Financial Statement Analysis And

Valuation

- Dr. Pratapsinh L. Chauhan

- Dr. Vishal G. Patidar

Preface

Financial Statement Analysis and Valuation is an introduction to the concepts, tools, and

applications of financial decisions. The purpose of this textbook is to communicate the

fundamentals of financial management and financial decision analysis. This textbook is

written in a way that will enable students understand financial decision-making and its

role in the decision-making process of the entire firm. An important aspect of financial

statement analysis is determining relevant relationships among specific items of

information. Companies typically present financial information for more than one time

period, which permits users of the information to make comparisons that help them

understand changes over time. Rupee and percentage changes and trend percentages are

tools for comparing information from successive time periods. Component percentages

and ratios, on the other hand, are tools for establishing relationships and making

comparisons within an accounting period. Both types of comparisons are important in

understanding an enterprise's financial position, results of operations, and cash flows.

Authors prudently compose the book in such a way that different groups of users of

financial statements get detailed coverage on Financial Statement and its Valuation

Techniques. In this book various techniques like, Profitability analysis, working capital

analysis, activity analysis, analyzing financial performance of bank, economic value

added, balance score card analysis and value based management has been explained with

suitable illustrations.

Contents

1. Financial Statement Analysis – An Introduction

2. Working Capital Analysis

3. Activity Analysis

4. Profitability Analysis

5. Productivity Analysis

6. Analyzing Financial Performance of Banks

7. Economic Value Added – A Tool for Performance Management

8. Balance Score Card

9. Value Based Management

Chapter – 1

Financial Statement Analysis – An Introduction

• Concept of Financial Statements

• Types of Financial Statements

• Need of Financial Statements

• Objectives of Financial Statements

• Importance and Usefulness of Financial Statements

• Tools of Financial Statement Analysis

• Limitations of Financial Statements

• Concept of Financial Analysis

• Need and Aims of Financial Analysis

• Illustration

• References

Concepts of Financial Statements:

Financial statements represent a summary of the financial information prepared in the

required manner for the purpose of use by managers and external stakeholders. Financial

reports are prepared basically to communicate to the external shareholders about the

financial position of the company that they own. Financial statement analysis is useful

both to help anticipate future conditions and, more important, as a starting point for

planning actions that will improve the firm’s future performance. Financial statement

analysis generally begins with a set of financial ratios designed to reveal a company’s

strengths and weaknesses as compared with other companies in the same industry, and to

show whether its financial position has been improving or deteriorating over time.

Financial statements provide an overview of a business financial condition in both short

and long term.

In the words of Hampton, “A financial statement is an organized collection of data

organized according to logical and consistent accounting procedures." Therefore, all the

statements and accounting reports which the accountants prepare at the end of a period

for a business enterprise may be taken as financial statements. But the principal financial

statements are the `balance sheet’ and the `profit and loss account'. In the word of

Howard and Upton, " Although any formal financial statements expressed in money

values might be thought of as financial statements, the term has come to be limited by

most accounting and business writers to mean the `balance sheet' and the `profit and loss

statements'.” The balance sheet states the assets, liabilities and capital of the business and

profit and loss statements shows the results of operations achieved during a certain

period. These financial statements may be of various types, but according to Miller all

the financial statements may be broadly classified in the following manner:

1. The audited statement

2. The interim statement

3. The un-audited year-end statement

4. The "estimated" statement

Accounting, which is the process of evolution, has three phases : (i) the recording of

transaction in the books of original entry, (ii) the classification of these transaction in

ledger, and (iii) the summarization of the records. The construction of the financial

statement is a part of the third phase of accounting techniques. Thus, financial

statements summarized periodical reports of financial and operating data accumulated

by an enterprise in its books of accounts. The accounting figures which are collected,

tabulated and summarized by accounting methods are presented in financial statements.

By nature, therefore, the financial statements are the end products of financial accounting

or they are the final repositories of all accounting figures. Financial statements are

periodical statements and the period for which they relate is known as accounting period,

usually of one year's duration.

Financial statement analysis is done to try and predict the future performance of a

company. It is the process of examining relationships among financial statement elements

and making comparisons with relevant information. It is a valuable tool used by investors

and creditors, financial analysts, and others in their decision-making processes related to

stocks, bonds, and other financial instruments. The goal in analyzing financial statements

is to assess past performance and current financial position and to make predictions about

the future performance of a company. Investors who buy stock are primarily interested in

a company's profitability and their prospects for earning a return on their investment by

receiving dividends and/or increasing the market value of their stock holdings. Creditors

and investors who buy debt securities, such as bonds, are more interested in liquidity and

solvency the company's short-and long-run ability to pay its debts. Financial analysts,

who frequently specialize in following certain industries, routinely assess the profitability,

liquidity, and solvency of companies in order to make recommendations about the

purchase or sale of securities, such as stocks and bonds. Analysts can obtain useful

information by comparing a company's most recent financial statements with its results in

previous years and with the results of other companies in the same industry. Three

primary types of financial statement analysis are commonly known as horizontal analysis,

vertical analysis, and ratio analysis.

An important aspect of financial statement analysis is determining relevant relationships

among specific items of information. Companies typically present financial information

for more than one time period, which permits users of the information to make

comparisons that help them understand changes over time. Financial statements based on

absolute value and percentage changes and trend percentages are tools for comparing

information from successive time periods. Component percentages and ratios, on the

other hand, are tools for establishing relationships and making comparisons within an

accounting period. Both types of comparisons are important in understanding an

enterprise’s financial position, results of operations, and cash flows.

Types of Financial Statements:

The time is gone when leaflet or `dance card' type of annual report was considered

sufficient as a folder in which the chairman and accountant `blessed' condensed financial

summaries. But in the present time, the Annual Reports contain financial statements and

the explanation of the various financial results.

There are two major financial statements which are vital to financial analysis and

financial management i.e., profit and loss account and balance sheet. These statements

contain various information’s often needed by various persons interested in the

enterprise such as shareholder, government, debenture holder, management etc. They

convey the financial condition and results of operation of an enterprise for a given period

and at a given date. In the annual report, together with these two statements, there may

be statement or schedules of retained earnings, stockholders, equity statement, capital

surplus fund , cash flow statement etc. Accounting is a language of `Finance' or

`Monetary'. A general search continues to be made for ways to improve readability of

financial statements. A lay man who reds these statements is not able to understand the

terminology used in these statements.

Balance Sheet:

The balance sheet is a statement of assets and liabilities of a firm or what it owns and

what it owes, as on a given date. In a balance sheet, the assets and liabilities are equal to

each other. In the word of Pyle, White and Larson, "A balance sheet is so called because

its two sides must always balance, the sum of the assets shown on the balance sheet must

equal liabilities plus owner equity. According to Block and Hirt, "The balance sheet

indicates hat the firm owns, and how these assets are financed in the form of liabilities or

ownership interest. It is a statement of affairs of an organisation at a point of time and

may be defined as a statement prepared with a view to measuring the financial position

of a business enterprise at a certain fixed date. In reveals the financial position of a

business as reflected by the accounting records and contains a list of assets, liability

and capital items as on a given date. The balance sheet is designed to show the

condition of the business in a form easily readable and more quickly comprehended

than would be possible form a survey of the facts shown in the detailed records. The

intention is to afford the shareholders who have placed their capital in an enterprise and

the creditor who does business with it, an opportunity of estimating from time to time the

financial stability.

A balance sheet is a `status report' and as such it shows `what we have' and from

`where' on the last date of the accounting year. In the word of Dennis, "The simplest

way for a layman to understand this is to think of balance sheet as a statement of the

`sources of funds' and a statement of the `deployment of funds'. It is always presented

at a definite date highlighting the bird's eye-view of the financial statements. It is

a statistical statement which shows the purpose of business at a certain moment of time.

The balance sheet is also known as `Statement of Financial Condition', `Statement of

Financial Position', `Statement of Assets and Liabilities', `Statements of

Resources and Liabilities', Statement of assets, Liabilities and Capital', `Statement of

worth', and `Financial Statement'. It is an instantaneous photograph of assets, liabilities

and net worth.

According to Hastings, "It reveals the property owned by the business, the assets and

the debts owned by the company, the liabilities."

Income Statements:

The income statement, usually designated as profit and loss account for the relevant

financial year, shows the net profit or net loss resulting from the operations of

business during a special field period of time. The items appearing in it are in the

nature of `revenue'. In the words of Walgenbach, Dittrich and Hanson, "To show the

results of operations for a period, an income statement is prepared, which lists the

revenues and expenses and presents the resulting net income amount." Foulke defines

income statement as "the mathematical interpretation of the policies, experience,

knowledge, foresight, and aggressiveness of the management of a business

enterprise from the point of view of income, expenses, gross margin, operating profit,

and net profit or loss." It provides a review of the factors directly concerned with the

determination of the net income- the revenue realised from the sale of goods or services

and the costs incurred in the process of producing the revenue.

The income statement summarises the changes that have taken place since the date of

preceding balance sheet and that have affected the owner's share in the business either

by gain or loss. It is a performance report recording the changes in income, expenses,

profit and loss as a result of business operations during the year between two balance

sheet dates. According to Guthmann, "The balance sheet might be described as

financial cross sections taken at certain intervals and earnings statements as condensed

history of the growth or decay between the cross sections." The income statement

suggests a long range view of a business and shows where it is going.

Statement of Retained Earnings:

The statement of retained earnings indicates the magnitude and causes of changes in

retained earnings of the enterprise due to year's activities. Retained earnings represent the

sum of the earnings which have been kept by the enterprise over the years that is earnings

not paid out in dividends. As defined by Walgenbach and Dittrich, "a retained

earnings statement is an analysis of the retained earnings accounts for the accounting

period and is usually presented with the other corporate financial statements." The

statement of retained earnings serves as the link between the income statement and the

balance sheet. Thus, changes in equity accounts between balance sheet dates are reported

in the statement of retained earnings. The retained earnings shown in the statement of

retained earnings are

retained by the enterprise primarily to expand business.

Statement of Changes in Financial Position:

The statement of changes in financial position is a logical adjunct to the balance sheet

and income statement. It has only recently become a required component of published

corporate report, equal in status to the balance sheet and the income statement.

According to Granof, "The statement of changes in financial position is most

commonly used to indicate changes during the year in the companies' working capital

position.

The statement of changes in financial position indicates both the sources and application

of working capital. Thus, it reveals the sources from which funds have been received

during the year and these funds were used within the enterprise. According to Hampton,

"This statement shows the movement of funds into the firm's current-asset accounts

from external sources such as stockholders, creditors, and customers. It also shows

the movement of funds to meet the firm’s obligations, retires stock, or pay dividends."

This statement is divided into two parts : I shows sources of working capital and part

II shows application of working capital. The difference in the sources and application

represents either net increase or decrease in working capital. Thus, it portrays the inflow

and outflow of funds. It shows causes of net changes that occur in working capital

between two balance sheet dates. In this way the variation in the flow of funds and their

sources is measurable and usable for financial and operating analysis.

Need of Financial Statements:

During each business day, many transactions occur between a cooperative and its patrons,

suppliers, employees, and customers. To understand and control the entire business

operation, information must be brought together from all parts of the organization.

Managers of individual operations or departments need information on physical units

such as tons of fertilizer or number of auto batteries. However, to manage all operations,

financial records are needed to control the total business. Financially, the performance of

a business is judged as a single unit. Banks look at the total business when lending.

Suppliers want to know about the strength of the total business before granting credit.

Managers and directors use financial information for the entire organization in making

many decisions, including if purchases of new facilities are possible or when member

equity can be redeemed. Members and patrons also have an interest in understanding

cooperative financial statements. Financial strength determines a cooperative’s ability to

control its future and provide services for its members and patrons. Services provided by

a local cooperative can be an important part of members’ operations. Members depend on

financially strong organizations to serve their current and future needs. Members build an

equity investment in their cooperative. Usually cooperatives do not pay dividends on this

investment but redeem the equity upon the board of directors’ decisions. A financially

secure cooperative is able to redeem equity regularly. A financially weak cooperative

may delay equity redemption indefinitely.

Objectives of Financial Statements:

The objective of financial statements is to provide information about the financial

position, performance and changes in financial position of an enterprise that is useful to a

wide range of users in making economic decisions. Financial statements should be

understandable, relevant, reliable and comparable. Reported assets, liabilities and equity

are directly related to an organization's financial position. Reported income and expenses

are directly related to an organization's financial performance.

The Accounting Principles Board of America mentions the objectives of financial

statements as follows:

1. To provide reliable financial information about economic resources and

obligations of a business enterprise.

2. To provide reliable information about in net resources (resources less obligations)

of an enterprise that results from its activities.

3. To provide financial information that assist in estimating the earning potentials of

a business.

4. To provide other needed information about changes in economic resources of

obligation.

5. To disclose, to the extent possible, other information related to the financial

statements that is relevant to the needs of the users of these statements.

In order to meet the above objectives and to suit the needs of the varied users, the

accountant entrusted with the task of compiling and presenting financial statements

must follow a set of guidelines to ensure consistency, completeness, and fairness of the

statements. These guidelines are called "generally accepted accounting principles". In

absence of these `generally accepted accounting principles' the statements prepared may

be un-understandable and misleading for the various groups of users. In addition to this,

the financial statements prepared must also be authenticated as to their accuracy and

fairness so that the confidence of the users is invoked. For this purpose it is necessary

that these statements be reviewed and certified by an independent reviewer, commonly

known as auditor.

Importance and Usefulness of Financial Statements:-

The importance and usefulness of financial statements, from the point of view of various

interested parties, are as follows:

1. Management:

Financial statements are of very great help to management in understanding the progress,

position and prospects of business. Using analogy, it can be said that financial statements

serve the business management as gauges and charts serve the engineer. In the absence

of information’s which are included in the financial statements, management can neither

plan nor fulfill easily the functions of operation and control.

2. Investors:

Financial statements are also significant for investor both present and prospective.

However, the investor looks to the financial position of business concern from a different

angle. Investors are interested in two things - firstly, they want to invest in such a

situation where they feel the financial structure of a company is sound. Secondly,

they want to invest only in such concern whose future is bright. Investor gives first

attention to the profits after taxes in the profit and loss account. In case of prospective

investors, financial statements serve as a mirror reflecting potential investment

opportunity.

3. Bankers:

A banker is primarily concerned with the ability of paying current debts and the current

operation results. He wants not only the payment of advances but he also wants that such

advance should be repaid at proper time also.

4. Government:

Central and State Governments and Local Authorities are also interested in published

financial statements in order to assess their revenues through various taxes to regulate

capital issue and public utility regulation.

5. Research Scholars:

The financial analysts and research workers are interested in published financial

statements for guiding management or for establishing certain principles. A financial

analyst can peep through these statements into the financial policies pursued by the

management and offer constructive suggestions to over come the financial malady, if

diagnosed.

6. Trade Creditors:

From the creditor's point of view the Financial statements act as magic eye highlighting

the credit worthiness, i.e., assurance whether the company will honour obligations as

and when they mature.

7. Labour Unions:

From social justice point of view in the present time, the labour unions may know if the

labour is getting its fair share of business earnings.

8. Public:

Financial statements are also valuable to the public who are interested in prospects of a

concern, in one way or the other. It is the securities of the enterprise alone that are

bought and sold on stock exchanges and the public is interested ,mostly in their

financial standing and also to avoid hostile feelings of the public.

Tools of Financial Statement Analysis:

The commonly used tools for financial statement analysis are:

• Financial Ratio Analysis

• Comparative financial statements analysis:

– Horizontal analysis/Trend analysis

– Vertical analysis/Common size analysis/ Component Percentages

Financial Ratio Analysis

• Financial ratio analysis involves calculating and analysing ratios that use data

from one, two or more financial statements.

• Ratio analysis also expresses relationships between different financial statements.

• Financial Ratios can be classified into 5 main categories:

– Profitability Ratios

– Liquidity or Short-Term Solvency ratios

– Asset Management or Activity Ratios

– Financial Structure or Capitalisation Ratios

– Market Test Ratios

Profitability Ratios

3 elements of the profitability analysis:

• Analysing on sales and trading margin

– focus on gross profit

• Analysing on the control of expenses

– focus on net profit

• Assessing the return on assets and return on equity

Profitability Ratios

• Gross Profit % = Gross Profit * 100

Net Sales

• Net Profit % = Net Profit after tax * 100

Net Sales

Or in some cases, firms use the net profit before tax figure. Firms have no control over

tax expense as they would have over other expenses.

⇒ Net Profit % = Net Profit before tax *100

Net Sales

• Return on Assets = Net Profit * 100

Average Total Assets

• Return on Equity = Net Profit *100

Average Total Equity

Liquidity or Short-Term Solvency ratios

Short-term funds management

• Working capital management is important as it signals the firm’s ability to meet

short term debt obligations.

For example: Current ratio

• The ideal benchmark for the current ratio is Rs. 2: Rs. 1 where there are two Rs.

of current assets (CA) to cover Rs. 1 of current liabilities (CL). The acceptable

benchmark is 1: 1 but a ratio below 1CA:1CL represents liquidity riskiness as

there is insufficient current assets to cover 1 of current liabilities.

Liquidity or Short-Term Solvency ratios

• Working Capital = Current assets – Current Liabilities

• Current Ratio = Current Assets

Current Liabilities

• Quick Ratio = Current Assets – Inventory – Prepayments

Current Liabilities – Bank Overdraft

Asset Management or Activity Ratios

• Efficiency of asset usage

– How well assets are used to generate revenues (income) will impact on the

overall profitability of the business.

For example: Asset Turnover

• This ratio represents the efficiency of asset usage to generate sales revenue

• Asset Turnover = Net Sales

Average Total Assets

• Inventory Turnover = Cost of Goods Sold

Average Ending Inventory

• Average Collection Period = Average accounts Receivable

Average daily net credit sales*

* Average daily net credit sales = net credit sales / 365

Financial Structure or Capitalisation Ratios

Long term funds management

• Measures the riskiness of business in terms of debt gearing.

For example: Debt/Equity

• This ratio measures the relationship between debt and equity. A ratio of 1

indicates that debt and equity funding are equal (i.e. there is Rs.1 of debt to Rs.1

of equity) whereas a ratio of 1.5 indicates that there is higher debt gearing in the

business (i.e. there is Rs. 1.5 of debt to Rs.1 of equity). This higher debt gearing is

usually interpreted as bringing in more financial risk for the business particularly

if the business has profitability or cash flow problems.

• Debt/Equity ratio = Debt / Equity

• Debt/Total Assets ratio = Debt *100

Total Assets

• Equity ratio = Equity *100 Total Assets

• Times Interest Earned = Earnings before Interest and Tax Interest

Market Test Ratios

• Based on the share market's perception of the company.

For example: Price/Earnings ratio

• The higher the ratio, the higher the perceived quality of the earnings by the share

market.

• Earnings per share = Net Profit after tax Number of issued ordinary shares

• Dividends per share = Dividends Number of issued ordinary shares

• Dividend payout ratio = Dividends per share *100 Earnings per share

• Price Earnings ratio = Market price per share Earnings per share

Horizontal analysis/Trend analysis

• Trend percentage

• Line-by-line item analysis

• Items are expressed as a percentage of a base year

• This is a time series analysis

• For example, a line item could look at increase in sales turnover over a period of 5

years to identify what the growth in sales is over this period.

Vertical analysis/Common size analysis/ Component Percentages

• All items are expressed as a percentage of a common base item within a financial

statement

• e.g. Financial Performance – sales is the base

• e.g. Financial Position – total assets is the base

• Important analysis for comparative purposes

– Over time and

– For different sized enterprises

Limitations of Financial Statements:

Financial statements are basically representatives of a business' financial activates. These

are: Balance sheet, Income Statement, Statement of retained earnings and Statement of

cash flows. The nature of figures which are reported and the way in which they are

reported tend to give the impression to the reader that financial statements are precise,

exact and final. Financial Statements are not free from limitations. Following are their

limitations to investors:

• Financial statements only reveal financial position of the company in a

summarized manner. In case of balance sheet it shows the financial position of

business on a particular day usually at the end of financial year.

• Financial statements do not record non-monetary transaction.

• Over time, conditions change and financial statements may not reflect current

market values.

• It is only the starting point of analysis, they do not show clearly the reasons

behind a certain trend, the investors have to search and analyze by themselves.

• Past financial performance does not signify what will happen with the investor in

future

• The financial statements are useless without the notes to the financial statements,

which are complex.

• Unless the statements are audited their authenticity is under doubt and they may

be misleading and fraudulent.

• Financial statements reflect the recorded facts and figures. Hence these are not

useful for control purpose.

• Valuation of inventories, method of depreciation, treatment of expenditure as

capital or revenue etc., are based upon personal judgment.

• These contain some estimated amounts such as provision for doubtful debts etc.

• Balance sheet shows the deferred expenses such as preliminary expenses.

These are not really assets.

• Many a times, consistency is not followed and hence the profitability is not

comparable from year to year.

• Debt-equity ratio as prescribed by the Controller of Capital Issue is not mentioned

in the financial statements.

Concept of Financial Analysis:

Financial analysis is the process of identifying the financial strengths and weaknesses of

the firm by property establishing relationships between the item of the balance sheet and

the profit and loss account. Financial analysis helps to determine smooth operation of the

project over its entire life cycle. The two major aspects of financial analysis are liquidity

analysis and capital structure analysis for which ratios are employed. Liquidity ratios

measure a project’s ability to meet its short-term obligations. Capital Structure analysis is

done to see long term solvency i.e. the project’s ability to meet long-term commitments

to creditors. Information contained in Balance Sheet and Profit and Loss Account

are often in the form of raw data rather than as information useful for decision

making. The process of converting the raw data contained in the financial statements

into meaningful information for decision making is known as financial statement analysis.

Profit and Loss Account is a dynamic statement which shows income and expenses

between two balance sheet dates. Likewise Balance Sheet is a `static' statement that

shows the financial position on a certain date. It is an instantaneous photograph of the

assets and liabilities of an enterprise at a particular unit of time. It is some what similar to

the view one gets when a motion picture projector is stopped and a single frame appears

of the screen.

Financial Analysis is a process of synthesis and intellectual activity. It is a technique of

X-raying the financial position as well as the progress of a company. An analysis of both

these statements gives a comprehensive understanding of business operations and

their impact on the financial health. If the business operations results in profits, the total

investment is enhanced, bringing prosperity to shareholders, increase in goodwill and

strengthening of credit. On the other hand, if these are looses, capital invested to the

extent of loss is lost or dissipated ability to pay creditors and lenders is weakened and the

business concern operates under a `handicap'.

Users of Financial Analysis

Trade creditors

Lenders

Investors

Management

Need and Aims of Financial Analysis:

Need:

Analysis of financial statements is an effort to find answers to a variety of practical and

important questions such as prospects for future earnings, ability to pay interest, debt

maturities-both current as well as long-term and probability of a sound dividend

policy, etc. The main importance of financial analysis is the pin-pointing of the

strengths and weakness of a business enterprise by regrouping and analyzing the figures

contained in financial statements i.e., Balance Sheet and Profit and Loss Account. An

analysis of financial statements is more meaningful to the management and other

interested in the concern.

