Performance Evaluation

Performance evaluation - An organisation should have certain targets for achievement. Targets can be expressed in terms of key metrics. The term ‘metric’ is now in common

Financial performance indicators (FPIs)

An organisation should have certain targets for achievement. Targets can be expressed in terms of key metrics. The term ‘metric’ is now in common use within the context of measurement of performance. It is a basis for analysing performance (both budgeted and actual).

A budget should not be approved by senior management unless budgeted performance is satisfactory, as measured by the key metrics. Actual performance should then be assessed in comparison with the targets. The term ‘key performance indicators’ might be used.

Financial performance indicators analyse:

Profitability
Liquidity
Risk

Profitability

A company should of course be profitable, and there are obvious checks on profitability.

The primary objective of a company is to maximise profitability. Profitability ratios can be used to monitor the achievement of this objective.

A key metric for profitability might be the profit/sales ratio (profit margin), or the contribution/sales ratio (contribution margin).

Gross profit margin

A high gross profit margin is desirable. It indicates that either sales prices are high or that production costs are being kept well under control.

Gross profit margin = Gross profit x100

Turnover

Net profit margin

A high net profit margin is desirable. It indicates that either sales prices are high or that all costs are being kept well under control.

Net profit margin = Net profit x 100

Turnover

Return on capital employed (ROCE)

This is a key measure of profitability. It is the net profit as a percentage of the capital employed. ROCE is sometimes calculated using operating profit (profit before finance charges and tax) instead of net profit. If net profit is not given in the question, use operating profit instead.

A high ROCE is desirable. An increase in ROCE could be achieved by:

Increasing net profit, e.g. through an increase in sales price or through better control of costs.
Reducing capital employed, e.g. through the repayment of long-term debt.

ROCE = Net profit x 100

Capital employed

*Where capital employed = total assets less current liabilities or total equity plus long term debt.

The ROCE can be understood further by calculating the net profit margin and the asset turnover:

ROCE = net profit margin × asset turnover

Asset turnover

This is the turnover divided by the capital employed. A high asset turnover is desirable. An increase in the asset turnover could be achieved by:

Increasing turnover, e.g. through the launch of new products or a successful advertising campaign.
Reducing capital employed, e.g. through the repayment of long-term debt.

There is a direct relationship between the key profitability indicators (ROCE, the asset turnover and the profit/sales percentage). Profit margin and asset turnover together explain the ROCE, and if the ROCE is the primary profitability ratio, these other two are the secondary ratios. The relationship between the three ratios is as follows:

Profit margin x Asset turnover = ROCE

PBIT x Sales = PBIT

Sales Capital employed Capital employed

Liquidity

A company needs liquid assets so that it can meet its debts when they fall due.

Liquidity is the amount of cash a company can obtain quickly to settle its debts (and possibly to meet other unforeseen demands for cash payments too).

Liquid funds include:

Cash
Short-term investments for which there is a ready market, such as investments in shares of other companies
Fixed-term deposits with a bank or building society, for example six-month deposits with a bank
Trade receivables
Bills of exchange receivable

In summary, liquid assets are current asset items that will or could soon be converted into cash, and cash itself. Two common definitions of liquid assets are all current assets or all current assets with the exception of inventories.

Current ratio

Liquidity comes from current assets, including cash. The need for liquidity comes from the need to settle current liabilities.

The current ratio is simply a ratio that compares short-term sources of cash (current assets) with short-term needs for cash (current liabilities).

Current assets

Current liabilities

As a very rough guide, an ‘ideal’ current ratio may be 1.5:1 or 2:1. A ratio of less than 1:1 could indicate liquidity problems, because the entity might be unable to obtain cash from normal business activities to settle its current liabilities.

Quick ratio (acid test ratio)

Inventory turnover could be very slow. In such cases, inventory is not a liquid asset and will not generate cash within a fairly short period of time in order to pay off the current obligations due in the next month or so.

The quick ratio or acid test ratio is similar to the current ratio, but it excludes inventory from current assets.

Current assets (less) Inventory

Current liabilities

By eliminating inventory, the quick ratio measures a worst-case-scenario. It can be used to ask the question: Does the entity appear to have sufficient cash and near cash assets (including receivables) to provide the money to settle all current liabilities on time?

‘Ideally’ the quick ratio should be about 0.8:1 to 1.0:1.

Inventory turnover

Inventory turnover is a measure of how quickly an entity uses its inventory. It is also a measure of how slowly an entity uses its inventory, and how long items are held in inventory before they are eventually used or sold.

Inventory turnover may be measured as ‘x times a year’.

Cost of Sales

Average Inventory

A low turnover indicates inefficient use of resources. The slower inventory turnover, the greater the risk of obsolescence.

Inventory turnover may also be measured as an average number of days, rather than as ‘x times a year’.

