Analysis of determinant factors of a company s performance

Transcription

1 Analysis of determinant factors of a company s performance Author: Gabriela Loagă Abstract: The purpose of this paper is to present the concept of performance and to identify the methods to measure the performance, in the attempt to answer to one question: which are the factors that determine the performance of a company? More specifically, I have tried to determine the extent to which accounting information contained in financial indicators has an impact over the total shareholder return. Chapter 1. Performance concept There is no universally recognized definition of performance, the concept of performance has many meanings, as it is perceived differently by each of us: performance is success; performance is the result of an action; performance is a state of competitiveness of the company, achieved trough a level of effectiveness and efficiency that ensures a sustainable market presence. There are three main guidelines in the definition of performance: definition of performance depending on the level of achievement of a company strategic objectives; definition of performance based on creation of added value; definition of performance based on productivity and business effectiveness. In my opinion, firm performance is achieved by balancing and merging the four forces : the efficiency of production processes, satisfying shareholders, ensuring customer satisfaction and company growth and development capacity, degree of innovation and use of opportunities. Chapter 2. Approaches regarding the methods of determining firm performance In this chapter, I have made a short review of the main theories on the company's objectives and the major studies regarding the determinant factors of firm performance.

2 1) The industry theory originates from the works of E. S. Mason (1939) and J. S. Bain (1951, 1956) - who believed that a firm is performant if it can achieve better market positioning and can maintain at that level through various entry barriers (R. Caves, M. Porter (1997)). The theory claims that certain industrial sectors tend to lead to an increase in the performance of all companies, while others cause a decrease in performance. 2) The Chicago School - firm-specific effects (differences in efficiency) must be considered the principal determinant of the performance of those firms, while their effects industry should play a minor role. 3) The resource theory (B. Wernerfelt, 1984 J. Barney, 1991) considers that the market of production factors (J. Barney, 1986), rather than the market of products (M. Porter, 1980) defines corporate success. M. Porter (1991) criticizes this approach that seeks the separation of managerial decisions from their company sectors of activity. Performing firms have the best resources and the best skills that enable them to produce in an effective and / or efficient manner offers that are valued by company s clients (S. Hunt, 2000, 1998). 4) Robert Kaplan and David Norton (1990) have proposed a system of performance measurement, named Balanced Scorecard, to complement financial measures of past performance with measures to ensure future performance. The objectives and measures of this model are derived from the vision and strategy of the organization and its performance is analyzed from four perspectives: financial results, customers, internal business processes, and learning and growth. 5) Fama and Jensen (1985) studied the impact of the organization form over the investment decision rules. According to Fama and Jensen's assumptions, we can say that the listed companies, regardless of their form of management, must comply with the principle of maximizing the company s value. 5.1) Maximizing the value of equity (or return on equity) - the most frequently encountered in the financial theory and leads to performance appraisal from the shareholders point of view. The indicators should be considered depending on the market value of capital. The method for determining the performance must be adjusted to risk. The Jensen's theory (2001) says that the company's manager must take the best decision to maximize firm value, is sustained also by Marsh (1999), Arnold (1998) who agree that the primary objective of the company s management is to increase the shareholders equity (the shareholders' theory). 2

3 5.2) Maximizing the total value of the firm (or economic return), differs in comparison to the first approach from the following aspects: - for the same value of the firm, the distribution may be made in favor of creditors, so at the expense of shareholders, or vice versa (first goal) - Fama and Miller (1972) and Fama (1978). - Jensen and Meckling (1976), Galai and Masulis (1976) - shareholders may be interested in the most risky investments, even if they conflict with the objective of maximizing the value of firm. The stakeholder theory argues that managers must make decisions taking into account the interests of all stakeholders of the company. Because the proponents of this theory do not specify how to reconcile potential conflicts of interest of stakeholders, managers are unable to make decisions for a particular purpose and thus they can not be responsible and accountable for their actions. If a manager is required to maximize profit, market share, increase future profits and any other objective, then the manager will be in no position to make a decision. Therefore, the manager will not have objectives. Wallace says that if a company has obtained added value for its shareholders is unlikely to meet other interest groups. Jensen (2001) and Rappaport (1998) also sustain this idea. Rappaport says that maximizing the equity value must not conflict with stakeholder approach, if this process is linked to socially responsible business conduct. Chapter 3. Measurement of firm performance 3.1 Financial indicators and non-financial indicators In this chapter, I underline the fact that financial indicators are absolutely necessary, but not sufficient in assessing a company's overall performance. Ittner, Larcker and Randall (2003) say that there is no study showing whether the application of non-financial performance indicators (eg Balanced Scorecard) has resulted in superior performance. However, Chenhall 3

