:

‰

Bhalla, V K. Financial Management and Policy, Anmol Publication, New Delhi, 2001-02.

‰

Brealey, Richard A. and Myers Stewart C. Principles of Corporate Finance., Tata McGraw Hill, New Delhi, 2001-02

‰

Gangadhar V., Financial Analyses of Companies in Erita: A Profitability and Efficiency Focus, The Management Accountant, Calcutta, Vol. 33 No. 11, Nov., 1997-98.

‰

Gitman, Managerial Finance, Pearson Education, New Delhi, 2004.

‰

Hampton J.J., Financial Decision Making: Concepts, Problems and Cases, Prentice Hall of India Pvt. Ltd., New Delhi1996.

‰

Narayansamy N. and S.R. Ramchandran, Profitability Performance of District Central Co-operative Bank: A Case Study, Indian Co-operative Review, Vol. XXV, No. 2, pp. 210-215, NCUI, New Delhi, 1987.

‰

Narware P.C., Working Capital and Profitability – An Empirical Analysis, The Management Accountant, Calcutta, June 2004.

‰

Pandey I.M., Financial Management, Vikash Publishing House, New Delhi, 200102.

‰

Rajesh Kumar B., Effect of ESOPs on Performance, Productivity and Risk, IIMB, Management Review, March 2004.

‰

Van Horne, Financial Management & Policy, Prentice Hall of India, New Delhi, 2002-03.

Chapter – 5 Productivity Management •

Introduction

•

Analysis of Material Productivity

•

Analysis of Labour Productivity

•

Analysis of Overhead Productivity

•

Analysis of Overall Productivity

•

Conclusion

•

References

Introduction: “Productivity is the basic mission of any organization to provide the maximum welfare for the maximum number. Productivity as a measure of efficiency and effectiveness and as a means of improving the quality of life is generic from achieving the highest output from the limited resources. Productivity implies the certainty of being able to do better than yesterday and keeping the tempo continuously to improve upon. Such continuous improvements are to be generated through the research for new technique, methods, process, materials, software, and expertise coupled with vision and dedicated leader ship having the ultimate faith in the welfare in the welfare of human system.” “

Productivity means different things to different people. To workers productivity means a

speed up in their work pattern. To union leaders it means the opportunities to negotiate for higher wages. To management, it means increased profitability. To customer, it betters goods after costs. To marketing directors productivity improvement increases the firm’s competitiveness abroad by reducing the coat of good sold in foreign market and to economists; it means an increase in country’s standard of living field to gain in output per man-hour. ”

Productivity is simply the ratio of output to input. When this ratio is

calculated in based price it indicates the change in productivity efficiency over the base year. As the input consist of a number of production factors and elements. Productivity can also be determined separately for each of these factors. Both the output and the input may be expressed in terms of physical units or interims of money. Productivity is measured as the ratio between the output of a given commodity or service and the inputs used for that product. Productivity ratio is the ratio of output of wealthy produced to the input of resources used in the process.

Analysis of Material Productivity The cost of materials used in production of ten surpasses, in this view materials are treated as the first factor in production or manufacturing. “Raw materials are the major inputs in an organization and form the bulk which gets converted in to output”3 Materials is one of the basic inputs which constitutes 50 to 70 percent of the total value of the

output of selected companies. Therefore to improve the performance selected companies, material productivity will have to be improved. Table – 1 Analysis of Material productivity

YEAR

Output

Input

1997-98

1466.07

321.95

1998-99

1758.67

383.57

1999-00

2013.1

388.87

2000-01

2253.33

429.07

2001-02

2312.48

475.57

2002-03

4769.56

2323.61

2003-04

5952.25

3100.88

2004-05

9337.95

4639.5

2005-06

11122.1

6603.37

40985.5 AVERGAE 4553.95

18666.4 2074.04

TOTAL

O/I 4.5537 4.585 5.1768 5.2517 4.8625 2.0527 1.9195 2.0127 1.6843 32.099 3.5665

STANDARD DEVIATION = 32.806 CO-Efficient of variation = 41.887

Coefficient factor Index

2.1947 704.89 704.89

I/o 0.2196 0.2181 0.1932 0.1904 0.2057 0.4872 0.521 0.4968 0.5937 3.1256

0.24386 78.3216 78.322

0.3473

0.3343

100

Trend 120.64

0.34591 100.69 110.06 0.4064

113.68 99.482

0.4117 115.33 88.902 0.3773 106.78 78.322 0.0923 45.076 67.741 0.076

42.153 57.161

0.0873 44.199

46.58

0.0635 36.987

36

A=78.3216

Std. input

Possible saving

279.163

42.78687

334.879

48.69116

383.326

5.543627

429.07

Nil

440.333

35.2369

908.2

1415.41

1133.4

1967.477

1778.09

2861.405

2117.83

4485.545

7804.3 867.144

10862.09 1357.762

Chi-square =36.23

B=(-10.5803)

The Table No.-1 showed that the ratio of material of Hindalco Ltd. was quite decreases i.e. In 1997-98 it showed 4.55 while in 2005-06 it highlights 1.68 with an average of 3.57. The trend was also declined. From 1997-98 to 2000-01 it showed increased trend while between 2001-02 to it showed declining trend. The impact of productivity ratio described the highly fluctuated trend in productivity index mainly during the study period. Input output ratio shows the required input for a unit of output, which is lowest in the year 20001. In this year company has achieved the highest productivity. The figures of possible savings show that the unit can save maximum up to 4485.54 P.A. This saving would reduce the cost of material in the total cost and would result in high profitability and better living standard for the member of the units. This is possible by better management of material, efficient handling in the plant. The material productivity of Hindalco Ltd.was highly fluctuating during the period of study as shown by value of Co-efficient of

variation 41.88. Further in order to test the null hypothesis, whether the distribution of material productivity indices of Hindalco confirms to the straight-line base least square method, it was found the calculated value of Chi-Square figured at 36.23 is more than the table value 15.50. Hence the null hypothesis is rejected. The computed value of productivity index showed a negative growth of 10.58.

Analysis of Labour Productivity The terms “labour productivity is generally defined as “the ratio of physical amount of output achieved in a given period to the corresponding amount of labour expended”. It may be true that any business organization all wage payments are directly or indirectly based on the skill and productivity of the workers, therefore labour productivity is considered as the most important factors in productivity computations. There are various types of methods for calculating the labour productivity. Very simple method describe in the above definition. ‘Output divided by input’ another method the output per man-years of man-hour and the input per man-years or per man-hour. In the present research study labour input calculated by cost/expenses labour productivity and capacity of utilization could be general indices, which are easily understandable and could be the basis for measurement of the employees.

Table – 2 Analysis of labour productivity YEAR

Output

Input

O/I

1997-98

1466.07

98.49

1998-99

1758.67

119.01

1999-00

2013.1

140.62

2000-01

2253.33

151.61

2001-02

2312.48

167.16

2002-03

4769.56

222.85

2003-04

5952.25

235.4

2004-05

9337.95

409.03

2005-06

11122.1

458.98

14.885 14.777 14.316 14.863 13.834 21.403 25.286 22.829 24.232 166.43

Coefficient factor

Index

1.0939

100

1.086

99.275

93.988 0.0677

1.0521

96.174

104.07 0.0699 79.614

61.0058

1.0922

99.847

114.15 0.0673 89.115

62.4951

1.0166

92.936

124.23 0.0723 91.454

75.7059

1.5729

143.78

134.31 0.0467 188.63

34.2231

1.8582

169.87

144.39 0.0395

235.4

Nil

1.6777

153.37

154.46 0.0438

369.3

39.7321

1.7808

162.79

164.54 0.0413 439.86

19.12241

Trend

I/o

Std. input

83.909 0.0672 57.9802 69.552

Possible saving 40.50976 49.458

12.23 1118.04 1118 0.5156 1620.9 382.2522 TOTAL 40985.5 2003.15 AVS. 4553.95 222.572 18.492 1.35894 124.227 124.23 0.0573 180.1 47.78152 STANDARD DEVIATION =30.50 A=124.227 Chi-square =18.85 CO-Efficient of variation =24.55 B=10.079 The Table No.-2 describe that Labour productivity ratio, Co-efficiency of Co-relationship, Productivity index, Trend value, input-output ratio, Standard deviation, Co-efficient of variation and value of Chi-Square. It is apparent from the table that Labour productivity of Hindalco Ltd, has showed the upward trend throughout the period of study. The output of Hindalco Ltd. amounted to Rs.1466.07 Crores in 1997-98, which is increased to Rs. 11122.1 Crores in 2005-06.On the other hand the labour input expanded from Rs. 98.49 Crores in 197-98 to 458.98 crorers in 2005-06. The productivity ratio ranged between 14.316 from 1999-2000 to 25.286 in 2003-04 similarly the productivity index also showed upward trend with the average 124.23.The straight line based on trend value showed positive growth rate of 10.079 per annum, which indicates good position of Labour productivity. It could also be seen from the table No.-2 that the average labour input per rupee of output for Hindalco Ltd. amounted to Rs. 0.0573. Input-output ratio was the lowest in 2003-04.It showed that the company achieved its maximum efficiency in that year. The value of Chi-Square showed 18.85 which is greater than the table value of 15.507 hence null hypothesis is rejected and alternative hypothesis is accepted.

Analysis of Overhead Productivity “Overheads costs are the operating costs of a business enterprise, which can be traced directly to a particular unit of output. The term ‘Overheads’ is used interchangeably with such terms as burden, supplementary costs, manufacturing expenses, and indirect expenses.” The major part of total cost including total overheads, office overheads, selling and distribution overheads, thus primary aim of accounting for overhead is to controlling. Present study outlined output in constant prices divided by total overheads input it gives overheads productivity ratio. The productivity ratio indices, Co-efficiency of co-relationship, input output ratio etc. Table – 3 Analysis of Overhead productivity Coefficient factor

Index

0.2327

100

100.35 0.3158 364.21

98.841

0.247

106.15

103.22 0.2975 436.898

86.39173

0.2507

107.75

106.1

500.105

90.00486

0.26134

112.32

108.97

559.784

73.84563

0.2372 0.2495

101.94 107.22

111.85

574.479

141.9913

1184.88

220.1502

0.2958

127.14

117.6

1478.69

Nil

0.2775

119.26

120.47

2319.78

153.1862

0.2905

124.87

123.35

2763.01

50.21802

10181.8 1131.32

914.6289 114.3286

YEAR

Output

Input

O/I

1997-98

1466.07

463.05

1998-99

1758.67

523.29

1999-00

2013.1

590.11

2000-01

2253.33

633.63

2001-02 2002-03

2312.48

716.47

4769.56

1405.03

2003-04

5952.25

1478.69

2004-05

9337.95

2472.97

2005-06

11122.1

2813.23

TOTAL

40985.5

11096.5 1232.94

3.1661 3.3608 3.4114 3.5562 3.2276 3.3946 4.0254 3.776 3.9535 31.872

2.3422 1006.65 1006.6

0.2931 0.2812 0.3098 0.2946 0.2484 0.2648 0.2529 2.5583

3.5413

0.26025

0.2843

AVERAGE 4553.95

STANDARD DEVIATION =9.24 CO-Efficient of variation =8.26

111.85

Trend

114.72

111.85

A=111.85

I/o

Std. input

Possible saving

Chi-square =2.39

B=2.874

Table No-3 showed the overhead productivity ratio, Co-efficiency of Co-relationship, Productivity index, average of indices, Trend value of indices, Chi-Square, Input-output ratio, Standard deviation as well as Co-efficient of variation for Hindalco Ltd. The table3 reveals that the output of Hindalco Ltd. was increased from 1466.07 Crores in 1997-98

to Rs. 11122.1 crores in 2005-06 while the overhead input increased from Rs. 463.05 crores in 1997-98 to Rs. 2813.23 crores in 2005-06. The output ratio showed increased trend and the productivity index also showed increasing trend i.g.100 in 1997-98 to 124.90 in 2005-06 with an average of 111.85.The value of Co-efficient of variation showed 8.26. In order to measure the null hypothesis based on Chi-Square has also been calculated, which is worked out to be 2.39 and the lower than the critical value of 15.50 hence the null hypothesis is accepted and alternative hypothesis is rejected. The straightline trend showed a positive pattern of overheads of 2.874.input output ratio makes us clear about the possible savings and standard input required for the production. It is the lowest in the 2003-04. Average possible saving in case of overhead input during the study is possible 114.328 P.A.

Analysis of Overall Productivity It has already been mentioned the productivity is a ratio of output to input. Productivity ratio is said to be a measure of efficiency. The various inputs are material, manpower, capital goods and expense of manufacturing, selling and distribution etc. When all the input is added together and the productivity ratio is calculated it is termed as overall productivity ratio. In order to revolve the problem of calculation of the overall productivity ratio the data needed are: output and total input. Total input includes the elements of costs such as material, manpower and overhead. “When a number of factors are not valued in the production process but the output is related to any single factor unit. Productivity thus measured is called factor or partial productivity According to Shrivastava J. P. “There is a general agreement among different writes that the over all productivity ratio measure the total productivity efficiency of the combined resources input used by an enterprise.’’ The present research study outlined total input includes labour, material, and overhead calculated with base year 1997-98 prices to indicate the change in productivity efficiency over the base year.

Table - 4 Analysis of Overall productivity YEAR

Output

Input

O/I

Index

1997-98

1466.07

883.49

100

1998-99

1758.67

1025.9

1999-00

2013.1

1119.6

2000-01

2253.33

1214.3

2001-02

2312.48

1359.2

2002-03

4769.56

3951.5

2003-04

5952.25

4815

2004-05

9337.95

7521.5

2005-06

11122.1

9875.6

1.6594 1.7143 1.7981 1.8556 1.7014 1.207 1.2362 1.2415 1.1262 13.54

Trend

I/o

Std. input

Possible saving

112.05 0.6026 790.059

93.43108

0.5833 0.5562 0.5389 0.5878 0.8285 0.8089 0.8055 0.8879 6.1996

947.74

78.13018

1084.85

34.74893

1214.31

Nil

1246.19

113.0143

2570.3

1381.194

3207.64

1607.328

5032.18

2489.318

5993.65

3881.927

103.31

106.7

108.36

101.35

111.83

96.007

102.53

90.66

72.739

85.313

74.496

79.966

74.816

74.619

67.869

69.272

TOTAL 40985.5 31766 815.938 815.94 22086.9 9679.092 AVERAGE 4553.95 3529.6 1.50441 90.6597 90.66 0.6888 2454.1 1209.887 STANDARD DEVIATION =16.67 A=90.6597 Chi-square =8.30 CO-Efficient of variation =18.39 B=(-5.346)

Table No.4 revealed various facts about the total productivity in Hindalco Ltd. during the research study. The table also manifested that the output remained same as explained earlier. While the total input increased from Rs. 883.49 crores in 1997-98 to Rs. 9875.58 crores in 2005-06. The average input figured at Rs. 3529.56 Crores. The overall productivity ratio showed declining trend during the study period. The Ratio ranged between 1.126 in 2005-06 to 1.856 in 2000-01 with an average of 1.504. The index also showed same position with an average of 90.66 percent. The value of Chi-square calculated at 8.30, which is less than the table value of 15.50. Therefore the null hypothesis assuming straight-line approximation for the productivity indices is accepted. The straight line in case of this company shows moderate pattern of productivity efficiency with an average annual negative rate of change (5.346). It may be observed from above table that there are considerable rise in material, labour and overhead. The selected units needs to constraint over planning and control of material recovery, lack of control over expenses and efficient handling. The total input requirements per rupees of output ranged between Rs. 0.539 and Rs.0.888 during the period of the study.

Conclusion: To improve total productivity of Hindalco LTd. some suggestions are made. Make the unit as much as “learning units” as possible. Make the organization as flexible as possible. Once the philosophy, values, attitudes and intend are established make use of the relevant productivity techniques and measures including the conventional and modern, like BPR and Benchmarking. Level of efficiency should be measured frequently, once level of efficiency achieved it does not go out of hand. Full capacity of each plant/equipment/facility should be utilized. Optimising energy consumption. Efficient handling of raw materials and reduction of wastages. The company should adapt better working practice and try to improve in environment.

References •

Brown David S. (1983), “Productivity of the professionals” productivity, New Delhi, Vol. XXIV, No.3, Oct - Dec,. pp.241-249

•

Jain A. and Jain N.(1998), An integrated approach to inventory management” Journal of accounting and Finance, Jaipur, Vol.12, No.2, Sep. pp. 166

•

Mohanty R.P. (1992), “Managing technology for strategic advantages ”, The Economics Times, (Thursday 9th Jan.), p.14

•

Shrivasthava J.P. (1982), “Labour Productivity socio Economic Midimesion, Oxford & IBH Publication, New .Delhi.

