Performance Management

Transcription

1 UNIVERSITY OF PAVIA Performance Management Chiara Demartini Master in International Business and Economics 1

2 Lectures and Test Lectures: Tuesday hr Room 15 Wednesday hr Room F Office hours: Mondays hr Written test: 18/01/ /02/2016 Tutor: Mr Davide Grillo 2

3 Structure of the module and materials First part: Principles of Financial Accounting Principles of Financial Statement Analysis Teaching notes Second part: Performance Management Teaching notes & Demartini C. (2013), Performance Management Systems. Design, Diagnosis and Use, Springer, Berlin. 3

4 Module grading Module grading: 30% case studies and other assessments over the module 30% presentation of a company s performance management system 40% written test 4

5 Part One: Principles of Financial Accounting Master in International Business and Economics 5

6 Financial Accounting Financial Accounting provides information: 1. primarily to people outside the company 2. that would be helpful in attracting capital Equity and debt (useful in debt contracts) Credit from suppliers Customers Employees 3. helpful in monitoring and evaluating management performance 6

7 Aims of Financial Accounting Resources flow: tomorrow Stakeholders: Present and potential investors Employees Suppliers Economic resources, claims to those resources and changes Information Resources flow: today Company 7

8 Financial accounting Financial accounting translates events into financial statements Events Rules & management choice Accounting Principles Financial statements GAAP Generally Accepted Accounting Standards IFRS International Financial Reporting Standards 8

9 IFRS 1 The objective of this IFRS is to ensure that an entity s first IFRS financial statements, and its interim financial reports for part of the period covered by those financial statements, contain high quality information that: (a) is transparent for users and comparable over all periods presented (b) provides a suitable starting point for accounting in accordance with International Financial Reporting Standards (IFRSs) (c) can be generated at a cost that does not exceed the benefits. 9

10 Delivery of financial information Demand for independence: Accounting enters objective, verifiable information into accounting records Information produced by managers alone is not believable. Outside investors demand independently audited financial information In the process, accounting misses out on forwardlooking information that might be valuable, but lacks objective evidence (e.g., research in progress) 10

11 Asymmetry in financial reporting Faced with uncertain bad news, accounting tends to enter it into the records Asymmetric treatment of good and bad news Faced with uncertain good news, tendency to ignore it Why? Demand for bad news Creditors with no upside, but all the downside Investors believe bad news disclosed by management, but sceptical of good news unless supported by objective evidence Management incentives affect credibility of their disclosures 11

12 International Financial Reporting Management letter The Annual Report Financial Statements Auditors report 12

13 The Auditors Report GAAS (Generally Accepted Auditing Standards) Actual opinion Reasonable assurance that financial statements are free of material misstatement Financial statements present fairly the financial position, the results of operations, etc. Assess the accounting principles used and significant estimates made by management Compliance with GAAP (Generally Accepted Accounting Principles) 13

14 The Auditors Report Management responsible for the preparation and integrity of the financial statements, etc. Statements prepared in accordance with GAAP. Estimated amounts based on management's best estimates and judgments. Maintenance of an internal control system to ensure that assets are safeguarded and transactions are properly authorized, recorded and reported. The Board has an Audit Committee composed entirely of outside directors This committee appoints the auditor who has direct access to the Audit Committee. 14

15 Financial statement auditing The objective of the ordinary audit of financial statements by the independent auditor is the expression of an opinion on the fairness with which they present fairly, in all material respects, financial position, results of operations, and its cash flow in conformity with generally accepted accounting principles. The auditor s report is the medium through which he expresses his opinion or, if circumstances require, disclaim an opinion. (para , AICPA, SAS N. 1, codification of Auditing Standards and Procedures) 15

16 Independence and objectivity «Objectivity is a state of mind, a quality that lends value to a member s services. It is a distinguishing feature of the profession. The principle of objectivity imposes the obligation to be impartial, intellectually honest, and free of conflicts of interest. Independence precludes relationships that may appear to impair a member s objectivity rendering attestation services.» AICPA. 16

17 Audit opinion 1) Unqualifed Opinion 2) Qualified Opinion 3) Adverse opinion 4) Disclaimers of opinion Emphasis of matter 17

18 Basics of double entry bookkeeping: The account All the events related to business transactions should be entered into ACCOUNTS twice. Accounts are the basic founding units of the double entry bookkeeping, which is the accounting methodology to record transactions. Accounts can be analysed according to two main cathegories: either economic (e.g. revenues, expenses) or financial (e.g. payables, receivables) ones. 18

19 The structure of an account DEBIT Euro Purchase a/c CREDIT DEBIT Bank account Euro CREDIT 19

20 Debit or credit an account? Balance Sheet Income Statement 20

21 Accrual & Cash Method There are two main methods of accounting (or bookkeeping): 1. Accrual method 2. Cash method The accrual method of accounting is the preferred method because it provides: a more complete reporting of the company's assets, liabilities, and stockholders' equity at the end of an accounting period, and a more realistic reporting of a company's revenues, expenses, and net income for a specific time interval such as a month, quarter or year. As a result, US and Italian GAAP requires most corporations to use the accrual method of accounting. 21