4 (1997), which correlates the presence of non-financial indicators to the incentive system, notes a significant increase in performance. Behn and Riley (1999) found a direct link between customer satisfaction and future performance of hotels and transport companies. Najar and Rajan (2001) have examined the relationship between future sales and nonfinancial indicators of industry companies from Jordan, and concluded that the two types of indicators are complementary in assessing the future volume of sales. 3.2 Measurement of financial performance based on accounting information In this chapter, I have presented two of the most used indicators calculated ex-post ROE and ROI, with emphasys on their advantages and disadvantages. 3.3 Performance measurement trough the rates method The financial rate of return depends on the commercial rate of return (the commercial policy), the economic rate of return (efficiency of capital employed), but also on the policy and the financial structure of the company. 3.4 Performance measurement based on financial market criteria The chapter presents the main modern financial ratios used in evaluating the financial performance of companies: Q Tobin, Marris Rate, Total shareholder return, Sharpe Rate, Treynor Rate, Jensen Rate, MVA and EVA. Here are also presented the main advantages and disadvantages of each indicator. O`Byrne (1996) developed a theory in his attempt to test whether EVA is systematically related to market value. He said that EVA should provide a better prediction of market value than other measures of performance. Garvey and Milbourn (2000) said that the degree of correlation between indicators that measure the value added and market value of capital is a relevant factor in choosing benchmarks for granting bonuses and incentives. D. Cormier, M. Magnan and D. Zeghal have made an empirical study on a sample of 300 companies from France, Switzerland and the USA; the conclusion - the most relevant financial performance indicators are: net income, operating cash flow, operational result, the residual result and the value added. 4

5 G.C. Biddle, Bowen R.M. and Wallace J.S. (2007) - study of a sample of 775 American companies; findings: the indicator that best explains the variation of the excess return obtained from holding company shares compared with average market return is the income tax, followed by economic profit. The theory of relevance of accounting information (Goodwin R, Ahmed M and N. Sawyer, 2004). When information becomes public, it is an important signal for all investors. Goodwin, Sawyer and Ahmed (2004) assume that the price formation process depends on the emergence of information and how it is filtered in company accounts. Lev (2006) - the relevance of accounting-financial indicators for shareholders is influenced by the quality of accounting information. Most studies (G. Feltham, Ohlson L. 2001, Biddle, Bowen and Wallace 2007, Moehrle F. Reynolds and Wallace 2008) that have tested the relevance of financial accounting information are based on assumptions that the company's shares are traded on an efficient market. Researchers like R. Schmalensee (1975), B. Wernerfelt and C. Montgomery (1988), R. P. Rumelt (1991) have concluded in their studies that the sector of activity explains around 12-20% of the variation of company s performance, while the diversification does not have significant effects, and the company's market share had a significant effect, but marginal. On the contrary, other researchers like Hansen și Wernerfelt (1989), RJ. A. Roquebert (1996), A. McGahan and M. Porter (1997), M. P. Michaels and A. J. Mauri (2003) have concluded that specific differences between firms have explained most of the variation of their performance. Comparing the indicator Q Tobin for diversified firms with that of non-diversified firms, Lang and Stulz (2000) showed that the financial market would value more the less diversified firms. Chapter 4. Description of the database This study aims to identify to what extent is explained the profitability of the market shares of firms listed on U.S. stock market by the financial-accounting indicators. The sample contains 34 companies with main activity in the IT sector, which are included in the major size categories (from 8 to 10); there were selected only those companies with financial year ending in December, thus leading to a relatively small number of firms to be analyzed. The financial- 5