•

Samanth Devid J, (1990), Productivity Engineering and management, TMH publication-1990.

•

Thomas.H. Connell (1978), How to Improve Human Performance, New York: Harper and row, pp.3

Chapter - 6 Analyzing Financial Performance of Banks Introduction Introduction to CAMELS How the Rating System came into Usage Adoption of CAMELS by RBI in its Supervisory Regulations of the Banking System On-Site and Off-Site Surveillance

Introduction: Banks are essentially intermediary institutions, which collect savings and then convert them into productive capital. They create or expand credit in the economy and thus accelerate economic growth. Though substantial part of bank credit is in the form of short-term credit to industries or businesses, the concept is changing rapidly. Today, Banks are lending for long-term purposes and also expanding their activities to nonbusiness entities. Banks are major lenders for consumer financing and housing finance. Like any other organisation, banks also handle large cash flows. In fact, the commodity they buy and sell is cash flows. Financial management becomes integral part of banking operations. Issues like liquidity management and risk management are equally important for banks as in the case of any commercial organisation. Banking is one of the more closely supervised industries in almost all the countries of the world, reflecting the view that bank failures have stronger adverse effects on economic activity than other business failures. The central government and the state governments grant authority to bank supervisors to limit the risk of failure assumed by banks. Supervisors impose sanctions on the banks that they have identified as being in poor

financial condition. Effective bank supervision, therefore, requires accurate information about the condition of banks. Bank supervisors use on-site examination and off-site surveillance to identify the banks most likely to fail. The most useful tool for identifying problem institutions is onsite examination, in which examiners travel to a bank and review all aspects of its safety and soundness. On-site examination (CAMELS Rating System) is, however, both costly and burdensome: costly to supervisors because of its labor-intensive nature and burdensome to bankers because of the intrusion into their day-to-day operations. As a result, supervisors also monitor bank condition off-site. Off-site surveillance yields an ongoing picture of bank condition, enabling supervisors to schedule and plan exams efficiently. Off-site surveillance also provides banks with incentives to maintain safety and soundness between on-site visits. Supervisors rely primarily on two analytical tools for off-site surveillance: supervisory screens and econometric models. Supervisory screens are combinations of financial ratios, derived from bank balance sheets and income statements that have, in the past, given forewarning of safety-and-soundness problems. Supervisors draw on their experience to weigh the information content of these ratios. Introduction to CAMELS CAMELS rating originated in 1979 with the creation of the Uniform Financial Institutions Rating System. An international bank-rating system with which bank supervisory authorities rate institutions according to six factors. The six areas examined are represented by the acronym "CAMELS." The six factors examined are as follows: 1.

C - Capital adequacy

2.

A - Asset quality

3.

M - Management quality

4.

E - Earnings

5.

L - Liquidity

6.

S - Sensitivity to Market Risk

Bank supervisory authorities assign each bank a score on a scale of 1 (best) to 5 (worst) for each factor. If a bank has an average score less than 2 it is considered to be a highquality institution while banks with scores greater than 3 are considered to be less-thansatisfactory establishments. The system helps the supervisory authority identify banks that are in need of attention. Banks with ratings of 1 or 2 are considered to present few, if any, supervisory concerns, while banks with ratings of 3, 4, or 5 present moderate to extreme degrees of supervisory concern. Table: 1 CAMELS RATINGS WHAT ARE CAMELS RATINGS? CAMELS composite rating Description Safe and sound Financial institutions with a composite one rating are 1 sound in every respect and generally have individual component ratings of one or two. 2

Unsatisfactory 3

4

5

Financial institutions with a composite two rating are fundamentally sound. In general, a two-rated institution will have no individual component ratings weaker than three. Financial institutions with a composite three rating exhibit some degree of supervisory concern in one or more of the component areas. Financial institutions with a composite four rating generally exhibit unsafe and unsound practices or conditions. They have serious financial or managerial deficiencies that result in unsatisfactory performance. Financial institutions with a composite five rating generally exhibit extremely unsafe and unsound practices or conditions. Institutions in this group pose a significant risk to the deposit insurance fund and their failure is highly probable.

How the Rating System came into Usage This rating system is used by the three federal banking supervisors (the Federal Reserve, the FDIC, and the OCC) and other financial supervisory agencies to provide a convenient summary of bank conditions at the time of an exam. During an on-site bank exam, supervisors gather private information, such as details on problem loans, with which to evaluate a bank's financial condition and to monitor its compliance with laws and regulatory policies. A key product of such an exam is a supervisory rating of the bank's overall condition, commonly referred to as a CAMELS rating. In fact the rating system initially emerged as CAMEL covering the first five parameters only. A sixth component, a bank's Sensitivity to market risk was added in 1997; hence the acronym was changed to CAMELS. All exam materials are highly confidential, including the CAMELS. A bank's CAMELS rating is directly known only by the bank's senior management and the appropriate supervisory staff. CAMELS ratings are never released by supervisory agencies, even on a lagged basis. While exam results are confidential, the public may infer such supervisory information on bank conditions based on subsequent bank actions or specific disclosures. Overall, the private supervisory information gathered during a bank exam is not disclosed to the public by supervisors, although studies show that it does filter into the financial markets.

Adoption of CAMELS by RBI in its Supervisory Regulations of the Banking System The focus of the statutory regulation of commercial banks by RBI in India until the early 1990s was mainly on licensing, administration of minimum capital requirements, pricing of services including administration of interest rates on deposits as well as credit, reserves and liquid asset requirements. In these circumstances, the supervision had to focus essentially on solvency issues

After the evolution of the BIS prudential norms in 1988, the RBI took a series of measures to realign its supervisory and regulatory standards almost on a par with international best practices. At the same time, it also took care to keep in view the socioeconomic conditions of the country, the business practices, payment systems prevalent in the country and the predominantly agrarian nature of the economy, and ensured that the prudential norms were applied over the period and across different segments of the financial sector in a phased manner. The entire supervisory mechanism has been realigned since 1994 under the directions of a newly constituted Board for Financial Supervision (BFS), which functions under the aegis of the RBI, to suit the demanding needs of a strong and stable financial system. The supervisory jurisdiction of the BFS now extends to the entire financial system barring the capital market institutions and the insurance sector. The periodical on-site inspections, and also the targeted appraisals by the Reserve Bank, are now supplemented by off-site surveillance which particularly focuses on the risk profile of the supervised institution. A process of rating of banks on the basis of CAMELS in respect of Indian banks and CACS (Capital, Asset Quality, Compliance and Systems & Control) in respect of foreign banks has been put in place from 1999. The Off-site Monitoring and Surveillance System (OSMOS) was introduced in 1995 as an additional tool for supervision of commercial banks to supplement the on-site examinations. Thesystem consists of 12 returns (called DSB returns) focussing on supervisory concerns such as capital adequacy, asset quality, large credits and concentrations, connected lending, earnings and risk exposures (viz. currency, liquidity and interest rate risks). The supervisory intervention by the RBI is normally triggered by the deterioration in the level of capital adequacy, NPAs, credit concentration, lower earnings, and larger incidence of frauds which reflect the quality of control.

RBI has issued a comprehensive Notification on the Supervisory System for Financial Institutions including the functions of the Board for Financial Supervision covering comprehensive information on the subject. ON-SITE AND OFF-SITE SURVEILLANCE The role of off-site surveillance and early warning models in bank supervision. Bank supervisors rely principally on regular on-site examinations to assess the condition of banks. Examinations ensure the integrity of bank financial statements and identify the banks that should be subject to supervisory sanctions. During a routine exam, the examiners assess six components of safety and soundness—capital protection (C), asset quality (A), management competence (M), earnings strength (E), liquidity risk (L) and market risk (S)—and assign a grade of 1 (best) through 5 (worst) to each component. Examiners then use these six scores to award a composite rating, also expressed on a 1 through 5 scale. Bank supervisors added the “S” component (market risk) in January 1997. Since examiners graded only five components of safety and soundness during most of our sample period, this paper refers to composite “CAMEL” ratings. Table 1 interprets the five composite CAMEL ratings. Although on-site examination is the most effective tool for constraining bank risk, it is both costly to supervisors and burdensome to bankers. As a result, supervisors face continuous pressure to limit exam frequency. Supervisors yielded to this pressure in the 1980s, and many banks escaped yearly examination (Reidhill and O’Keefe, 1997). Congress mandated the frequency of examinations in the Federal Deposit Insurance Corporation Improvement Act of 1991, which requires annual examinations for all but a handful of small, well-capitalized, highly-rated banks, and even these institutions must be examined every 18 months. This new mandate reflects the lessons learned from the wave of bank failures in the late 1980s: more frequent exams, though likely to increase the upfront costs of supervision, reduce the down-the-road costs of resolving failures by revealing problems at an early stage.

Although changes in public policy have mandated greater exam frequency since the early 1990s, supervisors still have reasons to use off-site surveillance tools to flag banks for accelerated exams and to plan exams. Bank condition can deteriorate rapidly between onsite visits (Cole and Gunther, 1998; Hirtle and Lopez, 1999). In addition, the Federal Reserve now employs a “risk-focused” approach to exams, in which supervisors allocate on-site resources according to the risk exposures of each bank (Board of Governors, 1996). Off-site surveillance helps supervisors allocate on-site resources efficiently by identifying institutions that need immediate attention and by identifying specific risk exposures for regularly scheduled as well as accelerated exams. For these reasons, an interagency body of bank and thrift supervisors—the Federal Financial Institutions Examinations Council (FFIEC)—requires banks to submit quarterly Reports of Condition and Income, often referred to as the call reports. Surveillance analysts use the call report data to monitor the condition of banks between exams. Supervisors have developed various tools for using call report data to schedule and plan exams, including econometric models. A common type of model used in surveillance estimates the marginal impact of a change in a financial ratio on the probability that a bank will fail, holding all other ratios constant. These models can examine many ratios simultaneously, capturing subtle but important interactions. The Federal Reserve uses two models in off-site surveillance. One model, called the SEER risk rank model, combines financial ratios to estimate the probability that each Fed supervised bank will fail within the next two years. Another model estimates a hypothetical CAMEL rating that is consistent with the financial data in the bank's most recent call report. Every quarter, economists at the Board of Governors feed the latest call report data into these models and forward the results to each of the twelve Reserve Banks. Surveillance analysts in the Reserve Banks then investigate the institutions that the models flag as “exceptions.”

References: •

Allen, Linda and Saunders, Anthony. “Bank Window Dressing: Theory and Evidence.” Journal of Banking and Finance, June 1992, 16(3), pp. 585-623.

•

Altman E. Avery R., Eisenbeis R., and Sinkey J. (1981) Applications of Classification Techniques in Business Banking and Finance, Connecticut.

•

Feldman, R. and J. Schmidt. “What Are CAMELS and Who Should Know?” Fedgazette Federal Reserve Bank of Minneapolis (January 1999).

•

Noulas, A. G. and K.W. Ketkar (1996) “Technical and Scale Efficiency in the Indian Banking Sector”, International Journal of Development Banking, Vol. 14, No.2, pp.19-27.

•

Sathye M. (2005), Privatization, Performance, and Efficiency: A Study of Indian Banks”, Vikalpa, Vol. 30, No. 1, pp. 7-16

Chapter – 7

Economic Value Added – A Tool for Performance Measurement •

Introduction

•

Concept of Profitability

•

The Calculation for EVA

•

Strategies for Increasing EVA

•

Usage of the EVA Method

•

Advantages of EVA

•

The approach of EVA

•

EVA and the Market Value of a company

•

References

Introduction EVA is a method to measure a company’s true profitability and to steer the company correctly from the viewpoint of shareholders. EVA helps the operating people to see how they can influence the true profitability. EVA is based on something we have known for a long time; what we call profits, the money left to service equity, is usually not profit at all. Until a business returns a profit that is greater than its cost of capital, it operates at a loss. Never mind that it pays taxes as if it has a genuine profit. The enterprise still returns less to the economy than it devours in resources… until then it does not create wealth; it destroys it. States by Peter F. Drucker, The Information Executive Truly Need, Harvard Business Review. Peter Drucker writes, “There is no profit unless you earn the cost of capital. Economic Value Added, or EVA is a measure that enables managers to see whether they are earning an adequate return, where returns are lower than might reasonable be expected for investments of similar risk (i.e., they are below the cost of capital), EVA is negative and the firm faces the flight of capital and a lower stock price. Quite Simply: EVA is a measure of profit less the cost of all capital employed. It is the one measure that properly accounts for all the complex trade-off, often between the income statement and balance sheet, involved in creating value. EVA is also the spread between a company’s return on and cost of capital multiplied by the invested capital. EVA = (Rate of Return – Cost of Capital) X Capital For example, Rs. 1,00,000 invested in a project produces a 5% return, where investment of similar risk elsewhere can earn 8%. The EVA from this case would be EVA = (5% - 8%) X Rs. 1,00,000 = (Rs. 3000) An accountant measures profit earned, whereas an economist looks at what could have been earned. Although the accounting profit in this example is Rs. 5000 (5% X 1,00,000) there was an opportunity to earn Rs. Rs. 8000. (8% X 1,00,000).

Under EVA, each business is effectively charged by investors for the use of capital through a “Line of Credit” that bears interest at a rate equal to the cost of capital. Therefore shareholders accountability is effectively decentralized into the operating units. EVA simultaneously focuses on both the profit and loss statements and the balance sheet. Finally, EVA sets a required rate of return – the cost of capital – as a hurdle rate below which performance is unacceptable. Concept of Profitability EVA is based on the concept that a successful firm should earn at least its cost of capital. Firms that earn higher returns than financing costs benefit shareholders and account for increased shareholder value. In its simplest form, EVA can be expressed in the following equation. EVA = Operating Profit after Tax (NOPAT) – Cost of Capital NOPAT is calculated as net operating income after depreciation, adjusted for items that move the profit measure closer to an economic measure of profitability. Adjustment include such items as additions for interest expenses after-taxes (including any implied interest expense on operating leases) increases in net capitalization R&D expenses; increase in LIFO reserve; and goodwill amortization. Adjustments made to operating earnings for these items reflect the investment made by the firm or capital employed to achieve those profits.

The Calculation for EVA Economic Value Added: EVA is the net operating profit after tax, less the change on economic capital employed. EVA = Net Operating Profits – (weighted Average Cost of Capital X Total Capital Employed). NOPAT = (Profit after Tax + Non-Recurring Expenses + Revenue Expenditure on R&D + Interest Expense + Provision for Taxes) – Non-recurring Income – R&D Amortization – Cash Operating Taxes. Cash Operating Taxes = (Provision for Taxes + Tax Benefit of Non-Recurring Expenses + Tax Benefit of Interest Expense – Tax on Non-Recurring Income) Economic Capital = Net Fixed Assets + Investments + Current Assets – (NIBCLs + Miscellaneous Expenditure Not Written Off + Intangible Assets + Cumulative NonRecurring Losses + Capitalized Expenditure on R&D) – Revaluation Reserve – Cumulative Non-Recurring Gains. Source: Business Today, April 13, 2003. Strategies for Increasing EVA •

Increase the return on existing projects: This might be achieved through higher prices or margins, more volume, or lower costs.

•

Profitability Growth: This might be achieved through investing capital where increased profits will adequately cover the cost of additional capital.

•

Use less capital to achieve the same return.

•

Reduce the cost of capital.

•

Liquidate capital or restrict further investment in substandard operations where inadequate returns are being earned

Usage of the EVA Method EVA can be used for the following purposes: •

Performance Measurement

•

Facilitate Communication with shareholders

•

Determining Bonuses

•

Motivation tool for managers

•

Capital Budgeting

•

Corporate Valuation

•

Analyzing Equity Securities

Advantages of EVA EVA is more than just performance measurement system and it is also marketed as a motivational, compensation-based management system that facilitates economic activity and accountability at all levels in the firm. Stern Stewart reports that companies that have adopted EVA have outperformed their competitors when compared on the basis of comparable market capitalization. Several advantages claimed for EVA are: •

EVA is closely related to NPV. It is closest in spirit to corporate finance theory that argues that the value of the firm will increase if you take positive NPV projects.

•

It avoids the problems associates with approaches that focus on percentage spreads - between ROE and Cost of Equity and ROC and Cost of Capital. These approaches may lead firms with high ROE and ROC to turn away good projects to avoid lowering their percentage spreads.

•

It makes top managers responsible for a measure that they have more control over - the return on capital and the cost of capital are affected by their decisions -

rather than one that they feel they cannot control as well - the market price per share. •

It is influenced by all of the decisions that managers have to make within a firm the investment decisions and dividend decisions affect the return on capital (the dividend decisions affect it indirectly through the cash balance) and the financing decision affects the cost of capital.