22 Accrual v Cash Method The following table compares the accrual and cash methods of accounting: 22

23 Financial statement The financial statements must "present fairly" the financial position, financial performance and cash flows of an entity. (IAS 1) It contains primarily historical information Balance Sheet Assets, liabilities & owners equity Income Statement Revenue (-) Expenses = Net Income Statement of changes in equity and retained earnings Cumulative sum of undistributed profits Statement of cash flows Operating, Investing and Financing activities Footnotes Significant accounting policies, estimates, etc. 23

24 Going Concern Principle The Conceptual Framework notes that financial statements are normally prepared assuming the entity is a going concern and will continue in operation for the foreseeable future. (IAS 1) If management has significant concerns about the entity's ability to continue as a going concern, the uncertainties must be disclosed. 24

25 Balance sheet Financial Statements: Balance Sheet Statement of the financial position of a business as of a certain date. Assets Resources owned by a corporation, e.g., cash, accounts receivable, equipment, land Liabilities amounts/services owed by the company, e.g., loans payable, accounts payable, customer advances, etc. Stockholders equity initial investment by the owners Plus the cumulative sum of undistributed profits (retained earnings). ACCOUNTING EQUATION ASSETS LIABILITIES EQUITY 25

26 Minimum line items (a) property, plant and equipment (b) investment property (c) intangible assets (d) financial assets (excluding amounts shown under (e), (h), and (i)) (e) investments accounted for using the equity method (f) biological assets (g) inventories (h) trade and other receivables (i) cash and cash equivalents (j) assets held for sale (k) trade and other payables (l) provisions (m) financial liabilities (excluding amounts shown under (k) and (l)) (n) current tax liabilities and current tax assets, as defined in IAS 12 (o) deferred tax liabilities and deferred tax assets, as defined in IAS 12 (p) liabilities included in disposal groups (q) non-controlling interests, presented within equity (r) ASSET SIDE LIABILITY AND EQUITY issued capital and reserves attributable to owners of the parent. SIDE 26

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28 Financial Statements: Income Statement Income statement measures the performance of a company over a period of time Expenses A measure of economic sacrifices incurred to earn the revenues of a given period Revenues A measure of economic benefits generated by the sale of products or providing of services over a period of time Net income Revenues Expenses 28

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30 Dividends Are dividends paid to owners considered an expense? Owners are residual claimants Dividends are distributions to the owners out of the profits earned by the business In determining accounting profits to the residual owners, we only subtract the costs of all factors of production, e.g., physical capital (depreciation), human capital (salaries), debt capital (interest cost), etc. Dividends are not a factor of production 30

31 Financial Statements: Retained Earnings and Shareholders Equity Retained earnings A measure of undistributed profits of a business Do not include capital contributed by owners Retained earnings = Cumulative sum of profits earned from the inception of business (-) Cumulative sum of all dividends distributed to the owners from the inception of business Statement of shareholders equity describes the change in retained earnings over a period of time (e.g., a year) Beginning balance in retained earnings Net income earned Dividends distribute d Ending balance in retained earnings 31

32 Financial Statements: Retained Earnings and Shareholders Equity 32

33 Financial Statements: Statement of Cash Flows The statement of cash flows details the enterprise s cash flows. This operating statement reveals how cash is generated and expended during a specific period of time. (a) operating activities (b) investing activities (c) financing activities 33

34 Financial Statements: Statement of Cash Flows Cash received from customers Inventory Purchased Cash Paid for Inventory Cash Paid for Salaries and Wages Total Sales minus the increase in Net Receivables (or, plus a decrease in net receivables) Cost of Goods Sold minus the decrease in Inventory (or, plus an increase in inventory) Inventory Purchased minus the increase in Accounts Payable (or, plus a decrease in accounts payable) Wages Expense Plus the Decrease in Wages Payable (or, minus an increase in wages payable) Cash paid for Taxes, interests and other normal business expenses (a) operating activities (b) investing activities (c) financing activities 34

35 Financial Statements: Statement of Cash Flows Cash inflows from sales of assets Cash outflows for purchase of assets Disposal of long-term assets (Land, Building, Equipment, Brands), sales of investment bonds or stocks, or loans to other companies etc. Payment for acquiring long-term assets (Land, Building, Equipment, Brands, etc.) or longterm investments in other firms (a) operating activities (b) investing activities (c) financing activities 35

36 Financial Statements: Statement of Cash Flows Cash inflows Cash outflows Stock or bonds issuing, borrowing under loans Repayment of borrowings, acquisition of treasury stock, dividend distribution (a) operating activities (b) investing activities (c) financing activities 36