• It helps in judging accounting quality by measuring overstatement/understatement

of profits; auditors qualifications; method of income recognition; inventory

valuation and depreciation policies; off balance sheet liabilities; etc.

• Earnings protection (sources of future earnings growth; profitability ratios;

earnings in relation to fixed income charges; etc.)

• Adequacy of cash flows (in relation to debt and fixed and working capital needs;

sustainability of cash flow; capital spending flexibility; working capital

management etc.)

• Financial flexibility (alternative financing plans in times of stress; ability to raise

funds; asset redeployment potential; etc.)

Need for Management:

Management of an enterprise use financial analysis for:

(i) Measuring the success or the failure of the operation, as a whole,

(ii) Making sound decisions relating to all the phase of operations,

(iii) Controlling operations and

(iv) Determining the relative efficiency of departments and process.

Need for outside parties:

(i) Creditors use analysis as a basis for granting credit.

(ii) Investors use it to come to a decision of buying, selling or holding shares in a

company, and

(iii) Government uses it for purposes of regulations and administration.

Aims:

The main aims of financial analysis are listed as follows:

1. To judge the financial health of the undertaking for management, creditors and

bankers.

2. To judge the earnings performance of the company and facility with which

dividends can be paid from out of earned profits. Potential investors are primarily

interested in this aspect.

3. In case of institutional investors the analysis is carried over a long period with a

view to identifying companies having growth potential and a sound financial base.

4. To judge the ability of the company to pay the principal and interest,

arrangements for amortization of debt and the security available for the loans

extended.

5. To judge the solvency of the undertaking. The trade creditors are mainly

interested in assessing the liquidity position for which they look into the

following:

(a) Whether the current assets are sufficient to pay off the current liabilities,

(b) The proportion of liquid assets to current assets,

(c) Whether the debenture-holders are secured by a floating charge on the current

assets and

(d) The business prospects with reference to the future growth and earnings.

Case -1: Financial statement analysis

• The following financial statements of XYZ Ltd were prepared. XYZ Ltd is a

diversified enterprise.

• The financial statements of XYZ Ltd need to be analysed. An investor is

considering purchasing shares in the company. Relevant ratios need to be selected

and calculated and a report needs to be written for the investor. The report should

evaluate the company’s performance and position

XYZ Ltd Statement of Financial Position as at 31 March

2007 2008 Horizontal

Analysis 000 000 000 000

Current Assets

Bank 33.5 41.0 Accounts receivable 240.8 210.2 Inventory 300.0 370.8 574.3 622.0 108 Non-current assets Fixtures & fittings (net)

64.6

63.2

Land & buildings (net)

381.2

376.2

445.8 439.4 99

Total assets 1,020.1 1,061.4

104

Current Liabilities

Accounts payable 261.6 288.8 Income tax 60.2 76.0 321.8 364.8 113 Non-current liabilities Loan 200.0 60.0 30

Shareholders Funds

Paid-up ordinary capital 300.0 334.1 Retained profit 198.3 302.5 498.3 636.6 128 Total liabilities & equity 1,020.1 1,061.4 104

XYZ Ltd

Statement of Financial Performance for year ended 31 March

2007 2008 Horizontal Analysis

000 000 000 000 Sales 2,240.8 2,681.2 120 Less Cost of goods sold

1,745.4 2,072.0119

Gross profit 495.4 609.2 123 Wages & salaries

185.8

275.6

Rates

12.2

12.4

Heat & light

8.4

13.6

Insurance

4.6

7.0

Interest expense

24.0

6.2

Postage & telephone

9.0

16.4

Depreciation - Buildings

5.0

5.0

Fixtures & fittings

27.0

276.0 32.8

369.0134

Net profit before tax

219.4

240.2

109 Less Income tax 60.2 76.0 126 Net profit after tax 159.2 164.2 103

XYZ Ltd

Statement of Cash Flows for the year ended 31 March

2007 2008

000 000 000 000

Cash flow from operations

Receipts from customers 2,281 2,711.8

Payments to suppliers & employees (2,050) (2,460.4)

Interest paid (24) (6.2)

Tax paid 46.4) (60.2)

Net cash flow from operating activities 160.6 185

Investing activities

Purchase of non-current assets (121.2) (31.4)

Net cash used in investing activities (121.2) (31.4)

Financing activities

Dividends paid (32.0) (40.2)

Issue of ordinary shares 20.0 34.1

Repayment of loan capital -__ (140.0)

Net cash outflow from financing

activities

(12) (146.1)

Increase in cash & cash equivalents 27.4 7.5

Additional information:

• Credit purchases for the year 2008 were Rs. 2,142,800.

• General prospects for the major industries in which XYZ is involved look good

with a forecast glut of oil set to reduce the cost of production and world demand

for product remaining strong.

Benchmarks:

• There are no exact benchmarks for Walker Ltd because it is a diversified

company. The following are average indicators that relate to the retailing and

manufacturing industries for the year 2008.

– Gross profit margin 25%

– Net profit margin 7%

– Inventory turnover 6 times

– Debt/equity ratio 0.6 : 1

– Return on Assets 12%

– Return on Equity 20%

Solution:

Relevant ratios

Important note: The calculations of the ratios in this illustration did not use

“averages” for total assets, equity and inventory. The 2007 and 2008 year end figures

were used and this is a slight variation to the formulas provided.

Profitability

ratios: Benchmarks 2005 2006

Gross Profit Margin

Industry 25%

22% 22.7%

Net Profit Margin

Industry 7%

7.1% 6.1%

Return on Assets

12% 15.6% 15.5%

Return on Equity

Industry 20%

32% 26%

Asset Management

ratios:

Benchmarks 2007 2008

Inventory Turnover

Industry 6 %

5.8 times 5.58 times

Asset Turnover Not given 2.2 2.53

Liquidity ratios: Benchmarks 2007 2008

Current Ratio Ideal standard 2:1

Acceptable standard

1:1

1.78:1 1.70:1

Quick Ratio Ideal standard 2:1

Acceptable standard

1:1

0.85:1 0.69:1

Days Payable Standard 30 days

Credit purchases not available

49.19 days

Financial Structure ratios:

Benchmarks 2005 2006

Debt/Equity Industry 0.6:1

Standard benchmark

1:1

1.05: 1 0.67:1

TIE Standard benchmark:

Between 3 and 5. Below 3 risky. Above 5 very

favourable

10.14 times 39.74 times

Report

• For the investor considering the purchase of shares in the company, the return

they will earn is the key financial factor but an overall evaluation of the

company’s performance and position is also important to get a better picture of

how well the company is actually doing.

• ROE in 2008 is 26%. Whether or not this is attractive depends on the perceived

riskiness of this investment and other alternatives available but this return is

certainly more attractive than current bank interest rates.

• ROE has decreased by 4% but the company’s ROE at 26% is still better than the

industry average of 20%

• Riskiness of business is being reduced by the significant repayment of loan in

2008.

• Profitability

• The NP% and ROA ratios show a small downward trend in % over the 2

year period. ROE% ratio shows a more significant decrease but is still

better than the industry average.

• Gross Profit Margin is slightly unfavourable at about 2.3% below the

industry benchmark of 25%.

• The horizontal analysis information show that Sales have increased by

20%. However operating costs have increased by 34%.

• Asset Management

• IT has gone down slightly from 5.8 to 5.58 times.

• IT is still close to the industry benchmark of 6 times.

• AT has increased showing more sales being generated from asset usage

• Liquidity

• Current ratios of 1.78:1 (2005) and 1.70: 1 are at above acceptable levels

but below ideal level.

• Quick ratios appear more of a concern being below acceptable levels in

both years and even more so in 2008 (0.69:1).

• Raises some concerns over the liquidity of the business and inventory

management (although IT ratio only shows a slight decline in 2008).

• Days Payable is a concern as there may be poor debt payment

management.

• Financial Structure

• Although slightly higher than D/E industry benchmark (0.67:1), business

has become less risky due to the significant repayment of loan in 2008.

• TIE is extremely good for the business at 39.74 times (well above 5 the

standard benchmark).

• Cash flow situation

• Strong cash flow from operating activities (increased from 160,600 to

185,000).

• Spending under investing activities suggest more growth.

• Repayment of debt under financing activities imply restructuring of

business to have more equity funding rather than debt funding.

Recommendation

Given:

1) The strong forecast for the industry (i.e. general prospects looking good and world

demand for products remaining strong),

2) The sales growth in this business,

3) Acceptable ratios as they are quite close to the industry averages,

4) Good cash flows from operating activities and

5) Favourable ROE, although it has decreased, it is still better than the industry

average ROE.

=> It is recommended that the investor purchase shares in the XYZ Ltd Company.

Case -2: Analysis the financial statement of Srujal-Mart

Srujal-Mart Stores

Balance Sheet For Fiscal Years 2007 and 2006

Period Ending March 31, 2007 March 31, 2006 Assets Current Assets Cash and cash equivalents Rs. 2,161 Rs,2,054Net receivables 2,000 1,768Inventory 22,614 21,442Other current assets 1,471 1,291Total current assets Rs. 28,246 Rs. 26,555Long-Term Assets Property plant and equipment Rs. 45,750 Rs. 40,934Goodwill 8,595 9,059Other assets 860 1,582Total assets Rs. 83,451 Rs.78,130Current Liabilities Payables and accrued expenses Rs. 24,134 Rs. 22,288Short-term and current long term debt 3,148 6,661Total current liabilities Rs.27,282 Rs.28,949Long-Term Liabilities Long-term debt Rs.18,732 Rs.15,655Deferred long-term liability charges 1,128 1,043Minority interest 1,207 1,140Total liabilities Rs.48,349 Rs.46,787Stockholders Equity Common Stock Rs.445 Rs.447Retained earnings 34,441 30,169Capital surplus 1,484 1,411Other stockholder equity (1,268) (684)Total stockholder equity Rs.35,102 Rs.31,343Total liabilities and equity Rs.83,451 Rs.78,130

Srujal-Mart Stores

Income Statement for 2007 and 2006

March 31,2007 March 31, 2006

Total Revenue Rs. 219,812 Rs.193,295

Cost of Revenue 171,562 150,255

Gross Profit Rs. 48,250 Rs.43,040

Selling General and

Administrative Expenses

36,173 31,550

Earnings Before Interest

and Taxes

Rs .12,077 Rs.11,490

Interest Expense 1,326 1,374

Income Before Tax Rs.10,751 Rs.10,116

Income Tax Expense 3,897 3,692

Minority Interest (183) (129)

Net Income Rs.6,671 Rs.6,295

Solution:

Selected Financial Ratios for Srujal-Mart Stores for 2007 and 2006

Ratio 2007 2006

Return

Basic earning power Rs.12,077/Rs.83,451 = 14.47% Rs.16,490/Rs.78,130 = 21.11%

Return on assets Rs.6,671/ Rs.83,451 = 7.9% Rs.6,295/ Rs.78,130 = 8.06%

Return on equity Rs.6,671/ Rs.35,102 = 19.00% Rs.6,295/ Rs.31,343 = 20.03%

Liquidity

Current ratio Rs.28,246/ Rs.27,282 = 1.04 times Rs.26.555/ Rs.28,949 = 0.92 times

Quick ratio Rs.5,628 / Rs.27,282 = 0.21 times Rs.5,113/ Rs.28,949 =0.18 times

Profitability

Gross profit margin Rs.48,250/ Rs.219,812 = 21.95% Rs.43,040/ Rs.193,295 = 22.27%

Operating profit margin Rs.12,877/ Rs.219,812 = 5.86% Rs.11,490/ Rs.193,295 = 5.94%

Net profit margin Rs.6,671/ Rs.219,812 = 3.03% Rs.6,295/ Rs.193,295 = 3.26%

Activity

Inventory turnover Rs.171,562/ Rs.22,618 = 7.59 times Rs.150,255/ Rs.21,442 = 7.01 times

Total asset turnover Rs.219,812/ Rs.83,451 = 2.63 times Rs.193,295/ Rs.78,130 = 2.47 times

Financial leverage

Total debt-to-assets Rs.48,319/ Rs.83,451 = 58.90% Rs.46,787/ Rs.78,130 = 59.88%

Total debt-to-equity Rs.48,319/Rs.35,102 = 1.38 times Rs.46,787/ Rs.31,343 = 1.49 times

Interest coverage Rs.12,077/ Rs.1,326 = 9.11 times Rs.11,490/ Rs.1,374 = 8.36 times

References:

• Hampton, John J. Financial Decision Making - Concepts, Problems and Cases,

Reston Pub. Co.,Inc., Virginia Ed.1976, p.62.

• Howard, Bion B. & Upton, Miller: Introduction to Business Finance, McGraw-

Hill Book Co.Inc., New York, Ed.1953, p.61.

• Miller, Donald E.: The Meaningful Interpretation of Financial Statements,

American Mgt. Asso., Inc., New York, Ed.1972, p.9.

• Pyle, William W.; White, John A. and Larson, Kermit D. : Fundamental

Accounting Principles, Richard D. Irwin, Inc., Homewood, Illinois, Ed.1978,

p.15.

• Block, Stanley B. and Hirt, Geoffrey A. : Foundation of Financial

Management, Richard D. Irwin, Inc.,Homewood Illinois, Ed. 1978, p.28.

• Dennis, Lock : Financial Management of Production, Grower Press Ltd.,

Epping-Essex, Ed. 1975, p.3.

• Guthmann,Harry G.: Analysis of Financial Statements, Prentice Hall of India

Pvt. Ltd., New Delhi, Ed.1964, p.20.

• Hastings, Paul G.: The Management of Business Finance, D.Von Nostrand

Co.Inc., New Jersey, Ed. 1966, p.16.

• Walgenbach, Paul H., Dittrich, Norman E. and Hanson, Earnest I. : Financial

Accounting - An Introduction, Harcourt Brace Jovanovich, Inc., New York,

Ed.1977, p.21.

• Foulke, Roy A. : Practical Financial Statement Analysis, Tata McGraw Hill

Publishing Co. Ltd., New Delhi, Ed. 1972, p.516.

• Walgenbach, Paul H. and Dittrich, Norman E.: Accounting - An Introduction,

Harcourt Brace Jovanovich, inc., New York, Ed. 1973, p.364.

• Shuckett, Donald H. and Mock, Edward J. : Decision Strategies in Financial

Management, Taraporevala Publishing Ind. Pvt. Ltd., Bombay, Ed. 1978,

p.112.

• Keneddy R.D. and McMullen S.Y., Financial Statements Analysis and

Interpretation, Richard D. irwin, Inc., Illions, Ed. 1968 p.4.

Chapter – 2

Working Capital Analysis

• Introduction

• Concept of Working Capital

• Types of Working Capital

• Working Capital Cycle

• Working Capital Needs of a Business

• Nature and Importance of Working Capital

• Working Capital Management Concepts

• Management of Working Capital

• Measures of Working Capital Management Efficiency

• Objective of Working Capital Management

• Analysis of Working Capital

1. Working Capital Trend Analysis

2. Efficiency Analysis

3. Analysis of Liquidity Position

• References

Introduction

Every business needs adequate liquid resources in order to maintain day-to-day cash flow.

It needs enough cash to pay wages and salaries as they fall due and to pay creditors if it is

to keep its workforce and ensure its supplies. Maintaining adequate working capital is not

just important in the short-term. Sufficient liquidity must be maintained in order to ensure

the survival of the business in the long-term as well. Even a profitable business may fail

if it does not have adequate cash flow to meet its liabilities as they fall due. Therefore,

when businesses make investment decisions they must not only consider the financial

outlay involved with acquiring the new machine or the new building, etc, but must also

take account of the additional current assets that are usually involved with any expansion

of activity. Increased production tends to engender a need to hold additional stocks of

raw materials and work in progress. Increased sales usually means that the level of

debtors will increase. A general increase in the firm’s scale of operations tends to imply a

need for greater levels of cash.

By minimizing the amount of funds tied up in current assets, firms are able to reduce

financing costs and/or increase the funds available for expansion. The importance of

efficient working capital management (WCM) is indisputable. Business viability relies on

its ability to effectively manage receivables, inventory, and payables. By minimizing the

amount of funds tied up in current assets, firms are able to reduce financing costs and/or

increase the funds available for expansion. Much managerial effort is put into bringing

non-optimal levels of current assets and liabilities back towards their optimal levels. The

definition of working capital is fairly simple; it is the difference between an

organization’s current assets and its current liabilities.

Concept of Working Capital

The core of the working capital concept has been subjected to considerable change over

the years. A few decades ago the concept was viewed as a measure of the debtor’s ability

to meet his obligations in case of liquidation. The prime concern was with whether or not

the current assets were immediately realizable and available to pay debts in case of

liquidation.

The Concept of working capital was, perhaps first evolved by Karl Marx though in a

somewhat different form. Karl Marx used the term ‘Variable Capital’ meaning outlays

for payrolls advanced to workers before the goods they worked on were complete. He

contrasted this with ‘Constant Capital’ which according to him, is nothing but ‘dead

labour’, i.e. outlays for raw materials and other instruments of production produced by

labour in earlier stages which are now needed for the line labour to work within the

present stage. This variable capital is nothing but wage fund which remains blocked in

terms of financial management, in work0in-process along with other operating expenses

until it is released through sale of finished goods.

Although Marx did not mention that workers also gave credit to the firm by accepting

periodical payment of wages which funded a portion of work-in-process, the concept of

working capital, as we understood today, was embedded in his ‘variable capital’.

Working capital is the difference between current assets and current liabilities:

Working Capital

Current Assets Current Liabilities

Cash Short-term Debt

Marketable Securities Current Portion of Long-term Debt

Accounts Receivable Accounts Payable

Inventory Accrued Liabilities

Prepaid Expenses

A firm is required to maintain a balance between liquidity and profitability while

conducting its day to day operations. Liquidity is a precondition to ensure that firms are

able to meet its short-term obligations and its continued flow can be guaranteed from a

profitable venture. The importance of cash as an indicator of continuing financial health

should not be surprising in view of its crucial role within the business. This requires that

business must be run both efficiently and profitably. In the process, an asset-liability

mismatch may occur which may increase firm’s profitability in the short run but at a risk

of its insolvency. On the other hand, too much focus on liquidity will be at the expense of

profitability. Thus, the manager of a business entity is in a dilemma of achieving desired

tradeoff between liquidity and profitability in order to maximize the value of a firm.

Working capital management (WCM) is of particular importance to the small business.

With limited access to the long-term capital markets, these firms tend to rely more

heavily on owner financing, trade credit and short-term bank loans to finance their

needed investment in cash, accounts receivable and inventory (Chittenden et al, 1998;

Saccurato, 1994).

TYPES OF WORKING CAPITAL

Low

BASIS OF TIME

Gross Working Capital

Net Working Capital

Permanent / Fixed

WC

Temporary / Variable

WC

Regular WC

Reserve WC

Special WC

Seasonal WC

WORKING CAPITAL

W o r k i n g c a p i t a l c y c l e

The working capital cycle can be defined as:

The period of time which elapses between the point at which cash begins to be expended

on the production of a product and the collection of cash from a customer

The diagram below illustrates the working capital cycle for a manufacturing firm

The upper portion of the diagram above shows in a simplified form the chain of events in

a manufacturing firm. Each of the boxes in the upper part of the diagram can be seen as a

tank through which funds flow. These tanks, which are concerned with day-to-day

activities, have funds constantly flowing into and out of them.

• The chain starts with the firm buying raw materials on credit.

• In due course this stock will be used in production, work will be carried out on the

stock, and it will become part of the firm’s work in progress (WIP)

• Work will continue on the WIP until it eventually emerges as the finished product

• As production progresses, labour costs and overheads will need to be met

• Of course at some stage trade creditors will need to be paid

• When the finished goods are sold on credit, debtors are increased

• They will eventually pay, so that cash will be injected into the firm

Each of the areas – stocks (raw materials, work in progress and finished goods), trade

debtors, cash (positive or negative) and trade creditors – can be viewed as tanks into and

from which funds flow.

Working capital is clearly not the only aspect of a business that affects the amount of

cash:

• The business will have to make payments to government for taxation

• Fixed assets will be purchased and sold

• Lessors of fixed assets will be paid their rent

• Shareholders (existing or new) may provide new funds in the form of cash

• Some shares may be redeemed for cash

• Dividends may be paid

• Long-term loan creditors (existing or new) may provide loan finance, loans will

need to be repaid from time to time, and

• Interest obligations will have to be met by the business.

Unlike movements in the working capital items, most of these ‘non-working capital’ cash

transactions are not everyday events. Some of them are annual events (e.g. tax payments,

lease payments, dividends, interest and, possibly, fixed asset purchases and sales). Others

(e.g. new equity and loan finance and redemption of old equity and loan finance) would

typically be rarer events.

Working Capital Needs of a Business

Different industries have different optimum working capital profiles, reflecting their

methods of doing business and what they are selling.

• Businesses with a lot of cash sales and few credit sales should have minimal trade

debtors. Supermarkets are good examples of such businesses;

• Businesses that exist to trade in completed products will only have finished goods

in stock. Compare this with manufacturers who will also have to maintain stocks

of raw materials and work-in-progress.

• Some finished goods, notably foodstuffs, have to be sold within a limited period

because of their perishable nature.

• Larger companies may be able to use their bargaining strength as customers to

obtain more favourable, extended credit terms from suppliers. By contrast,

smaller companies, particularly those that have recently started trading (and do

not have a track record of credit worthiness) may be required to pay their

suppliers immediately.

• Some businesses will receive their monies at certain times of the year, although

they may incur expenses throughout the year at a fairly consistent level. This is

often known as “seasonality” of cash flow.

Nature and Importance of Working Capital

The working capital meets the short-term financial requirements of a business enterprise.

It is a trading capital, not retained in the business in a particular form for longer than a

year. By minimizing the amount of funds tied up in current assets, firms are able to

reduce financing costs and/or increase the funds available for expansion. The money

invested in it changes form and substance during the normal course of business

operations. The need for maintaining an adequate working capital can hardly be

questioned. Just as circulation of blood is very necessary in the human body to maintain

life, the flow of funds is very necessary to maintain business. If it becomes weak, the

business can hardly prosper and survive. Working capital starvation is generally credited

as a major cause if not the major cause of small business failure in many developed and

developing countries (Rafuse, 1996).

The success of a firm depends ultimately, on its ability to generate cash receipts in excess

of disbursements. The cash flow problems of many small businesses are exacerbated by

poor financial management and in particular the lack of planning cash requirements

(Jarvis et al, 1996).

Working Capital Management Concepts

The working capital meets the short-term financial requirements of a business enterprise.

It is the investment required for running day-to-day business. It is the result of the time

lag between the expenditure for the purchase of raw materials and the collection for the

sales of finished products. The components of working capital are inventories, accounts

to be paid to suppliers, and payments to be received from customers after sales. Financing

is needed for receivables and inventories net of payables.

The proportions of these components in the working capital change from time to time

during the trade cycle. The working capital requirements decide the liquidity and

profitability of a firm and hence affect the financing and investing decisions. Lesser

requirement of working capital leads to less need for financing and less cost of capital

and hence availability of more cash for shareholders. However the lesser working capital

may lead to lost sales and thus may affect the profitability.