•

EVA eliminates economic distortions of GAAP to focus decisions on real economic results

•

EVA provides for better assessment of decisions that affect balance sheet and income statement or tradeoffs between each through the use of the capital charge against NOPAT

•

EVA decouples bonus plans from budgetary targets.

•

EVA covers all aspects of the business cycle.

•

Goal congruence of managerial and shareholder goals achieved by tying compensation of managers and other employees to EVA measures (Dierks & Patel, 1997)

•

Improvement in EVA necessarily indicates improvement in shareholder wealth, which may not be true in case of other measures like ESP, Profit.

•

EVA can act as an internal system of corporate governance, bringing all departments together.

The approach of EVA Different investments have always some average return •

The average return is easily achievable

•

Therefore it is not wise to accept lower returns

•

Losing a part of average return is losing capital

EVA and the Market Value of a company Theoretically EVA is much better than conventional measures in explaining the market value of a company. Financial theory suggests that the market value of a company depends directly on the future EVA-values: The market value of a company = Book value of equity + present value of future EVA Positive EVA builds up a premium to the market value of equity, since investors pay for the excess return. While negative EVA builds up a discount to the market value of equity. This is because companies have insufficient future expected return to meet the expectation on investors. The bigger expected EVA the company has, the bigger is the market value of the company and the stock price especially profitable growth (growth in EVA) gears up stock prices. Therefore companies like Intel, Microsoft and Nokia trade many times above their book values. Stock prices reflect the future EVA expectations. Those expectations are very uncertain and continuously changing and thus also stock prices are volatile. Therefore it might be in short term difficult to see the underlying connection between EVA (financial performance) and stock prices. Long term perspective helps in this sense. Firm Value using EVA Approach Capital Invested in Assets in Place = Rs. 100 EVA from Assets in Place = (.15 - .10) (1000)/.10 = Rs. 50 + PV of EVA from New Investments in Year 1 = [(.15 - .10)(10)/.10] = Rs. 5 + PV of EVA from New Investments in Year 2 = [(.15 - .10)(10)/.10]/1.12 = Rs. 4.55 + PV of EVA from New Investments in Year 3 = [(.15 - .10)(10)/.10]/1.13 = Rs. 4.13 + PV of EVA from New Investments in Year 4 = [(.15 - .10)(10)/.10]/1.14 = Rs. 3.76 + PV of EVA from New Investments in Year 5 = [(.15 - .10)(10)/.10]/1.15 = Rs. 3.42 Value of Firm = Rs. 170.86

Year-by-year EVA Changes •

Firms are often evaluated based upon year-to-year changes in EVA rather than the present value of EVA over time.

•

The advantage of this comparison is that it is simple and does not require the making of forecasts about future earnings potential.

•

Another advantage is that it can be broken down by any unit - person, division etc., as long as one is willing to assign capital and allocate earnings across these same units.

•

While it is simpler than DCF valuation, using year-by-year EVA changes comes at a cost. In particular, it is entirely possible that a firm which focuses on increasing EVA on a year-to-year basis may end up being less valuable. Year-to-Year EVA Changes 0 Rs. 15.00 Rs. 10.00 Rs.5.00

EBIT(1-t) WACC(Capital) EVA PV of EVA Terminal Value of EVA Value: Assets in Rs. 100.00 Place = PV of EVA = Rs. 70.85 Value of Firm = Rs. 170.85

1 Rs. 16.50 Rs. 11.00 Rs. 5.50 Rs. 5.00

2 Rs. 18.00 Rs. 12.00 Rs. 6.00 Rs. 4.96

3 Rs. 19.50 Rs. 13.00 Rs. 6.50 Rs. 4.88

4 Rs. 21.00 Rs. 14.00 Rs. 7.00 Rs. 4.78

5 Rs. 22.50 Rs. 15.00 Rs. 7.50 Rs. 4.66

Term. Yr. Rs. 23.63 Rs. 16.13 Rs. 7.50

Rs. 75.00

When Increasing EVA on year-to-year basis may result in lower Firm Value 1. If the increase in EVA on a year-to-year basis has been accomplished at the expense of the EVA of future projects. In this case, the gain from the EVA in the current year may be more than offset by the present value of the loss of EVA from the future periods. •

For example, in the example above assume that the return on capital on year 1 projects increases to 17%, while the cost of capital on these projects stays at 10%. If this increase in value does not affect the EVA on future projects, the value of the firm will increase.

•

If, however, this increase in EVA in year 1 is accomplished by reducing the return on capital on future projects to 14%, the firm value will actually decrease. Firm Value and EVA Tradeoffs over Time 0 15% 10%

Return on Capital Cost of Capital EBIT(1-t) WACC(Capital) EVA PV of EVA Terminal Value of EVA Value: Assets in Place = PV of EVA = Value of Firm =

Rs. 15.00 Rs. 10.00 Rs. 5.00

1 17% 10%

2 14% 10%

3 14% 10%

4 14% 10%

Rs. 16.70 Rs. 11.00 Rs. 5.70 Rs. 5.18

Rs. 18.10 Rs. 12.00 Rs. 6.10 Rs.5.04

Rs. 19.50 Rs. 13.00 Rs. 6.50 Rs. 4.88

Rs. 20.90 Rs. 14.00 Rs. 6.90 Rs. 4.71

5 14% 10%

Term. Yr. 10% 10%

Rs. 22.30 Rs. 23.42 Rs. 15.00 Rs. 16.12 Rs. 7.30 Rs. 7.30 Rs. 4.53 Rs. 73.00

Rs. 100.00 Rs. 69.68 Rs. 169.68

EVA with Changing Cost of Capital 0

1

2

3

4

5

Term. Yr.

Return on Capital

15%

16%

16%

16%

16%

16%

11%

Cost of Capital

10%

11%

11%

11%

11%

11%

11%

EBIT(1-t)

Rs.15.00 Rs.16.60 Rs.18.20 Rs.19.80 Rs.21.40 Rs.23.00 Rs.24.15

WACC(Capital)

Rs.10.00 Rs.11.10 Rs.12.20 Rs.13.30 Rs.14.40 Rs.15.50 Rs.16.65

EVA

Rs.5.00

PV of EVA

Rs.5.50 Rs.6.00 Rs.6.50 Rs.7.00 Rs.7.50 Rs.7.50 Rs.4.95 Rs.4.87 Rs.4.75 Rs.4.61 Rs.4.45

Terminal Value

Rs.68.18

Value of Assets in Place =

Rs.100.00

PV of EVA =

Rs.64.10

Value of Firm =

Rs.164.10

Vishal Export Ltd: - EVA Trend Analysis (Rs. in crore) 2000 1999 Cost of Capital Employed (COCE) 1. Average Debt 135 97 2. Average Equity

2001

2002

2003

2004

2005

2006

2007

2008

110

156

160

165

162

93

50

45

359

462

588

815

1127

1487

1908

2296

2766

3351

494

559

698

971

1287

1652

2070

2389

2816

3396

6.76

7.36

7.56

7.88

8.82

9.10

8.61

8.46

7.72

6.45

19.70

19.70

19.70

19.70

19.70

19.70

19.70

19.70

16.70

14.4

6. Weighted Average Cost of Capital % (WACC)

16.17

17.57

17.79

17.80

18.34

18.64

18.83

19.27

16.54

14.3

7. COCE(3) x (6)

80

98

124

173

236

308

390

460

466

486

190

239

413

580

837

1070

1310

1541

1716

13

15

11

32

21

19

14

8

5

6

140

205

250

445

601

856

1084

1318

1546

1722

(80)

(98)

(124)

(173)

(236)

(308)

(390)

(460)

(466)

(486)

60

107

126

272

365

548

694

858

1080

1236

3. Average Capital Employed (1) + (2) 4. Cost of Debt, post-tax% 5. Cost of Equity %

Economic Value Added (EVA) 8. Profit after tax 127 before exceptional items 9. Add : Interest, after taxes 10. Net Operating Profits After Taxes (NOPAT) 11. COCE, as per (7) above 12. EVA (10) – (11)

Economic Value Added (Rs. in Crore) 1400 1236

1200 1080

1000 858

800 694

600

548

400 272

200 0

60 1999

107 2000

365

126 2001

2002

2003

2004

There is a constant growth in EVA during last ten years.

2005

2006

2007

2008

The most empirical studies have supported this theoretical connection between EVA and market value: •

Stewart 1990

•

Lehn nad Makhija (1996)

•

Uyemura, Kanto and Pettit (1996)

•

O´Byrne (1996)

•

Milunovich and Tsuei (1996)

•

Grant (1996)

Conclusion: EVA is more than just performance measurement system. It helps companies to create values for its shareholders. EVA is a method to measure a company’s true profitability and to steer the company correctly from the viewpoint of shareholders. EVA helps the operating people to see how they can influence the true profitability. A sustained increase in EVA will bring an increase in the market value of a company. Reference: •

AICPA (2000a). Improving Shareholder Wealth. New York: Issues Paper, American Institute of Certified Public Accountants.

•

AICPA (2000b). Measuring and Managing Shareholder Wealth Creation. New York: Issues Paper, American Institute of Certified Public Accountants.

•

Amit, R. and P. Schoemaker (1993). Strategic assets and organizational rent. Strategic Management Journal, 14 (1), 33-46.

•

Anthony, J. and K. Ramesh (1992). Association between accounting performance measures and stock prices: A test of the life cycle hypothesis. Journal of Accounting and Economics, 15 (2-3), 203-227.

•

Anthony, R. (1965). Planning and Control Systems: Framework for Analysis. Boston: Graduate School of Business Administration, Harvard University.

•

Biddle, G., R. Bowen and J. Wallace (1997). Does EVA beat Earnings? Evidence on associations with stock returns and firm values. Journal of Accounting and Economics, 24 (3), 301-336.

•

Biddle, G., R. Bowen and J. Wallace (1999). Evidence on EVA®. Journal of Applied Corporate Finance, 12 (2), 8-18.

•

Black, A., Ph. Wright, and J. Bachman (1998). In Search of Shareholder Value. Managing the Drivers of Performance. London: Financial Times Management.

•

Kleiman, R. (1999). Some New Evidence on EVA Companies. Journal of Applied Corporate Finance, 12 (2), 80-91.

•

Ottosson, E., and F. Weissenrieder (1996). CVA, Cash Value Added - a new method for measuring financial performance. Gothenburg University, Study no. 1996:1.

•

Weissenrieder, F (1997). Value based management: Economic Value Added or Cash Value Added? Gothenburg Studies in Financial Economics, Study No 1997:3.

•

Young, D. (1999). Economic Value Added. Note at INSEAD, Fontainebleau, France.

•

Young, D. and S. O’Byrne (2001). EVA and Value-based Management. A Practical Guide to Implementation. New York: McGraw-Hill.

Chapter – 8 Balanced Scorecard •

Introduction

•

Concept of the Balanced Scorecard

•

Importance of the BSC

•

The 4 Perspectives of the Balanced Scorecard

•

The process of the BSC – Building the Balanced Scorecard

•

Pre-requisites for a successful scorecard

•

Benefits of the Balanced Scorecard

•

Conclusion

•

References

Introduction The balanced scorecard is a strategic planning and management system that is used extensively in business and industry, government, and nonprofit organizations worldwide to align business activities to the vision and strategy of the organization, improve internal and external communications, and monitor organization performance against strategic goals. It was originated by Drs. Robert Kaplan (Harvard Business School) and David Norton as a performance measurement framework that added strategic non-financial performance measures to traditional financial metrics to give managers and executives a more 'balanced' view of organizational performance. Concept of the Balanced Scorecard A new approach to strategic management was developed in the 1990s by Dr. Robert Kaplan of Harvard business school, together with David Norton of Renaissance solutions of Massachusetts. They named this system the ‘Balanced Scorecard’. Recognizing some of the weaknesses and vagueness of previous management approaches, the Balanced Scorecard approach provides a clear prescription as to what companies should measure in order to balance the financial perspective. The Balanced Scorecard is a management system (not only a measurement system) that enables organizations to clarify their vision and strategy and translate them into action. It provides feedback around both the internal business processes and external outcomes in order to continuously improve strategic performance and results. When fully deployed, the Balanced Scorecard transforms strategic planning from an academic exercise into the nerve centre of an enterprise. “Balanced Scorecard is a frame work which translates a company’s vision and strategy into a coherent set of performance measures. It helps business to evaluate how well they meet their strategic objectives. It typically has four to six components, each with a series of sub-measures. Each component highlights one aspect of the business. The BSC includes measures of performance that are lagging indicator, medium term indicators and leading indicators. – Harvard Business Review, Jan-Feb. 1991.

Kaplan and Norton describe the innovation of the Balanced Scorecard as follows: “The Balanced Scorecard retains traditional financial measure. But financial measures tell the story of past events. An adequate story for industrial age companies for which investment in long term capabilities and customer relationships were not critical for success. These financial measures are inadequate, however, for guiding and evaluating the journey that information age companies must make to create future value through investment, in customers, suppliers, employees, processes, technologies and innovations”. The general concept of the BSC is as under; “The BSC provides an inter-connected model for measuring performance and revolves around for distinct perspectives- financial, customer, internal business and learninggrowth. Each of these perspectives is stated in terms of the company’s objectives, performance measures, target and initiatives and all are harnessed to implement corporate vision-strategy.” This explains four perspectives of the BSC to implement corporate strategy. “The BSC is a conceptual framework for translating an organization’s strategic objectives into a set of performance indicators distributed among four perspective- financial, customer, internal business process and learning-growth. Some indicators are maintained to measure an organization’s progress towards achieving its vision, others indicators are maintained to measure the long term drivers of successes. Through the BSC an organization monitors both its current performance and its effect to improve processes, motivate-educate employees and enhance information systems- its ability to learn and improve”. Importance of the BSC Harvard’s Robert Kaplan and his consulting Partner David Norton developed the BSC to broaden the focus of mangers from traditional and rigid financial measures to as more

diverse set of measures including non-financial one. Its appeal is so strong that some estimate 50% of fortunes 1000 firms are using BSC in some form or another. BSC literature is replete with testimonials from satisfied users and consultants, suggesting importance of the BSC. 1.

Clarify, translate and communicate vision and strategy The scorecard process starts with the senior executive management working together to translate its business unit’s strategy into objectives. BSC clarifies and translates the into operational terms. According

team

specific

strategic

organization’s vision and strategies

to Kaplan and Norton, the implementation

and rollout of a BSC can communicate and clarify to employees’ key strategic objectives and of strategy

their critical drivers. Research shows that effective communication can

have

positive

impact

on

the

success

of

strategy

implementation. 2.

Link strategic objectives and measures To achieve success in strategy implementation it is essential to relate strategic objectives with performance measures. This will result in effective strategy implementation and up to the mark performance. BSC translates strategy into operational terms- objective and link performance measures with strategic objectives. It shapes performance measures; financial and non-financial, in such a way which meet operational objective and there by meet strategic goal. Kaplan and Norton say ‘ a critical components of establishing linkages between strategic objectives and the scorecard performance measures is the identification of the cause-effect relations between outcomes lag indicators and critical lead indicators of those outcomes.’

3.

Plan, set targets and aligns initiatives The Balanced Scorecard has its greatest impact when it is deployed to drive organizational change. Senior executives should establish targets for the scorecard measures. The targets should represent a discontinuity in business unit performance. The success of planning, target setting and aligning performance measures to strategic initiatives often depends on whether the managerial

performance evaluation system directs managerial attention to these areas. The BSC enables employees to understand strategy and link strategic objectives to their day to day operation and also link performance to compensation. 4.

Enhance strategic feedback and learning The provision of feed-back as to whether the strategic objectives are being accomplished is one of the most important benefits of the BSC. By monitoring whether performance on the critical lead measures is having expected consequences on key lag measures, managers are able to evaluate that whether strategic objectives are achievable. The final management process embeds the BSC in a strategic learning framework. It is considered as the most innovative and most important aspect of the entire scorecard management process. This process provides the capacity for organizational learning at the executive level. Managers in organizations today do not have a procedure to receive feedback about their strategy and to test the hypothesis on which the strategy is based. The BSC enables them to monitor and adjust the implementation of their strategy, and, if necessary, to make fundamental changes in the strategy itself. By having near term milestones established for financial, as well as other BSC measures, monthly and quarterly management review can still examine financial results.

Thus, the BSC fills the void that exists in most management system-the lack of a systematic process to implement and obtain feedback about strategy. Management processes built around the scorecard enables the organization to become aligned and focused on implementing the long term strategy. Used in this way, the BSC becomes the foundation for managing information age organization. These all are the important reasons why an organization requires the BSC. THE 4 PERSPECTIVES OF THE BALANCED SCORECARD The Balanced Scorecard method of Kaplan and Norton is a strategic approach, and performance management system, that enables organizations to translate a company's vision and strategy into implementation, working from 4 perspectives: 1.

Financial perspective.

2.

