How to measure and monitor the performance of a company?
- Financial perspective: stock price, ROI, ROA, EVA.
- Customer perspective: market share, customer satisfaction, # repeat visitors.
- Internal business process perspective: quality, cleanliness, time to…
- Learning and growth perspective: employee turnover, education levels.
Monitor: Business Balance Score Card
Most commonly focus areas: financial / customer / internal business processes / learning and
growing.
Decentralization:
- Plenty of advantages, used by vast majority of international operating companies (to
optimize the value of the company).
- A disadvantage is that it is difficult to make sure that every department performs well,
goal congruence, performance measurement.
Four common measures of economic performance:
1. Return on investment.
2. Residual income.
3. Economic value added.
4. Return on sales (does not account for investment).
Selecting subunit operating income as a metric is inappropriate because it obviously differs
simply on the differing size of subunits.
Designing accounting-based performance measures requires some steps:
1. Choose performance measures that align with top management’s financial goals
(goal congruence).
2. Choose the level of details of each performance measures.
3. Choose a target level of performance.
4. Choose a feedback mechanism for each performance measure.
DuPont system of analysis = a system used to dissect the firm’s financial statements and to
assess its financial condition.
- The advantage of the DuPont system is that it allows the firm to break its ROE into a
profit-on-sales component (net profit margin), an efficiency-of-asset use component
(total asset turnover), and a use-of-financial-leverage component (financial leverage
multiplier).
, - Analysts can decompose the total return to owners into these components:
net income sales total assets
ROE= x x
sales total assets average shareholder equity
DuPont formula = multiplies the firm’s net profit margin by its total asset turnover to calculate
the return on assets (ROA).
Modified DuPont formula = relates the firm’s ROA to its ROE using the FLM.
total assets
Financial leverage multiplier (FLM) = . This is the ratio linking ROA to
common stock equity
ROE.
- ROE = ROA x FLM
Return on Total Assets (ROA) =
earnings available for common stockholders earnings available for common stockholders sales
= x
totel assets sales total assets
.
- ROA indicates how efficiently you use your assets to generate sales.
Return on Common Equity (ROE) =
earnings available for common stockholders earnings available for common stockholders total assets
= x
common sotck equity total assets common sotck equ
- ROE focuses on the equity invested in the company, instead of the assets.
- ROE = ROA x financial leverage OR net profit turnover x asset turnover x financial
leverage.
ROE > ROA if earnings are positive. ROE < ROA if earnings are negative.
Dangers of using profitability ratios (particularly when using ROE): it is easy to be fooled by
the numbers. Therefore, we have to consider as company’s financial leverage = the degree
that a company increases its financial risk with the aim to increase its return. ROA does not
discriminate on how it was financed; it just tells how efficient you are with your total assets.
Higher financial leverage means higher risks! The challenge of financial leverage is to strike
a balance between the benefits and costs of debt financing.
income income revenues
Return on Investment (ROI) = = x
investment revenues investment
Can also be written as, return on sales x investment turnover
- With income, we mean operating income (EBIT) when measuring.
- Most popular messages for two reasons:
1. Blends all ingredients of profitability (revenues, costs, and investment) into a
single percentage.
2. May be compared to other ROIs both inside and outside the firm.
Understand the dynamics behind ROI to improve the ratio:
- Decrease assets.
- Increase revenues.
- Decrease costs.
Residual income (RI) = an accounting measure of income minus a dollar amount for
required return on an accounting measure of investment.
RI =icnome−( RRR x investment )
- RRR = required rate of return.
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