6 accounting indicators are calculated using information available in accounting reports of companies for three consecutive years: The selected financial indicators are: Total shareholder return - TSR (Rappaport, 1986) dependent variable; Independent variables: Gross profit margin (MBE); Growth rate in sales (CCA); Net current assets (ACRnete); Rate of tangible assets; Weight of intangible assets in total assets; Financial Leverage; Earnings per share (EPS); Operating cash-flow (CFE); Return on investment (ROI);Return on assets (ROA); Return o equity (ROE); Working capital ratio; MB - Market to book ratio Chapter 5. Research methodology Testing the correlation between the size of the selected accounting indicators and the TSR obtained by the shareholders of the analyzed companies was achieved through the regression model represented by the equation: R t =β 0 + β 1 * X t-1 + β 2 * (X t - X t-1 )+u t where: R t = TSR for financial year t; X t = financial indicator calculated for financial year t; β = regression coefficient; u t = residual term for financial year t. Chapter 6. Results For year 2008 the regression equation is: 6

7 TSR = *ACRNETE_CA *ANCORP_A *CCA *CFE *EPS *LEVIERUL *MB *MBE *RATA_AI *RATA_FR *ROA *ROE *ROI The conclusions resulted from testing the data for year 2008 are: - Indicators that have an impact on the level of TSR are: Financial leverage, Market to Book ratio (MB) and weight of intangible assets in total assets. The information contained in these financial indicators is relevant for investors in U.S. capital markets, the change in their size having an impact on the size of TSR. - An increase of 1% recorded by the indicator Financial leverage causes a 0.17% decrease in the TSR. Also to an increase of 1% recorded by the MB causes a 0.07% increase in the TSR, and the increase by 1% recorded by the weight of intangible assets in total assets will generate a 1.54% increase of TSR. - The three indicators explain a proportion of 46.6% (R 2 -adjusted) the variance of TSR variability at the level of the sample studied. - No other tested financial indicator is relevant (p-value is less than 5%), which means that there is little correlation between the total shareholder return obtained by investors in the capital market with the firm performance expected by them, taking as reference the evolution of the accounting and financial indicators. - The result of Durbin-Watson test is 2.07, close to the value of 2, which indicates no autocorrelation between the residual terms. - Also for the Q-statistic test, the results showed no autocorrelation between the residuals because the p-value associated to estimated values (for different time lags of the residual) are high. - The White test reveals a p-value greater than 0.05, hence the residual terms are homoskedastics. From the study of the correlation matrix, resulted that the strongest links are established between ROI and ROA (0.97) between Gross operating margin and ROA (0.89), followed by the link between Gross operating margin and ROI, the link between ROI and EPS (0.86) and 7

8 ROA (0.85) and the link between ROA and EPS. By eliminating the three factors ROI, EPS and Gross operating margin, it results the regression with Adjusted R 2 of 0.42 and only two relevant factors: MB and Weight of intangible assets in total assets. The study of the correlation matrix for year 2009 shows that the strongest links are established between ROI and ROE (0.77), between ROE and MB (0.70), followed by those between ROI and ROA (0.68) and Gross operating margin (0.63). Of all indicators, TSR is best correlated with MB (0.34). Eliminating the two financial indicators ROI and ROE, results the following regression equation for 2009: TSR = *ACRNETE_CA *ANCORP_A *CCA *CFE *EPS *LEVIERUL *MB *MBE *RATA_AI *RATA_FR *ROA The conclusions resulted from testing the data for year 2009 are: - Indicators that have an impact on the level of TSR are: Market to Book ratio (MB) and working capital ratio. The information contained in these financial indicators is relevant for investors in U.S. capital markets, a change in their size having an impact on the size of TSR. - Thus, an increase of 1% recorded by the indicator working capital causes a decrease by 0.85% of the TSR. Also to an increase of 1% recorded by the MB causes a 0.33% increase of TSR. - The two indicators explained a much smaller proportion (adjusted-r 2 is only 0.20) the variability of TSR in the studied sample, compared with No other tested financial indicator is relevant (p-value is less than 5%), which means that there is little correlation between the total shareholder return obtained by investors in the capital market with the firm performance expected by them, taking as reference the evolution of the accounting and financial indicators. - The result of Durbin-Watson test is 2.15, close to the value of 2, which indicates no autocorrelation between the residual terms 8