Customer perspective.

3.

Business process perspective.

4.

Learning and growth perspective.

The traditional financial view of performance measurement as a vehicle to control performance is immature. They fail to link current actions with long-term strategy. But the BSC is said to take a long term, strategic view and considers all financial as well as non-financial actions and variables that are necessary for the sustainability and excellence of an organization. It provides a finer blending of financial and non-financial measures of performance. It considers financial performance measures as a result of the non-financial variables-the leading variables. The BSC allows management to look at business from four important perspectives;

1.

i.

How do customers see the firm?

ii.

What must they excel at?

iii.

Can they continue to improve and create value?

iv.

How do they look to shareholders?

The Financial Perspective Kaplan and Norton do not disregard the traditional need for financial data. Timely and accurate funding data will always be a priority, and managers will make sure to provide it. In fact, there is often more than sufficient handling and processing of financial data. With the implementation of a corporate database, it is hoped that more of the processing can be centralized and automated. But the point is that the current emphasis on financial issues leads to an unbalanced situation with regard to other perspectives. There is perhaps a need to include additional financial related data, such as risk assessment and cost-benefit data, in this category. Building a BSC should encourage business units to link their objectives to corporate strategy. The financial objectives serve as the focus for the objectives and measure in all other perspectives. Every measure selected should be a part of a link of cause and effect relationships that culminate in improving financial

performance. The scorecard should tell the story of strategy, starting with long run financial objectives and then linking them to the sequence of actions that must be taken with financial process, customers, internal processes and finally employees and systems to deliver the desired long run economic performance. There are three financial themes that drive the business strategy: (A)

Revenue growth and mix – the most common revenue growth measure would be sales growth rates and market share for targeted regions, markets and customers. New products – a common measure for this objective is the percentage of revenue from new products and services introduced with a specified period. This measure has been extensively used by innovative companies. New applications – Businesses may find it easier to grow revenues by taking existing products and findings new applications for them. If a new product application is an objective, the percentage of sales in new applications would be useful measure. New customers and markets – Taking excising products and services to new customers and markets also can be a desirable route for revenue growth. Many industries have excellent information on the size of the total market and of relative market share by participants. Increasing a unit’s share of targeted market segment is a frequently used metric. New relationships – some companies have attempted to realize synergies from their different strategic business units by having them cooperate to develop new products. The objective can be translated into the amount of revenue generated from cooperative relationships across multiple SBUs. New product and service mix – business may choose to increase revenues by shifting their product and service mix. For ex. toward low cost strategy or towards premium price strategy and tracked the success of this strategy with a measure of revenue growth from these mix.

New pricing strategy – some companies have discovered that price of products can be increased for niche products or for demanding customer prices on products and services. (B)

Cost Reduction/ Productivity Improvement - In addition to establishing objectives for revenue growth, a business may wish to improve its cost and productivity performance. Increase Revenue Productivity – it focuses on revenue enhancement- say revenue per employee-to encourage shifts to higher value added products and to enhance capabilities of organizations resources. Reduce unit cost – in sustain stage businesses aim to reduce the unit cost of performing work. For the firm producing homogeneous output, reducing cost per unit can suffice. Improve Channel mix – as especially promising method for reducing cost is to shift customer and suppliers from high cost manually processes channel to low cost electronic channel. Reduce Operating expenses – many organizations are now actively trying to lower their selling, general and administrative expenses. It can be measured by tracking their percentage to total expenses.

(C)

Asset utilization/ Investment Strategy - Companies may also wish to identify the specific drivers they will use to increase asset intensity. Cash to Cash Cycle – one measure of the efficiency of the working capital is the cash-to-cash cycle, measured as the sum of days cost of sales of inventory, days sales in account receivable, less days purchases in account payables. Improve asset utilization – it focuses on capital investment procedures, both to improve productivity from capital investment projects and accelerate the capital investment process to maximize early cash returns.

2.

THE CUSTOMER PERSPECTIVE

Recent management philosophy has shown an increasing realization of the importance of customer focus and customer satisfaction in any company. These are called leading indicators: if customers are not satisfied, they will eventually find other suppliers that will meet their needs. Poor performance from this perspective is thus a leading indicator of future decline. In developing metrics for satisfaction, customers should be analyzed. These segments represent the sources that will deliver the revenue component of the company’s financial objectives. In fact these are leading indicators, which enables companies to align their core customer outcome measures- satisfaction, loyalty, retention, acquisition, and profitability – to targeted customers. It also enables them to identify and measure, explicitly, the value propositions they will deliver to targeted customers. The value propositions represent the drivers, lead indicators, for the core customer outcome measures. In the past, the companies could concentrate on their internal capabilities, emphasizing product performance and innovation. But companies that did not understand their customer’s needs eventually found that competitors could make inroads by offering products or services better aligned to their customer’s preferences. Thus, the companies are shifting their focus extremely to customers. Clearly, if business units are to achieve long run superior financial performance, they must create and deliver products that are valued by customers. Beyond aspiring to satisfying and delighting customers, business unit mangers must, in the customer perspective of the BSC translate their mission and strategy statements into specific market and customer based objectives. They must identify the market segments as well as the value propositions that will be delivered to targeted segments becomes the key to developing objectives and measures for the customer perspective. Thus this perspective translates an organization’s mission and strategy into specific objectives about targeted customers. Core measures The core measurement group of customer outcomes is generic across all kinds of the organizations. The core measurement group includes measures of:

•

Market share – measuring market share is straightforward once the targeted customer group has been specified. It reflects the proportion of business in a given market that a business unit sells. The second market share measure is the account share of the customer. The overall market share measure based on business with these companies could be affected by the total amount of business these companies offer in a given period. That is, the share of business with these targeted customers could decrease because the customers are giving less business to all their suppliers.

•

Customer retention – a desirable way for maintaining or increasing market share in targeted customer segments is to start by retaining existing customer in those segments. Companies that can readily identify all of their customers, can readily measure customer retention from period to period. Beyond this many companies want to measure loyalty of existing customers.

•

Customer acquisition – the customer acquisition measure tracks, in absolute or relative terms, the rate at which a business unit attracts or wins new customers or business. It could be measured by either the number of new customers or the total sales to new customers in these segments. Ratio of cost and revenue of new customer acquired can also be measured.

•

Customer Satisfaction – This measure provides feedback on how well the company is doing. The importance of customer satisfaction probably can not be overemphasized. Further just scoring adequately on customer satisfaction is not sufficient for achieving high degree of loyalty, retention and profitability. Customer Profitability – succeeding in the first four core measures, does not guarantee that a company has profitable customer. Since, customer satisfaction and high market share are only a means to achieving higher financial returns, companies probably wish to measure profitability of this business. Activity based costing system permit companies to measure individual profitability. A financial measure like customer profitability helps to keep customer focused organization from becoming customer obsessed.

Measuring customer Value prepositions It represents the attributes that create loyalty and satisfaction in targeted customer segments. It varies across the industries and countries, but the followings are the common attributes. Product and service attributes – these encompass the functionality of the product/service, its price, and its quality. Few Customers may prefer low price at the cost of quality, on the other hand few may prefer quality and unique feather at even high rates, depending upon the type of customers. •

Time - it has become major competitive weapon in today’s competition. Being able to respond rapidly and reliably to a customer’s request is often the critical skill for obtaining and retaining valuable customer’s business. Customers may be concerned with the reliability of lead time than with just obtaining the shortest lead times. Lead time is important both for existing product as well as for new products. A short lead time for introducing new product can add value to the customers.

•

Quality – it was a critical competitive dimension during 1980s and remains important till this day. Quality is now no more competitive advantage but it has become hygiene factor. Customers take for granted that their suppliers will execute according to product specification. It can be measured in terms of incidence of defects, returns by customers, warranty claims, field service request and also performance along time dimension.

•

Price – one can be assured that whether a business unit is following a lowcost or a differential strategy, customer will always be concerned with the price they pay for the product. It is a major influence on the purchasing decision.

•

Customer relationship – it includes the delivery of the product/service to the customer, including the response and delivery time dimension, and how customer feels about purchasing from the company. It also encompasses long term commitment and qualification of supplier so that incoming items are delivered directly to the customers.

•

Image and reputation – it reflects the intangible factors that attract a customer to a company. Some companies are able, through advertising and delivered quality of product and service, to generate customer loyalty well beyond the tangible aspects of the product and service. Consumer preference for certain brands of shoes, clothing, soft drinks connote the power of image and reputation for the targeted customer segments.

3.

THE BUSINESS PROCESS PERSPECTIVE This perspective refers to internal business processes. Measurements based on this perspective will show the managers how well their business is running, and whether its products and services conform to customer requirements. These metrics have to be carefully designed by those that know these processes most intimately. In addition to the strategic management processes, two kinds of business processes may be identified: •

Mission-oriented processes. Many unique problems are encountered in these processes.

•

Support processes. The support processes are more repetitive in nature, and hence easier to measure and to benchmark. Generic measurement methods can be used.

4.

Learning and Growth perspective This perspective includes employee training and corporate cultural attitudes related to both individual and corporate self-improvement. In a knowledge worker organization, people are the main resource. In the current climate of rapid technological change, it is becoming necessary for knowledge workers to learn continuously. Government agencies often find themselves unable to hire new technical workers and at the same time is showing a decline in training of existing employees. Kaplan and Norton emphasize that 'learning' is something more than 'training'; it also includes things like mentors and tutors within the organization, as

well as that ease of communication among workers that allows them to readily get help on a problem when it is needed. It also includes technological tools such as an Intranet. There are three principal categories for the learning and growth perspective. Employee Capabilities – in current environment of rapid technological changes, employees need to continuously learn. For an organization just to maintain its existing relative performance, it must continually improve. This shift requires major re-skilling of employees so that their minds and creative abilities can be mobilized for achieving organizational objectives. The three core employee measurements are; 1. Employee satisfaction – it recognizes that employee morale and overall job satisfaction are now considered highly important by most organizations. Satisfied employees are a precondition for increasing productivity, responsiveness, quality, and customer service. Companies typically measure employee satisfaction with an annual survey, a rolling survey in which a specified percentage of randomly chosen employees is surveyed each month. 2. Employee retention – it captures an objective to retain those employees in whom the organization has long term interest. Long term- loyal employees carry the values of the organization, knowledge of organization processes, and sensitivity to the needs of customers. Employee productivity – it is an outcome measure of the aggregate impact from enhancing employee skills and morale, innovation, improving internal processes, and satisfying customers. The goal is to relate the output produced by employees to the number of employees used to produce that output. Information system capabilities – employee skills and motivation are necessary to achieve targets for customer and internal process objectives. But to be effective in the information age, they need excellent information – on customer, on internal processes and of the financial consequences of their decisions. Front-line employees need accurate and timely information about each customer’s total relationship with the organization, and feedback on products produced or delivered. Only by having such feedback can

employees be expected to sustain improvement programme where they systematically eliminate defects and drive excess cost, time, and waste out of the production system. Strategic information coverage ratio is a tool to assess the current availability of information relative to anticipated needs. Motivation, Empowerment and Alignment – even skilled employees, provided with superb access to information, will not contribute to organizational success if they are not motivated to act in the best interests of an organization. Thus the third of the enablers for the learning and growth objectives focuses on the organizational climate for employee motivation and initiative. The measures for these enablers are: •

Measure of suggestions made and implemented – one of the simple way to measure the outcome of having motivated employees is the number of suggestions per employees. This measure captures ongoing participation of employees in improving the organization’s performance.

1. Measure of improvement – the tangible outcome from successfully implemented employee suggestions does not have to be restricted to expense saving. Organizations can also look for improvements, say in quality, time. Or performance, for specific internal and customer processes. 2. Measure of individual and organizational alignment – it focuses on whether departments and individuals have their goals aligned with the company objectives articulated in the BSC. 3. Measurement of team performance – now organizations are turning to teams to accomplish important business processes- product development, customer service and internal operations. So organization requires measures to motivate and monitor the success of team building and team performance.

The process of the BSC – Building the Balanced Scorecard Constructing an organization’s first Balanced Scorecard can be accomplished by a systematic process that builds consensus and clarity about how to translate a unit’s mission and strategy into operational objectives and measures. The followings are the main steps to build the BSC in any organization. 1.

Select the appropriate organizational unit – Senior executive team should define the business unit for which a top-level scorecard is appropriate. The initial scorecard process works best in a strategic business unit, ideally one that conducts activities across an entire value chain; innovation, operation, marketing, selling, and service. It would have its own products, customers, marketing, distribution channels and its own financial summery.

2.

Identify SBU/Corporate Linkages – once the SBU has been defined and selected, the team should learn about the relationship of the SBU to other SBUs and to the divisional and corporate organization. Interviews should be conducted

with key senior divisional and corporate executives to learn about financial objectives, corporate themes and linkages to other SBUs. This will help to optimize the whole organization along with the SBU. 3.

Conduct first round of interview - The back ground material on the BSC as well as internal documents on the company’s and SBU’s vision, mission and strategy should be supplied to senior mangers. Then after the leader should conducts interview of each senior manager to obtain their input on the company’s strategic objectives and tentative proposals for the BSC. The objective of these interviews is to introduce the concept of the BSC to senior managers, to respond to questions of the mangers and to get their initial input about the strategy and its translation into objectives and measures.

4.

Synthesis session – after interviews the team should highlight issues and develop a tentative list of objectives and measures that will provide the basis for the first meeting of the top-management team. The output of the synthesis session should be a listing and ranking of objectives in the four perspectives. They should attempt to determine whether the tentative list of prioritized objectives represents the business unit’s strategy and whether the objectives across the four perspectives appear to be linked in casual-effect relationships.

5.

Executive workshop – First round – Primary workshop is arranged to facilitate a group debate on the mission, objectives and strategy statements. The leader can show listing of objectives during the interviews, views of customers- shareholders etc. Each candidate will prepare four to five objectives. After introduction and discussion of objectives of all the candidate, the group votes on top three to four candidates. For the highest rank objectives, the group will prepare primary measures. At the end of the session the team will identify three to four objectives for each perspective and list of potential measures.

6.

Subgroup meetings – the leader should organize several subgroup meetings to discuss on; i. refining the wordings of the objectives, ii. Identifying the measures, iii. Identify the sources of necessary information, iv. Identifying key linkages among the measures. The final output of these meetings should be list of

objectives, descriptions of measures, method to quantify measures and graphical model to link various objectives and measures of all four perspectives. 7.

Executive Workshop – Second round – it involves the senior management team, their direct subordinates and a large number of middle mangers, who debates on vision, strategy, tentative objectives and measures. The output of subgroup meeting is presented here, which will help to understand entire scorecard. Participant can comment and discuss on the same. The objective of the workshop is to communicate the scorecard intentions to all the employees and to encourage participants to formulate targets to be achieved by the next 3 to 5 years

8.

Develop the implementation plan – a newly formed team, often made up of the leaders of each subgroup formalizes the stretch targets and develops an implementation plan for the scorecard. As a result of this process, an entirely new executive information system that links top-level business units metrics down through ship floor level and site specific operational measures could be developed.

9.

Executive workshop - Third round – the senior executive team meets for a third time to reach final consensus on the vision, objectives, and measurements developed in the first two workshops and to validate the stretch targets proposed by the implementation team. It includes primary action programme to achieve the targets. It ends up by aligning the unit’s various change initiatives to the scorecard objectives, measures and targets as well as by deciding programme of communicating BSC and developing information system to support the scorecard.

10.

Finalize the implementation plan - For a BSC to create value, it must be integrated into the organization’s management system. Management should begin the use of the BSC within 60 days.

Pre-requisites for a successful scorecard There are several reasons for high burn-out rate among scorecard companies. One important reason is over-enthusiasm to measure anything and everything. Other pitfalls that can sidetrack a BSC programme includes a lack of commitment from senior

management, treating it as a one-time event and failure to let scorecard responsibilities ‘cascade down’ to all employees. Success depends on whether company knows why they are opting for BSC. After clear vision, they require systematic implementation of BSC. The following are the pre-requisites for proper implementation of the BSC. 1.

Top management commitment and support The essential pre-condition for the successful implementation of the BSC is, support and commitment from top management. CEOs and senior management must be committed to the BSC to drive it down through the organization. It is necessary that the top management fully understand the concept and the process of the BSC. They should be educated through seminars and workshops. The role of CEO is much more critical in the success of the BSC. They should take keen interest and lead role in introducing and implementing the BSC. A number of organizations started the BSC by first creating it for the top management and the CEO and then cascading it down to other levels of the organization. Without dedication and support from top management, the BSC will be visionless. In short, at each and every step of implementing the BSC, support and co operation from the top management is must.

2.