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40 Further information No dividends were due or paid on the $300,000 of preferred stock which was issued in exchange for a building in late 20X5. Average common equity is assumed to be $2,095,000 ((($2,910,000 - $300,000) + $1,580,000)/2). Assume most other balance sheet items change uniformly throughout the year (e.g., average receivables = ($600,000 + $850,000)/2 = $725,000, etc.). The year-end market value of the common stock was $10 per share, and the cash dividend was paid on shares outstanding at the end of the year ($50,000/910,000 shares = $0.055 per share). 40

41 Financial Statements: Statement of Cash Flows 41

42 Financial Statements Linkages Income statement, statement of retained earnings, and balance sheet articulate. The income for the period ties into the statement of retained earnings Income statement Statement of retained earnings the ending retained earnings ties into the balance sheet. This final tie-in causes the balance sheet to balance. Balance Sheet 42

43 Part One: Principles of Financial Statements Analysis Master in International Business and Economics 43

44 Financial Statements Analysis Investors must be very thorough in examining the financial statements of companies in which they are considering making an investment. Sometimes, the evaluation of complex situations can be assisted by the use of key metrics or ratios. LIQUIDITY RATIOS DEBT SERVICE RATIOS TURNOVER RATIOS OTHER INDICATORS PROFITABILITY RATIOS 44

45 Liquidity Ratios CURRENT QUICK Ability to meet near time obligations Narrower than Current Ratio Current Assets Current Liabilities (Cash+Short-term investment+receivables) Current Liabilities 45

46 Debt Service Ratios Debt to Total Assets Debt to Total Equity Times Interests Earned Percentage of TA financed by long-term and short-term debts Proportion of financing that is debt related Ability to meet interest obligations Total Debt Total Assets Total Debt Total Equity Income before Income taxes and Interests Interest charges 46

47 Based on this information alone, which company would likely obtain the less favorable interest rate on additional debt financing? 47

48 Turnover Ratios ACCOUNT RECEIVABLE TURNOVER Frequency of collection cycle INVENTORY TURNOVER Frequency of inventory rotation Net Credit Sales Average Net Accounts Receivable Cost of goods sold Average inventory 48

49 Profitability Ratios Net Profit on Sales Gross Profit Margin Return on Assets Return on Equity Profitability on sales; for comparison and trend analysis Gross Profit Rate Assets utilisation in producing returns Effectiveness of equity invested in producing returns Net income Net sales Gross Profit Net sales Net income + interest expense Total Assets Net income Preferred Dividends Avg common E 49

50 Other Indicators EPS P/E Dividend rate yield Amount of earnings attributable to a single common share Price of stock in relation to EPS Yield to investors through dividend payments Income N. Of common shares Market price PS EPS Annual Cash Dividend Market price PS 50

51 Other Indicators Dividend Payout Ratio Book Value Proportion of earnings distributed as dividends The amount of shareholders equity per common share outstanding Annual Cash Dividend EPS Common Equity Common share outstanding 51

52 Horizontal Analysis Horizontal analysis, also called trend analysis, refers to studying the behavior of individual financial statement items over several accounting periods. These periods may be several quarters within the same fiscal year or they may be several different years. ABSOLUTE VALUE ANALYSIS PERCENTAGE VALUE ANALYSIS 52

53 Absolute v Percentage Analysis Absolute Analysis Financial statement users with expertise in particular industries might evaluate amounts reported for research and development costs to judge whether a company is spending excessively or conservatively. Users are particularly concerned with how amounts change over time. Percentage Analysis It involves computing the percentage relationship between two amounts. Percentage analysis sidesteps the materiality problems of comparing different size companies by measuring changes in percentages rather than absolute amounts. 53

54 Horizontal Analysis 54

55 Vertical Analysis Vertical analysis uses percentages to compare individual components of financial statements to a key statement figure. Horizontal analysis compares items over many time periods Vertical analysis compares many items within the same time period. 56

56 Vertical Analysis of the Income Statement Vertical analysis of an income statement (also called a common size income statement) involves converting each income statement component to a percentage of sales. Although vertical analysis suggests examining only one period, it is useful to compare common size income statements for several years. 57

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58 Vertical Analysis of the Balance Sheet Vertical analysis of the balance sheet involves converting each balance sheet component to a percentage of total assets. Even small individual percentage changes, however, may represent substantial dollar increases. 59

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60 Limitations of Financial Statement Analysis External users can rely on financial statement analysis only as a general guide to the potential of a business. They should resist placing too much weight on any particular figure or trend. Many factors must be considered simultaneously before making any judgments. The analysis techniques discussed are all based on historical information. Future events and unanticipated changes in conditions will also influence a company s operating results. 61

61 Sources of Limitations of Financial Statement Analysis Different Industries Changing Economic Environment Accounting Principles Different industries may be affected by unique social policies, special accounting procedures, or other individual industry attributes. When comparing firms, analysts must be alert to changes in general economic trends from year to year. Two particular concepts, conservatism and historical cost, have a tremendous impact on financial reporting. 62

62 Groupwork 63

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