The management of working capital by managing the proportions of the WCM

components is important to the financial health of businesses from all industries. To

reduce accounts receivable, a firm may have strict collections policies and limited sales

credits to its customers. This would increase cash inflow. However the strict collection

policies and lesser sales credits would lead to lost sales thus reducing the profits.

Maximizing account payables by having longer credits from the suppliers also has the

chance of getting poor quality materials from supplier that would ultimately affect the

profitability. Minimizing inventory may lead to lost sales by stock-outs. The working

capital management should aim at having balanced; optimal proportions of the WCM

components to achieve maximum profit and cash flow.

Management of Working Capital

While the performance levels of small businesses have traditionally been attributed to

general managerial factors such as manufacturing, marketing and operations, working

capital management may have a consequent impact on small business survival and

growth (Kargar and Blumenthal, 1994). The management of working capital is important

to the financial health of businesses of all sizes. The amounts invested in working capital

are often high in proportion to the total assets employed and so it is vital that these

amounts are used in an efficient and effective way. However, there is evidence that small

businesses are not very good at managing their working capital. Given that many small

businesses suffer from under capitalisation, the importance of exerting tight control over

working capital investment is difficult to overstate. A firm can be very profitable, but if

this is not translated into cash from operations within the same operating cycle, the firm

would need to borrow to support its continued working capital needs. Thus, the twin

objectives of profitability and liquidity must be synchronized and one should not impinge

on the other for long. Investments in current assets are inevitable to ensure delivery of

goods or services to the ultimate customers and a proper management of same should

give the desired impact on either profitability or liquidity. If resources are blocked at the

different stage of the supply chain, this will prolong the cash operating cycle. Although

this might increase profitability (due to increase sales), it may also adversely affect the

profitability if the costs tied up in working capital exceed the benefits of holding more

inventory and/or granting more trade credit to customers.

Another component of working capital is accounts payable, but it is different in the sense

that it does not consume resources; instead it is often used as a short term source of

finance. Thus it helps firms to reduce its cash operating cycle, but it has an implicit cost

where discount is offered for early settlement of invoices.

Working capital management (WCM) is the management of short-term financing

requirements of a firm. This includes maintaining optimum balance of working capital

components – receivables, inventory and payables – and using the cash efficiently for

day-to-day operations. Optimization of working capital balance means minimizing the

working capital requirements and realizing maximum possible revenues. Efficient WCM

increases firms’ free cash flow, which in turn increases the firms’ growth opportunities

and return to shareholders. Even though firms traditionally are focused on long term

capital budgeting and capital structure, the recent trend is that many companies across

different industries focus on WCM efficiency.

Measures of Working Capital Management Efficiency

The form and amount of working capital components vary over the operating cycle. It

would be hard to get the amounts of the components used in operations for an operating

cycle. Hence the working capital management efficiency is measured in terms of the

“days of working capital” (DWC). DWC value is based on the Rupee amount in each of

equally weighted receivable, inventory and payable accounts. The DWC represents the

time period between purchases of materials on account from suppliers until the sale of

finished product to the customer, the collection of the receivables, and payment receipts.

Thus it reflects the company’s ability to finance its core operations with vendor credit.

The firm’s profitability is measured using the operating income plus depreciation related

to total assets (IA). This measure is indicator of the raw earning power of the firm’s

assets. Another profitability measure used for this analysis is the operating income plus

depreciation related to the sales (IS). This indicates the profit margin on sales. To

measure the liquidity of the firm the cash conversion efficiency (CCE) and current ratio

(CR) are used. The CCE is the cash flow generated from operating activities related to the

sales

Objective of Working Capital Management

To run the firm efficiently with as little money as possible tied up in Working

Capital

Involves trade-offs between easier operation and the cost of carrying

short-term assets

• Benefit of low working capital

• Able to funnel money into accounts that generate a higher

payoff

• Cost of low working capital

• Risky

Inventory

High Levels Low Levels

Benefit:

Happy customers

Few production delays (always have

needed parts on hand)

Cost:

Expensive

High storage costs

Risk of obsolescence

Cost:

Shortages

Dissatisfied customers

Benefit:

Low storage costs

Less risk of

obsolescence

Cash

High Levels Low Levels

Benefit:

Reduces risk

Cost:

Increases financing costs

Benefit:

Reduces financing

costs

Cost:

Increases risk

Accounts Receivable

High Levels (favorable credit terms) Low Levels (unfavorable

terms)

Benefit:

Happy customers

High sales

Cost:

Expensive

High collection costs

Increases financing costs

Cost:

Dissatisfied customers

Lower Sales

Benefit:

Less expensive

Payables and Accruals

High Levels Low Levels

Benefit:

Reduces need for external finance--

using a spontaneous financing source

Cost:

Unhappy suppliers

Benefit:

Happy

suppliers/employees

Cost:

Not using a

spontaneous financing

source

Analysis of Liquidity Position

Liquidity

Liquidity reflects the ability of a firm to meet its short-term obligations using those assets

that are most readily converted into cash. Assets that may be converted into cash in a

short period of time are referred to as liquid assets; they are listed in financial statements

as current assets. Current assets are often referred to as working capital, since they

represent the resources needed for the day-to-day operations of the firm’s long-term

capital investments. Current assets are used to satisfy short-term obligations, or current

liabilities. The amount by which current assets exceed current liabilities is referred to as

the net working capital.

The Operating Cycle

How much liquidity a firm needs depends on its operating cycle. The operating cycle is

the duration from the time cash is invested in goods and services to the time that

investment produces cash. For example, a .rm that produces and sells goods has an

operating cycle comprising four phases:

1. Purchase raw materials and produce goods, investing in inventory.

2. Sell goods, generating sales, which may or may not be for cash.

3. Extend credit, creating accounts receivable.

4. Collect accounts receivable, generating cash.

The four phases make up the cycle of cash use and generation. The operating cycle would

be somewhat different for companies that produce services rather than goods, but the idea

is the same—the operating cycle is the length of time it takes to generate cash through the

investment of cash.

What does the operating cycle have to do with liquidity? The longer the operating cycle,

the more current assets are needed (relative to current liabilities) since it takes longer to

convert inventories and receivables into cash. In other words, the longer the operating

cycle, the greater the amount of net working capital required.

To measure the length of an operating cycle we need to know:

1. The time it takes to convert the investment in inventory into sales (that is, cash

inventory sales accounts receivable).

2. The time it takes to collect sales on credit (that is, accounts receivable cash).

Liquidity and Working Capital Analysis

Liquidity and Operating Additional Liquidity

Working Capital Activity Measures

Current Assets Receivables Liquidity Asset Composition

Current Liabilities Inventory Turnover Liquidity Index

Working Capital Liquidity of Current Acid-test Ratio

Current Ratio Liabilities Cash Flow Measures

Cash-based Ratio Financial Flexibility

What if analysis

Liquidity Ratios

Liquidity ratios (or solvency ratios) include the current ratio, the quick ratio, and net

working capital.

Current Ratio

The current ratio compares current assets to current liabilities. It measures the margin of

safety a company has for paying short-term debts in the event of a reduction in current

assets. It also gives an idea of a company’s ability to meet day-to-day payment

obligations. Generally, a higher ratio is better. This is the standard measure of any

business’s financial health.

Current ratio = Current assets

Current liabilities

Current assets include cash, accounts receivable, marketable securities, inventory, and

any prepaid expenses like insurance or taxes. Current liabilities include accounts payable,

current interest due on long-term debt, like taxes payable and salaries payable.

Generally, the higher the current ratio, the greater the safety margin between current

obligations and the ability to pay them. The benchmark current ratio is 2:1.

Hypothetical Example:

Table: Current Ratios

March-2003 March-2004 March-2005 March-2006 March-2007

Company 2.2 2.1 3.7 1.9 2.0

Industry 1.4 1.3 1.5 1.5 1.4

The Company’s current ratio was consistently above the industry average over the period,

as shown in Table. The Company’s ratio is higher than the industry due to lower current

liabilities.

Quick Ratio: “Acid Test”

The quick ratio is similar to the current ratio, but it’s a tougher measure of liquidity than

the current ratio, because it excludes inventories. Inventories typically take time to

convert to ready cash. Thus, most analysts find them illiquid, not a cash equivalent.

Generally a higher ratio is better.

Quick ratio = (Current assets – Inventory)

Current liabilities

Generally, the quick ratio should be lower than the current ratio, because the inventory

figure drops from the calculation. A higher ratio correlates to a higher level of liquidity.

This usually corresponds to better financial health. The quick ratio also indicates whether

a business could pay off its debts quickly, if necessary. The desired quick ratio is at least

1:1. A lower ratio flags questions about whether the firm can continue to meet its

outstanding obligations.

Hypothetical Example:

Table: Quick Ratios

March-2003 March-2004 March-2005 March-2006 March-2007

Company 1.8 1.6 2.4 0.9 1.7

Industry 1.1 1.0 1.1 1.2 1.4

As shown in Table, the Company’s quick ratios fluctuated over the period. The basic

difference between the current and quick ratio is that the quick ratio includes only cash

and receivables as the numerator. Thus, inventory is not included. As can be seen from

the table, the industry averages contained a larger inventory base due to the lower ratio.

The Company carried a minimal inventory of materials and supplies. In 2006, the

Company’s ratio was lower than the industry average due to a large increase in current

liabilities in that year. Other than that year, the Company has been very liquid and could

easily cover its current maturities.

Liquidity is a matter of degree

Lack of liquidity can limit:

• Advantages of favorable discounts

• Profitable opportunities

• Management actions

• Coverage of current obligations

Severe illiquidity often proceeds:

• Lower profitability

• Restricted opportunities

• Loss of owner control

• Loss of capital investment

• Insolvency and bankruptcy

References:

• Chiou, J. R., Cheng, L. and Wu, H.W. (2006). “The determinants of working

capital management”, The Journal of American Academy of Business, Vol. 10,

No. 1, pp. 149-155.

• Deloof, M. (2003). “Does working capital management affect profitability of

Belgian firms?” Journal of Business Finance and Accounting, 30(3) & (4), pp.

573-587.

• Filbeck, G. and Krueger, T. M. (2005). “An analysis of working capital

management results across industries”, American Journal of Business, Vol. 20,

Issue 2, pp. 11-18.

• Kuchhal, S.C., 1985. Financial Management, Chaitanya Publishing

• Kulkarni, P.V., 1985. Financial Management, Himalaya Publishing

• Shin, H. H. and Soenen, L. (1998). “Efficiency of working capital management

and corporate profitability”, Financial Practice and Education, Vol. 8, No. 2, pp.

37-45.

• Solomon, Eraz and Pringle John, 1978. An Introduction to Financial Management,

Prentice-Hall of India

• Van Horne, James C., 1985. Fundamentals of Financial Management, Prentice-

Hall of India.

Chapter - 3

Analysis of Activity

• Concept of Activity

• Activity in Relation to Total Resources

1. Total Assets Turnover Ratio

2. Fixed Assets Turnover Ratio

3. Current Assets Turnover Ratio

• Sales Trend and Cost Structure Analysis

• Analysis of Sales Trend

• Analysis of Cost Structure

(a) Raw Materials and Stores Consumed

(b) Salaries and Wages

(c) Indirect Taxes

(d) Power and Fuel

(e) Depreciation

(f) Administrative, Selling, Distribution and Other Expenses

(g) Financial Charges

• References

Concept of Activity Analysis:

Sale of product is the primary object of any business enterprise. It is pivot around which

all business operations cluster. The increase or decrease of the business profits depend

upon the magnitude of sale because it is the key figure in the business enterprise. Income

from net sales is the life blood of every commercial and industrial business. Sales

support life of business. More sales more profit and or less sales less profit or even there

may be loss. Thus re-sales, are to a business enterprise what oxygen is to the human

being, a very Material increase in the volume of net sales has the same effect upon the

business organism as an increase in the quantity of inhaled oxygen has upon the

human organism.1 The quantity quality and regularity of flow of sales revenue

govern the physical appearance and the internal conditions of the business organism.

In fact, with the higher volume of sales, the business operates with greater profits and

effectiveness and operations are speeded up.

It is apparent, therefore, that the significance of any business activity can be measured in

terms of its contribution towards sales. Activity ratios are turnover ratios where the

significance of financial figures is measured in terms of sales of business enterprise.

The approach to the activity analysis in Cement Industry in India is as follows:

1. The growth of activity and its measurement in terms of investment

2. Activity in relation to total resources

3. The conduct of activity and

4. The impact of activity.

Activity in Relation to Total Resources:

Sale is the major factor of judging the activity of an enterprise and it is affected by the

total resources available in the business. The term 'Sales' indicates the efficiency with

which investment in the asset is rotated in the process of doing business. Efficient

rotation of capital or total resources would lead to higher profitability therefore

profitability depends up the sales or turnover ratio. Sales ratio is calculated usually by

comparing the net sales with the total investment (total assets or total resources)

As the management of the concern is responsible for making proper use of resources, it is

necessary to clarify the word `Total Resources'. The total resources available in the

enterprise are characterised by total assets which are made up of fixed assets and current

assets. Since the assets of a business are use for the purpose of producing revenue,

hence, efficient utilization of the assets is a must for business activity.

Activity is judged in relation to total investment as represented by total assets. This is

ascertained by the sales to total sales assets ratio or `an activity index'.

Some of the principal ratios which have been used in the study are as under.

Total Assets Turnover Ratio

This ratio is also termed as capital turnover ratio. The total assets turnover measures as

how many rupees of sales are supported by each rupee in total assets .A high ratio

suggests management’s ability to make a good use of its tangible assets but low ratio may

be caused due to large outlays on fixed assets.

Table No.1

Total Assets Turnover Ratio

COMPANY

1999-

2000

2000-

01

2001-

02

2002-

03

2003-

04

2004-

05

2005-

06 AVE. S.D. C.V. Min Max

RELAINCE 1.46 1.44 1.44 1.16 1.11 1.05 1 1.24 0.2 16.35 1 1.46

ESSAR 0.08 0.07 0.07 0.06 0.06 0.06 0.06 0.07 0.01 11.97 0.06 0.08

HPCL 4.28 3.84 3.66 3.65 3.45 3.36 3.32 3.65 0.33 9.125 3.32 4.28

BPCL 6.87 6.52 6.01 5.7 5.42 5.25 4.99 5.82 0.69 11.77 4.99 6.87

IOC 2.84 2.61 2.46 2.4 2.35 2.28 2.13 2.44 0.23 9.48 2.13 2.84

CPCL 2.85 3.69 3.67 3.6 3.19 2.99 2.68 3.24 0.42 12.9 2.68 3.69

Ave. 3.06 3.028 2.89 2.76 2.6 2.5 2.36 2.7 0.31 11.9 2.36 3.2

In Reliance the ratio ranged between 1.00 times in 2005-06 to 1.46 times in 1999-2000

with an average of 1.24. The standard deviation was 0.20 and coefficient of variation is

16.35. In Essar the ratio was less than 1 times and its average was 0.07 times. It indicates

the management of units was unsuccessful in the utilization of fixed assets. Where as the

ratio fixed assets turnover was fluctuated between 3.32 times to 4.28 times in HPCL and

4.99 times to 6.87 times in BPCL and 2.13 times to 2.84 times in IOC. The average ratio

CPCL was 3.24 which were more than the industry’s average. The BPCL has the highest

ratio which has indicated good efficiency in assets utilization.

Fixed Assets Turnover Ratio

The fixed assets turnover ratio measures the efficiency with the firm is utilizing its

investment in fixed assets. It also indicates the adequacy of sales in relation to the

investment in fixed assets. The fixed assets turnover ratio is sales divided by fixed assets

less depreciation. The greater the ratio more will be efficiency of assets usage.

Table No.2

Fixed Assets turnover ratio

COMPANY

1999-

2000

2000-

01

2001-

02

2002-

03

2003-

04

2004-

05

2005-

06 AVE. S.D. C.V. Min Max

RPL 0.85 1.04 1.36 1.09 1.14 1.42 1.34 1.18 0.21 17.47 0.85 1.42

ESSAR 0.5 0.44 0.32 0.35 0.35 3.71 2.48 1.16 1.37 117.4 0.32 3.71

HPCL 4.79 5.53 4.6 5.19 5.22 5.52 5.99 5.26 0.47 8.967 4.6 5.99

BPCL 4.23 5.25 5.99 4.56 5.04 5.06 5.36 5.07 0.57 11.19 4.23 5.99

IOC 4.76 4.88 4.05 3.88 3.8 4.03 4.62 4.29 0.45 10.48 3.8 4.88

CPCL 3.14 3.5 3.02 3.95 3.14 3.82 5.31 3.7 0.8 21.52 3.02 5.31

Average 3.05 3.44 3.22 3.17 3.12 3.93 4.18 3.4 0.64 31.2 2.8 4.55

It is evident from table No.2 that the fixed assets turnover ratio of HPCL was the highest

among all companies. The average turnover was at 1.18 times, 1.16 times 5.07 times,

4.29 times and 3.70 times in RPL, ESSAR, BPCL, IOC and CPCL respectively. The S.D.

of these companies is 0.21, 1.37, 0.47, 0.57, 0.45 and 0.80 respectively.

Current Assets Turnover Ratio

This ratio applied to measure the turnover and profitability of total current assets applied

to conduct the operation of firm. The ratio is calculated by dividing the amount of sales

by the amount of current assets. The ideal behind the current assets turnover ratio is to

give an over-all impression of how rapidly the total investment in current assets is being

turned and is thought of by some as an index of ‘efficiency’. The lower the turnover of

the current assets worse is the utilization of current assets. The higher the turnover, the

better is the use of current assets.

Table No.3

Current Assets turnover ratio

COMPANY

1999-

2000

2000-

01

2001-

02

2002-

03

2003-

04

2004-

05

2005-

06 AVE. S.D. C.V. Min Max

RPL 1.749 2.2758 2.094 2.127 2.22 2.269 3.361 2.3 0.5 21.8 1.749 3.36

ESSAR 0.245 0.2744 0.217 0.366 0.21 0.939 0.553 0.4 0.27 66.4 0.209 0.94

HPCL 4.947 5.5643 6.414 5.781 5.47 6.306 6.569 5.87 0.59 10.05 4.947 6.57

BPCL 6.035 5.7904 6.488 6.139 5.27 5.565 5.673 5.85 0.4 6.913 5.266 6.49

IOC 3.731 4.0362 4.503 3.847 3.8 3.779 4.184 3.98 0.28 7.05 3.731 4.5

CPCL 3.137 3.8355 3.726 3.688 3.8 3.62 4.102 3.7 0.29 7.913 3.137 4.1

Average 3.307 3.6294 3.907 3.658 3.46 3.746 4.074 3.68 0.39 20.02 3.173 4.33

The current assets turnover ratio of refinery industry registered an increasing trend during

the research period. It is ranged between 3.307 times in 1999-2000 to 4.074 times in

2005-06. The average ratio of RPL and Essar was lower than the industry’s average

which indicates lower utilization of current assets in these units. But the same ratio was

good in HPCL, BPCL, IOC and CPCL which showed proper utilization of current assets.

As whole it can be concluded that the performance of HPCL and BPCL was satisfactory.

Sales Trend and Cost Structure Analysis

Trend analysis examines the tendencies by (a) selecting a representative year as the

base and (b) expressing the figures of the remaining years in relation to the base

year. The significance of the choice of base lies in the fact that the values of the

items in the base year are assumed to be 100 and the index numbers are calculated for

other years based on the amount of that item in those years. It is not necessary that a

year should be chosen as the base. If there is no year which qualifies to be the base, for

whatever reason, and then an `average concept' can be employed.

In India, the financial analysis made by the Stock Exchange Authorities follows the

`average concept' in presenting trend data. According to the stock exchange official

directory, "A trend analysis has been made showing the percentage of major items in

the balance sheet and profit and loss statement compared to a base value ...., for the

purpose of calculation the base value has been taken as the average for each item over

the last ten years or as many years for which the data is available."

Trend analysis is effective only when relevant and related items are studied together.

Thus, the results which are shown are an enterprise has to be viewed in conjunction with

the resources employed. For instances, sales trend have to be studied alongwith debtors,

inventory and even fixed assets, because it would be unhealthy development if a

downward trend in sales is accompanied by an upward trend in inventories and trend

debts or by a marked increase in plant and equipment, especially if financed by

borrowed funds.

In present paper an attempt has been made to study the cost component of cement units

under study. For the purpose of analysis of cost component the all components cost has

been calculated as percentage of sales. While to analyze the sales position of units trend

analysis is made.

ANALYSIS OF SALES TREND:

`Sales' is the value of the output supplied to the customers. It is the life blood of a

business enterprise. Without which the business can not survive. Further, `Sales' is the

indicator of the operational efficiency of management in to how efficiently the

management has used the assets of the business. The higher the volume of sales, the

more efficient the management. Sales is also related to profitability of an enterprise,

if other things remain constant. The higher the amount of sales, the more profitable the

business is and vice versa. The matching of costs incurred during a certain period with

sales generated during that period reveals the net income or net loss.

The trend of sales indicates the direction in which a concern is going on and on the

basis of which forecast for further can be made. The trend analysis of sales makes to

understand the growth of a business enterprise. For proper trend analysis, the trend

should be studied at least over period of 5 or more years.

To study the trend of sales in cement companies under study, the year 1998-99 has been

chosen as the base year and figure of sales in the base year have been taken equal to

100. Index numbers have been calculated for the remaining years based on the amount of

sales for the base year. The following table shows the trend of sales in the companies

under study.

Table - 1

Sales Trend

Year 1998-99 1999-2000 2000-01 2001-02 2002-03 Average S.D.

DCL 100 113.530 127.721 129.559 136.527 121.467 14.622

GACL 100 105.335 119.571 130.485 163.557 123.790 25.252

ICL 100 103.301 108.669 88.107 73.623 94.740 14.008

MCL 100 98.693 118.577 135.602 120.253 114.625 15.452

SCL 100 98.191 95.828 112.345 107.338 102.740 6.881

Average 100 103.81 114.073 119.22 120.26 111.4725

Sales trend of units under study showed a fluctuating trend. DCL and GACL trend

indicates an increasing trend thought the study period. Where ICL, MCL and SCL trend

indicated a fluctuating trend. The average trend of units under study was 111.47. While

the average trend of DCL and GACL were higher than this on other hand ICL, MCL, and

SCL trend were lower than the average of units under study. The standard deviation

figure shows a high fluctuation in trend value of all the units under study.

Analysis of Cost Structure:

The data of total cost in various cement companies under study have been rearranged and

classified under the coming heads:

(a) Raw Materials and Stores Consumed:

Raw materials consumed consists of the amount spend on various types of raw materials

and components consumed during the course of manufacturing. Further the figure has

been arrived at by adding the cost of opening stock of raw materials to the purchases of

raw material and deducting the cost of closing stock. It also includes the amount spent on

octroi, carriage inwards as well stores consumed etc.