Determine the critical success factors This is most critical aspect of the BSC implementation. For a number of companies in India, that are just coming out of the protected environment and have started facing competition, it is not very difficult to realize that the driving force for survival is customer satisfaction. Hence, the critical success factors are superior quality, low cycle time, high customer response, after sales service, employee competition etc. But for those organizations which have already reached high levels of customer satisfaction superior quality and other measures, the area of improvements are not very obvious. The challenge is to identify the most fundamental critical success factors (CSFs). The problem is compounded because of the requirement s of multiple stakeholders including government and society. The BSC will have to consider the requirements of all stakeholders,

which at times create conflict. The BSC can not be limited to four perspectives; the new one can be added as per requirement. The social responsibility, environment etc. can be new perspectives. The entire organization must be involved in identifying CSFs. The organization must assign priorities to the stakeholder’s requirements and rate in term of their impact. Thus, as per need and circumstances of the organization, CSFs should be decided precisely. 3.

Translate CSFs into measurable objectives (metrics) Clear and precise BSC, requires proper CSFs as well as translation of CSFs into metrics. The identified objectives will not lead the organization anywhere else unless the CSFs are converted into good measures or metrics. There are several measures of financial variables and over the years they have been refined. For example, the economic value added is a useful aggregated financial measure which links with value creation for shareholders. It is a real challenge to develop metrics for non-financial measures as a number of them could be unique to an organization for which no standards exist. The BSC is a device to link performance measures to strategy and performance outcomes. These measures should be precise and consistent for achieving the desired objective. They should be based on objective facts and information, verifiable and accessible. There should not be possibility of these measures being manipulated. The target of measure should be challenging but achievable. It is also important that a number of measures may be kept to a level which can be easily managed. Thus, CSFs should be converted in performance measures precisely.

4.

Link performance measures to reward The success of any performance management system depends on its link to rewards and motivation to human being. A reward system that is easily understood and is prompt in rewarding employees is essential. Performance measures should be linked to reward system in such a way so that it motivates employees at all levels and influence them to achieve the given performance targets. The BSC should be understood from top to bottom. The people at bottom

level should be dedicated for the implementation of the BSC. And for this purpose, employees should be motivated through reward system. Thus, performance measures should be linked properly with reward system for effective performance. 5.

Use of tracking system Planning does not have value until supported by proper control system. In the same way, the performance metrics and targets have no value if they are not tracked quickly. The BSC establishes a system of feed-back and learning. But for real time review the organization requires to set proper feed-back system, so that errors can be tracked quickly and corrected on time. The organization should follow frequent and regular reporting system. Many organizations which have implemented the BSC successfully, believe in daily or twice in day reporting. The employees must know where they are? Where they should be? And the managers must know where they need corrective actions? Thus, for the successful implementation of the BSC, the firm requires good tracking system.

6.

Create and links the BSC at all levels of the organization An organization will better serve its purpose of providing delight to all its stakeholders if it develops scorecard at corporate, divisional and even at the individual levels. There should be a link between these scorecards. The divisional scorecards should follow from the corporate scorecard and the individual scorecard from the divisional scorecards. The achievement of the targets of the scorecard at a lower level must ensure that targets of higher scorecards are met. The scorecard measures, particularly relating to strategic objectives, must be disaggregated so that every one understands them and are able to relate to their actions to strategy. Thus, from top to bottom and from corporate to SBU scorecard to divisional scorecard, co-ordination is essential. In short, all the levels of organization must be linked properly.

7.

Communication The BSC is a communication device – a device to communicate strategy and its components to all levels of organization. It provides a common language. But this

does not happen automatically. An organization should develop an effective organizational communication system to make all employees understand the common language of the BSC. The BSC should be exposed to all the employees. Employees must be clear about the strategy, goal, their target, achievements and gap. For this, an effective and precise communication system should be established in the organization. There should be two-way communication i.e. from top to bottom as well as from bottom to top. Ideas of employees should be given a chain of communication. 8.

Link strategic planning, BSC and Budgeting process There should be a co-relation among strategic planning, Balanced Scorecard and Budgeting process. The strategic planning process should be linked to BSC. And in the same way the BSC should be linked to Budgeting process. The strategic initiatives to meet the targets require funds. The BSC should be linked to the budgeting process and set priorities to allocate resources to strategic initiatives. Thus, dreams of the strategic planning must be formed in physical form in the BSC as well as the data of the BSC must be linked to figures- budgets properly.

9.

Change Management The BSC requires a culture shift in the organization, which requires change management in the organization, David Norton said that to execute strategy is to execute change at all levels of an organization. Seems self even, but overlooking this truth is one of the important causes of a failed transformation effort. Best practice is organization should give equal weight to the soft issues of leadership, culture and team work and undergoing three phases of change management; mobilization of change, design and roll out and sustainable execution.

10.

Implementation in Phased manner The BSC is not a tale of a day or a month. It requires change in the whole measurement and management system. So, implementation of the BSC should be in a phased manger. Many firms first implement it to the top level and gradually spread in the whole organization. Experience suggests that if the number of measures traced is increased over a period of time, it is easier for employees to adapt. It reduces the time spent on the initial phase and speed up implementation.

BENEFITS OF THE BALANCED SCORECARD Kaplan and Norton cite the following benefits of the usage of the Balanced Scorecard: •

Focusing the whole organization on the few key things needed to create breakthrough performance.

•

Helps to integrate various corporate programs. Such as: quality, reengineering, and customer service initiatives.

•

Breaking down strategic measures towards lower levels, so that unit managers, operators, and employees can see what's required at their level to achieve excellent overall performance.

There are several pluses to having a scorecard. But the most fundamental reason for its use is the shift in the source of value. In the old economy, companies added value primarily by investing in tangible assets, plant, machinery, sales offices and technology. Kaplan estimates that till 20 years ago, nearly two third of the market value of a company came from the tangible assets it owned. Today an analysis of the S & P 500 companies in the US show that 85% comes from intangible assets. If value whether seen from the point of view of the customers or markets- has shifted to intangibles, companies need to understand the underlying factors that deliver better customer and shareholder value. Kaplan says that service companies have adopted the BSC more eagerly because in their case values is delivered to the customer at a point for away from the top-management. The BSC scores precisely because it does not look at strategy from a unidirectional perspective. The following are the major benefit of BSC. 1.

Clarify the vision throughout the organization - The BSC is not a tool of control; rather it is a tool of communication. The BSC clarifies the vision of the organization throughout the all levels of the organization. Unlike the traditional measurement system, here each and every member of the organization is clear about the vision, strategy and objectives of the organization. Thus, BSC helps to link organization in a specific way.

2.

Filter initiatives - Companies take different initiatives to improve their performance. With the scorecard, the utility of each initiative can be judged from its contribution to the achievement of strategic targets. And by this way companies can filter initiatives and can use specific initiatives for the best performance.

3.

Make strategy every body’s job – The scorecard is a communication tool. It enables management to explain the strategy to employees at all levels, showing what is measured and encouraging the free flow of relevant information. This helps to align the personal objectives of individual and their compensation to the organization’s objective. Thus, BSC circulates strategy from top to bottom and make strategy everybody’s job. In short employees at all levels are linked with and involved in strategy.

4.

Facilitate organizational learning – The BSC enables double-loop learning. On one hand, since the BSC links existing strategy to the objectives, it can test its workability and incorporate the feedback into strategy. But as strategic objectives and targets are also linked to initiatives and programmes at operational level, the result of these initiatives can offer clues to emerging strategies once again. In short, by present and futuristic view, the BSC guides the organization and improves organizational learning process.

5.

Drive the capital and resource allocation process – The BSC links strategic planning and budgeting process. As per strategic planning the BSC, determines priorities for all the areas. And then after it is linked to the budgeting process. Thus, allocation of resources will be in the line of strategic planning. Thus, due to planned resource allocation process, the efficiency may go up. In short, the BSC guides and drives capital and other resource allocation.

6.

Integrate the strategic management process across the organization The BSC makes strategy everybody’s job. That means it connects and links whole organization including all the levels, divisions and department in the process of strategic management. All the divisions, top management, middle management and shop floor level is clear about the vision, strategy, objectives and measures of the organization.

7.

Focus teams and individual on strategic priorities – The BSC moves from top to bottom. The corporate BSC is transferred to SBU-BSC and SBU-BSC is transferred to divisional BSC. Further divisional BSC is translated into team goals, objectives and measures and in the same way individual receive specific objectives, targets and measurement. Thus, the BSC gives focus from corporate to an individual.

Conclusion Information age companies will succeed by investing in and managing their intellectual assets. Functional specialization must be integrated into customer-based business processes. Mass production and service delivery of standard of products and services must be replaced by flexible, responsive and high quality deliver of innovative products and services that can be individualized to targeted customer segments. Innovations and improvement of products, services, and processes will be generated by reskilled employees, superior information technology, and aligned organizational procedures. As organization invest in acquiring these new capabilities, their success cannot be motivated or measured in the short run by the traditional financial accounting model. It measures events of the past, not the investments in the capabilities that provide value for the future. The BSC is a new frame work for integrating measures derived from strategy. While retaining financial measures of past performance, the BSC introduces the drivers of future financial performance. The drivers, encompassing customer, internal-businessprocess, and learning and growth perspectives, are derived from an explicit and rigorous translation of the organization’s strategy into tangible objectives and measures. The BSC, however, is more than a new measurement system. Innovative companies use the scorecard as the central, organizing framework for their management processes. The real power of the BSC occurs when it is transformed from a measurement system to a management system. As more companies work with the BSC, they can see how it can be used to clarify strategy and communicate strategy, to align organization with strategy, to link strategic objectives to long term targets and budgets, to perform periodic strategic review and to obtain feedback to learn about and improve strategy.

References: •

Anand Manoj and Sahay B S, (2005), “Balanced Scorecard in Indian companies”, Vikalpa, Volume 30, No.2, April-June, 11-25

•

Crowther David, (2002), “Understanding the Balanced Scorecard”, Effective Executive, March, 33-41

•

Kaplan R.S. and Norton, D.P. (1996a). The Balanced Scorecard – Translating Strategy into Action, Boston ; Harvard Business School Press

•

Kaplan R.S. and Norton, D.P. (2001). The Strategy Focused Organization : How Balanced Scorecard Companies Thrive in the New Business Environment, Boston ; Harvard Business School Press

•

Kaplan R.S. and Norton, D.P. (1992). “The Balanced Scorecard – Measures that Drives Performance,” Harvard Business Review, January-February, 71- 79 ( The best of HBR – July- August, 2005)

•

Kaplan R.S. and Norton, D.P. (1993). “Putting the Balanced Scorecard to Work”, Harvard Business Review, September – October, 140 – 147

•

Kaplan R.S. and Norton, D.P. (2000). “Having Trouble With Strategy –Then map it’, Harvard Business Review, September – October, 167-175

•

Kaplan R.S. and Norton, D.P. (2006), “How to Implement a new Strategy Without Disturbing Your Organization”, Harvard Business Review, March 100 – 109

•

Kaplan R.S., (2005), “Designing Strategy”, The Smart Manager, AugustSeptember,53-59

•

Pandey I M. (2005), “Balanced Scorecard – Myth and Reality”, Vikalpa, Volume 30, No.1, January-March, 51-66

•

Pandya Pradeep. (2002), “Keeping Score on Strategy”, Indian Management, August, 30-38

•

Schneiderman, Arthur M. (1999), “Why Balanced Scorecard Fail”, Journal of Strategic Performance Measurement, January, 6-11

•

Schneiderman, Arthur M. (2004) http. //www. scheneiderman. com/ concepts/ The_First_Balanced_scorecard.htm

Chapter – 9 Value Based Management •

Introduction

•

Characteristics of Value Based Management

•

Value Based Management Concept

•

Value-Based Management Techniques and Systems

•

Economic Concept of Profit

•

Shareholder Value Analysis

•

Cash Flow Return on Investment

•

Cash Value Added

•

Accounting Concept of Profit

•

Residual Income

•

Economic Value Added

•

Economic Profit

•

Marakon Approach

•

BCG Approach

•

BCG Matrix

•

McKinsey Approach

Introduction: The terms ‘Shareholder Value’ and ‘Value-based Management’ may be relatively new, but the ideas behind it obviously are not, long past Smith, 1776 emphasized on shareholder value. It realized that a company only makes a profit when all the costs are covered, including the costs of capital (both debt and equity). It did not gain much attention, though, until the publication of the book ‘Creating Shareholder Value’ by Alfred Rappaport in 1986. From that time, organizations focus on shareholder value instead of accounting profits. At that time the term ‘Value-based Management’ (VBM) was coined to operationalize shareholder value creation. Value-based Management in a principal-agent (i.e., capital market-firm) perspective in order to see to what extent VBMmetrics could be helpful in this external agency relationship. Many authors defined and described VBM (Rappaport, 1986; Stewart, 1991; McTaggert et al., 1994; Weissenrieder, 1997; Arnold, 1998; Copeland et al., 2000; Young & O’Byrne, 2001). Definition: Value-based Management is a managerial approach to create value by investing in projects exceeding the cost of capital and by managing key value drivers. Characteristics: The following characteristics are generally shared in common: ™ Value Based Management takes all costs of capital into account. Where accounting profits only include the cost of debt (interest), economic value is only created when net profits also exceed the costs for debt as well as for equity. ™ Value Based Management is a managerial approach. Applying VBM takes more than calculating a measure that includes the cost of capital. It is an approach where techniques, concepts, and tools are used to meet the firm’s objectives,

relating to all organizational functional areas (e.g., production, logistics, strategy, finance, accounting, and human resources) and levels. ™ Value Based Management is built around value drivers. This stresses the fact again that it is not about the calculation, but about the variables that are related to the calculation. These activities can be expressed in both financial and nonfinancial terms, and involve all organizational levels. Ways to operationalize this ‘break-down’ is by using for example the Balanced Scorecard or a ‘value tree.’ Value-based Management, predominantly describes the various metrics that are used to calculate and express value creation, or try to find empirical evidence on capital market performance about correlations with share prices compared with the more ‘traditional’ accounting performance measures such as earnings. Value-based Management is used and applied in organizations, and how this affects the management control system in order to meet the shareholders’ interests. Regarding management control, Anthony & Govindarajan’s (2001) definition, They describe the activities that are involved with management control as follows (Anthony & Govindarajan, 2001, pp. 6–7): (1)

Planning what the organization should do,

(2)

Coordinating the activities of several parts of the organization,

(3)

Communicating information,

(4)

Evaluating information,

(5)

Deciding what, if any, action should be taken, and

(6)

Influencing people to change their behavior.

Moreover, they state that ‘management controls are only one of the tools managers use in implementing desired strategies,’ besides organization structure, human resources management, and culture (p. 8). This leads to Anthony & Govindarajan’s definition of management control: ‘the process by which managers influence other members of the organization to implement the organization’s strategies’ (Anthony & Govindarajan, 2004, p. 7).

Value Based Management Concept Organization

Strategy

Financial Performance

Shareholders Returns • Organizational Structure • Strategic Management Process

Business Unit Strategy • Participation

Market Potential

• Competitive Economic Profit

Strategy

• Targets Organizations

SBU Strategy

• Control

Economic Value

Competitive Position

Process • Remuneration System Input

Output

Figure: Value-based Management Process (Source: Broersen and Verdonk, 2002)

Value-Based Management Techniques and Systems To measure how Value-based Management contributes to contracting agents, several metrics are developed, mostly by consulting firms. They all argue that their metric correlates most closely with share price or measure shareholder value most accurately, especially compared to traditional accounting measures. The most fundamental economic relationship underlying Value-based Management (in countries with well-developed capital markets) is that shareholder value (i.e., the market value of the company’s common stock) is determined by discounting the cash flows investors (i.e., principals) expect to receive over a long-time horizon at the minimum acceptable rate of return they require for holding equity investments, also known as the cost of equity capital (Rappaport, 1986; Stewart, 1991; McTaggert et al., 1994; Young & O’Byrne, 2001). The value of the firm is subsequently a function of three major factors: the magnitude, the timing, and the degree of uncertainty of the future cash flows resulting from executing investment projects and stemming from decisions made with regard to the financing of

Total Returns to shareholders

the firm (Young & O’Byrne, 2001; Brealey et al., 2004; Damodaran, 1996). The magnitude in cash flows will vary from asset to asset – dividends for stocks, coupons (interest) and face value for bonds, and after-tax cash flows for a real project. The magnitude tells little about the current value unless timing is also known. Cash has a time element, which means that we would rather have it today than have to wait for it (Young & O’Byrne, 2001; Brealey et al., 2004). The function of the uncertainty or riskiness of the estimated cash flows, with higher rates for riskier assets and lower rates for safer projects, results in the discount rate. These are the elements of the ‘present value’ rule, where the value of any asset is the present value of expected future cash flows on it (the discounted cash flow model):

Where n

=

Economic life of the asset or investment

CFt

=

Cash flow in period t

r

=

Discount rate that reflects the riskiness of the estimated cash flows.

