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Financial Management notesWeek 1 – Training
Chapter 23 – Performance Measurement, compensation and multinational considerations
Decentralization has plenty of advantages, used by a vast majority of international operating
companies (to optimize the value of the company). One of the disadvantages: it’s difficult to make
sure that evert department performs well performance-measurement
Four common measures of economic performance:
1. Return on Investment (ROI)
ROI is an accounting measures of income divided by an accounting measure of investment.
With “income” we mean “Operating Income” (EBIT) when measuring a project or an
organizations (sub)unit.
ROI = INCOME / INVESTMENTS
Most popular metric for two reasons:
a. Blends all the ingredients of profitability (revenues, costs, and investments) into a
single percentage
b. May be compared to other ROI’s both inside and outside the company.
ROI may be decomposed into its two components as follows:
ROI = INCOME / INVESTMENT INCOME / REVENUES X REVENUES / INVESTMENTS
This is known as the DuPont Method of Profitability Analysis, it recognizes the two basic in
profit making: increasing income per dollar of revenue and using assets to generate more
revenues. An improvement to either with no change in the other increases the ROI.
DuPont System of Analysis
System used to dissect the firm’s financial statements and to assess its financial condition. It
multiplies the firm’s net profit margin by its total asset turnover to calculate the firm’s return
on total assets (ROA).
ROA = EARNINGS AVAILBLE COMMON STOCKHOLDERS / SALES X SALES / TOTAL
ASSETS
EARNINGS AVAIBLE FOR COMMON STOCK HOLDERS / TOTAL ASSETS
Modified Dupont Formula
Relates the firm’s return on total assets (ROA) to its return on equity (ROE) using the
financial leverage multiplier (FLM).
FLM = TOTAL ASSETS / COMMON STOCK EQUITY
The ration of the firm’s total assets to its common stock equity.
ROE = EARNINGS AVAILABLE FOR COMMON STOCKHOLDERS TOTAL ASSETS X
TOTAL ASSETS / COMMON STOCK EQUITY
EARNINGS AVAILBLE FOR COMMON STOCKHOLDERS / COMMON STOCK
EQUITY
1
, Applying the DuPont System
The advantage of the DuPont system is that it allows the firm to break its return on equity 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 important components.
2. Residual Income (RI)
Residual Income is an accounting measure of income minus a dollar amount for required
return on an accounting measure of investment.
RI = INCOME – (REAL RATE OF RETURN X INVESTMENT)
Required rate of return times the investment is the imputed cost of the investment. Imputed
costs are recognized in some situations, but not in the financial accounting records.
3. Economic Value Added (EVA)
EVA is a specific type of residual income calculation that has recently gained popularity.
Weighted Average Cost of Capital (WACC) equals the after-tax average cost of all long-
term funds in use.
EVA is better and more precise:
1. After-tax operating income because now you know what you ACTUALLY have as an
income
2. WACC compared to RRR RRR is just whatever you want it to be
3. Total assets – Current Liabilities better dan “investment” because it is more precise
When calculating WACC you deduct the tax. Debt is tax deductible, equity is not equity is
money from investors.
!!!!!DEBT – TAX!!!!!!!
4. Return on Sales (ROS) (this measure does not account for investment)
OPERATING INCOME / REVENUE (SALES)
Selecting subunit operating income as a metric is inappropriate because it obviously differs simply on
the differing size of the subunits. Designing accounting based performance measures requires several
steps:
1. Choose performance measures that align with top management’s financial goals (Goal
Congruence)
2. Choose the level of details of each performance measure
2
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