Average Inventory x 365

Cost of Sales

This calculates the number of days a company takes to sell its average holding of inventory.

Separate turnover ratios could be calculated for:

raw materials
work in progress (the production cycle), and
finished goods

Receivables turnover

It is sometimes called ‘debtor days’ or ‘days sales outstanding’. The receivables turnover ratio is usually measured in days. It is the average time that it takes an entity to collect amounts due from customers.

Average Trade Receivables x 365

Credit Sales

The ratio should ideally use credit sales, but the financial statements do not provide an analysis of sales into cash sales and credit sales. Therefore, total sales must normally be used, and this may produce an unrealistic ratio.

A change in the ratio from one year to the next may be due to:

A change in settlement terms for credit customers, to encourage new business
the introduction of debt factoring, which will reduce the average receivables collection period
exceptional factors, such as one large new customer being offered extended credit.

Payables payment period

It is the average payment period to suppliers. It is normally measured in days.

Average Trade Payables x 365

Credit Purchases

The ratio should ideally use purchases on credit. However, this figure is not available from the financial statements, and the figure for the annual cost of sales should be used instead.

Risk

In addition to managing profitability and liquidity it is also important for a company to manage its risk. A company finances its net assets with a combination of equity and reserves and long-term debt. An entity is ‘high geared’ when a large proportion of its long-term capital is in the form of debt. High financial gearing is seen as a high-risk strategy.

‘Gearing’ examines the financing structure of a business and indicates to shareholders the level of financial risk to which the company is exposed because of its long-term capital structure.

These ratios, and changes in the ratios over time, can help them to assess the credit risk in their investment.

Gearing ratio

The gearing ratio (or leverage ratio) is usually calculated as follows:

Debt or Debt x 100

Equity Equity + Debt

Debt = Loans + Preference shares

Equity = Equity share capital + reserves + non-controlling interest

Notes on financial gearing

A highly geared company, with a substantial proportion of its capital in the form of debt, is seen by investors as ‘more risky’.
High gearing is acceptable if it is accompanied by stable annual profits (PBIT) or increasing profits.
A highly-geared company may find it more difficult to raise additional debt capital.

Interest cover

The interest cover ratio measures the ability of a company to meet its obligations to pay interest on debt (out of its profits).

The ratio therefore compares profit before interest and tax with the annual interest charges.

Profit before interest

Interest

A high interest cover suggests a sensible financing structure.

An interest cover of 2 times or less generally indicates that the company might have difficulty paying its interest if there is a fall in its profits.

Dividend cover

The dividend cover ratio measures the earnings of a company relative to the size of its dividend payments.

EPS/Net Profit

Net dividend per share

A decrease in the dividend cover indicates that the company is facing an increased risk of not being able to make its dividend payments to shareholders.

Non-financial performance indicators (NFPIs)

Changes in cost structures, the competitive environment and the manufacturing environment have led to an increased use of non-financial performance indicators (NFPIs).

As well as evaluating performance using financial performance indicators, companies can use non- financial indicators. NFPIs can usefully be applied to employees and product/service quality.

Non-Financial Performance Indicators (NFPIS) – are ‘measures of performance based on non-financial information that may originate in, and be used by, operating departments to monitor and control their activities without any accounting input’.

As with any performance indicator, an NFPI has to be viewed in some context in order to be most meaningful. A good control report will express indicators in terms of a deviation from plan, relative to an industry benchmark or as part of a trend analysis covering comparable earlier periods.

Further, it is best to consider performance indicators as part of a package giving a multidimensional impression of how the organisation is performing.

One of the many criticisms of traditional accounting performance measurement systems is that they do not measure the skills, morale and training of the workforce, which can be as valuable to an organisation as its tangible assets.

The Balanced scorecard

The balanced scorecard is an approach to performance measurement and control emphasises the need to provide management with a set of information which covers all relevant areas of performance.

The balanced scorecard approach is an ‘Approach to the provision of information to management to assist strategic policy formulation and achievement. It emphasises the need to provide the user with a set of information which addresses all relevant areas of performance in an objective and unbiased fashion. The information provided may include both financial and non-financial elements, and cover areas such as profitability, customer satisfaction, internal efficiency and innovation.’

The traditional performance measure for a business is of course financial, but one problem is that the financial measures relate to the past. The Balanced Scorecard incorporates non-financial measures of the drivers of future performance as well as financial measures of past performance.

The balanced scorecard focuses on four different perspectives, as follows:

Customer – what is it about us that new and existing customers value?
Internal – what processes must we excel at to achieve our financial and customer objectives?
Innovation and learning – how can we continue to improve and create future value?
Financial – how do we create value for our shareholders?

The scorecard is ‘balanced’ in the sense that managers are required to think in terms of all four perspectives, to prevent improvements being made in one area at the expense of another.

Within each of these perspectives a company should seek to identify a series of goals and measures.