Table - 2

Raw Materials and Stores Cost as Percentage of Sales

Year 1998-99 1999-2000 2000-01 2001-02 2002-03 Average S.D.

DCL 29.7 34.11 32.09 32.73 28.8 31.486 2.191

GACL 13.29 11.39 13.34 15.46 15.05 13.706 1.624

ICL 15.03 16.35 14.1 13.64 17.73 15.37 1.677

MCL 19.33 20.01 22.21 19.52 22.13 20.64 1.419

SCL 15.58 13.8 15.95 13.06 17.54 15.186 1.783

Average 18.586 19.132 19.538 18.882 20.25 19.2776

Table – 2 indicates the percentage of raw materials and stores cost to sales. The cost

showed a fluctuating trend in all units under study. The average raw material cost of the

entire study was 19.277 per cent, where as the average raw material cost of DCL was

31.486 per cent, which was highest among all units under study. While the raw material

cost of GACL was 13.706 per cent, which is lowest among all units under study. The

average raw material cost of ICL, MCL and SCL were 15.37 per cent, 20.64 per cent and

15.186 per cent respectively. The standard deviation of DCL indicates high fluctuation in

cost.

Raw Materials and Stores Consumed Cost and ANOVA Test:

Ho = There is no any significant difference in percentage of Raw Materials and

Stores Consumed cost in companies.

Table - 3

ANOVA

Source of

Variation SS df MS F F crit

Between Groups 8.346896 4 2.086724 0.037157 2.866081

Within Groups 1123.206 20 56.1603

Total 1131.553 24

It is evident from table - 3 that there is no any difference in Raw Materials and Stores

Consumed among the units under study because calculated value of F (0.037) is lower

than table vale of 2.86.

(b) Salaries and Wages:

The amount paid to employees by way of salaries, wages, bonus, gratuties and

contribution towards the provident funds, superannuation funds, family pension scheme,

gratuity funds have been classified as `Salaries and Wages' in the present study.

Table - 4

Wages & Salaries Cost as Percentage of Sales

Year 1998-99 1999-2000 2000-01 2001-02 2002-03 Average S.D.

DCL 7.37 6.87 5.57 5.4 5.07 6.056 1.003

GACL 2.68 3.4 3.2 3.36 3.4 3.208 0.306

ICL 5.63 4.97 5.35 7.51 9.09 6.51 1.743

MCL 4.6 5.47 5.58 4.54 4.73 4.984 0.500

SCL 3.31 3.03 2.99 3.41 4.14 3.376 0.463

Average 4.718 4.748 4.538 4.844 5.286 4.8268

Wages and salaries cost as percentage of sales has been presented in table – 4. The

portion of this cost in total cost is very low. It ranged between 3 to 6 per cent. The

average wages and salaries cost of study was 4.82 per cent; while the GACL cost is

lowest (3.20 per cent) among all units under study. The standard deviation of GACL also

indicates that very low fluctuation in cost.

Wages and Salaries Cost and ANOVA test:

Ho = There is no any significant difference in percentage of Salaries and Wages

cost in companies.

Table - 5

ANOVA

Source of

Variation SS df MS F F crit

Between Groups 1.563064 4 0.390766 0.125411 2.866081

Within Groups 62.31768 20 3.115884

Total 63.88074 24

It is clear from table – 5 that there is no any difference in wages and salaries cost in all

units under study. Because of table value of F is higher than calculated value of F.

Standard deviation also indicates very low fluctuations in cost.

(c) Indirect Taxes:

The indirect taxes includes excise duty charged at the time of production by the

Central Government has been consider under this head.

Table - 6

Indirect Taxes as Percentage of Sales

Year 1998-99 1999-2000 2000-01 2001-02 2002-03 Average S.D.

DCL 13.4 15.03 12.98 12.89 13.51 13.562 0.862

GACL 15.43 14.38 12.43 12.71 14.46 13.882 1.271

ICL 16.07 16.92 14.54 16.15 18.46 16.428 1.427

MCL 2.07 2.45 1.93 15.11 17.85 7.882 7.911

SCL 15.77 15.59 15.95 16.22 17.01 16.108 0.555

Average 12.548 12.874 11.566 14.616 16.258 13.5724

Table – 6 showed a portion of indirect taxes as percentage of sales in cement industry.

The data showed fluctuating trends in all units under study. The average ratio of units

under study was 13.57 per cent. Out of five units under study the average cost of two

units were below the study average. MCL indirect cost was lowest (7.88 per cent) among

all units under study. The result of standard deviation also indicates very low fluctuation

in all units under study except MCL.

Indirect Cost and ANOVA test:

Ho = There is no any significant difference in percentage of Indirect Cost in

companies.

Table - 7

ANOVA

Source of

Variation SS df MS F F crit

Between Groups 69.32174 4 17.33043 0.796606 2.866081

Within Groups 435.1065 20 21.75533

Total 504.4283 24

From the above table, it is clear that there is no any difference in indirect cost of all units.

Because the calculated value of F is lower than table value of F.

(d) Power and Fuel:

Electricity expenses in cement industry played a vital role. For the purpose of analysis

any expenses related to electricity and for other fuel have been considered under this head.

Table – 8

Power and Fuel Cost as Percentage of Sales

Year 1998-99 1999-2000 2000-01 2001-02 2002-03 Average S.D.

DCL 17.72 16.4 15.72 15.44 16.34 16.324 0.880

GACL 19.2 21.38 20.46 20.45 21.18 20.534 0.855

ICL 24.74 26.11 24.34 25.46 30.22 26.174 2.361

MCL 22.85 24.88 23.16 20.17 21.99 22.61 1.721

SCL 25.31 28.63 23.59 22.74 20.5 24.154 3.043

Average 21.964 23.48 21.454 20.852 22.046 21.9592

Power and fuel cost as percentages of sales presented in table – 8. The range of power

and fuel cost in selected units was between 16.324 to 26.174 per cent. The average power

and fuel cost of the study was 21.959 per cent; while the average power and fuel cost of

DCL (16.32 per cent) and GACL (20.534 per cent) were lower than the average of study.

The standard deviation of SCL indicates high fluctuation in cost, while standard deviation

of DCL (0.88) indicates a low fluctuation in cost.

Power and Fuel Cost and ANOVA test:

Ho = There is no any significant difference in percentage of Power and Fuel cost

in companies.

Table -9

ANOVA

Source of

Variation SS df MS F F crit

Between Groups 19.00754 4 4.751886 0.277747 2.866081

Within Groups 342.1732 20 17.10866

Total 361.1808 24

Anova table indicates there is no any significance difference in power and fuel cost

among all the units under study because calculated value of F is lower than table value of

F at 5% level of significance.

(e) Depreciation:

In the cost structure of Indian cement industry the absolute figure of depreciation is very

high. So the amount of depreciation of all fixed assets is considered under this head in

present study.

Table - 10

Depreciation Cost as Percentage of Sales

Year 1998-99 1999-2000 2000-01 2001-02 2002-03 Average S.D.

DCL 5.95 5.41 4.77 4.83 4.73 5.138 0.532

GACL 9.82 9.51 8.93 8.7 8.44 9.08 0.572

ICL 5.17 5.25 5.76 7.36 7.93 6.294 1.270

MCL 8.33 8.95 8.51 7.45 8.53 8.354 0.554

SCL 5.67 5.09 4.62 10.86 10.37 7.322 3.034

Average 6.988 6.842 6.518 7.84 8 7.2376

Depreciation cost as percentage of sales presented in table – 10. The average depreciation

cost of DCL, GACL, ICL, MCL and SCL were 5.13 per cent, 9.08 per cent, 6.29 per cent,

8.35 per cent and 7.32 per cent respectively. The table data and standard deviation

indicates a low fluctuation in the cost in all units under study.

Depreciation Cost and ANOVA test:

Ho = There is no any significant difference in percentage of Depreciation cost in

companies.

Table - 11

ANOVA

Source of

Variation SS df MS F F crit

Between Groups 8.403816 4 2.100954 0.476043 2.866081

Within Groups 88.26744 20 4.413372

Total 96.67126 24

Table – 11 indicates that calculated value of F is lower than table value so, null

hypothesis is accepted. It means there is no any significance difference in the

depreciation cost among all units under study.

(f) Administrative, Selling, Distribution and Other Expenses:

The expenses relating to office and general administration of companies like the

director's fees, auditor's remuneration, legal expenses, rent, rates, taxes and depreciation

of office building and equipments have been groped as administrative and other

expenses. Selling and Distribution expenses include the amount spent during the course

of sales, boosting the sales and delivery of goods sold has been termed as selling and

distribution expenses. The expenses relating to advertisement , commission to selling

agents and other incentive and service charge, delivery charges, freight and

transportation etc. are covered under the above head.

Table - 12

Administrative, Selling, Distribution & Other Expenses as Percentage of Sales

Year 1998-99 1999-2000 2000-01 2001-02 2002-03 Average S.D.

DCL 11.48 12.28 11.98 10.97 9.95 11.332 0.919

GACL 18.65 17.03 16.31 16.12 18.31 17.284 1.150

ICL 16.3 16.44 16.4 17.85 15.02 16.402 1.002

MCL 17.18 17.41 16.5 16.45 11.04 15.716 2.647

SCL 21.09 21.28 22.98 23.57 22.54 22.292 1.077

Average 16.94 16.888 16.834 16.992 15.372 16.6052

Table – 12 reveals administrative, selling, distribution and miscellaneous expenses as

percentage of sales. The average ratio of DCL, MCL and ICL were 11.33 per cent, 15.71

per cent and 16.402 per cent which were lower than the average ratio of industry. While

SCL ratio was 22.29 per cent highest among all units under study.

Administrative, Selling, Distribution and Other Expenses ages and Salaries Cost

and ANOVA test:

Ho = There is no any significant difference in percentage of Administrative,

Selling, Distribution and Other Expenses cost in companies.

Table - 13

ANOVA

Source of

Variation SS df MS F F crit

Between Groups 8.403816 4 2.100954 0.476043 2.866081

Within Groups 88.26744 20 4.413372

Total 96.67126 24

Table shows that there is no any significance difference in Administrative, Selling, and

Distribution & Other Expenses of units under study because of the acceptance of null

hypothesis.

(g) Financial Charges

In Indian cement industry structure indicates that most of the companies satisfied their

financial need through Equity, Preference, Loans and Debentures. So the portion of

Financial Charges in the cost structure of industry has played vital role in the

performance of the companies. Expenses related to interest and other financial charges

have been considered under this head for the purpose of the study.

Table - 14

Financial Charges Cost as Percentage of Sales

Year 1998-99 1999-2000 2000-01 2001-02 2002-03 Average S.D.

DCL 9.56 8.35 7.84 7.12 6.33 7.84 1.226

GACL 10.35 9.63 9.78 7.31 6.45 8.704 1.714

ICL 11.51 12.17 13.2 17.32 25.18 15.876 5.670

MCL 13.71 12.06 10.85 9.68 9.03 11.066 1.877

SCL 10.91 10.31 8.74 8.44 5.99 8.878 1.919

Average 11.208 10.504 10.082 9.974 10.596 10.4728

Table – 14 reveals that the ratio of financial charges to total sales in cement industry of

India. The ratio showed a fluctuating trend. The average ratio of study was 10.47 per cent

where as the ratio of ICL and MCL were higher than average ratio of study. The standard

deviation of ICL indicates high fluctuations.

Financial Charges Cost and ANOVA test:

Ho = There is no any significant difference in percentage of Financial Charges

cost in companies.

Table - 15

ANOVA

Source of

Variation SS df MS F F crit

Between Groups 4.790984 4 1.197746 0.062848 2.866081

Within Groups 381.1547 20 19.05774

Total 385.9457 24

Table – 15 indicates that critical value of F is higher than calculated value of F means

null hypothesis accepted and alternative hypothesis is accepted. Result of Anova

indicates there is no any significance difference in financial charges cost among all units

under study.

References

• Chowdhry S.B. Analysis of Company Financial Statement, Asia Publishing

House, 1964, p.71

• Foulke A. Roy, Practical Financial Statement Analsis, Tata McGraw Hill Ed.

VI, p.155.

Chapter – 4

Profitability Analysis

• Introduction

• Concept of Profitability

• Measurement of Profitability

• Profitability from the view point of Financial Management

(i) Gross Profit Ratio

(ii) Operating Profit Ratio

(iii) Return on Capital Employed

• Analysis of the profitability from the view of shareholder's

(i) Net Profit Ratio

(ii) Return on Owners' Equity

(iii) Return on Equity Capital

(vi) Earning Per Share

(v) Dividend Pay-out Ratio

• Case Study of Profitability Analysis

• References

Introduction: The financial manager has to take rational decisions from time to time keeping in view

the objectives of his company. Always the decisions must be based on the analytical tools.

Financial analysis is the most useful techniques in this regard. Financial analysis relies on

the comparisons or relationships of the data that enhances the utility or the practical value

of the accounting information. This analysis consists in applying various analytical tools

and techniques to the financial data.

Concept of Profitability:-

The Word ‘profitability’ is composed of two words ‘profit’ and ‘ability’. Therefore,

profitability means the profit-making ability of the enterprise. Profits are the soul of the

business without which it is lifeless. For accounting purpose the profit is the difference

between total revenue and total expenditure over a period of time. The term ability is also

referred to as ‘earning power’ or ‘operating performance’ of the concerned investment.

Profitability indicates the capacity of management to generate surplus in the process of

business operations. Sometimes the terms ‘profitability’ and ‘profit’ are used

synonymously but there is difference between the two. Profitability has a sense of

relativity, where as the term profit is used in absolute sense.

Measurement of Profitability:-

Profitability is the result of financial as well as operational efficiency. It is the outcome

of all business activities. Measurement of profitability is a multi-stage concept. A

measure of ‘profitability’ is the overall measure of efficiency.”

Profitability is a concept based on profits but since it is a relative concept, profits are to

be expressed in relation to some other variables. Several ratios can be computed to

measure the extent of profitability in quantitative terms. Profitability ratios are calculated

to measure the operating efficiency of an enterprise. Profits can be related mainly to

sales and investment to determine profitability. An enterprise should be able to produce

adequate profit on each rupee of sales. If sufficient profits are not generated through

sales, it becomes problematic for an enterprise to cover its operating costs and the interest

burden.

An appraisal of the financial position of any enterprise is incomplete unless its overall

profitability is measured in relation to the sales, assets, capital employed, net worth and

the earning per share.

Profitability from the view point of Financial Management A financial manager is very much interested to locate and pin-point the causes which

are responsible for low or high profitability. The Financial Manager should

continuously evaluate the efficiency of its company in terms of profit. In analysing the

profitability of cement industry in India, from the point of view of Financial

Management, the following ratios are considered:

(i) Gross Profit Ratio

(ii) Operating Profit Ratio

(iii) Return on Capital Employed

1. Gross Profit Ratio:

This ratio expresses the relationship of gross profit to net sales, in term of percentage.

The determinants of this ratio are the gross profit and sales, which means net sales,

obtained after deducting the value of goods returned by the customers from total sales.

This ratio is of vital importance for gauging business results. A low gross profit ratio

will suggests decline in business which may be to insufficient sales, higher cost of

production with the existing or reduced selling price or the all-round inefficient

management. The financial Manager must be able to detect the causes of a falling gross

profit ratio and initiate action to improve the situation.

A high gross profit is a sign of good and efficient management.

It is calculated as follows:

Gross Profit Gross Profit Ratio = --------------- * 100 Net Sales

2. Operating Profit Ratio:

This ratio indicates the relationship between operating profit and net sales in the form of

percentage. Operating profit arrived at by adjusting all non-operating expenses and

incomes in net profit in the other words, we can say profits before depreciation and

taxes. A consistently high ratio tells us the effective and efficient operation of the

business. It is calculated as below;

Operating Profit Operating profit ratio = ------------------ * 100 Net Sales

3. Return on Net Capital Employed:

In the words of Anthony, "Return on net capital employed looks at income in relation to

the permanent funds invested in the enterprise. The permanent funds consist of

shareholders' equity plus non-current liabilities or the same figure may be found by

subtracting current liabilities from total assets thus, net capital employed consists of

total assets in the enterprise less its current liabilities. The term `return' signifies

operating profit before interest and taxes. The ratio is more appropriate for evaluating the

efficiency of internal management. It enables the management to show whether the funds

entrusted to enterprise have been properly used or not.

A high ratio is a test of better performance and low ratio is an indication of poor

performance. This ratio is the most important for studying the management efficiency of

the enterprise. It is used to study the operational efficiency of the enterprise. It shows the

earning capacity of the capital.

The formula for derivation of this ratio is:

Operating profit before Interest and Tax Return on Net Capital = --------------------------------------- Employed Net Capital Employed

Analysis of the Profitability from the view of Shareholder's

The owners- the shareholders- have permanent stake in the enterprise and as such they

have to share the prosperity marked by higher profitability and adversity marked by

losses. The financial welfare of the owners increases when net profit after tax has

increases and also when they receive larger share of dividend. For this analysis, following

ratio are calculated:

(i) Net Profit Ratio (ii) Return on Owners' Equity (iii) Return on Equity Capital (vi) Earning Per Share (v) Dividend Pay-out Ratio

1. Net Profit Ratio:

Net profit margin is a good indicator of the efficiency of a firm. As pointed out by Van

Horne this ratio "tells us the relative efficiency of the firm after taking into account

all expenses and income-taxes, but not extraordinary charges." Net profit margin ratio is

determined by relating net income after taxes to net sales.

Net profit margin ratio(in percentages) is calculated by dividing the amount of net

surplus by the amount of operating revenue(sales) multiplying by 100. The formula for

calculating the ratio is:

Net Profit Net Profit Ratio = -------------- * 100 Sales

2. Return on Owner's Equity (Net Worth):

The ratio of return on owner’s equity is a valuable measure for judging the profitability of

an organisation. This ratio helps the shareholders of a company to know the return on

investment in terms of profits. Shareholders are always interested in knowing as to what

return they earned on their invested capital. Anthony and Reece opine that this ratio

"reflects that how much the firm has earned on the funds invested by the shareholders

(either directly or through retained earnings).

They further point out that the ratio of return on owner's equity is most significant when

the book value of net worth is close to the market value of the stock since new capital

is raised at market prices rather than at book value and firms are usually judged on

their earnings performance relative to the market price of their stock.

This ratio is expressed in the percentage from of net profit earned to the owners' equity.

The formula for the derivation of this ratio is:

Net Profit(after int. & tax) Return on Owner's Equity = ----------------------------- * 100 Owners' Equity

3. Return on Equity Capital:

The net surplus after tax expressed as a percentage to the equity capital shows the degree

of availability of current profits to the equity shareholders. According to Bierman and

Drebin, "The stock equity earning ratio gives an indication of how effectively the

investment of stockholders is being used".

A high stock equity earnings rate may be obtained by using a large amount of debt if the

rate of earnings on assets exceeds the interest rate on the debt. This is called trading on

equity.

The formula for calculating return on equity capital ratio can be expressed as:

Net Profit (after int. & tax) Return on Equity Capital = ------------------------------ * 100 Equity Capital (Paid-up)

4. Earning Per Share (EPS):

In the word of A. Tom Neslon, "Investment circles often quote earning per share as a

measure of profitableness of the ordinary shareholders' investment. It has become one of

the most important measure by which outsiders evaluate performance of management."

Earning per share is considered one of the most important indicator of profitability

because it can easily be compared with previous EPS figures and with those of

other companies and investors find it convenient to compare the amount earned for a

single share of stock. Hampton, John, J. observes that, "Earning per share is arrived at by

dividing the earning available to the equity or common shareholders by the number of

outstanding shares. However, the shares authorised but not used or authorised, issue and

repurchased are omitted from the calculation."

To interpret, this ratio properly requires a good understanding of how primary and fully

diluted EPS are calculated. It is expressed by the formula given below:

Net profit Earning Per Share = ---------------------- Total number of shares

5. Dividend Pay-out Ratio:

This ratio indicates what percentage of the firms earnings, after tax less preference

dividend is being paid to equity shareholders in the form of dividends. The percentage

not paid out is retained in the business for ploughing back. Thus, the pay-out ratio is a

major aspects of the dividend policy of a firm, because it measures the relationship

between the earnings belonging to equity shareholders and the cash dividend paid to

them. If the dividend pay-out ratio is subtracted from 100, it will give the percentage

share of the net profits retained in the business. If the pay-out ratio is more than 100, it

means dividend has been paid from the previous reserves.

Equity Dividend Dividend Pay-out Ratio = ---------------------------- * 100 Profit after tax & Pref. Div.

Case Study of Profitability Analysis:

Profitability is the overall measure of the companies with regard to efficient and effective

utilization of the resources at their command. It indicates in a nutshell the effectiveness of

the decisions taken by the management from time to time. The profitability is also known

as the “Return on the Total Assets” (ROI).

It can be calculated by using the following formula:

Return on Investment (ROI) = Net Profit/Total Capital Employed.

Table –1

Profitability Ratios of the Companies Return on Investment Ratio 1997-98 1998-99

1999-2000

2000-01

2001-02

2002-03 Average S.D. C.V.

GACL 6.07 6.42 5.47 5.72 5.07 5.44 5.698 0.484 8.500DCL 5.86 3.7 3.77 4.81 4.33 0.96 3.905 1.647 42.164MCL 3.93 4.55 4.28 4.24 2.03 1.1 3.355 1.431 42.651Net Profit Ratio GACL 12.72 13.13 12.16 14.25 13.38 12.13 12.962 0.807 6.226DCL 10.16 6.31 6.15 7.52 7.11 1.56 6.468 2.806 43.378MCL 6.79 7.61 7.76 7.82 3.69 2.28 5.992 2.400 40.056Total Assets Turnover Ratio GACL 0.478 0.481 0.454 0.404 0.376 0.45 0.441 0.042 9.530DCL 0.595 0.621 0.663 0.674 0.623 0.554 0.622 0.044 7.099MCL 0.599 0.58 0.568 0.546 0.549 0.483 0.554 0.040 7.230Return on Net Worth Ratio GACL 12.62 12.51 10.22 11.93 11.85 13.13 12.043 1.011 8.391DCL 14.27 8.87 9.08 11.47 11.26 2.73 9.613 3.900 40.571MCL 10.78 11.95 11.12 12.3 7.68 5.33 9.860 2.758 27.970 It is evident from table –1 that the highest ROI among all units was at 6.42 percent in

1998-99, 5.68 percent in 1997-98 and 4.55 percent in 1998-99 for GACL, DCL and MCL

respectively. In DCL and MCL the ROI in 2002-03 was 0.96 percent and 0.11 percent

respectively, which was lowest ROI among all units under study.

The average rate of return was at 5.698 percent in GACL, 3.905 percent in DCL and

3.355 per cent in MCL. The standard deviation (0.484) and C.V. (8.50) of GACL shows

consistency in the ratio as compared to DCL and MCL.

Return on Investment and ANOVA Test:

Null Hypothesis: The profitability of all three units is uniform.