Because investments tie up cash, their value is based on the amount of future cash flows that will accrue to investors. These free cash flows can be thought of as the amount of cash flow left over from the company’s operating activities after investments have been made. It is from this residual cash flow that companies can then return cash to their investors (principals). In brief, free cash flow makes it possible for companies to make (i)

Interest payments,

(ii)

Pay off the principal on the loans,

(iii)

Pay dividends, and

(iv)

Buy back shares.

These are the four ways that companies return cash to their investors, and therefore, the expectations of such cash flows will be the ultimate determinant of a company’s value from a capital market perspective (Young & O’Byrne, 2001). Economic Concept of Profit The economic concept of profit (Hicks, 1946), or economic income (Brealey & Myers, 1996), rests on the concept described above. When applying this concept, profit is defined as the free cash flow in a specific time period (year t) plus the change in present value between year-ends t-1 and t. In other words: Economic Income = free cash flow + year’s change in present value Economic Incomet = FCFt + PVt – PVt-1 Where FCF is defined as the cash flow that is left from the operating cash flow after investments have been made and which is subsequently available to the investors. Various value-based metrics (i.e., metrics that take costs of all capital into account) are based on these principles, and will be discussed below. Shareholder Value Analysis When looking at Rappaport’s Shareholder Value Analysis (Rappaport, 1986), the basic thought behind this concept takes the change in present value of future cash flows as starting point to calculate Shareholder Value Created. The definition is as follows: Shareholder Value = Corporate Value -/- Debt Where Corporate Value is subsequently defined as (Rappaport, 1986: 51):

Present value of cash flow from operations during the forecast period + Residual value (which represents the present value of the business attributable to the period beyond the forecast period) + Marketable Securities For most businesses only a small proportion of value can be reasonably attributed to its estimated cash flow for the next five or ten years. The residual value often constitutes the largest portion of the value of the firm. Moreover, two issues should be borne in mind regarding residual value. First, while residual value is a significant component of corporate value, its size depends directly upon the assumptions made for the forecast period. Second, there is no unique formula for residual value. Its value depends on an assessment of the competitive position of the business at the end of the forecast period (Rappaport, 1986: 60). Debt, as second component of Shareholder Value, includes the market value of debt, unfunded pension liabilities, and the market value of other claims such as preferred stock. In line with the economic concept of profit (or economic income), shareholder value creation addresses the change in value over the forecast period. This is based on the fact that the cost of capital incorporates the returns demanded by both debt holders and shareholders because pre-interest cash flows are discounted, i.e., cash flows on which both debt holders and shareholders have claims. Rappaport states (1986: 56) that the relevant weights for debt and equity should be based on the proportions of debt and equity in the firm’s target capital structure over the long-term. In calculating the weights of the target capital structure, the conceptual superiority of market values is in finance literature generally accepted, despite their volatility, on the grounds that to justify its valuation the firm will have to earn competitive rates of return for debt holders and shareholders on their respective current market values (Brealey & Myers, 1986; Copeland et al., 1996; Stewart, 1991; Young & O’Byrne, 2001). Measuring the cost of debt is a relatively straightforward matter once it is established that what is appropriate is the cost of new debt and not the outstanding debt. This is so because the economic desirability of a prospective investment depends upon future costs and not past or sunk costs. In addition, since interest on debt is tax deductible, the rate of

return that must be earned on debt-financed instruments is the after-tax cost of debt (Rappaport, 1986: 56). The second component of the cost of capital, the cost of equity, is more difficult to estimate. In contrast to the debt-financing case where the firm contracts to pay a specific rate for the use of capital, there is no explicit agreement to pay common shareholders any particular rate of return. Rational, risk-averse investors expect to earn a rate of return that will compensate them for accepting greater investment risk. Thus, in assessing the company’s cost of equity capital, it is reasonable to assume that they will demand the risk-free rate as reflected in the current yields available in government securities, plus an additional return or equity risk premium for investing in the company’s more risky shares (Rappaport, 1986: 57). In the absence of a truly risk-less security, the rate on long-term Treasury bonds serves as the best estimate of the risk-free rate. The use of long-term Treasury bonds also accomplishes that there is consistency with the long-term horizon of the cash flow forecast period, and in addition captures the premium for expected inflation. The second component of the cost of equity is the equity risk premium. One way of estimating the risk premium of a particular stock is by computing the product of the market risk premium for equity (the excess of the expected rate of return on a representative market index such as the Standard & Poor’s 500 stock index [rm] over the risk-free rate [rf]) and the individual security’s systematic risk8, as measured by its beta (V) coefficient9 (Rappaport 1986: 57-58). The market risk premium (rm – rf) has averaged 8.4 percent a year over a period of 69 years (Brealey & Myers, 1996: 180). These variables are combined in the Capital Assets Pricing Model (CAPM). Sharpe (1964) and Lintner (1965) described this model, where in a competitive market the expected risk premium varies in direct proportion to beta. Hence, the CAPM can be written as: Cost of equity = rf + V(rm – rf) Value created by strategy = shareholder value -/- pre-strategy shareholder value, or Cumulative Present Value of cash flows

+ Present Value of Residual Value + Marketable Securities - Market Value of Debt = Shareholder Value - Pre-strategy Shareholder Value = Shareholder Value Created In order to be able to manage shareholder value, Rappaport introduces the Threshold Margin, which represents the minimum operating profit margin a business needs to attain in any period in order to maintain shareholder value in that period, thus the level at which the business will earn exactly its minimum acceptable rate of return, that is, its cost of capital (Rappaport, 1986: 69). It can be expressed in two ways: either as the margin required on incremental sales (i.e., incremental threshold margin) or as the margin required on total sales (i.e., threshold margin). The change in shareholder value (Shareholder Value Created) can be defined as: (Incremental Sales)(Operating Profit Margin on Incremental Sales) (1 - Income Tax Rate) (Cost of capital) -/- (Incremental Sales)(Incremental Fixed Plus Working Capital Investment Rate) (1 + Cost of Capital) The first term represents the present value of the firm’s incremental cash inflows, which are assumed to begin at the end of the first period and continue into perpetuity. The second term represents the present value of the investment (also assumed to take place at the end of the period) necessary to generate the incremental cash inflows. Consequently, the incremental threshold margin is the operating profit margin on incremental sales that equates the present value of the cash inflows to the present value of the cash outflows.

The incremental threshold margin can be subsequently be defined as: (Incremental Fixed Plus Working Capital Investment Rate)(Cost of Capital) (1 + Cost of Capital)(1-Income Tax Rate) While the incremental threshold margin is the ‘break-even’ profit margin on incremental sales only, the threshold margin is equal to the ‘break-even’ operating profit margin on total sales in any period (Rappaport, 1986: 73). The threshold margin is thus calculated as follows: (Prior Period Operating Profit) + (Incremental Threshold Margin) (Incremental Sales) Prior Period Sales + Incremental Sales Essential point that follows from the above is, that when a business is operating at the threshold margin, sales growth does not create value. Once the investment requirements and risk characteristics of a strategy have been established, shareholder value creation is determined by the product of three factors: 1.

Sales growth

2.

Incremental threshold spread (= profit margin on incremental sales -/- incremental threshold margin)

3.

Duration over which the threshold spread is expected to be positive (value growth duration).

This means that shareholder value creation by a strategy in a given period t can also be defined as: (Incremental Sales in Period t)(1 – Income Tax Rate)(Incremental Threshold Spread in Period t) (Cost of Capital)(1 + Cost of Capital) t periods - 1

The above equations provide the essential link between the corporate objective of creating shareholder value (which serves as the foundation for providing shareholder

returns from dividends and capital gains) and the seven basic valuation parameters or value drivers: •

Sales Growth Rate, Operating Profit Margin and Income Tax Rate: Operational decisions

•

Working Capital Investment and Fixed Capital Investment: Investment decisions

•

Cost of Capital: Financing decisions

•

Value Growth Duration: Management’s best estimate of the number of years that investments can be expected to yield rates of return greater than the cost of capital (Rappaport, 1986: 76-77).

Shareholder Value Analysis (SVA) can be used for whole business, divisions, operating units, projects, product lines or customers. Cash Flow Return on Investment An other metric that is rooted in the company’s cash flows is developed and promoted by Holt Value Associates and the Boston Consulting Group: Cash Flow Return on Investment (CFROI)(Madden, 1999; Damodaran, 1999). The CFROI measure was developed to minimize accounting distortions in measuring a firms’ economic performance; particularly distortions related to inflation (Madden, 1999: xii). In calculating CFROI, four inputs are required (Madden, 1999: 110): (1) the life of the assets, (2) the amount of total assets, (3) the periodic cash flows assumed over the life of those assets, and (4) the release of non-depreciating assets in the final period of the life of the assets. CFROI is subsequently calculated as follows:

Where: Gross Cash Flow

= earnings before interest, after taxes + depreciation

Economic Depreciation

= based on replacement cost in current currency

Gross Inflation Adjusted Assets = net value of assets + accumulated depreciation, adjusted for inflation The inflation adjusted Gross Cash Flow conceptually seeks to capture the amount of cash flow resulting from the company’s business operations, regardless of how financed. The items added to accounting Net Income are Depreciation & Amortization, Adjusted Interest Expense, Rental Expense, Monetary Holding Gain (Loss), LIFO Charge to FIFO Inventories (subtractive item), Net Pension Expense, Special Item After Tax, and Minority Interest (Madden, 1999: 133). Holt’s CFROI procedure organizes nondepreciating assets into Monetary Assets (i.e., cash and short-term items are susceptible to loss of purchasing power of the monetary unit11), and All Other Non-depreciating Assets, which include Investments & Advances, Inventory, Land, and when appropriate, a reduction of a portion of the firm’s Deferred Tax Assets. Shareholder value is calculated as (CFROI * GIAA – DA)(1 – t) – (CX – DA) – ∆WC (kc - gn) Where: GIAA

=

Gross Inflation Adjusted Assets

DA

=

Depreciation and Amortization

t

=

Tax Rate

CX

=

Capital Expenditures

∆WC

=

Change in Working Capital

kc

=

Cost of Capital

gn

=

Sustainable Growth rate

The CFROI valuation model is rooted in the previously described Discounted Cash Flow principles (e.g., Young & O’Byrne, 2001; Brealey & Myers, 1996): (a) more cash is preferred to less, (b) cash has a time value, sooner is preferred to later, and (c) less uncertainty is better. The real numbers used in CFROIs, asset growth rates, and discount rates help to make a performance/valuation model useful on a worldwide basis. Inflation adjustments are made from the perspective of the firm’s capital suppliers, not from the

going-concern perspective. The capital suppliers’ perspective requires that all monetary values – all cash-in/cash-out amounts – be measured in monetary units of equivalent purchasing power (Madden, 1999: 109). Managerial skill and competition are the fundamental determinants of the path of a firm’s economic performance through time. The CFROI valuation model incorporates these in the form of a competitive life-cycle framework for analyzing firms’ past performance and forecasting future performance. The life-cycle framework postulates that over the long term there is competitive pressure for above-average CFROI firms to fade downward toward the average economic return and the below-average firms to fade upward. The primary focus is on the fade patterns for forecasted CFROIs and for reinvestment rates (asset growth), with particular attention given to the next five years (Madden, 1999: 9-10; Stigler, 1963 in: Madden, 1999: 19). Regarding the discount rate (cost of capital) component of DCF valuation, Madden (1999) rejects conventional CAPM and beta procedures for estimating firms’ discount rates (cost of capital), because they are rooted in a backward-looking estimate of a premium for the general equity market over a riskfree rate coupled to a dubious volatility measure of risk (beta). In contrast to CAPM/beta, CFROI does not import a discount rate determined without regard to the model’s forecasting procedures. In this model, a firm’s discount rate is determined by the market rate plus a company-specific risk differential.

Figure: CFROI Valuation Model Map (Source: Madden, 1999: 65) The market’s discount rate is derived using monitored forecast data for an aggregate of firms with known market values. This makes it a forward-looking rate, derived much in the manner that a bond’s yield-to-maturity is calculated from a known price and a forecast of future cash receipts from interest and principal. A firm’s risk differential is a function of the firm’s size and financial leverage (Madden, 1999: 10). On the other hand, the forward-looking perspective makes this rate more subjective than a rate based on objective, historical data. For that reason, CFROI has limited use with start-up operations, where the portfolio of projects as a whole is still being penalized by very substantial expenses and limited revenues. In this instance, operating milestones of a non-financial nature are crucial: e.g., getting a prototype product to meet or exceed target performance standards, engineering the product so that manufacturing costs will not exceed a target level, et cetera (Madden, 1999: 80). Madden (1999: 14) states that ‘at a basic level, economic performance can be described in terms of a completed contract … measured by the firm’s achieved ROI (return on investment) adjusted for any changes in the purchasing power of the monetary unit. The

ROI is the internal rate of return that equates a project’s net cash receipt (NCR) stream to its cost, where the NCR represents what the firm receives less what it gives up along the way, which is at the heart of valuation analysis. Cash outflows and inflows are expressed in monetary units of the same purchasing power (e.g., constant dollars) by adjusting for period-to-period changes in the general price level. The measurement of economic performance requires inflation adjustments; otherwise, the cash amounts reflect a combination of economic performance and monetary unit changes. In final form, the firm’s economic performance for that project can be expressed as a real, achieved ROI.’ To outside investors, individual projects cannot be identified from financial statements, so the data for the separate projects would not be available. However, financial statements do reveal the amount of total assets, total depreciating assets, total nondepreciating assets, and total cash flow. It is reasonable to infer that the cash tied up in non-depreciating assets (net working capital) is released over the life of the depreciating assets (Madden, 1999: 79). Madden explains (1999: 67) that analyzing a conventional statement of sources and uses of funds, with a focus on net working capital, helps to identify the NCR from both the firm’s perspective and from the capital suppliers’ perspective. Since the CFROI model utilizes accrual accounting to represent economic transactions, the funds statements based on net working capital (NWC) (not cash) are appropriate. Capital suppliers, both debt holders and equity owners, have claims on the firm. For a non-financial firm, the standard CFROI perspective is to value the entire firm. The total-firm warranted value less debt provides the warranted equity value. The firm’s NCR stream thus represents receipts to which both debt and equity suppliers have a claim. From the firm’s perspective, a NCR is gross cash flow less reinvestment, consisting of gross capital expenditures and change in net working capital. From the capital suppliers’ perspective, cash in their pockets takes the form of interest payments, debt principal repayments, dividends, and share repurchases. The NCR of this group is these cash receipts less new debt and sale of additional equity shares (Madden, 1999: 67). In working with aggregate financial statements, investors need to assess likely ROIs on future projects in relation to the firm’s cost of capital. This is the language of discounted cash flow: internal rates of return and discount rates. This is not the language of accounting-based ratios derived from financial statements and often loosely referred to as

‘ROIs’ (Madden, 1999: 14). Madden continues (p. 15): ‘Holt’s CFROI valuation model is particularly rigorous in its inflation-adjustment procedures, i.e., in calculating ‘real’ magnitudes. This added complexity is necessary in order to better observe patterns and important relationships in time-series data and to better judge the plausibility of forecast data.’ The CFROI is a much more informative performance measure compared to the historical cost accounting earnings/book ratio. CFROI is a cross-sectional return measure derived at a point in time from aggregate data contained in conventional financial statements. ‘ROI’, in CFROI lexicon, denotes an internal rate of return for a project. Displayed as a timeseries track record, CFROI is a measure with which to judge levels of and trends in a firm’s economic performance, which then can be used to help forecast ROIs on future projects. Madden further says (1999: 21) that ‘a significant advantage of the CFROI valuation model is that firms’ track records of CFROIs and real asset growth rates provide a visual display of past performance which corresponds exactly with the key drivers of forecasted future performance. This is not to say that the future must be much like the past. Rather, the point is that if performance for established firms is forecasted to be substantially improved, the business plans for doing it would be expected to break with business-as-usual. The better one understands the past, the better equipped one is to deal with the future. Cash Value Added Cash Value Added is a measure that is used by different authors in explaining different concepts, but by using one similar name. Conceptually, its calculation varies in using cash based variables or accounting-based variables. The first CVA-concept to explain is from Ottoson & Weissenrieder (1996) and Weissenrieder (1997). In their definition, CVA is calculated as: Operating Cash Flow -/- Operating Cash Flow Demand

Where Operating Cash Flow =

Sales -/- Costs +/- Working Capital Movement -/Non-strategic Investments

Operating CF Demand

=

Cash Flow needed for Strategic Investments Where the NPV of that investment equals zero given the investor’s cost of capital

Shareholder value is defined as the cumulative present value of future CVAs, while the shareholder value added equals the annual CVA. Like Rappaport’s Shareholder Value Analysis, this metric is also explicitly built around value drivers. These are: •

Operating surplus (sales -/- costs)

•

Working capital movement

•

Non-strategic Investments

•

Operating Cash Flow Demand

The CVA-analysis can be done at each level of the company, like the other metrics, where the CVA for the company is the aggregate CVA of its Strategic Investments. It makes in that respect a distinction between investments that are supposed to create value (strategic investments) and investments required to maintain the value created by those strategic investments (non-strategic investments). The Boston Consulting Group (BCG) describes Cash Value Added (or its financial services equivalent AVE—Added Value to Equity), as an absolute measure of operating performance contribution to value creation. It provides a strong directional indication of when and how value creation is being improved. CVA reflects operating cash flow minus a cost of capital charge against gross operating assets employed (BCG, 2003). According to the BCG, CVA is an accurate tool for determining priority value drivers and assessing value-driver trade-offs. In particular, it is a useful strategic indicator that allows managers to balance the high level trade-offs between improving profitability versus growing the business. Because its measurement is based on cash flow and original cash investment, it avoids the key accounting distortions that cause profit-oriented measures to give misleading trends in capital-intensive businesses (BCG, 2003). In BCG’s view, CVA is an effective measure for annual incentives at the business-unit and

operational levels. Moreover, CVA can be disaggregated into a value-driver tree of practical measures, beginning with cash flow return on investment (CFROI) and its appropriate value levers, cash flow margin and capital turnover, as well as profitable growth in terms of gross investment increase. For that matter, CVA can also be interpreted as the spread between CFROI and the cost of capital, multiplied by the asset base. When further broken down into operational value drivers for each business unit, it provides insight into how value is created in different areas and levels of responsibility throughout a company. This breakdown into the key performance indicators (KPIs) which are relevant to each management area, form the basis for internal or external performance benchmarking and for establishing annual incentive targets (BCG, 2003).