9 The study of the correlation matrix for year 2010 shows that the strongest links are established between ROI and ROE (0.79), between ROI and MBE (0.78). Of all indicators, TSR is best correlated with MB (0.68). By eliminating the financial indicator ROI, it results the following regression equation for 2010: TSR = *ACRNETE_CA *ANCORP_A *CCA *CFE *EPS *LEVIERUL *MB *MBE *RATA_AI *RATA_FR *ROA *ROE According to test performed on the 34 companies in the sample, the explanatory power of MB increases more - adjusted R 2 is 0.57, and an increase of 1% recorded by the MB causes a 0.06% increase in the TSR. No other financial indicator has turned out to be relevant. Durbin- Watson test result is 2.17, close to the value 2, which indicates no autocorrelation between the residuals. Jarque-Bera test shows a p-value associated with the estimated value of the test of 0.43, higher than 0.05, so we do not reject the null hypothesis of normal distribution of residual terms resulting from the regression equation. Chapter 7. Conclusions and recommendations After these tests were realized, very few selected key financial indicators have resulted as being relevant in terms of the information contained, concerning the future performance of analyzed companies. In addition, they were not maintained from one period to another, except the financial indicator MB, but its explanatory power varies significantly from one year to another. Therefore, we can not consider this as an useful reference for the management of these firms in managing their business and maximizing the value of equity. There are various studies according to which capital market investors do not consider as relevant the information contained in the accounting performance indicators. Therefore, they do not base their investment decision by considering the available information in financial reports. Inconclusive results of tests performed may be the effect of selection for the analysis of a set of financial indicators which are not in fact considered when investors are making investment decisions. 9

10 This inconvenience can be overcome by resorting to a more extensive database of financial indicators, respectively non-financial indicators, measuring this way a wider range of information available to investors on the capital market. Given the complex nature of the causality relations between financial indicators, it is difficult to separate the direct influence that each of them have on the level of TSR (as tested with the regression equation). The period for which the data were available could be considered a special one, given the international financial crisis that began in late 2008, with considerable negative impact on the activity of companies in the following year and a sensible comeback in year In conclusion, it is impossible to use a single measure of financial performance, given the complex and diverse nature of economic processes of the companies and of the economy as a whole. Bibliography - Anamaria Ciobanu, Analiza performanței întreprinderii, Editura ASE, I. Stancu Finanțe - Teoria pieţelor financiare, Finanțele întreprinderilor, Analiza și gestiunea financiară, Ed. Economică, Niculescu M., Lavalette G., Strategii de creștere economică, Ed. Economică, București, Alazadarc S. Controle de gestion, Ed. Dunod, M. Niculescu - Diagnostic global strategic, Ed. Economică, București, M. Ristea - Contabilitatea rezultatului întreprinderii Ed. Tribuna Economică, București - Behn, Bruce K., Jr. Richard A. Riley (1999) - Using Nonfinancial Information to Predict Financial Performance: The Case of the U.S. Airline Industry - Journal of Accounting, Auditing & Finance - Najar, V. și Rajan, M., "The revenue implications of financial and operational measures of product quality", The Accounting Review, Vol. 76, No. 4, (2001) - Saborowski J., Cancino J. (2007) - "About the benefits of poststratification in forest inventories". - Vintilă G Gestiunea financiară a întreprinderii -White, H., 1980, A heterroskedasticity-consistent covariance matrix estimator and direct test for heteroskedasticity, Econometrica 48, pp

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