Table – 2

ANOVA Table Source of Variation Sum of

Squares Degree of Freedom

Mean Square

‘F’ Ratio 5% F Limit From Table F

Between Companies With in Companies

18.02 24.97

2 15

9.01 1.66

5.41 F(2,15) 3.68

Total 42.99 17

It is evident from the table - 2 that the difference between in Return on Investment of

companies was significant because the calculated value of ‘F’ (5.41) was higher than that

of table value (3.68) at 5% level of significance. Hence the null hypothesis is rejected and

the alternative hypothesis is accepted. The difference in between was significant because

of variation in return on investment ratio of the companies.

Analysis of Sales and Assets Efficiency: Sales and assets efficiency ratios are components of the ROI. Sales efficiency can be

measured with the help of net profit margin; whereas the assets efficiency is presented by

assets turn over ratio.

Efficiency of Sales: This ratio explains per rupee profit generating capacity of the sales. If the cost of goods

sold is lower, then the profit will be higher and then we divide it with the net sales the

Return On Investment

02468

1997-98

1998-99

1999-2000

2000-01

2001-02

2002-03

YearR

OI (

%)

GACLDCLMCL

result is the high sales efficiency. If lower is the net profit per rupee of sales, lower will

be the sales efficiency. The companies must try for achieving greater sales efficiency for

maximizing the ROI. Sales efficiency ratio = Net Profit/Net Sales.

Efficiency of Assets: This ratio measures the efficiency of the assets use. The efficient use of assets will

generate greater sales per rupee invested in all the assets of the company. The inefficient

use of the assets will result in low sales volume coupled with higher overhead charges

and under utilization of the available capacity. Hence, the management must strive for

using of total resources at optimum level, to achieve higher ROI.

Assets Efficiency Ratio = Net Sales/Total Net Assets

Analysis of Sales Efficiency Profit margin ratio of GACL shows fluctuating trend, the average ratio of GACL was

12.962 percent, which was highest among all the units of study. The net profit margin of

DCL and MCL was 1.56 percent and 2.28 percent in 2002-03, which was lowest in entire

study. It shows the sales efficiency of these units were poor. The S.D. of GACL was

0.807, which indicates consistency in net profit margin. The sales efficiency ratios have

been showing a significant feature of higher rates with greater reliability and uniformity

in GACL than the DCL and MCL during the entire period under the study.

Analysis of Assets Efficiency The analysis of the assets efficiency ratios indicates that in 2002-03 these were at 0.45,

0.554 and 0.483 times in GACL, DCL and MCL respectively. The average ratio of DCL

was highest among all the units. The S. D. of all units was near 0.04 indicates consistency

in this ratio.

Impact of sales and assets efficiency on ROI

The analysis revealed that the sales efficiency was more uniform and significantly higher

in GACL followed by DCL. The assets efficiency was more consistent in DCL and MCL

as compared to GCAL. Thus, this indicates that the sales efficiency was maximum in

GACL, while assets efficiency was maximum in DCL. However to pinpoint the possible

influencing factor, contributing for the fluctuations in ROI, we analyze the highest/lowest

years of ROI with reference to sales and assets efficiency ratios we observe the following:

• The highest ROI in 1998-99 at 6.42 percent in GACL was influenced by the

increase in the assets efficiency and sales efficiency.

• The low rate of ROI in 2001-02 in GACL was attributed to low rate of assets

efficiency rather than the sales efficiency.

• In DCL the highest ROI in 1997-98 at 5.86 per cent was the reasons of higher

sales efficiency and in MCL ROI was highest in 1998-99 at 4.55 per cent was

also the reason of higher sales efficiency.

• The reason for lower ROI in DCL and MCL was the lower the efficiency of

sales and assets.

Tables and analysis indicates that the sales efficiency was the major contribution factor

for the fluctuation in the rates of ROI in all the companies.

Return on Net Worth: The return on net worth in GACL was highest in 2002-03 at 13.13 percent and its average

return was 12.043 where as the average return on net worth of DCL and MCL was 9.613

per cent and 9.860 percent respectively. In the year 2002-03 the return of both these

companies was lower during the study. The reason behind on this was lower ROI in these

years. The ratio of GACL also shows a steady return on net worth.

Analysis of Liquidity Position: Next, it is decided to make an attempt to study the liquidity position of the companies, in

order to highlight the relative strength of the companies in meeting their current

obligations to maintain sound liquidity and to pinpoint the difficulties if any in it. Using

the following two liquidity ratios makes the analysis of the liquidity position:

1. Current Ratio = Current Assets/Current Liabilities

2. Quick Ratio = Quick Assets/Current Liabilities

Table –3

Liquidity Ratios of the Companies (Times) Current Ratio 1997-98 1998-99 1999-20002000-012001-022002-03Average S.D. C.V.GACL 1.717 1.264 0.564 0.976 1.465 0.709 1.116 0.446 39.976DCL 2.362 2.622 1.875 2.189 1.533 1.239 1.970 0.522 26.484MCL 1.688 1.411 1.283 1.85 1.341 1.234 1.468 0.246 16.762Quick Ratio GACL 0.84 0.44 0.14 0.19 0.34 0.14 0.348 0.269 77.255DCL 0.74 0.87 0.56 0.62 0.27 0.22 0.547 0.257 47.047MCL 0.78 0.53 0.36 0.58 0.41 0.39 0.508 0.158 31.115 Current Ratio: A close examination of the data pertaining to the current ratios reveals that these ratios

are significantly lower in all the companies as compared to standard norms of 2:1. The

average ratios are at 1.11 in GACL, 1.97 in DCL and 1.46 in MCL. This ratio indicates

that the liquidity position of DCL was sound as compared to GACL and MCL. In 2002-

03 the ratio of GACL was 0.709 indicate the scarcity of liquidity. Where the ratio of

MCL shows consistency in liquidity position of the company because of its S.D. is 0.24

lower among all companies.

Current Ratio and ANOVA Test: Null Hypothesis: The liquidity position of all three units is satisfactory.

Table – 4

ANOVA Table

Source of Variation Sum of Squares

Degree of Freedom

Mean Square

‘F’ Ratio 5% F Limit From Table F

Between Companies With in Companies

2.21 2.66

2 15

1.11 0.18

6.24 F(2,15) 3.68

Total 4.87 17 It is clear from table- 4 that the difference in between companies was significant because

the calculated value of F was higher than table value. So, null hypothesis is rejected and

alternative hypothesis is accepted. The difference is due to working capital policy of

companies.

Quick Ratio: The quick ratio was of GACL, DCL and MCL were at 0.14, 0.22 and 0.39 times in 2002-

03 respectively as compared to standard norms of 1:1. It signals that companies have

been suffering from the problem of liquidity. During the study period average ratio of

DCL was higher as compared to GACL and MCL, but the consistency was maintain by

MCL because its S.D. was lower as compared to GACL and DCL.

The analysis of both current and quick ratio revels that the companies were not able to

maintain sound liquidity position. Hence, it is advise that the companies maintain the

sound liquidity position by reducing the burden of excessive current liquidities or by

Current Ratio

0123

1997-98

1998-99

1999-2000

2000-01

2001-02

2002-03

YearC

.R. (

Tim

es)

GACLDCLMCL

increasing the investing in components of current assets depending upon the requirement

of the companies.

Analysis of Leverage Position: The leverage ratios explain the extent to which, the debt is employed in capital structure

of the companies. Always companies use debt fund along with equity funds, in order to

maximize the after tax profits, thereby optimizing earning available to equity

shareholders. The basic facility of debt funds is that after tax cost of them will be

significantly lower, and which can be paid back depending upon their terms of issue.

Further, debt funds will not dilute the equity holders control position. However, the debts

funds are used very carefully by considering the liquidity and risk factors. The debts will

increase the risk of the company. Now, let us analyze the leverage position of the

companies. For this purpose we have made using the following ratios:

1. Capital Gearing Ratio = Loan Capital + Preference Capital/Equity Capital

2. Debt Equity Ratio = Long-term Debt/Equity

3. Time Interest Earned = EBIT/Interest

Table -5

Leverage Ratios of the Companies (Times) Capital Gearing Ratio 1997-98 1998-991999-20002000-012001-022002-03 Average S.D. C.V.GACL 1.088 0.779 0.851 1.083 1.114 1.086 1.000 0.14614.562DCL 1.222 1.16 1.174 1.06 1.285 1.223 1.187 0.076 6.431MCL 1.563 1.284 1.5 1.795 2.808 2.661 1.935 0.64233.171Debt Equity Ratio GACL 0.995 0.692 0.784 1.083 1.114 1.086 0.959 0.17818.580DCL 1.222 1.16 1.174 1.06 1.285 1.223 1.187 0.076 6.431MCL 1.563 1.284 1.5 1.795 2.808 2.661 1.935 0.64233.171Interest Coverage Ratio GACL 2.06 2.16 4.64 2.46 2.94 2.94 2.867 0.94632.987DCL 2.08 1.72 1.74 2.11 2.19 1.91 1.958 0.19910.169MCL 1.45 1.5 1.69 1.83 1.51 1.34 1.553 0.17711.376

Capital Gearing: The average capital gearing of GACL was 1.00 indicates there is no gearing. While in

MCL ratio was 1.935 times indicates high gearing, it discloses that companies are more

dependants on fixed interest bearing securities. While in DCL the average ratio (1.187

times) indicates low gearing.

Debt Equity Ratio: It measures the extent of equity covering the debt. It is computed by dividing debt by

equity. Normally 2:1 debt equity ratio is considered to be standard. The range of debt

equity ratio in GACL was 0.692 to 1.114 times in 1998-99 and 2001-02 respectively.

Where as the average ratio of DCL and MCL were 1.187 and 1.935 times respectively.

The ratio indicates that MCL is highly dependent on debt. While GACL’s debt is less that

its equity indicated conservatives approach of financial management. The DCL ratio

shows moderate approach of financing of organization need.

Debt Equity Ratio and ANOVA Test: Null Hypothesis: The capital structure of all three units is uniform.

Table – 6

ANOVA Table Source of Variation Sum of

Squares Degree of Freedom

Mean Square

‘F’ Ratio 5% F Limit From Table F

Between Companies With in Companies

3.13 2.25

2 15

1.56 0.15

10.44 F(2,15) 3.68

Total 5.38 17

Debt Equity Ratio

0123

1997-98

1998-99

1999-2000

2000-01

2001-02

2002-03

Year

D.E

.R. (

Tim

es)

GACLDCLMCL

From above table it is clear that calculated value of ‘F’ is higher than table value so, null

hypothesis is rejected and alternative hypothesis is rejected. The difference is due to un

uniform debt equity proportion of companies.

Interest Coverage Ratio: It really measures the ability of the companies to service the debt. The ratio of GACL

was highest among all the companies under study. The average ratio of GACL, DCL and

MCL were 2.86 percent, 1.958 percent and 1.553 percent respectively. In 2002-03 the

ratio of GACL was highest between all the year and all the companies. It indicates sound

position of companies to pay the interest to its creditors. The DCL shows consistency

Analysis of Activity Ratio: These ratios are also called as turnover ratios. These will indicate position of the assets

usage. In order to compute these ratios sales are divided by various types of assets such

as inventory, debtors and net fixed assets. The ratios are expressed in number of times.

The greater the ratio more will be efficiency of assets usage. The lower ratio will reflect

the under utilization of the resources available at the command of the companies. Always

the companies must plan for efficient use of the assets to increase the overall efficiency.

In this analysis we will be covering the following ratios:

1. Inventory Turnover Ratio = Sales/Average Inventory

2. Debtors Turnover Ratio = Sales/Average Debtors

3. Net Fixed Assets Turnover Ratio = Sales/Net Fixed Assets

Table – 7

Activity Ratios of the Companies (Times) Inventory Turnover Ratio 1997-981998-991999-20002000-012001-02 2002-03 Average S.D. C.V.GACL 14.26 17.47 22.12 20.86 20.15 25.16 20.003 3.77418.869DCL 10.38 9.74 8.67 6.62 4.91 4.21 7.422 2.56734.590MCL 15.17 16.71 17.19 15.67 20.45 25.87 18.510 4.05321.897Debtors Turnover Ratio GACL 58.13 50.49 42.46 42.7 43.72 47.87 47.562 6.07912.782DCL 13.51 13.62 12.85 12.07 12.83 16.6 13.580 1.58111.644MCL 26.62 15.79 13.48 13.78 16.29 14.25 16.702 4.98629.853Fixed Assets Turnover Ratio GACL 0.739 0.723 0.818 0.912 0.79 0.885 0.811 0.076 9.404DCL 1.239 1.179 1.29 1.37 1.32 1.235 1.272 0.068 5.370MCL 0.83 0.776 0.768 0.77 0.746 0.625 0.753 0.068 9.092 Inventory Turnover Ratio: Table – 5 indicates that inventory turnover was 25.16, 4.21 and 25.87 time in GACL,

DCL and MCL respectively in 2002-03. This went to explain that rupee invested in

inventory was able to generate 7 to 20 times of sales in the companies. The ratio indicates

there was much distinctive difference in the inventory turnover, but with regards to the

stability of the ratio, it was more uniform in DCL.

Debtors Turnover: In GACL highest debtors turnover was at 58.13 times in 1997-98, while it was lowest

42.7 times in 2001. The trend of ratio shows fluctuating, with an average ratio of 47.562

times. As compared to GACL the ratio of DCL and MCL was lower in all the years of

study period. The average ratio of DCL and MCL was 13.580 times and 16.702 times

respectively. The DCL ratio was more stable as compared to GACL and MCL. The ratio

of GACL indicates effective management of debtors.

Net Fixed Assets Turnovers: It is evident from the Table – 5 that the fixed assets turnover ratio of DCL was higher

among all companies. The average turnover was at 0.811, 1.272 and 0.753 times in

GACL, DCL and MCL respectively. The S.D. of DCL and MCL was shown same

consistency in both companies.

Summary of Findings and Suggestions:

Return on the investment in 2002-03 was at 5.44, 0.96, and 1.1 in GACL, DCL

and MCL respectively, reflecting very low return in DCL and MCL. The average

return of all companies is also very low. The ROI of GACL was consistent and

higher than DCL and MCL.

F test suggest that there is no uniformity in return on investment of all companies.

The sales efficiency of GACL was significantly higher than DCL and MCL.

While no feature of assets efficiency was shown in GACL.

The study of impact of sales and assets efficiency on the ROI shows that sales

efficiency was major contributing factor more than the assets efficiency for the

variation in the rates of ROI of the companies. It is suggested that the

management of GACL has to pursue the policy of maximizing assets efficiency,

while DCL and MCL has to strive for the maximizing the sales efficiency by

generating maximum profit by introducing cost minimization and cost efficiency

techniques.

The return on net worth of GACL was higher among all companies. While DCL

and MCL return was mostly equal.

The liquidity position of GACL was quite alarming since they are facing chronic

liquidity problems. While DCL and MCL liquidity position also not quite good.

Therefore, it is suggested that the companies improve the liquidity position wither

by reducing excessive burden of current liabilities or increasing the level of

current assets depending upon the requirements.

The leverage position of the companies reveals that GACL has no any gearing

while gearing in MCL is higher. In MCL debt equity ratio is higher and in GACL

it is lower. The GACL are not using high debt even though its ROI is higher.

While MCL is not succeed in taking the benefits of trading on equity.

The result of F test indicates that the un uniform proportion of debt and equity in

the companies under study.

In activity analysis inventory turnover of GACL and MCL are satisfactory while

inn DCL it is poor. The debtor’s turnover of GACL is very high but its fixed

assets turnover is low. The debtors and fixed assets turnover of DCL and MCL

should improve for generating higher profits.

References:

Bhalla, V K. Financial Management and Policy, Anmol Publication, New Delhi,

2001-02.

Brealey, Richard A. and Myers Stewart C. Principles of Corporate Finance., Tata

McGraw Hill, New Delhi, 2001-02

Gangadhar V., Financial Analyses of Companies in Erita: A Profitability and

Efficiency Focus, The Management Accountant, Calcutta, Vol. 33 No. 11, Nov.,

1997-98.

Gitman, Managerial Finance, Pearson Education, New Delhi, 2004.

Hampton J.J., Financial Decision Making: Concepts, Problems and Cases,

Prentice Hall of India Pvt. Ltd., New Delhi1996.

Narayansamy N. and S.R. Ramchandran, Profitability Performance of District

Central Co-operative Bank: A Case Study, Indian Co-operative Review, Vol.

XXV, No. 2, pp. 210-215, NCUI, New Delhi, 1987.

Narware P.C., Working Capital and Profitability – An Empirical Analysis, The

Management Accountant, Calcutta, June 2004.

Pandey I.M., Financial Management, Vikash Publishing House, New Delhi, 2001-

02.

Rajesh Kumar B., Effect of ESOPs on Performance, Productivity and Risk, IIMB,

Management Review, March 2004.

Van Horne, Financial Management & Policy, Prentice Hall of India, New Delhi,

2002-03.

Chapter – 5

Productivity Management

• Introduction

• Analysis of Material Productivity

• Analysis of Labour Productivity

• Analysis of Overhead Productivity

• Analysis of Overall Productivity

• Conclusion

• References

Introduction: “Productivity is the basic mission of any organization to provide the maximum welfare

for the maximum number. Productivity as a measure of efficiency and effectiveness and

as a means of improving the quality of life is generic from achieving the highest output

from the limited resources. Productivity implies the certainty of being able to do better

than yesterday and keeping the tempo continuously to improve upon. Such continuous

improvements are to be generated through the research for new technique, methods,

process, materials, software, and expertise coupled with vision and dedicated leader -

ship having the ultimate faith in the welfare in the welfare of human system.” “Productivity means different things to different people. To workers productivity means a

speed up in their work pattern. To union leaders it means the opportunities to negotiate

for higher wages. To management, it means increased profitability. To customer, it

betters goods after costs. To marketing directors productivity improvement increases the

firm’s competitiveness abroad by reducing the coat of good sold in foreign market and to

economists; it means an increase in country’s standard of living field to gain in output per

man-hour. ” Productivity is simply the ratio of output to input. When this ratio is

calculated in based price it indicates the change in productivity efficiency over the base

year. As the input consist of a number of production factors and elements. Productivity

can also be determined separately for each of these factors. Both the output and the input

may be expressed in terms of physical units or interims of money. Productivity is

measured as the ratio between the output of a given commodity or service and the inputs

used for that product. Productivity ratio is the ratio of output of wealthy produced to the

input of resources used in the process.

Analysis of Material Productivity The cost of materials used in production of ten surpasses, in this view materials are

treated as the first factor in production or manufacturing. “Raw materials are the major

inputs in an organization and form the bulk which gets converted in to output”3 Materials

is one of the basic inputs which constitutes 50 to 70 percent of the total value of the

output of selected companies. Therefore to improve the performance selected companies,

material productivity will have to be improved.

Table – 1

Analysis of Material productivity

YEAR Output Input O/I

Co-efficient factor Index Trend I/o

Std. input

Possible saving

1997-98 1466.07 321.95 4.5537 0.3343 100 120.64 0.2196 279.163 42.78687

1998-99 1758.67 383.57 4.585 0.34591 100.69 110.06 0.2181 334.879 48.69116

1999-00 2013.1 388.87 5.1768 0.4064 113.68 99.482 0.1932 383.326 5.543627

2000-01 2253.33 429.07 5.2517 0.4117 115.33 88.902 0.1904 429.07 Nil

2001-02 2312.48 475.57 4.8625 0.3773 106.78 78.322 0.2057 440.333 35.2369

2002-03 4769.56 2323.61 2.0527 0.0923 45.076 67.741 0.4872 908.2 1415.41

2003-04 5952.25 3100.88 1.9195 0.076 42.153 57.161 0.521 1133.4 1967.477

2004-05 9337.95 4639.5 2.0127 0.0873 44.199 46.58 0.4968 1778.09 2861.405

2005-06 11122.1 6603.37 1.6843 0.0635 36.987 36 0.5937 2117.83 4485.545

TOTAL 40985.5 18666.4 32.099 2.1947 704.89 704.89 3.1256 7804.3 10862.09 AVERGAE 4553.95 2074.04 3.5665 0.24386 78.3216 78.322 0.3473 867.144 1357.762 STANDARD DEVIATION = 32.806 A=78.3216 Chi-square =36.23 CO-Efficient of variation = 41.887 B=(-10.5803)

The Table No.-1 showed that the ratio of material of Hindalco Ltd. was quite decreases

i.e. In 1997-98 it showed 4.55 while in 2005-06 it highlights 1.68 with an average of 3.57.

The trend was also declined. From 1997-98 to 2000-01 it showed increased trend while

between 2001-02 to it showed declining trend. The impact of productivity ratio described

the highly fluctuated trend in productivity index mainly during the study period. Input

output ratio shows the required input for a unit of output, which is lowest in the year 200-

01. In this year company has achieved the highest productivity. The figures of possible

savings show that the unit can save maximum up to 4485.54 P.A. This saving would

reduce the cost of material in the total cost and would result in high profitability and

better living standard for the member of the units. This is possible by better management

of material, efficient handling in the plant. The material productivity of Hindalco Ltd.was

highly fluctuating during the period of study as shown by value of Co-efficient of

variation 41.88. Further in order to test the null hypothesis, whether the distribution of

material productivity indices of Hindalco confirms to the straight-line base least square

method, it was found the calculated value of Chi-Square figured at 36.23 is more than the

table value 15.50. Hence the null hypothesis is rejected. The computed value of

productivity index showed a negative growth of 10.58.

Analysis of Labour Productivity The terms “labour productivity is generally defined as “the ratio of physical amount of

output achieved in a given period to the corresponding amount of labour expended”. It

may be true that any business organization all wage payments are directly or indirectly

based on the skill and productivity of the workers, therefore labour productivity is

considered as the most important factors in productivity computations. There are various

types of methods for calculating the labour productivity. Very simple method describe in

the above definition. ‘Output divided by input’ another method the output per man-years

of man-hour and the input per man-years or per man-hour. In the present research study

labour input calculated by cost/expenses labour productivity and capacity of utilization

could be general indices, which are easily understandable and could be the basis for

measurement of the employees.

Table – 2

Analysis of labour productivity

YEAR Output Input O/I

Co-efficient factor Index Trend I/o

Std. input

Possible saving

1997-98 1466.07 98.49 14.885 1.0939 100 83.909 0.0672 57.9802 40.50976 1998-99 1758.67 119.01 14.777 1.086 99.275 93.988 0.0677 69.552 49.458 1999-00 2013.1 140.62 14.316 1.0521 96.174 104.07 0.0699 79.614 61.0058 2000-01 2253.33 151.61 14.863 1.0922 99.847 114.15 0.0673 89.115 62.4951 2001-02 2312.48 167.16 13.834 1.0166 92.936 124.23 0.0723 91.454 75.7059 2002-03 4769.56 222.85 21.403 1.5729 143.78 134.31 0.0467 188.63 34.2231 2003-04 5952.25 235.4 25.286 1.8582 169.87 144.39 0.0395 235.4 Nil 2004-05 9337.95 409.03 22.829 1.6777 153.37 154.46 0.0438 369.3 39.7321 2005-06 11122.1 458.98 24.232 1.7808 162.79 164.54 0.0413 439.86 19.12241 TOTAL 40985.5 2003.15 166.43 12.23 1118.04 1118 0.5156 1620.9 382.2522

AVS. 4553.95 222.572 18.492 1.35894 124.227 124.23 0.0573 180.1 47.78152 STANDARD DEVIATION =30.50 A=124.227 Chi-square =18.85

CO-Efficient of variation =24.55 B=10.079

The Table No.-2 describe that Labour productivity ratio, Co-efficiency of Co-relationship,

Productivity index, Trend value, input-output ratio, Standard deviation, Co-efficient of

variation and value of Chi-Square. It is apparent from the table that Labour productivity

of Hindalco Ltd, has showed the upward trend throughout the period of study. The output

of Hindalco Ltd. amounted to Rs.1466.07 Crores in 1997-98, which is increased to Rs.