Table: shows how these metrics relate with aligning shareholders’ (principals) and management’s (agents) interests, and to which extent they are applicable regarding data. Principal-Agent Compliance • Uses market values of debt and equity • Cost of equity includes equity risk premium • Uncertainty about residual value, which constitutes largest portion of value Cash Flow • Minimize accounting distortions, Return on particularly inflation, from Investment capital supplier’s perspective • Managerial skills and competition are fundamental determinants of value • Relative rate (internal rate of return) reflecting market rate plus company specific risk differential. Shareholder Value Analysis

Cash Value Added (Ottoson and Weissenrieder)

Cash Flows

Data Availability

• Estimates of cash flow

Data

implications on strategy • Linked with value drivers

• Forecasted data used in determining variables • Linked with CFROI valuation model map • Limited use for start –up operations

• Distinct between strategic and • Forecasted cash flows of non-strategic investments non-strategic investments • Discount rate future CVAs is investor’ cost of capital (using • Linked with value drivers CAPM for equity)

Cash Value • Related to CFROI • Forecasted cash flows Added (BCG) • Accurate tool for determining • Linked with value drivers priority value drivers trading off profitability Vs. growth • Effective measure for annual incentives at Business Unit and operational levels • Useful for internal and external performance benchmarking Table: Compliance of cash flow-based metrics with capital markets

not

readily

available to outsider investors

• Data not readily available outside investors • Annual CFROI data extractable

from

annual accounts, not firm value • Data not readily available outside investors • Data not readily available outside investors

Accounting Concept Of Profit Data on cash flows are often not as easily and readily available as accounting data (as a result of the legal and regulatory requirements; see below), making cash-based Value-

based metrics less easily applicable. Besides, cash flows by themselves are not by definition required for purposes of performance measurement and management compensation (see previous section). Financial statements created under cash basis normally postpone or accelerate recognition of revenues and expenses long before or after goods and services are produced and delivered (when cash is received or paid). They also do not necessarily reflect all assets or liabilities of a company on a particular date. For these two considerations, measures have been developed which are based on accounting data, but take the inefficacies of traditional accounting measures (like profits, Return On Investment, or Return On Sales) as discussed in a previous section to some or a major extent into account. Either way, they include the cost of both equity and interest-bearing debt in order to express a company’s economic value created. Finally, failing capital markets (judging the numerous newspaper articles and news reports published over the past few years) result in a fading reliance on finance-based measures, i.e., cash flows, to the benefit of measures based on accounting figures. Therefore, most countries’ generally accepted accounting principles require accrual basis accounting for financial reporting purposes (e.g., Libby et al., 2004). In accrual accounting, revenues and expenses are recognized when the transactions and other events that cause them occur, not necessarily when cash is received or paid. That is, revenues are recognized when they are earned and expenses when they are incurred (Libby et al., 2004). The accrual accounting adjusting entries affect net income on the income statement, and they affect profitability comparisons from one accounting period to the next. They also affect assets and liabilities on the balance sheet and thus provide information about a company’s future cash inflows and outflows. This information is needed to assess management’s short-term goal of achieving sufficient liquidity to meet its need for cash to pay ongoing obligations. The potential for abuse arises because considerable judgment underlies the application of adjusting entries. One must be careful, though, that misuse of this judgment can result in misleading measures of performance (Needles & Powers, 2004). Auditors’ reports prevent this to a certain extent.

Residual Income Residual income (RI) is based on the premise that a firm must earn more on its total invested capital than the cost of that capital (Hicks, 1946, 1979; Ittner & Larcker, 1998; Bromwich & Walker, 1998; Dechow et al., 1999; Young & O’Byrne, 2001). Where DuPont developed the Return On Investment (ROI) measure around 1910 in order to assess the return on their capital-intensive activities, in the 1920s Alfred Sloan implemented a Residual Income-like system for General Motors’ operating divisions. The Japanese company Matsushita established a similar system in the 1930s, as did General Electric in the 1950s in order to assess the return on their widely diversified activities which required different use of capital (Sloan, 1996; Lewis, 1955; Solomons, 1965; Young, 1999; Young & O’Byrne, 2001). Residual Income can be calculated in two ways (Young & O’Byrne, 2001): 1.

Invested Capital x (RONA - WACC)

2.

NOPAT - (Invested Capital x WACC)

Where Invested Capital

=

Total Assets - Non-interest-bearing current liabilities (at beginning of the year, at book value)

RONA

=

NOPAT / Invested Capital

NOPAT

=

(Operating Income + Interest Income) x (1 - Tax Rate)

In 1965 Wharton Professor David Solomons devoted a large portion of his influential work on divisional performance measurement to residual income (RI), helping to fuel an interest in the topic among finance and accounting academics in the 1960s and 1970s (Young & O’Byrne, 2001). However, RI has never been widely used. A study by Reece & Cool (1978) showed that only 2 percent of their respondents measured an investment center’s performance using RI, compared to 65% using Return on Investment. However, 28% were measuring both ROI and RI (out of in total 459 respondents). According to Young & O’Byrne (2001: 105), the reason for this rare implementation can be found in that only few corporate executives really understood it or felt that they needed to. Even

those who did understand the concepts, could not figure out how to estimate the ‘interest’ on the equity portion of a company’s capital base. According to Kaplan & Atkinson (1998: 507-8): ‘Despite the appeal of the residual income calculation and its apparent theoretical superiority over the ROI measure, virtually no company used it extensively for measurement of business unit performance. But a revolution in thinking occurred starting in the late 1980s, when several financial consulting firms published studies that showed a high correlation between the changes in companies’ residual incomes and the changes in their stock market valuation. These correlations were significantly higher than the correlations between changes in ROI and stock price changes. The move toward the RI measure received even greater publicity when it was renamed into a far more accessible and acceptable term – Economic Value Added – by the Stern Stewart consulting organization, a prime advocate for the Economic Value Added concept’. With RI, a company’s accounting policies are taken as given, without adjusting for potential biases or distortions caused by the application of generally accepted accounting principles (GAAP). Economic Value Added Stern Stewart & Co. claim that (Stewart, 1991: 2-3) ‘Management should focus on maximizing a measure called economic value added (EVA), which is operating profits less the cost of all the capital employed to produce those earnings. EVA will increase if operating profits can be made to grow without tying up any more capital, if new capital can be invested in projects that will earn more than the full cost of the capital and if capital can be diverted or liquidated from business activities that do not provide adequate returns.’ Young & O’Byrne (2001) add that EVA will also increase if the company can achieve longer periods over which it is expected to earn a RONA greater than its WACC and by reductions in the cost of capital. According to Stewart (1991: 3), EVA is the only performance measure that is entirely consistent with the standard capital budgeting rule: accept all positive and reject all negative net present value investments. They continue that ‘Earnings per share, on the other hand, will increase as long as new capital investments earn anything more than the after-tax cost of borrowing, which is hardly an

acceptable return’. It is also Stewart’s claim that however important cash flow may be as a measure of value, it is virtually useless as a measure of performance (p. 4). The more management invests in rewarding projects, the more negative the immediate cash flows will be, but at the same time the more valuable the company will be. It is only then when cash flows become significant if they are considered over the life of the business, instead of for any given year. Economic Value Added (EVA) (Stewart, 1991) can also be calculated in two ways, similar to RI: 1.

Adjusted invested capital * (Adjusted return on Capital - WACC)

2.

Adjusted operating profits after tax - (Adjusted invested Capital * WACC)

The first calculation is known as the ‘spread’ method, while the second is known as the ‘capital charge’ method. Shareholder value can subsequently be defined as the Adjusted Book Value plus the cumulative present value of EVAs. The shareholder value added equals EVA. For determining ‘capital’, two approaches can be followed: the Operating Approach, which adds Net Working Capital to Net Fixed Assets, and the Financing Approach, which adds Debt to Equity. Both are taking Equity Equivalents (EEs) into account, that gross up the standard accounting book value into what Stewart (1991: 91) calls ‘economic book value’. EEs eliminate accounting distortions by converting from accrual to cash accounting, e.g., with respect to deferred income tax reserve, the LIFO inventory valuation reserve, the cumulative amortization of goodwill, a capitalization of R&D and other market-building outlays, and cumulative unusual write-offs (less gains) after taxes (Stewart, 1991: 91). Stern Stewart & Co. suggest over 150 possible adjustments to invested capital and profits to arrive at the ‘economic book value.’ As the equations show, EVA is basically a variant of residual income, but it attempts to overcome some of the problems outlined before regarding traditional accounting measures by means of the adjustments as suggested by Stewart (1991). As residual income came to be resurrected and repackaged as EVA, three distinctive features began to emerge (Young & O’Byrne, 2001):

1.

EVA draws on advances in capital market theory unavailable to the early users of residual income, to derive credible estimates for the cost of equity, e.g., by means of the Capital Assets Pricing Model or the Arbitrage Pricing Theory.

2.

Conventional measures of residual income accept operating profit as given. With EVA, perceived biases or distortions inherent in GAAP are corrected, providing presumably more credible measures of performance than unadjusted residual income, therefore approaching an Economic Concept of Profit.

3.

As EVA is applicable to any level in an organization, EVA is seen as a way of offering divisional management value-creating incentives similar to stock options and other equity-based schemes set aside for top management.

Economic Profit In McKinsey’s economic profit model (Copeland et al., 1996), the value of a company equals the amount of capital invested plus a premium equal to the present value of the value created each year going forward. The concept of economic profit dates back at least to the economist Alfred Marshall. Economic Profit is defined as follows: Economic Profit = Invested Capital x (ROIC -/- WACC)

EP therefore also follows the principles of RI, as the equation shows. The Net Operating Profits Less Adjusted Taxes (NOPLAT) represents the after-tax operating profits of the company after adjusting the taxes to a cash basis, making taxes the only adjustment to the profit and loss account (Copeland et al., 1996). The latter is the consequence of the fact that the provision for income taxes in the income statement generally does not equal the actual taxes paid in cash by the company due to differences between financial accounting and tax accounting. The adjustment to a cash basis can generally be calculated from the change in accumulated deferred income taxes on the company’s balance sheet (the net of long- and short-term deferred tax assets and long- and short-term deferred tax liabilities) (Copeland et al., 1996).

Invested Capital represents the amount invested in the operations of the business, and is calculated as the sum of operating working capital, net property, plant, and equipment, and net other assets (net of non-current, non-interest-bearing liabilities). Working capital is defined as operating current assets minus non-interest bearing current liabilities, such as accounts payable. With reference to the operating current assets, specifically excluded are excess cash and marketable securities, since these generally represent temporary imbalances in the company’s cash flow. Excess cash and marketable securities are defined as the short-term cash and investments that the company holds over and above its target cash balances to support operations. The target balances can be estimated by observing the variability in the company’s cash and marketable security balances over time and by comparing these against similar companies (Copeland et al., 1996). Net property, plant, and equipment is the book value of the company’s fixed assets. Copeland et al. (1996: 169) ‘disagree with using replacement cost and believe that market values should be used only in certain situations.’ They argue that replacement costs should not be used ‘for the simple reason that assets do not have to be and may never be replaced.’ According to Copeland et al. (1996: 170) ‘using the market values of assets is appropriate when the realizable market value of the assets substantially exceeds the historical cost book value.’ In this case, NOPLAT must be adjusted to reflect the annual appreciation of the value of the assets. According to Copeland et al., analysts often ignore the economic profit associated with the write-up. This way, they can analyze whether the company makes the best use of its assets. However, by ignoring the NOPLAT-adjustment it is not possible to analyze the company’s actual performance. Net other assets relate to the operations of the business, excluding special investments. Whether an item is operating or non-operating, depends on the consistency in treatment of the asset and any associated income or expense in calculating NOPLAT. Industry norms also prevail in order to achieve consistency with the company’s peers (Copeland et al., 1996). Copeland et al. recommend as a practical matter to use invested capital measured at the beginning of the period or the average of beginning and ending capital. Technically, they argue, for the economic profit valuation to exactly equal the DCF valuation, one must use beginning capital. If average capital is used, the variance will generally be very small.

Another way of defining EP is as after-tax operating profits less a charge for the capital used by the company: Economic Profit

= NOPLAT -/- Capital Charge = NOPLAT -/- (Invested Capital x WACC)

The value of the company is subsequently calculated as: Value = Invested Capital + Present Value of Projected Economic Profit The present value consists of the present value of the forecasted economic profits during an explicit forecast period plus the present value of the forecasted economic profit after the explicit forecast period (or ‘continuing value’ - CV). According to Copeland et al., the recommended economic profit formula for the continuing value is as follows (Copeland et al., 1996: 291):

Where Economic Profit T+1

= the normalized economic profit in the first year after the explicit forecast period

NOPLAT T+1

= the normalized NOPLAT in the first year after the explicit forecast period

g

= the expected growth rate in NOPLAT in perpetuity.

If therefore a company earns exactly its WACC every period, then the discounted value of its projected free cash flow should exactly equal its invested capital. Or, the company would be worth exactly what was originally invested. A company is worth more or less than its invested capital only to the extent it earns more or less than its WACC. Hence, the premium or discount relative to invested capital must equal the present value of the company’s future EP (Copeland et al., 1996). Economic profit is an important measure because it combines size and ROIC into a single result. According to Copeland et al. (1996: 178) ‘too often companies focus on either size (often measured by earnings) or ROIC. Focusing on size (e.g., earnings or earnings growth) could destroy value if returns on capital are too low. Conversely, earning a high ROIC on a low capital base may mean missed opportunities.’

It is important to realize that economic profit measures realized value creation, while the increase in the market value of a company is represented by the Total Shareholder Return, defined as share price appreciation plus dividends. The change in market value will equal economic profit only if there is no change in expected future performance and if the WACC remains constant during the year. The philosophy behind the MfV concept is that an organization develops the right strategies to realize an improved financial performance that leads to an increasing share price. Marakon thus assumes that an increase in EV is related to a higher value for the shareholder, which leads to an increase in TRS. With the emphasis on building a superior organization, conditions are created to develop the right strategies. These are formulated by means of a bottom-up process that contribute to meeting the corporate objectives. The implementation trajectory was divided into three phases. Phase 1

Involved setting up a trajectory for the SBU and approval of this plan by the Managing Board. Subsequently, the plan was communicated into the organization. Concepts were developed and described, while the underlying ideas and foundations were explained that were necessary to maximize the value of ABN AMRO. Last step in this phase was preparing the organization, in terms of both management and structure, to adopt VBM as of January 1, 2001.

Phase 2

Was characterized by setting up the internal and external fact-sheets, management agendas, the training of top management in using the new concepts and improving communication by introducing management dialogues. In addition, considerable time and effort had been devoted to designing performance contracts. These were rooted in financial projections based on EP and were designed for SBU and BU level. In strategic planning, these financial projections were followed by the strategy on how these financial ambitions were expected to be realized by means of explicit initiatives and actions.