The important features of balanced scorecard approach are:

It looks at both internal and external matters concerning the organisation.
It is related to the key elements of a company’s strategy.
Financial and non-financial measures are linked together.

Benefits of the balanced scorecard:

It focuses on factors, including non-financial ones, which will enable a company to succeed in the long-term.
It provides external as well as internal information.

Problems with the balanced scorecard:

The selection of measures can be difficult.
Information overload due to the large number of measures that may be chosen.
Conflict between measures.

Benchmarking

Analysing performance by a single comparison of data (e.g.: current year vs prior year) can be difficult. Benchmarking is a type of comparison exercise through which an organisation attempts to improve performance. The idea is to seek the best available performance against which the organisation can monitor its own performance.

‘Benchmarking is the establishment, through data gathering, of targets and comparators, through whose use relative levels of performance (and particularly underperformance) can be identified. By the adoption of identified best practices it is hoped that performance will improve.’

Benchmarking is an attempt to identify best practices and to achieve improved performance by comparison of operations.

Financial information about competitors is easier to acquire than non-financial information. Information about processes (how an organisation deals with customers or suppliers) is more difficult to find. Such information can be obtained through the following channels:

In intra-group benchmarking, groups of companies in the same industry agree to pool data on their processes. The processes are benchmarked against each other and an ‘improvement taskforce’ is established to undertake strategic benchmarking to identify and transfer ‘best practice’ to all members of the group.
In inter-industry benchmarking, a non-competing business with similar processes is identified and asked to participate in a functional benchmarking exercise. The participants in the scheme are able to benefit from the experience of the other and establish ‘best practice’ in their common business processes.

The reasons for benchmarking may be summarised as:

To receive an alarm call about the need for change
Learning from others in order to improve performance
Gaining a competitive edge (in the private sector)
Improving services (in the public sector)

Approaches to Benchmarking

Three distinct approaches to benchmarking are:

Metric benchmarking – The practise of comparing appropriate metrics to identify possible areas for improvement. For example, IT investment as a percentage of total assets may be compared across different departments within the same company to identify areas of the company where additional investment is required.
Process benchmarking – The practise of comparing processes with a partner as part of an improvement process. For example, a distributor of personal computers may analyse a competitor’s supply chain function in the hope of identifying successful elements of the process that it can use to its advantage.
Diagnostic benchmarking – The practise of reviewing the processes of a business to identify those which indicate a problem and offer a potential for improvement. For example, a company may critically assess each element of the value chain and conclude that there is potential for improvement within the marketing and sales function.

Types of benchmarking

Internal benchmarking – With internal benchmarking, other units or departments in the same organisation are used as the benchmark. This might be possible if the organisation is large and divided into a number of similar regional divisions. Internal benchmarking is also widely used within government.
Competitive benchmarking – With competitive benchmarking, the most successful competitors are used as the benchmark. Competitors are unlikely to provide willingly any information for comparison, but it might be possible to observe competitor performance.
Functional benchmarking – In functional benchmarking, comparisons are made with a similar function (for example selling, order handling, despatch) in other organisations that are not direct competitors.
Strategic benchmarking – Strategic benchmarking is a form of competitive benchmarking aimed at reaching decisions for strategic action and organisational change. Companies in the same industry might agree to join a collaborative benchmarking process, managed by an independent third party such as a trade organisation. With this type of benchmarking, each company in the scheme submits data about their performance to the scheme organiser. The organiser calculates average performance figures for the industry as a whole from the data supplied. Each participant in the scheme is then supplied with the industry average data, which it can use to assess its own performance.

Benchmarking – the Disadvantages

There a number of potential disadvantages that businesses should consider prior to performing a benchmarking exercise.

Businesses may experience difficulties in deciding which activities to benchmark.
Businesses may find it difficult to identify the ‘best in class’ for each activity.
It is often difficult to persuade other organisations to share information.
Successful practices in one organisation may not transfer successfully to another.
There is a risk of drawing incorrect conclusions from inappropriate comparisons.

The building block model – Performance evaluation in Service industry

The building block model is based on three building blocks:

Dimensions
Standards
Rewards

Dimensions

Dimensions are the goals for the business and suitable measures must be developed to measure each performance dimension. Dimensions are the areas that yield specific performance metrics for a company.

The six dimensions in the building block model can be split into two categories:

downstream results (competitive and financial performance) and
upstream determinants (quality of service, flexibility, resource utilisation and innovation) of those results.

The last four are the drivers of the top two.

Standards

Standards are the targets set for the metrics chosen from the dimensions. To ensure success it is vital that employees view standards as achievable, fair and take ownership of them.

Rewards

Rewards are the motivators for the employees to work towards the standards set. The reward system should be clearly understood by the staff and ensure their motivation. The rewards should be related to areas of responsibility that the staff member controls in order to achieve that motivation.