11122.1 Crores in 2005-06.On the other hand the labour input expanded from Rs. 98.49

Crores in 197-98 to 458.98 crorers in 2005-06. The productivity ratio ranged between

14.316 from 1999-2000 to 25.286 in 2003-04 similarly the productivity index also

showed upward trend with the average 124.23.The straight line based on trend value

showed positive growth rate of 10.079 per annum, which indicates good position of

Labour productivity. It could also be seen from the table No.-2 that the average labour

input per rupee of output for Hindalco Ltd. amounted to Rs. 0.0573. Input-output ratio

was the lowest in 2003-04.It showed that the company achieved its maximum efficiency

in that year. The value of Chi-Square showed 18.85 which is greater than the table value

of 15.507 hence null hypothesis is rejected and alternative hypothesis is accepted.

Analysis of Overhead Productivity “Overheads costs are the operating costs of a business enterprise, which can be traced

directly to a particular unit of output. The term ‘Overheads’ is used interchangeably with

such terms as burden, supplementary costs, manufacturing expenses, and indirect

expenses.” The major part of total cost including total overheads, office overheads,

selling and distribution overheads, thus primary aim of accounting for overhead is to

controlling. Present study outlined output in constant prices divided by total overheads

input it gives overheads productivity ratio. The productivity ratio indices, Co-efficiency

of co-relationship, input output ratio etc.

Table – 3

Analysis of Overhead productivity

YEAR Output Input O/I

Co-efficient factor Index Trend I/o

Std. input

Possible saving

1997-98 1466.07 463.05 3.1661 0.2327 100 100.35 0.3158 364.21 98.841 1998-99 1758.67 523.29 3.3608 0.247 106.15 103.22 0.2975 436.898 86.39173 1999-00 2013.1 590.11 3.4114 0.2507 107.75 106.1 0.2931 500.105 90.00486 2000-01 2253.33 633.63 3.5562 0.26134 112.32 108.97 0.2812 559.784 73.84563

2001-02 2312.48 716.47 3.2276 0.2372 101.94 111.85 0.3098 574.479 141.9913 2002-03 4769.56 1405.03 3.3946 0.2495 107.22 114.72 0.2946 1184.88 220.1502 2003-04 5952.25 1478.69 4.0254 0.2958 127.14 117.6 0.2484 1478.69 Nil 2004-05 9337.95 2472.97 3.776 0.2775 119.26 120.47 0.2648 2319.78 153.1862 2005-06 11122.1 2813.23 3.9535 0.2905 124.87 123.35 0.2529 2763.01 50.21802

TOTAL 40985.5 11096.5 31.872 2.3422 1006.65 1006.6 2.5583 10181.8 914.6289 AVERAGE 4553.95 1232.94 3.5413 0.26025 111.85 111.85 0.2843 1131.32 114.3286

STANDARD DEVIATION =9.24 A=111.85 Chi-square =2.39 CO-Efficient of variation =8.26 B=2.874

Table No-3 showed the overhead productivity ratio, Co-efficiency of Co-relationship,

Productivity index, average of indices, Trend value of indices, Chi-Square, Input-output

ratio, Standard deviation as well as Co-efficient of variation for Hindalco Ltd. The table-

3 reveals that the output of Hindalco Ltd. was increased from 1466.07 Crores in 1997-98

to Rs. 11122.1 crores in 2005-06 while the overhead input increased from Rs. 463.05

crores in 1997-98 to Rs. 2813.23 crores in 2005-06. The output ratio showed increased

trend and the productivity index also showed increasing trend i.g.100 in 1997-98 to

124.90 in 2005-06 with an average of 111.85.The value of Co-efficient of variation

showed 8.26. In order to measure the null hypothesis based on Chi-Square has also been

calculated, which is worked out to be 2.39 and the lower than the critical value of 15.50

hence the null hypothesis is accepted and alternative hypothesis is rejected. The straight-

line trend showed a positive pattern of overheads of 2.874.input output ratio makes us

clear about the possible savings and standard input required for the production. It is the

lowest in the 2003-04. Average possible saving in case of overhead input during the

study is possible 114.328 P.A.

Analysis of Overall Productivity

It has already been mentioned the productivity is a ratio of output to input. Productivity

ratio is said to be a measure of efficiency. The various inputs are material, manpower,

capital goods and expense of manufacturing, selling and distribution etc. When all the

input is added together and the productivity ratio is calculated it is termed as overall

productivity ratio. In order to revolve the problem of calculation of the overall

productivity ratio the data needed are: output and total input. Total input includes the

elements of costs such as material, manpower and overhead. “When a number of factors

are not valued in the production process but the output is related to any single factor unit.

Productivity thus measured is called factor or partial productivity According to

Shrivastava J. P. “There is a general agreement among different writes that the over all

productivity ratio measure the total productivity efficiency of the combined resources

input used by an enterprise.’’ The present research study outlined total input includes

labour, material, and overhead calculated with base year 1997-98 prices to indicate the

change in productivity efficiency over the base year.

Table - 4

Analysis of Overall productivity

YEAR Output Input O/I Index Trend I/o Std. input

Possible saving

1997-98 1466.07 883.49 1.6594 100 112.05 0.6026 790.059 93.43108 1998-99 1758.67 1025.9 1.7143 103.31 106.7 0.5833 947.74 78.13018 1999-00 2013.1 1119.6 1.7981 108.36 101.35 0.5562 1084.85 34.74893 2000-01 2253.33 1214.3 1.8556 111.83 96.007 0.5389 1214.31 Nil 2001-02 2312.48 1359.2 1.7014 102.53 90.66 0.5878 1246.19 113.0143 2002-03 4769.56 3951.5 1.207 72.739 85.313 0.8285 2570.3 1381.194 2003-04 5952.25 4815 1.2362 74.496 79.966 0.8089 3207.64 1607.328 2004-05 9337.95 7521.5 1.2415 74.816 74.619 0.8055 5032.18 2489.318 2005-06 11122.1 9875.6 1.1262 67.869 69.272 0.8879 5993.65 3881.927 TOTAL 40985.5 31766 13.54 815.938 815.94 6.1996 22086.9 9679.092

AVERAGE 4553.95 3529.6 1.50441 90.6597 90.66 0.6888 2454.1 1209.887 STANDARD DEVIATION =16.67 A=90.6597 Chi-square =8.30

CO-Efficient of variation =18.39 B=(-5.346)

Table No.4 revealed various facts about the total productivity in Hindalco Ltd. during the

research study. The table also manifested that the output remained same as explained

earlier. While the total input increased from Rs. 883.49 crores in 1997-98 to Rs. 9875.58

crores in 2005-06. The average input figured at Rs. 3529.56 Crores. The overall

productivity ratio showed declining trend during the study period. The Ratio ranged

between 1.126 in 2005-06 to 1.856 in 2000-01 with an average of 1.504. The index also

showed same position with an average of 90.66 percent. The value of Chi-square

calculated at 8.30, which is less than the table value of 15.50. Therefore the null

hypothesis assuming straight-line approximation for the productivity indices is accepted.

The straight line in case of this company shows moderate pattern of productivity

efficiency with an average annual negative rate of change (5.346). It may be observed

from above table that there are considerable rise in material, labour and overhead. The

selected units needs to constraint over planning and control of material recovery, lack of

control over expenses and efficient handling. The total input requirements per rupees of

output ranged between Rs. 0.539 and Rs.0.888 during the period of the study.

Conclusion:

To improve total productivity of Hindalco LTd. some suggestions are made. Make the

unit as much as “learning units” as possible. Make the organization as flexible as possible.

Once the philosophy, values, attitudes and intend are established make use of the relevant

productivity techniques and measures including the conventional and modern, like BPR

and Benchmarking. Level of efficiency should be measured frequently, once level of

efficiency achieved it does not go out of hand. Full capacity of each

plant/equipment/facility should be utilized. Optimising energy consumption. Efficient

handling of raw materials and reduction of wastages. The company should adapt better

working practice and try to improve in environment.

References

• Brown David S. (1983), “Productivity of the professionals” productivity, New

Delhi, Vol. XXIV, No.3, Oct - Dec,. pp.241-249

• Jain A. and Jain N.(1998), An integrated approach to inventory management”

Journal of accounting and Finance, Jaipur, Vol.12, No.2, Sep. pp. 166

• Mohanty R.P. (1992), “Managing technology for strategic advantages ”, The

Economics Times, (Thursday 9th Jan.), p.14

• Shrivasthava J.P. (1982), “Labour Productivity socio Economic Midimesion,

Oxford & IBH Publication, New .Delhi.

• Samanth Devid J, (1990), Productivity Engineering and management, TMH

publication-1990.

• Thomas.H. Connell (1978), How to Improve Human Performance, New York:

Harper and row, pp.3

Chapter - 6

Analyzing Financial Performance of Banks

Introduction

Introduction to CAMELS

How the Rating System came into Usage

Adoption of CAMELS by RBI in its Supervisory Regulations of the Banking System

On-Site and Off-Site Surveillance

Introduction:

Banks are essentially intermediary institutions, which collect savings and then convert

them into productive capital. They create or expand credit in the economy and thus

accelerate economic growth. Though substantial part of bank credit is in the form of

short-term credit to industries or businesses, the concept is changing rapidly. Today,

Banks are lending for long-term purposes and also expanding their activities to non-

business entities. Banks are major lenders for consumer financing and housing finance.

Like any other organisation, banks also handle large cash flows. In fact, the commodity

they buy and sell is cash flows. Financial management becomes integral part of banking

operations. Issues like liquidity management and risk management are equally important

for banks as in the case of any commercial organisation.

Banking is one of the more closely supervised industries in almost all the countries of the

world, reflecting the view that bank failures have stronger adverse effects on economic

activity than other business failures. The central government and the state governments

grant authority to bank supervisors to limit the risk of failure assumed by banks.

Supervisors impose sanctions on the banks that they have identified as being in poor

financial condition. Effective bank supervision, therefore, requires accurate information

about the condition of banks.

Bank supervisors use on-site examination and off-site surveillance to identify the banks

most likely to fail. The most useful tool for identifying problem institutions is onsite

examination, in which examiners travel to a bank and review all aspects of its safety and

soundness. On-site examination (CAMELS Rating System) is, however, both costly and

burdensome: costly to supervisors because of its labor-intensive nature and burdensome

to bankers because of the intrusion into their day-to-day operations. As a result,

supervisors also monitor bank condition off-site. Off-site surveillance yields an ongoing

picture of bank condition, enabling supervisors to schedule and plan exams efficiently.

Off-site surveillance also provides banks with incentives to maintain safety and

soundness between on-site visits. Supervisors rely primarily on two analytical tools for

off-site surveillance: supervisory screens and econometric models. Supervisory screens

are combinations of financial ratios, derived from bank balance sheets and income

statements that have, in the past, given forewarning of safety-and-soundness problems.

Supervisors draw on their experience to weigh the information content of these ratios.

Introduction to CAMELS

CAMELS rating originated in 1979 with the creation of the Uniform Financial

Institutions Rating System. An international bank-rating system with which bank

supervisory authorities rate institutions according to six factors. The six areas examined

are represented by the acronym "CAMELS."

The six factors examined are as follows:

1. C - Capital adequacy

2. A - Asset quality

3. M - Management quality

4. E - Earnings

5. L - Liquidity

6. S - Sensitivity to Market Risk

Bank supervisory authorities assign each bank a score on a scale of 1 (best) to 5 (worst)

for each factor. If a bank has an average score less than 2 it is considered to be a high-

quality institution while banks with scores greater than 3 are considered to be less-than-

satisfactory establishments. The system helps the supervisory authority identify banks

that are in need of attention. Banks with ratings of 1 or 2 are considered to present few, if

any, supervisory concerns, while banks with ratings of 3, 4, or 5 present moderate to

extreme degrees of supervisory concern.

Table: 1 CAMELS RATINGS

WHAT ARE CAMELS RATINGS? CAMELS composite rating Description Safe and sound 1 2

Financial institutions with a composite one rating are sound in every respect and generally have individual component ratings of one or two. Financial institutions with a composite two rating are fundamentally sound. In general, a two-rated institution will have no individual component ratings weaker than three.

Unsatisfactory 3 4 5

Financial institutions with a composite three rating exhibit some degree of supervisory concern in one or more of the component areas. Financial institutions with a composite four rating generally exhibit unsafe and unsound practices or conditions. They have serious financial or managerial deficiencies that result in unsatisfactory performance. Financial institutions with a composite five rating generally exhibit extremely unsafe and unsound practices or conditions. Institutions in this group pose a significant risk to the deposit insurance fund and their failure is highly probable.

How the Rating System came into Usage

This rating system is used by the three federal banking supervisors (the Federal Reserve,

the FDIC, and the OCC) and other financial supervisory agencies to provide a convenient

summary of bank conditions at the time of an exam. During an on-site bank exam,

supervisors gather private information, such as details on problem loans, with which to

evaluate a bank's financial condition and to monitor its compliance with laws and

regulatory policies. A key product of such an exam is a supervisory rating of the bank's

overall condition, commonly referred to as a CAMELS rating.

In fact the rating system initially emerged as CAMEL covering the first five parameters

only. A sixth component, a bank's Sensitivity to market risk was added in 1997; hence the

acronym was changed to CAMELS.

All exam materials are highly confidential, including the CAMELS. A bank's CAMELS

rating is directly known only by the bank's senior management and the appropriate

supervisory staff. CAMELS ratings are never released by supervisory agencies, even on a

lagged basis. While exam results are confidential, the public may infer such supervisory

information on bank conditions based on subsequent bank actions or specific disclosures.

Overall, the private supervisory information gathered during a bank exam is not disclosed

to the public by supervisors, although studies show that it does filter into the financial

markets.

Adoption of CAMELS by RBI in its Supervisory Regulations of the Banking System

The focus of the statutory regulation of commercial banks by RBI in India until the early

1990s was mainly on licensing, administration of minimum capital requirements, pricing

of services including administration of interest rates on deposits as well as credit, reserves

and liquid asset requirements. In these circumstances, the supervision had to focus

essentially on solvency issues

After the evolution of the BIS prudential norms in 1988, the RBI took a series of

measures to realign its supervisory and regulatory standards almost on a par with

international best practices. At the same time, it also took care to keep in view the socio-

economic conditions of the country, the business practices, payment systems prevalent in

the country and the predominantly agrarian nature of the economy, and ensured that the

prudential norms were applied over the period and across different segments of the

financial sector in a phased manner.

The entire supervisory mechanism has been realigned since 1994 under the directions of

a newly constituted Board for Financial Supervision (BFS), which functions under the

aegis of the RBI, to suit the demanding needs of a strong and stable financial system. The

supervisory jurisdiction of the BFS now extends to the entire financial system barring the

capital market institutions and the insurance sector.

The periodical on-site inspections, and also the targeted appraisals by the Reserve Bank,

are now supplemented by off-site surveillance which particularly focuses on the risk

profile of the supervised institution. A process of rating of banks on the basis of

CAMELS in respect of Indian banks and CACS (Capital, Asset Quality, Compliance and

Systems & Control) in respect of foreign banks has been put in place from 1999.

The Off-site Monitoring and Surveillance System (OSMOS) was introduced in 1995 as

an additional tool for supervision of commercial banks to supplement the on-site

examinations. Thesystem consists of 12 returns (called DSB returns) focussing on

supervisory concerns such as capital adequacy, asset quality, large credits and

concentrations, connected lending, earnings and risk exposures (viz. currency, liquidity

and interest rate risks).

The supervisory intervention by the RBI is normally triggered by the deterioration in the

level of capital adequacy, NPAs, credit concentration, lower earnings, and larger

incidence of frauds which reflect the quality of control.

RBI has issued a comprehensive Notification on the Supervisory System for Financial

Institutions including the functions of the Board for Financial Supervision covering

comprehensive information on the subject.

ON-SITE AND OFF-SITE SURVEILLANCE

The role of off-site surveillance and early warning models in bank supervision. Bank

supervisors rely principally on regular on-site examinations to assess the condition of

banks. Examinations ensure the integrity of bank financial statements and identify the

banks that should be subject to supervisory sanctions. During a routine exam, the

examiners assess six components of safety and soundness—capital protection (C), asset

quality (A), management competence (M), earnings strength (E), liquidity risk (L) and

market risk (S)—and assign a grade of 1 (best) through 5 (worst) to each component.

Examiners then use these six scores to award a composite rating, also expressed on a 1

through 5 scale. Bank supervisors added the “S” component (market risk) in January

1997. Since examiners graded only five components of safety and soundness during most

of our sample period, this paper refers to composite “CAMEL” ratings. Table 1 interprets

the five composite CAMEL ratings.

Although on-site examination is the most effective tool for constraining bank risk, it is

both costly to supervisors and burdensome to bankers. As a result, supervisors face

continuous pressure to limit exam frequency. Supervisors yielded to this pressure in the

1980s, and many banks escaped yearly examination (Reidhill and O’Keefe, 1997).

Congress mandated the frequency of examinations in the Federal Deposit Insurance

Corporation Improvement Act of 1991, which requires annual examinations for all but a

handful of small, well-capitalized, highly-rated banks, and even these institutions must be

examined every 18 months. This new mandate reflects the lessons learned from the wave

of bank failures in the late 1980s: more frequent exams, though likely to increase the

upfront costs of supervision, reduce the down-the-road costs of resolving failures by

revealing problems at an early stage.

Although changes in public policy have mandated greater exam frequency since the early

1990s, supervisors still have reasons to use off-site surveillance tools to flag banks for

accelerated exams and to plan exams. Bank condition can deteriorate rapidly between on-

site visits (Cole and Gunther, 1998; Hirtle and Lopez, 1999). In addition, the Federal

Reserve now employs a “risk-focused” approach to exams, in which supervisors allocate

on-site resources according to the risk exposures of each bank (Board of Governors,

1996). Off-site surveillance helps supervisors allocate on-site resources efficiently by

identifying institutions that need immediate attention and by identifying specific risk

exposures for regularly scheduled as well as accelerated exams. For these reasons, an

interagency body of bank and thrift supervisors—the Federal Financial Institutions

Examinations Council (FFIEC)—requires banks to submit quarterly Reports of Condition

and Income, often referred to as the call reports. Surveillance analysts use the call report

data to monitor the condition of banks between exams.

Supervisors have developed various tools for using call report data to schedule and plan

exams, including econometric models. A common type of model used in surveillance

estimates the marginal impact of a change in a financial ratio on the probability that a

bank will fail, holding all other ratios constant. These models can examine many ratios

simultaneously, capturing subtle but important interactions. The Federal Reserve uses

two models in off-site surveillance. One model, called the SEER risk rank model,

combines financial ratios to estimate the probability that each Fed supervised bank will

fail within the next two years. Another model estimates a hypothetical CAMEL rating

that is consistent with the financial data in the bank's most recent call report. Every

quarter, economists at the Board of Governors feed the latest call report data into these

models and forward the results to each of the twelve Reserve Banks. Surveillance

analysts in the Reserve Banks then investigate the institutions that the models flag as

“exceptions.”

References:

• Allen, Linda and Saunders, Anthony. “Bank Window Dressing: Theory and

Evidence.” Journal of Banking and Finance, June 1992, 16(3), pp. 585-623.

• Altman E. Avery R., Eisenbeis R., and Sinkey J. (1981) Applications of

Classification Techniques in Business Banking and Finance, Connecticut.

• Feldman, R. and J. Schmidt. “What Are CAMELS and Who Should Know?”

Fedgazette Federal Reserve Bank of Minneapolis (January 1999).

• Noulas, A. G. and K.W. Ketkar (1996) “Technical and Scale Efficiency in the

Indian Banking Sector”, International Journal of Development Banking, Vol. 14,

No.2, pp.19-27.

• Sathye M. (2005), Privatization, Performance, and Efficiency: A Study of Indian

Banks”, Vikalpa, Vol. 30, No. 1, pp. 7-16

Chapter – 7

Economic Value Added – A Tool for Performance Measurement

• Introduction

• Concept of Profitability

• The Calculation for EVA

• Strategies for Increasing EVA

• Usage of the EVA Method

• Advantages of EVA

• The approach of EVA

• EVA and the Market Value of a company

• References

Introduction

EVA is a method to measure a company’s true profitability and to steer the company

correctly from the viewpoint of shareholders. EVA helps the operating people to see how

they can influence the true profitability. EVA is based on something we have known for a

long time; what we call profits, the money left to service equity, is usually not profit at all.

Until a business returns a profit that is greater than its cost of capital, it operates at a loss.

Never mind that it pays taxes as if it has a genuine profit. The enterprise still returns less

to the economy than it devours in resources… until then it does not create wealth; it

destroys it. States by Peter F. Drucker, The Information Executive Truly Need, Harvard

Business Review. Peter Drucker writes, “There is no profit unless you earn the cost of

capital. Economic Value Added, or EVA is a measure that enables managers to see

whether they are earning an adequate return, where returns are lower than might

reasonable be expected for investments of similar risk (i.e., they are below the cost of

capital), EVA is negative and the firm faces the flight of capital and a lower stock price.

Quite Simply: EVA is a measure of profit less the cost of all capital employed. It is the

one measure that properly accounts for all the complex trade-off, often between the

income statement and balance sheet, involved in creating value. EVA is also the spread

between a company’s return on and cost of capital multiplied by the invested capital.

EVA = (Rate of Return – Cost of Capital) X Capital

For example, Rs. 1,00,000 invested in a project produces a 5% return, where investment

of similar risk elsewhere can earn 8%. The EVA from this case would be

EVA = (5% - 8%) X Rs. 1,00,000 = (Rs. 3000)

An accountant measures profit earned, whereas an economist looks at what could have

been earned. Although the accounting profit in this example is Rs. 5000 (5% X 1,00,000)

there was an opportunity to earn Rs. Rs. 8000. (8% X 1,00,000).

Under EVA, each business is effectively charged by investors for the use of capital

through a “Line of Credit” that bears interest at a rate equal to the cost of capital.

Therefore shareholders accountability is effectively decentralized into the operating units.

EVA simultaneously focuses on both the profit and loss statements and the balance sheet.

Finally, EVA sets a required rate of return – the cost of capital – as a hurdle rate below

which performance is unacceptable.

Concept of Profitability

EVA is based on the concept that a successful firm should earn at least its cost of capital.