Phase 3

Started executing the concepts of VBM. In addition, managers were more and more confronted with and held responsible for their performance. As will be described later, to align management’s attitude and behavior with

VBM the remuneration structure was changed in accordance with VBM principles. Much attention was paid to train employees in changing their mindset and to act upon it. Of the utmost importance in this phase was also the implementation of a new bottom-up strategic management process.

Marakon Approach: Marakon Associates, an international management-consulting firm founded in 1978, has done pioneering work in the area of value-based management. This measure considers the difference between the ROE and required return on equity (cost of equity) as the source of value creation. This measure is a variation of the Economic Value (EV) measures. Instead of using capital as the entire base and the cost of capital for calculating the capital charge, this measure uses equity capital and the cost of equity to calculate the capital (equity) charge. Correspondingly, it uses economic value to equity holders (net of interest charges) rather than total firm value. According to Marakon model shareholder wealth creation is measured as the difference between the market value and the book value of a firm's equity. The book value of a firm's equity, B, measures approximately the capital contributed by the shareholders, whereas the market value of equity, M, reflects how productively the firm has employed the capital contributed by the shareholders, as assessed by the stock market. Hence, the management creates value for shareholders if M exceeds B, decimates value if m is less than B, and maintains value is M is equal to B. According to the Marakon model, the market-to-book values ratio is function of the return on equity, the growth rate of dividends, and cost of equity. For an all-equity firm, both EV and the equity-spread method will provide identical values because there are no interest charges and debt capital to consider. Even for a firm that relies on some debt, the two measures will lead to identical insights provided there are no extraordinary gains and losses, the capital structure is stable, and a proper re-estimation of the cost of equity and debt is conducted. A market is attractive only if the equity spread and economic profit earned by the average competitor is positive. If the average competitor's equity spread and economic profit are negative, the market is unattractive. For an all-equity firm, both EV and the equity spread method will provide identical values because there are no interest charges and debt capital to consider. Even for a firm that relies on some debt, the two measures will lead to identical insights provided there

are no extraordinary gains and losses, the capital structure is stable, and a proper reestimation of the cost of equity and debt is conducted. A market is attractive only if the equity spread and economic profit earned by the average competitor is positive. If the average competitor's equity spread and economic profit are negative, the market is unattractive. The consultants of Marakon who were hired to implement Value Based Management (VBM) emphasized that VBM is a management approach rather than a calculus exercise using VBM metrics. Therefore, not only strategy is involved, but also the organizational structure and processes. MfV will be much more than just a financial exercise for us. Companies which practice MfV adopt a holistic approach which combines three fundamentals of business: organisation, strategy and finance. It is a necessary condition for the success of so major an initiative as MfV that its progress be reflected in management incentives. In this respect it is noteworthy to show how VBM is related to shareholder value, which could conflict with a stakeholder approach of managing a firm (Freeman, 1984; Donaldson & Preston, 1995; Jones & Wicks, 1999; Friedman & Miles, 2002). Various authors (Cools & Van der Ven, 1995; AICPA, 2000b; Copeland et al., 2000; Jensen, 2001; Wallace, 2003) explain that by trying to serve multiple stakeholders, as suggested with the stakeholder approach, they will all end up being inadequately served. Without the clarity provided by a single-value objective, ‘companies embracing stakeholder theory will experience managerial confusion, conflict, inefficiency, and perhaps even competitive failure’ (Jensen, 2001: 9). However, the same authors (Cools & Van der Ven, 1995; AICPA, 2000b; Copeland et al., 2000; Jensen, 2001; Wallace, 2003) admit that other stakeholders cannot be ignored either. As Jensen (2001: 9) puts it (in line with Atkinson et al. (1997) and Wallace (2003)): ‘In order to maximize value, corporate managers must not only satisfy, but enlist the support of, all corporate stakeholders— customers, employees, managers, suppliers, local communities. Top management plays a critical role in this function through its leadership and effectiveness in creating, projecting, and sustaining the company’s strategic vision.’ This is what Jensen (2001)

calls enlightened stakeholder theory and Wallace (2003) enlightened value maximization. Wallace (2003: 127) states: ‘Through correlation analysis, and then through regression analysis, I provide evidence supporting enlightened value maximization and suggesting a complementary relationship between VBM and stakeholder theory. Companies must create shareholder value in order to satisfy their stakeholders. At the same time, my findings also suggest that, up to a certain point, increasing stakeholder benefits helps create additional shareholder value. In other words, companies generally do well by doing good – but at the same time, they must do well to be able to do good. The research also showed that a focus on shareholders’ interests, as residual claimants, serve all other stakeholders interests as well. Srivastava et al. (1998) relate to the marketers’ perspective that customers and channels are market-based assets that arise from the mingling of the firm with entities in its external environment. These assets increase shareholder value by accelerating and enhancing cash flows, lowering the volatility and vulnerability of cash flows, and increasing the residual value of cash flows. Leveraging the market-based assets expands the external stakeholders of

marketing to

include explicitly the shareholders and potential shareholders of the firm and requires broader input into marketing decisions making by other functional managers.

Boston Consulting Group (BCG) Approach The Boston Consulting Group (BCG) is a management consulting firm founded by Harvard Business School alum Bruce Henderson in 1963. The growth-share matrix is a chart created by group in 1970 to help corporation analyze their business units or product lines, and decide where to allocate cash. It was popular for two decades, and is still used as an analytical tool. To use the chart, corporate analysts would plot a scatter graph of their business units, ranking their relative market shares and the growth rates of their respective industries. To ensure longterm value creation, a company should have a portfolio of products that contains both high-growth products in need of cash inputs and low-growth products that generate a lot of cash. The BCG matrix is a tool that can be used to determine what priorities should be given in the product portfolio of a business unit. It has 2 dimensions: market share and market growth. The basic idea behind it is that the bigger the market share a product has or the faster the product’s market grows the better it is for the company. The portfolio approach is a historical starting point for strategic analysis and choice in multi-business firms Boston Consulting Group (BCG) pioneered an approach called portfolio techniques that attempted to help managers “balance” the flow of cash resources among their various businesses while identifying their basic strategic purpose within the overall portfolio. This led to a categorization of four different types of businesses: Relative Market Share High Stars

Low Question Marks

Cash Cows

•

Dogs

Cash cows Units with high market share in a slow-growing industry. These units typically generate cash in excess of the amount of cash needed to maintain the

business. They are regarded as staid and boring, in a "mature" market, and every corporation would be thrilled to own as many as possible. They are to be "milked" continuously with as little investment as possible, since such investment would be wasted in an industry with low growth. •

Dogs More charitably called pets, units with low market share in a mature, slowgrowing industry. These units typically "break even", generating barely enough cash to maintain the business's market share. Though owning a break-even unit provides the social benefit of providing jobs and possible synergies that assist other business units, from an accounting point of view such a unit is worthless, not generating cash for the company. They depress a profitable company's return on assets ratio, used by many investors to judge how well a company is being managed. Dogs, it is thought, should be sold off.

•

Question marks Units with low market share in a fast-growing industry. Such business units require large amounts of cash to grow their market share. The corporate goal must be to grow the business to become a star. Otherwise, when the industry matures and growth slows, the unit will fall down into the dog’s category.

•

Stars Units with a high market share in a fast-growing industry. The hope is that stars become the next cash cows. Sustaining the business unit's market leadership may require extra cash, but this is worthwhile if that's what it takes for the unit to remain a leader. When growth slows, stars become cash cows if they have been able to maintain their category leadership.

As a particular industry matures and its growth slows, all business units become either cash cows or dogs. The overall goal of this ranking was to help corporate analysts decide which of their business units to fund, and how much; and which units to sell. Managers were supposed to gain perspective from this analysis that allowed them to plan with confidence to use money generated by the cash cows to fund the stars and, possibly, the question marks. As the BCG stated in 1970: Only a diversified company with a balanced portfolio can use its strengths to truly capitalize on its growth opportunities. The balanced portfolio has:

•

Stars whose high share and high growth assure the future;

•

Cash cows that supply funds for that future growth; and

•

Question marks to be converted into stars with the added funds.

Practical Use of the Boston Matrix For each product or service the 'area' of the circle represents the value of its sales. The Boston Matrix thus offers a very useful 'map' of the organization's product (or service) strengths and weaknesses (at least in terms of current profitability) as well as the likely cash flows. The need which prompted this idea was, indeed, that of managing cash-flow. It was reasoned that one of the main indicators of cash generation was relative market share, and one which pointed to cash usage was that of market growth rate. Relative market share This indicates likely cash generation, because the higher the share the more cash will be generated. As a result of 'economies of scale' (a basic assumption of the Boston Matrix), it is assumed that these earnings will grow faster the higher the share. The exact measure is the brand's share relative to its largest competitor. Thus, if the brand had a share of 20 per cent, and the largest competitor had the same, the ratio would be 1:1. If the largest competitor had a share of 60 per cent, however, the ratio would be 1:3, implying that the organization's brand was in a relatively weak position. If the largest competitor only had a share of 5 per cent, the ratio would be 4:1, implying that the brand owned was in a relatively strong position, which might be reflected in profits and cash flow. If this technique is used in practice, it should be noted that this scale is logarithmic, not linear. On the other hand, exactly what is a high relative share is a matter of some debate. The best evidence is that the most stable position (at least in FMCG markets) is for the brand leader to have a share double that of the second brand, and treble that of the third. Brand leaders in this position tend to be very stable - and profitable

The reason for choosing relative market share, rather than just profits, is that it carries more information than just cash flow. It shows where the brand is positioned against its main competitors, and indicates where it might be likely to go in the future. It can also show what type of marketing activities might be expected to be effective. BCG’s Strategic Environments Matrix •

Volume businesses are those that have few sources of advantage, but the size is large—typically the result of scale economies

•

Stalemate businesses have few sources of advantage, with most of those small

•

Fragmented businesses have many sources of advantage, but they are all small

•

Specialization businesses have many sources of advantage and find those advantages potentially sizable

Limitations 1.

Viewing every business as a star, cash cow, dog, or question mark is overly simplistic.

2.

Many businesses fall right in the middle of the BCG matrix and thus are not easily classified.

3.

The BCG matrix does not reflect whether or not various divisions or their industries are growing over time.

4.

Other variables besides relative market share position and industry growth rate in sales are important in making strategic decisions about various divisions.

5.

It does not address how value is being created across business units

6.

Truly accurate measurement for matrix classification was not as easy as the matrices portrayed

7.

The underlying assumption about the relationship between market share and profitability varied across industries and market segments

8.

The limited strategic options came to be seen more as basic strategic missions

9.

It ignored capital raised in capital markets

10.

It typically failed to compare the competitive advantage a business received from being owned by a particular company with the costs of owning it

Boston Consulting Group (BCG) Matrix The Internal-External (IE) Matrix This is also an important matrix of matching stage of strategy formulation. This matrix already explains earlier. It relate to internal (IFE) and external factor evaluation (EFE). The findings form internal and external position and weighted score plot on it. It contains nine cells. Its characteristics is a s follow •

Positions an organization’s various divisions in a nine-cell display.

•

Similar to BCG Matrix except the IE Matrix:

•

•

•

Requires more information about the divisions

•

Strategic implications of each matrix are different

Based on two key dimensions •

The IFE total weighted scores on the x-axis

•

The EFE total weighted scores on the y-axis

Divided into three major regions •

Grow and build – Cells I, II, or IV

•

Hold and maintain – Cells III, V, or VII

•

Harvest or divest – Cells VI, VIII, or IX

Steps for the development of IE matrix 1.

Based on two key dimensions IFE and EFE.

2.

Plot IFE total weighted scores on the x-axis and the EFE total weighted scores on the y axis

3.

On the x-axis of the IE Matrix, an IFE total weighted score of 1.0 to 1.99 represents a weak internal position; a score of 2.0 to 2.99 is considered average; and a score of 3.0 to 4.0 is strong.

4.

On the y-axis, an EFE total weighted score of 1.0 to 1.99 is considered low; a score of 2.0 to 2.99 is medium; and a score of 3.0 to 4.0 is high.

5.

IE Matrix divided into three major regions. Grow and build – Cells I, II, or IV Hold and maintain – Cells III, V, or VII Harvest or divest – Cells VI, VIII, or IX

Conclusion After discussion, the BCG matrix is an important matrix regarding strategy adopted by firm. Still this matrix concern four strategy first growth or build strategy enhance market share, second is hold strategy (hold existing position), third Harvesting strategy (no further growth or select other opportunity), fourth is diversity (sell out the part of business)

McKinsey’s Approach GE Planning Grid General Electric (or McKinsey) matrix uses market attractiveness as not merely the growth rate of sales of the product, but as a compound variable dependent on different factors influencing the future profitability of the business sector. The important steps in the McKinsey approach to value maximization are as follows: •

Emphasis on value maximization

•

Finding value drivers

•

Establishing appropriate managerial processes

•

Implementing value based management properly

In the early 1980s, McKinsey came up with the famous 7-S framework. The 7-S referred to the seven variables involved in an intelligent approach to organizing. These 7 variables are: strategy, structure, systems, staff, style, skills and shared values. The 7 variables covered the hardware and the software. Structure Strategy

Systems

Shared Values Skills

Systems Staff Fig.: The McKinsey 7-S Framework

The frame suggests that there is a multiplicity of factors that influence an organization’s ability to change and its proper mode of change. Shared values: The values and beliefs of the company. Ultimately they guide employees towards 'valued' behavior. Shared values are commonly held beliefs, mindsets, and assumptions that shape how an organization behaves – its corporate culture. Shared values are what engender trust. They are an interconnecting center of the 7Ss model. Values are the identity by which a company is known throughout its business areas, what the organization stands for and what it believes in, it central beliefs and attitudes. These values must be explicitly stated as both corporate objectives and individual values. Strategy: The direction and scope of the company over the long term. Strategy are plans an organization formulates to reach identified goals, and a set of decisions and actions aimed at gaining a sustainable advantage over the competition. Structure: The basic organization of the company, its departments, reporting lines, areas of expertise and responsibility (and how they inter-relate). The way the organization's units relate to each other: centralized, functional divisions (top-down); decentralized (the trend in larger organizations); matrix, network, holding, etc. These relationships are frequently diagrammed in organizational charts. Most organizations use some mix of structures pyramidal, matrix or networked ones - to accomplish their goals. The design of organizational structure is a critical task of the top management of an organization. Organizational structure performs four major functions: •

It reduces external uncertainty through forecasting, research and planning in the organization.

•

It reduces internal uncertainty arising out of car variables, unpredictable, random human behaviour within the organization through control mechanism.

•

It undertakes a wide variety of activities through devices such as departmentalized, specialization, division of labour and delegation of authority.

•

It enables the organization to keep its activities coordinated and have a focus in the mindset of diversity in the pursuit of it objectives

Organizational structure must be designed in accordance with the needs of the strategy. Systems: Formal and informal procedures that govern everyday activity, covering everything from management information systems, through to the systems at the point of contact with the customer (retail systems, call center systems, online systems, etc). Systems define the flow of activities involved in the daily operation of business, including its core processes and its support systems. They refer to the procedures, processes and routines that are used to manage the organization and characterize how important work is to be done. Systems include: Business System Business Process Management System (BPMS) Management information system Innovation system Performance management system Financial system/capital allocation system Compensation system/reward system Customer satisfaction monitoring system Skills: The capabilities and competencies that exist within the company. What it does best. These are developed over a period of time and are a result of the interaction of a number of factors; performance certain tasks successfully over a period of time, the kind of

people in the organization, the top management style, the organizational structure, the management style, the external environmental influences, etc. Hence, when organizations make a strategic shift it becomes necessary to consciously build new skills. Staff: The company's people resources and how they are developed, trained and motivated. According to Waterman and his colleagues the term “staff” refers to the way organizations introduce young recruits into the mainstream of their activities and the manner in which they manage their careers as the new entrants develop into future managers. Style: The leadership approach of top management and the company's overall operating approach. "Style" refers to the cultural style of the organization, how key managers behave in achieving the organization's goals, how managers collectively spend their time and attention, and how they use symbolic behavior. How management acts is more important that what management says. Conclusion: In this chapter, we discuss various strategic analysis options at corporate level to maintain its market value.

References: •

Boston Consulting Group, Perspectives on Experience, BGC, 1972

•

Hill Charles W.L. Jones Gareth R., (2001): Strategic Management Theory – An Integrated Approach, All India Publishers & Distributors – New Delhi

•

Indira Gandhi National Open University , School of Management Studies, (1996): Corporate Policies and Practices – Strategic Choices, IGNOU

•

Pearce II John A, Robinson Jr. Richard B. (2005): Strategic Management – Formulation, Implementation & Control, Tata McGraw -Hill Publishing, New Delhi

•

W. Thomas L., Hunger David J., (1983): Strategic Management and Business Policy, Addison Wesley Publishing Company, London.