Firms that earn higher returns than financing costs benefit shareholders and account for

increased shareholder value. In its simplest form, EVA can be expressed in the following

equation.

EVA = Operating Profit after Tax (NOPAT) – Cost of Capital

NOPAT is calculated as net operating income after depreciation, adjusted for items that

move the profit measure closer to an economic measure of profitability. Adjustment

include such items as additions for interest expenses after-taxes (including any implied

interest expense on operating leases) increases in net capitalization R&D expenses;

increase in LIFO reserve; and goodwill amortization. Adjustments made to operating

earnings for these items reflect the investment made by the firm or capital employed to

achieve those profits.

The Calculation for EVA

Economic Value Added: EVA is the net operating profit after tax, less the change on

economic capital employed.

EVA = Net Operating Profits – (weighted Average Cost of Capital X Total Capital

Employed).

NOPAT = (Profit after Tax + Non-Recurring Expenses + Revenue Expenditure on R&D

+ Interest Expense + Provision for Taxes) – Non-recurring Income – R&D Amortization

– Cash Operating Taxes.

Cash Operating Taxes = (Provision for Taxes + Tax Benefit of Non-Recurring

Expenses + Tax Benefit of Interest Expense – Tax on Non-Recurring Income)

Economic Capital = Net Fixed Assets + Investments + Current Assets – (NIBCLs +

Miscellaneous Expenditure Not Written Off + Intangible Assets + Cumulative Non-

Recurring Losses + Capitalized Expenditure on R&D) – Revaluation Reserve –

Cumulative Non-Recurring Gains.

Source: Business Today, April 13, 2003.

Strategies for Increasing EVA

• Increase the return on existing projects: This might be achieved through higher

prices or margins, more volume, or lower costs.

• Profitability Growth: This might be achieved through investing capital where

increased profits will adequately cover the cost of additional capital.

• Use less capital to achieve the same return.

• Reduce the cost of capital.

• Liquidate capital or restrict further investment in substandard operations where

inadequate returns are being earned

Usage of the EVA Method

EVA can be used for the following purposes:

• Performance Measurement

• Facilitate Communication with shareholders

• Determining Bonuses

• Motivation tool for managers

• Capital Budgeting

• Corporate Valuation

• Analyzing Equity Securities

Advantages of EVA

EVA is more than just performance measurement system and it is also marketed as a

motivational, compensation-based management system that facilitates economic activity

and accountability at all levels in the firm. Stern Stewart reports that companies that have

adopted EVA have outperformed their competitors when compared on the basis of

comparable market capitalization.

Several advantages claimed for EVA are:

• EVA is closely related to NPV. It is closest in spirit to corporate finance theory

that argues that the value of the firm will increase if you take positive NPV

projects.

• It avoids the problems associates with approaches that focus on percentage

spreads - between ROE and Cost of Equity and ROC and Cost of Capital. These

approaches may lead firms with high ROE and ROC to turn away good projects to

avoid lowering their percentage spreads.

• It makes top managers responsible for a measure that they have more control over

- the return on capital and the cost of capital are affected by their decisions -

rather than one that they feel they cannot control as well - the market price per

share.

• It is influenced by all of the decisions that managers have to make within a firm -

the investment decisions and dividend decisions affect the return on capital (the

dividend decisions affect it indirectly through the cash balance) and the financing

decision affects the cost of capital.

• EVA eliminates economic distortions of GAAP to focus decisions on real

economic results

• EVA provides for better assessment of decisions that affect balance sheet and

income statement or tradeoffs between each through the use of the capital charge

against NOPAT

• EVA decouples bonus plans from budgetary targets.

• EVA covers all aspects of the business cycle.

• Goal congruence of managerial and shareholder goals achieved by tying

compensation of managers and other employees to EVA measures (Dierks &

Patel, 1997)

• Improvement in EVA necessarily indicates improvement in shareholder wealth,

which may not be true in case of other measures like ESP, Profit.

• EVA can act as an internal system of corporate governance, bringing all

departments together.

The approach of EVA

Different investments have always some average return

• The average return is easily achievable

• Therefore it is not wise to accept lower returns

• Losing a part of average return is losing capital

EVA and the Market Value of a company

Theoretically EVA is much better than conventional measures in explaining the market

value of a company. Financial theory suggests that the market value of a company

depends directly on the future EVA-values:

The market value of a company = Book value of equity + present value of future EVA

Positive EVA builds up a premium to the market value of equity, since investors pay for

the excess return. While negative EVA builds up a discount to the market value of equity.

This is because companies have insufficient future expected return to meet the

expectation on investors.

The bigger expected EVA the company has, the bigger is the market value of the

company and the stock price especially profitable growth (growth in EVA) gears up stock

prices. Therefore companies like Intel, Microsoft and Nokia trade many times above their

book values. Stock prices reflect the future EVA expectations. Those expectations are

very uncertain and continuously changing and thus also stock prices are volatile.

Therefore it might be in short term difficult to see the underlying connection between

EVA (financial performance) and stock prices. Long term perspective helps in this sense.

Firm Value using EVA Approach

Capital Invested in Assets in Place = Rs. 100 EVA from Assets in Place = (.15 - .10) (1000)/.10 = Rs. 50 + PV of EVA from New Investments in Year 1 = [(.15 - .10)(10)/.10] = Rs. 5 + PV of EVA from New Investments in Year 2 = [(.15 - .10)(10)/.10]/1.12 = Rs. 4.55 + PV of EVA from New Investments in Year 3 = [(.15 - .10)(10)/.10]/1.13

= Rs. 4.13 + PV of EVA from New Investments in Year 4 = [(.15 - .10)(10)/.10]/1.14 = Rs. 3.76 + PV of EVA from New Investments in Year 5 = [(.15 - .10)(10)/.10]/1.15 = Rs. 3.42 Value of Firm = Rs. 170.86

Year-by-year EVA Changes

• Firms are often evaluated based upon year-to-year changes in EVA rather than the

present value of EVA over time.

• The advantage of this comparison is that it is simple and does not require the

making of forecasts about future earnings potential.

• Another advantage is that it can be broken down by any unit - person, division

etc., as long as one is willing to assign capital and allocate earnings across these

same units.

• While it is simpler than DCF valuation, using year-by-year EVA changes comes

at a cost. In particular, it is entirely possible that a firm which focuses on

increasing EVA on a year-to-year basis may end up being less valuable.

Year-to-Year EVA Changes 0 1 2 3 4 5 Term. Yr.EBIT(1-t) Rs. 15.00 Rs. 16.50 Rs. 18.00 Rs. 19.50 Rs. 21.00 Rs. 22.50 Rs. 23.63 WACC(Capital) Rs. 10.00 Rs. 11.00 Rs. 12.00 Rs. 13.00 Rs. 14.00 Rs. 15.00 Rs. 16.13 EVA Rs.5.00 Rs. 5.50 Rs. 6.00 Rs. 6.50 Rs. 7.00 Rs. 7.50 Rs. 7.50 PV of EVA Rs. 5.00 Rs. 4.96 Rs. 4.88 Rs. 4.78 Rs. 4.66 Terminal Value of EVA Rs. 75.00

Value: Assets in Place = Rs. 100.00

PV of EVA = Rs. 70.85 Value of Firm = Rs. 170.85

When Increasing EVA on year-to-year basis may result in lower Firm Value

1. If the increase in EVA on a year-to-year basis has been accomplished at the expense

of the EVA of future projects. In this case, the gain from the EVA in the current year

may be more than offset by the present value of the loss of EVA from the future

periods.

• For example, in the example above assume that the return on capital on year 1

projects increases to 17%, while the cost of capital on these projects stays at 10%.

If this increase in value does not affect the EVA on future projects, the value of

the firm will increase.

• If, however, this increase in EVA in year 1 is accomplished by reducing the return

on capital on future projects to 14%, the firm value will actually decrease.

Firm Value and EVA Tradeoffs over Time 0 1 2 3 4 5 Term. Yr.Return on Capital 15% 17% 14% 14% 14% 14% 10% Cost of Capital 10% 10% 10% 10% 10% 10% 10% EBIT(1-t) Rs. 15.00 Rs. 16.70 Rs. 18.10 Rs. 19.50 Rs. 20.90 Rs. 22.30 Rs. 23.42 WACC(Capital) Rs. 10.00 Rs. 11.00 Rs. 12.00 Rs. 13.00 Rs. 14.00 Rs. 15.00 Rs. 16.12 EVA Rs. 5.00 Rs. 5.70 Rs. 6.10 Rs. 6.50 Rs. 6.90 Rs. 7.30 Rs. 7.30 PV of EVA Rs. 5.18 Rs.5.04 Rs. 4.88 Rs. 4.71 Rs. 4.53 Terminal Value of EVA Rs. 73.00

Value: Assets in Place = Rs. 100.00

PV of EVA = Rs. 69.68 Value of Firm = Rs. 169.68

EVA with Changing Cost of Capital 0 1 2 3 4 5 Term. Yr. Return on Capital 15% 16% 16% 16% 16% 16% 11% Cost of Capital 10% 11% 11% 11% 11% 11% 11% EBIT(1-t) Rs.15.00 Rs.16.60 Rs.18.20 Rs.19.80 Rs.21.40 Rs.23.00 Rs.24.15 WACC(Capital) Rs.10.00 Rs.11.10 Rs.12.20 Rs.13.30 Rs.14.40 Rs.15.50 Rs.16.65 EVA Rs.5.00 Rs.5.50 Rs.6.00 Rs.6.50 Rs.7.00 Rs.7.50 Rs.7.50 PV of EVA Rs.4.95 Rs.4.87 Rs.4.75 Rs.4.61 Rs.4.45 Terminal Value Rs.68.18 Value of Assets in Place = Rs.100.00

PV of EVA = Rs.64.10 Value of Firm = Rs.164.10

Vishal Export Ltd: - EVA Trend Analysis

(Rs. in crore)

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Cost of Capital Employed (COCE) 1. Average Debt 135 97 110

156 160 165

162 93 50 45

2. Average Equity 359

462 588 815 1127 1487 1908 2296 2766 3351

3. Average Capital Employed (1) + (2)

494

559 698 971 1287 1652 2070 2389 2816 3396

4. Cost of Debt, post-tax%

6.76

7.36 7.56 7.88 8.82 9.10 8.61 8.46 7.72 6.45

5. Cost of Equity % 19.70

19.70 19.70 19.70 19.70 19.70 19.70 19.70 16.70 14.4

6. Weighted Average Cost of Capital % (WACC)

16.17

17.57 17.79 17.80 18.34 18.64 18.83 19.27 16.54 14.3

7. COCE(3) x (6) 80

98 124 173 236 308 390 460 466 486

Economic Value Added (EVA) 8. Profit after tax before exceptional items

127

190 239 413 580 837 1070 1310 1541 1716

9. Add : Interest, after taxes

13

15 11 32 21 19 14 8 5 6

10. Net Operating Profits After Taxes (NOPAT)

140

205 250 445 601 856 1084 1318 1546 1722

11. COCE, as per (7) above

(80)

(98) (124) (173) (236) (308) (390) (460) (466) (486)

12. EVA (10) – (11) 60

107 126 272 365 548 694 858 1080 1236

Economic Value Added (Rs. in Crore)

60 107 126272

365

548694

858

1080

1236

0

200

400

600

800

1000

1200

1400

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

There is a constant growth in EVA during last ten years.

The most empirical studies have supported this theoretical connection between EVA and

market value:

• Stewart 1990

• Lehn nad Makhija (1996)

• Uyemura, Kanto and Pettit (1996)

• O´Byrne (1996)

• Milunovich and Tsuei (1996)

• Grant (1996)

Conclusion:

EVA is more than just performance measurement system. It helps companies to create

values for its shareholders. EVA is a method to measure a company’s true profitability

and to steer the company correctly from the viewpoint of shareholders. EVA helps the

operating people to see how they can influence the true profitability. A sustained increase

in EVA will bring an increase in the market value of a company.

Reference:

• AICPA (2000a). Improving Shareholder Wealth. New York: Issues Paper,

American Institute of Certified Public Accountants.

• AICPA (2000b). Measuring and Managing Shareholder Wealth Creation. New

York: Issues Paper, American Institute of Certified Public Accountants.

• Amit, R. and P. Schoemaker (1993). Strategic assets and organizational rent.

Strategic Management Journal, 14 (1), 33-46.

• Anthony, J. and K. Ramesh (1992). Association between accounting performance

measures and stock prices: A test of the life cycle hypothesis. Journal of

Accounting and Economics, 15 (2-3), 203-227.

• Anthony, R. (1965). Planning and Control Systems: Framework for Analysis.

Boston: Graduate School of Business Administration, Harvard University.

• Biddle, G., R. Bowen and J. Wallace (1997). Does EVA beat Earnings? Evidence

on associations with stock returns and firm values. Journal of Accounting and

Economics, 24 (3), 301-336.

• Biddle, G., R. Bowen and J. Wallace (1999). Evidence on EVA®. Journal of

Applied Corporate Finance, 12 (2), 8-18.

• Black, A., Ph. Wright, and J. Bachman (1998). In Search of Shareholder Value.

Managing the Drivers of Performance. London: Financial Times Management.

• Kleiman, R. (1999). Some New Evidence on EVA Companies. Journal of Applied

Corporate Finance, 12 (2), 80-91.

• Ottosson, E., and F. Weissenrieder (1996). CVA, Cash Value Added - a new

method for measuring financial performance. Gothenburg University, Study no.

1996:1.

• Weissenrieder, F (1997). Value based management: Economic Value Added or

Cash Value Added? Gothenburg Studies in Financial Economics, Study No

1997:3.

• Young, D. (1999). Economic Value Added. Note at INSEAD, Fontainebleau,

France.

• Young, D. and S. O’Byrne (2001). EVA and Value-based Management. A

Practical Guide to Implementation. New York: McGraw-Hill.

Chapter – 8

Balanced Scorecard

• Introduction

• Concept of the Balanced Scorecard

• Importance of the BSC

• The 4 Perspectives of the Balanced Scorecard

• The process of the BSC – Building the Balanced Scorecard

• Pre-requisites for a successful scorecard

• Benefits of the Balanced Scorecard

• Conclusion

• References

Introduction

The balanced scorecard is a strategic planning and management system that is used

extensively in business and industry, government, and nonprofit organizations worldwide

to align business activities to the vision and strategy of the organization, improve internal

and external communications, and monitor organization performance against strategic

goals. It was originated by Drs. Robert Kaplan (Harvard Business School) and David

Norton as a performance measurement framework that added strategic non-financial

performance measures to traditional financial metrics to give managers and executives a

more 'balanced' view of organizational performance.

Concept of the Balanced Scorecard

A new approach to strategic management was developed in the 1990s by Dr. Robert

Kaplan of Harvard business school, together with David Norton of Renaissance solutions

of Massachusetts. They named this system the ‘Balanced Scorecard’. Recognizing some

of the weaknesses and vagueness of previous management approaches, the Balanced

Scorecard approach provides a clear prescription as to what companies should measure in

order to balance the financial perspective.

The Balanced Scorecard is a management system (not only a measurement system) that

enables organizations to clarify their vision and strategy and translate them into action. It

provides feedback around both the internal business processes and external outcomes in

order to continuously improve strategic performance and results. When fully deployed,

the Balanced Scorecard transforms strategic planning from an academic exercise into the

nerve centre of an enterprise. “Balanced Scorecard is a frame work which translates a

company’s vision and strategy into a coherent set of performance measures. It helps

business to evaluate how well they meet their strategic objectives. It typically has four to

six components, each with a series of sub-measures. Each component highlights one

aspect of the business. The BSC includes measures of performance that are lagging

indicator, medium term indicators and leading indicators. – Harvard Business Review,

Jan-Feb. 1991.

Kaplan and Norton describe the innovation of the Balanced Scorecard as follows:

“The Balanced Scorecard retains traditional financial measure. But financial measures

tell the story of past events. An adequate story for industrial age companies for which

investment in long term capabilities and customer relationships were not critical for

success. These financial measures are inadequate, however, for guiding and evaluating

the journey that information age companies must make to create future value through

investment, in customers, suppliers, employees, processes, technologies and innovations”.

The general concept of the BSC is as under;

“The BSC provides an inter-connected model for measuring performance and revolves

around for distinct perspectives- financial, customer, internal business and learning-

growth. Each of these perspectives is stated in terms of the company’s objectives,

performance measures, target and initiatives and all are harnessed to implement corporate

vision-strategy.” This explains four perspectives of the BSC to implement corporate

strategy.

“The BSC is a conceptual framework for translating an organization’s strategic objectives

into a set of performance indicators distributed among four perspective- financial,

customer, internal business process and learning-growth. Some indicators are maintained

to measure an organization’s progress towards achieving its vision, others indicators are

maintained to measure the long term drivers of successes. Through the BSC an

organization monitors both its current performance and its effect to improve processes,

motivate-educate employees and enhance information systems- its ability to learn and

improve”.

Importance of the BSC

Harvard’s Robert Kaplan and his consulting Partner David Norton developed the BSC to

broaden the focus of mangers from traditional and rigid financial measures to as more

diverse set of measures including non-financial one. Its appeal is so strong that some

estimate 50% of fortunes 1000 firms are using BSC in some form or another. BSC

literature is replete with testimonials from satisfied users and consultants, suggesting

importance of the BSC.

1. Clarify, translate and communicate vision and strategy

The scorecard process starts with the senior executive management team

working together to translate its business unit’s strategy into specific strategic

objectives. BSC clarifies and translates the organization’s vision and strategies

into operational terms. According to Kaplan and Norton, the implementation

and rollout of a BSC can communicate and clarify to employees’ key strategic

objectives and their critical drivers. Research shows that effective communication

of strategy can have positive impact on the success of strategy

implementation.

2. Link strategic objectives and measures

To achieve success in strategy implementation it is essential to relate strategic

objectives with performance measures. This will result in effective strategy

implementation and up to the mark performance. BSC translates strategy into

operational terms- objective and link performance measures with strategic

objectives. It shapes performance measures; financial and non-financial, in such a

way which meet operational objective and there by meet strategic goal. Kaplan

and Norton say ‘ a critical components of establishing linkages between strategic

objectives and the scorecard performance measures is the identification of the

cause-effect relations between outcomes lag indicators and critical lead indicators

of those outcomes.’

3. Plan, set targets and aligns initiatives

The Balanced Scorecard has its greatest impact when it is deployed to drive

organizational change. Senior executives should establish targets for the scorecard

measures. The targets should represent a discontinuity in business unit

performance. The success of planning, target setting and aligning performance

measures to strategic initiatives often depends on whether the managerial

performance evaluation system directs managerial attention to these areas. The

BSC enables employees to understand strategy and link strategic objectives to

their day to day operation and also link performance to compensation.

4. Enhance strategic feedback and learning

The provision of feed-back as to whether the strategic objectives are being

accomplished is one of the most important benefits of the BSC. By monitoring

whether performance on the critical lead measures is having expected

consequences on key lag measures, managers are able to evaluate that whether

strategic objectives are achievable. The final management process embeds the

BSC in a strategic learning framework. It is considered as the most innovative and

most important aspect of the entire scorecard management process. This process

provides the capacity for organizational learning at the executive level. Managers

in organizations today do not have a procedure to receive feedback about their

strategy and to test the hypothesis on which the strategy is based. The BSC

enables them to monitor and adjust the implementation of their strategy, and, if

necessary, to make fundamental changes in the strategy itself. By having near

term milestones established for financial, as well as other BSC measures, monthly

and quarterly management review can still examine financial results.

Thus, the BSC fills the void that exists in most management system-the lack of a

systematic process to implement and obtain feedback about strategy. Management

processes built around the scorecard enables the organization to become aligned and

focused on implementing the long term strategy. Used in this way, the BSC becomes the

foundation for managing information age organization. These all are the important

reasons why an organization requires the BSC.

THE 4 PERSPECTIVES OF THE BALANCED SCORECARD

The Balanced Scorecard method of Kaplan and Norton is a strategic approach, and

performance management system, that enables organizations to translate a company's

vision and strategy into implementation, working from 4 perspectives:

1. Financial perspective.

2. Customer perspective.

3. Business process perspective.

4. Learning and growth perspective.

The traditional financial view of performance measurement as a vehicle to control

performance is immature. They fail to link current actions with long-term strategy. But

the BSC is said to take a long term, strategic view and considers all financial as well as

non-financial actions and variables that are necessary for the sustainability and excellence

of an organization. It provides a finer blending of financial and non-financial measures of

performance. It considers financial performance measures as a result of the non-financial

variables-the leading variables. The BSC allows management to look at business from

four important perspectives;

i. How do customers see the firm?

ii. What must they excel at?

iii. Can they continue to improve and create value?

iv. How do they look to shareholders?

1. The Financial Perspective

Kaplan and Norton do not disregard the traditional need for financial data. Timely

and accurate funding data will always be a priority, and managers will make sure

to provide it. In fact, there is often more than sufficient handling and processing

of financial data. With the implementation of a corporate database, it is hoped that

more of the processing can be centralized and automated. But the point is that the

current emphasis on financial issues leads to an unbalanced situation with regard

to other perspectives. There is perhaps a need to include additional financial

related data, such as risk assessment and cost-benefit data, in this category.

Building a BSC should encourage business units to link their objectives to

corporate strategy. The financial objectives serve as the focus for the objectives

and measure in all other perspectives. Every measure selected should be a part of

a link of cause and effect relationships that culminate in improving financial

performance. The scorecard should tell the story of strategy, starting with long run

financial objectives and then linking them to the sequence of actions that must be

taken with financial process, customers, internal processes and finally employees

and systems to deliver the desired long run economic performance.

There are three financial themes that drive the business strategy:

(A) Revenue growth and mix – the most common revenue growth measure would be

sales growth rates and market share for targeted regions, markets and customers.

New products – a common measure for this objective is the percentage of

revenue from new products and services introduced with a specified period. This

measure has been extensively used by innovative companies.

New applications – Businesses may find it easier to grow revenues by taking

existing products and findings new applications for them. If a new product

application is an objective, the percentage of sales in new applications would be

useful measure.

New customers and markets – Taking excising products and services to new

customers and markets also can be a desirable route for revenue growth. Many

industries have excellent information on the size of the total market and of

relative market share by participants. Increasing a unit’s share of targeted market

segment is a frequently used metric.

New relationships – some companies have attempted to realize synergies from

their different strategic business units by having them cooperate to develop new

products. The objective can be translated into the amount of revenue generated

from cooperative relationships across multiple SBUs.

New product and service mix – business may choose to increase revenues by

shifting their product and service mix. For ex. toward low cost strategy or towards

premium price strategy and tracked the success of this strategy with a measure of

revenue growth from these mix.

New pricing strategy – some companies have discovered that price of products

can be increased for niche products or for demanding customer prices on products

and services.

(B) Cost Reduction/ Productivity Improvement - In addition to establishing

objectives for revenue growth, a business may wish to improve its cost and

productivity performance.

Increase Revenue Productivity – it focuses on revenue enhancement- say

revenue per employee-to encourage shifts to higher value added products and to

enhance capabilities of organizations resources.

Reduce unit cost – in sustain stage businesses aim to reduce the unit cost of

performing work. For the firm producing homogeneous output, reducing cost per

unit can suffice.

Improve Channel mix – as especially promising method for reducing cost is to

shift customer and suppliers from high cost manually processes channel to low

cost electronic channel.

Reduce Operating expenses – many organizations are now actively trying to

lower their selling, general and administrative expenses. It can be measured by

tracking their percentage to total expenses.

(C) Asset utilization/ Investment Strategy - Companies may also wish to identify

the specific drivers they will use to increase asset intensity.

Cash to Cash Cycle – one measure of the efficiency of the working capital is the

cash-to-cash cycle, measured as the sum of days cost of sales of inventory, days

sales in account receivable, less days purchases in account payables.

Improve asset utilization – it focuses on capital investment procedures, both to

improve productivity from capital investment projects and accelerate the capital

investment process to maximize early cash returns.

2. THE CUSTOMER PERSPECTIVE

Recent management philosophy has shown an increasing realization of the

importance of customer focus and customer satisfaction in any company. These

are called leading indicators: if customers are not satisfied, they will eventually

find other suppliers that will meet their needs. Poor performance from this

perspective is thus a leading indicator of future decline. In developing metrics for

satisfaction, customers should be analyzed. These segments represent the sources

that will deliver the revenue component of the company’s financial objectives. In

fact these are leading indicators, which enables companies to align their core

customer outcome measures- satisfaction, loyalty, retention, acquisition, and

profitability – to targeted customers. It also enables them to identify and measure,

explicitly, the value propositions they will deliver to targeted customers. The

value propositions represent the drivers, lead indicators, for the core customer

outcome measures. In the past, the companies could concentrate on their internal

capabilities, emphasizing product performance and innovation. But companies

that did not understand their customer’s needs eventually found that competitors

could make inroads by offering products or services better aligned to their

customer’s preferences. Thus, the companies are shifting their focus extremely to

customers. Clearly, if business units are to achieve long run superior financial

performance, they must create and deliver products that are valued by customers.

Beyond aspiring to satisfying and delighting customers, business unit mangers

must, in the customer perspective of the BSC translate their mission and strategy

statements into specific market and customer based objectives. They must identify

the market segments as well as the value propositions that will be delivered to

targeted segments becomes the key to developing objectives and measures for the

customer perspective. Thus this perspective translates an organization’s mission

and strategy into specific objectives about targeted customers.

Core measures

The core measurement group of customer outcomes is generic across all kinds of

the organizations. The core measurement group includes measures of:

• Market share – measuring market share is straightforward once the

targeted customer group has been specified. It reflects the proportion of

business in a given market that a business unit sells. The second market

share measure is the account share of the customer. The overall market

share measure based on business with these companies could be affected

by the total amount of business these companies offer in a given period.

That is, the share of business with these targeted customers could decrease

because the customers are giving less business to all their suppliers.

• Customer retention – a desirable way for maintaining or increasing

market share in targeted customer segments is to start by retaining existing

customer in those segments. Companies that can readily identify all of

their customers, can readily measure customer retention from period to

period. Beyond this many companies want to measure loyalty of existing

customers.

• Customer acquisition – the customer acquisition measure tracks, in

absolute or relative terms, the rate at which a business unit attracts or wins

new customers or business. It could be measured by either the number of

new customers or the total sales to new customers in these segments. Ratio

of cost and revenue of new customer acquired can also be measured.

• Customer Satisfaction – This measure provides feedback on how well

the company is doing. The importance of customer satisfaction probably

can not be overemphasized. Further just scoring adequately on customer

satisfaction is not sufficient for achieving high degree of loyalty, retention

and profitability. Customer Profitability – succeeding in the first four core

measures, does not guarantee that a company has profitable customer.

Since, customer satisfaction and high market share are only a means to

achieving higher financial returns, companies probably wish to measure

profitability of this business. Activity based costing system permit

companies to measure individual profitability. A financial measure like

customer profitability helps to keep customer focused organization from

becoming customer obsessed.

Measuring customer Value prepositions

It represents the attributes that create loyalty and satisfaction in targeted customer

segments. It varies across the industries and countries, but the followings are the

common attributes.

Product and service attributes – these encompass the functionality of the

product/service, its price, and its quality. Few Customers may prefer low price at the

cost of quality, on the other hand few may prefer quality and unique feather at even

high rates, depending upon the type of customers.

• Time - it has become major competitive weapon in today’s competition.

Being able to respond rapidly and reliably to a customer’s request is often the

critical skill for obtaining and retaining valuable customer’s business.

Customers may be concerned with the reliability of lead time than with just

obtaining the shortest lead times. Lead time is important both for existing

product as well as for new products. A short lead time for introducing new

product can add value to the customers.

• Quality – it was a critical competitive dimension during 1980s and remains

important till this day. Quality is now no more competitive advantage but it

has become hygiene factor. Customers take for granted that their suppliers

will execute according to product specification. It can be measured in terms of

incidence of defects, returns by customers, warranty claims, field service

request and also performance along time dimension.

• Price – one can be assured that whether a business unit is following a low-

cost or a differential strategy, customer will always be concerned with the

price they pay for the product. It is a major influence on the purchasing

decision.

• Customer relationship – it includes the delivery of the product/service to the

customer, including the response and delivery time dimension, and how

customer feels about purchasing from the company. It also encompasses long

term commitment and qualification of supplier so that incoming items are

delivered directly to the customers.

• Image and reputation – it reflects the intangible factors that attract a

customer to a company. Some companies are able, through advertising and

delivered quality of product and service, to generate customer loyalty well

beyond the tangible aspects of the product and service. Consumer preference

for certain brands of shoes, clothing, soft drinks connote the power of image

and reputation for the targeted customer segments.

3. THE BUSINESS PROCESS PERSPECTIVE

This perspective refers to internal business processes. Measurements based on this

perspective will show the managers how well their business is running, and

whether its products and services conform to customer requirements. These

metrics have to be carefully designed by those that know these processes most

intimately. In addition to the strategic management processes, two kinds of

business processes may be identified:

• Mission-oriented processes. Many unique problems are encountered in

these processes.

• Support processes. The support processes are more repetitive in nature,

and hence easier to measure and to benchmark. Generic measurement

methods can be used.

4. Learning and Growth perspective

This perspective includes employee training and corporate cultural attitudes

related to both individual and corporate self-improvement. In a knowledge worker

organization, people are the main resource. In the current climate of rapid

technological change, it is becoming necessary for knowledge workers to learn

continuously. Government agencies often find themselves unable to hire new

technical workers and at the same time is showing a decline in training of existing

employees. Kaplan and Norton emphasize that 'learning' is something more than

'training'; it also includes things like mentors and tutors within the organization, as

well as that ease of communication among workers that allows them to readily get

help on a problem when it is needed. It also includes technological tools such as

an Intranet. There are three principal categories for the learning and growth

perspective.

Employee Capabilities – in current environment of rapid technological changes,

employees need to continuously learn. For an organization just to maintain its existing

relative performance, it must continually improve. This shift requires major re-skilling of

employees so that their minds and creative abilities can be mobilized for achieving

organizational objectives. The three core employee measurements are;

1. Employee satisfaction – it recognizes that employee morale and overall job

satisfaction are now considered highly important by most organizations. Satisfied

employees are a precondition for increasing productivity, responsiveness, quality,

and customer service. Companies typically measure employee satisfaction with an

annual survey, a rolling survey in which a specified percentage of randomly

chosen employees is surveyed each month.

2. Employee retention – it captures an objective to retain those employees in whom

the organization has long term interest. Long term- loyal employees carry the

values of the organization, knowledge of organization processes, and sensitivity to

the needs of customers.

Employee productivity – it is an outcome measure of the aggregate impact from

enhancing employee skills and morale, innovation, improving internal processes,

and satisfying customers. The goal is to relate the output produced by employees

to the number of employees used to produce that output.

Information system capabilities – employee skills and motivation are necessary to

achieve targets for customer and internal process objectives. But to be effective in the

information age, they need excellent information – on customer, on internal processes

and of the financial consequences of their decisions. Front-line employees need accurate

and timely information about each customer’s total relationship with the organization,

and feedback on products produced or delivered. Only by having such feedback can

employees be expected to sustain improvement programme where they systematically

eliminate defects and drive excess cost, time, and waste out of the production system.

Strategic information coverage ratio is a tool to assess the current availability of

information relative to anticipated needs.

Motivation, Empowerment and Alignment – even skilled employees, provided with

superb access to information, will not contribute to organizational success if they are not

motivated to act in the best interests of an organization. Thus the third of the enablers for

the learning and growth objectives focuses on the organizational climate for employee

motivation and initiative. The measures for these enablers are:

• Measure of suggestions made and implemented – one of the simple way to

measure the outcome of having motivated employees is the number of

suggestions per employees. This measure captures ongoing participation of

employees in improving the organization’s performance.

1. Measure of improvement – the tangible outcome from successfully

implemented employee suggestions does not have to be restricted to expense

saving. Organizations can also look for improvements, say in quality, time. Or

performance, for specific internal and customer processes.

2. Measure of individual and organizational alignment – it focuses on

whether departments and individuals have their goals aligned with the

company objectives articulated in the BSC.

3. Measurement of team performance – now organizations are turning to

teams to accomplish important business processes- product development,

customer service and internal operations. So organization requires measures to

motivate and monitor the success of team building and team performance.

The process of the BSC – Building the Balanced Scorecard

Constructing an organization’s first Balanced Scorecard can be accomplished by a

systematic process that builds consensus and clarity about how to translate a unit’s

mission and strategy into operational objectives and measures. The followings are the

main steps to build the BSC in any organization.

1. Select the appropriate organizational unit – Senior executive team should

define the business unit for which a top-level scorecard is appropriate. The initial

scorecard process works best in a strategic business unit, ideally one that conducts

activities across an entire value chain; innovation, operation, marketing, selling,

and service. It would have its own products, customers, marketing, distribution

channels and its own financial summery.

2. Identify SBU/Corporate Linkages – once the SBU has been defined and

selected, the team should learn about the relationship of the SBU to other SBUs

and to the divisional and corporate organization. Interviews should be conducted

with key senior divisional and corporate executives to learn about financial

objectives, corporate themes and linkages to other SBUs. This will help to

optimize the whole organization along with the SBU.

3. Conduct first round of interview - The back ground material on the BSC as well

as internal documents on the company’s and SBU’s vision, mission and strategy

should be supplied to senior mangers. Then after the leader should conducts

interview of each senior manager to obtain their input on the company’s strategic

objectives and tentative proposals for the BSC. The objective of these interviews

is to introduce the concept of the BSC to senior managers, to respond to questions

of the mangers and to get their initial input about the strategy and its translation

into objectives and measures.

4. Synthesis session – after interviews the team should highlight issues and develop

a tentative list of objectives and measures that will provide the basis for the first

meeting of the top-management team. The output of the synthesis session should

be a listing and ranking of objectives in the four perspectives. They should

attempt to determine whether the tentative list of prioritized objectives represents

the business unit’s strategy and whether the objectives across the four

perspectives appear to be linked in casual-effect relationships.

5. Executive workshop – First round – Primary workshop is arranged to facilitate a

group debate on the mission, objectives and strategy statements. The leader can

show listing of objectives during the interviews, views of customers- shareholders

etc. Each candidate will prepare four to five objectives. After introduction and

discussion of objectives of all the candidate, the group votes on top three to four

candidates. For the highest rank objectives, the group will prepare primary

measures. At the end of the session the team will identify three to four objectives

for each perspective and list of potential measures.

6. Subgroup meetings – the leader should organize several subgroup meetings to

discuss on; i. refining the wordings of the objectives, ii. Identifying the measures,

iii. Identify the sources of necessary information, iv. Identifying key linkages

among the measures. The final output of these meetings should be list of

objectives, descriptions of measures, method to quantify measures and graphical

model to link various objectives and measures of all four perspectives.

7. Executive Workshop – Second round – it involves the senior management team,

their direct subordinates and a large number of middle mangers, who debates on

vision, strategy, tentative objectives and measures. The output of subgroup

meeting is presented here, which will help to understand entire scorecard.

Participant can comment and discuss on the same. The objective of the workshop

is to communicate the scorecard intentions to all the employees and to encourage

participants to formulate targets to be achieved by the next 3 to 5 years

8. Develop the implementation plan – a newly formed team, often made up of the

leaders of each subgroup formalizes the stretch targets and develops an

implementation plan for the scorecard. As a result of this process, an entirely new

executive information system that links top-level business units metrics down

through ship floor level and site specific operational measures could be developed.

9. Executive workshop - Third round – the senior executive team meets for a third

time to reach final consensus on the vision, objectives, and measurements

developed in the first two workshops and to validate the stretch targets proposed

by the implementation team. It includes primary action programme to achieve the

targets. It ends up by aligning the unit’s various change initiatives to the scorecard

objectives, measures and targets as well as by deciding programme of

communicating BSC and developing information system to support the scorecard.

10. Finalize the implementation plan - For a BSC to create value, it must be

integrated into the organization’s management system. Management should begin

the use of the BSC within 60 days.

Pre-requisites for a successful scorecard

There are several reasons for high burn-out rate among scorecard companies. One

important reason is over-enthusiasm to measure anything and everything. Other pitfalls

that can sidetrack a BSC programme includes a lack of commitment from senior

management, treating it as a one-time event and failure to let scorecard responsibilities

‘cascade down’ to all employees. Success depends on whether company knows why they

are opting for BSC. After clear vision, they require systematic implementation of BSC.

The following are the pre-requisites for proper implementation of the BSC.

1. Top management commitment and support

The essential pre-condition for the successful implementation of the BSC is,

support and commitment from top management. CEOs and senior management

must be committed to the BSC to drive it down through the organization. It is

necessary that the top management fully understand the concept and the process

of the BSC. They should be educated through seminars and workshops. The role

of CEO is much more critical in the success of the BSC. They should take keen

interest and lead role in introducing and implementing the BSC. A number of

organizations started the BSC by first creating it for the top management and the

CEO and then cascading it down to other levels of the organization. Without

dedication and support from top management, the BSC will be visionless. In short,

at each and every step of implementing the BSC, support and co operation from

the top management is must.

2. Determine the critical success factors

This is most critical aspect of the BSC implementation. For a number of

companies in India, that are just coming out of the protected environment and

have started facing competition, it is not very difficult to realize that the driving

force for survival is customer satisfaction. Hence, the critical success factors are

superior quality, low cycle time, high customer response, after sales service,

employee competition etc. But for those organizations which have already

reached high levels of customer satisfaction superior quality and other measures,

the area of improvements are not very obvious. The challenge is to identify the

most fundamental critical success factors (CSFs). The problem is compounded

because of the requirement s of multiple stakeholders including government and

society. The BSC will have to consider the requirements of all stakeholders,

which at times create conflict. The BSC can not be limited to four perspectives;

the new one can be added as per requirement. The social responsibility,

environment etc. can be new perspectives. The entire organization must be

involved in identifying CSFs. The organization must assign priorities to the

stakeholder’s requirements and rate in term of their impact. Thus, as per need and

circumstances of the organization, CSFs should be decided precisely.

3. Translate CSFs into measurable objectives (metrics)

Clear and precise BSC, requires proper CSFs as well as translation of CSFs into

metrics. The identified objectives will not lead the organization anywhere else

unless the CSFs are converted into good measures or metrics. There are several

measures of financial variables and over the years they have been refined. For

example, the economic value added is a useful aggregated financial measure

which links with value creation for shareholders. It is a real challenge to develop

metrics for non-financial measures as a number of them could be unique to an

organization for which no standards exist. The BSC is a device to link

performance measures to strategy and performance outcomes. These measures

should be precise and consistent for achieving the desired objective. They should

be based on objective facts and information, verifiable and accessible. There

should not be possibility of these measures being manipulated. The target of

measure should be challenging but achievable. It is also important that a number

of measures may be kept to a level which can be easily managed. Thus, CSFs

should be converted in performance measures precisely.

4. Link performance measures to reward

The success of any performance management system depends on its link to

rewards and motivation to human being. A reward system that is easily

understood and is prompt in rewarding employees is essential. Performance

measures should be linked to reward system in such a way so that it motivates

employees at all levels and influence them to achieve the given performance

targets. The BSC should be understood from top to bottom. The people at bottom

level should be dedicated for the implementation of the BSC. And for this purpose,

employees should be motivated through reward system. Thus, performance

measures should be linked properly with reward system for effective performance.

5. Use of tracking system

Planning does not have value until supported by proper control system. In the

same way, the performance metrics and targets have no value if they are not

tracked quickly. The BSC establishes a system of feed-back and learning. But for

real time review the organization requires to set proper feed-back system, so that

errors can be tracked quickly and corrected on time. The organization should

follow frequent and regular reporting system. Many organizations which have

implemented the BSC successfully, believe in daily or twice in day reporting. The

employees must know where they are? Where they should be? And the managers

must know where they need corrective actions? Thus, for the successful

implementation of the BSC, the firm requires good tracking system.

6. Create and links the BSC at all levels of the organization

An organization will better serve its purpose of providing delight to all its

stakeholders if it develops scorecard at corporate, divisional and even at the

individual levels. There should be a link between these scorecards. The divisional

scorecards should follow from the corporate scorecard and the individual

scorecard from the divisional scorecards. The achievement of the targets of the

scorecard at a lower level must ensure that targets of higher scorecards are met.

The scorecard measures, particularly relating to strategic objectives, must be

disaggregated so that every one understands them and are able to relate to their

actions to strategy. Thus, from top to bottom and from corporate to SBU

scorecard to divisional scorecard, co-ordination is essential. In short, all the levels

of organization must be linked properly.

7. Communication

The BSC is a communication device – a device to communicate strategy and its

components to all levels of organization. It provides a common language. But this

does not happen automatically. An organization should develop an effective

organizational communication system to make all employees understand the

common language of the BSC. The BSC should be exposed to all the employees.

Employees must be clear about the strategy, goal, their target, achievements and

gap. For this, an effective and precise communication system should be

established in the organization. There should be two-way communication i.e.

from top to bottom as well as from bottom to top. Ideas of employees should be

given a chain of communication.

8. Link strategic planning, BSC and Budgeting process

There should be a co-relation among strategic planning, Balanced Scorecard and

Budgeting process. The strategic planning process should be linked to BSC. And

in the same way the BSC should be linked to Budgeting process. The strategic

initiatives to meet the targets require funds. The BSC should be linked to the

budgeting process and set priorities to allocate resources to strategic initiatives.

Thus, dreams of the strategic planning must be formed in physical form in the

BSC as well as the data of the BSC must be linked to figures- budgets properly.

9. Change Management

The BSC requires a culture shift in the organization, which requires change

management in the organization, David Norton said that to execute strategy is to

execute change at all levels of an organization. Seems self even, but overlooking

this truth is one of the important causes of a failed transformation effort. Best

practice is organization should give equal weight to the soft issues of leadership,

culture and team work and undergoing three phases of change management;

mobilization of change, design and roll out and sustainable execution.

10. Implementation in Phased manner

The BSC is not a tale of a day or a month. It requires change in the whole

measurement and management system. So, implementation of the BSC should be

in a phased manger. Many firms first implement it to the top level and gradually

spread in the whole organization. Experience suggests that if the number of

measures traced is increased over a period of time, it is easier for employees to

adapt. It reduces the time spent on the initial phase and speed up implementation.

BENEFITS OF THE BALANCED SCORECARD

Kaplan and Norton cite the following benefits of the usage of the Balanced Scorecard:

• Focusing the whole organization on the few key things needed to create

breakthrough performance.

• Helps to integrate various corporate programs. Such as: quality, re-

engineering, and customer service initiatives.

• Breaking down strategic measures towards lower levels, so that unit managers,

operators, and employees can see what's required at their level to achieve

excellent overall performance.

There are several pluses to having a scorecard. But the most fundamental reason for its

use is the shift in the source of value. In the old economy, companies added value

primarily by investing in tangible assets, plant, machinery, sales offices and technology.

Kaplan estimates that till 20 years ago, nearly two third of the market value of a company

came from the tangible assets it owned. Today an analysis of the S & P 500 companies in

the US show that 85% comes from intangible assets. If value whether seen from the point

of view of the customers or markets- has shifted to intangibles, companies need to

understand the underlying factors that deliver better customer and shareholder value.

Kaplan says that service companies have adopted the BSC more eagerly because in their

case values is delivered to the customer at a point for away from the top-management.

The BSC scores precisely because it does not look at strategy from a unidirectional

perspective. The following are the major benefit of BSC.

1. Clarify the vision throughout the organization - The BSC is not a tool of

control; rather it is a tool of communication. The BSC clarifies the vision of the

organization throughout the all levels of the organization. Unlike the traditional

measurement system, here each and every member of the organization is clear

about the vision, strategy and objectives of the organization. Thus, BSC helps to

link organization in a specific way.

2. Filter initiatives - Companies take different initiatives to improve their

performance. With the scorecard, the utility of each initiative can be judged from

its contribution to the achievement of strategic targets. And by this way

companies can filter initiatives and can use specific initiatives for the best

performance.

3. Make strategy every body’s job – The scorecard is a communication tool. It

enables management to explain the strategy to employees at all levels, showing

what is measured and encouraging the free flow of relevant information. This

helps to align the personal objectives of individual and their compensation to the

organization’s objective. Thus, BSC circulates strategy from top to bottom and

make strategy everybody’s job. In short employees at all levels are linked with

and involved in strategy.

4. Facilitate organizational learning – The BSC enables double-loop learning. On

one hand, since the BSC links existing strategy to the objectives, it can test its

workability and incorporate the feedback into strategy. But as strategic objectives

and targets are also linked to initiatives and programmes at operational level, the

result of these initiatives can offer clues to emerging strategies once again. In

short, by present and futuristic view, the BSC guides the organization and

improves organizational learning process.

5. Drive the capital and resource allocation process – The BSC links strategic

planning and budgeting process. As per strategic planning the BSC, determines

priorities for all the areas. And then after it is linked to the budgeting process.

Thus, allocation of resources will be in the line of strategic planning. Thus, due to

planned resource allocation process, the efficiency may go up. In short, the BSC

guides and drives capital and other resource allocation.

6. Integrate the strategic management process across the organization The BSC

makes strategy everybody’s job. That means it connects and links whole

organization including all the levels, divisions and department in the process of

strategic management. All the divisions, top management, middle management

and shop floor level is clear about the vision, strategy, objectives and measures of

the organization.

7. Focus teams and individual on strategic priorities – The BSC moves from top

to bottom. The corporate BSC is transferred to SBU-BSC and SBU-BSC is

transferred to divisional BSC. Further divisional BSC is translated into team goals,

objectives and measures and in the same way individual receive specific

objectives, targets and measurement. Thus, the BSC gives focus from corporate to

an individual.

Conclusion

Information age companies will succeed by investing in and managing their intellectual

assets. Functional specialization must be integrated into customer-based business

processes. Mass production and service delivery of standard of products and services

must be replaced by flexible, responsive and high quality deliver of innovative products

and services that can be individualized to targeted customer segments. Innovations and

improvement of products, services, and processes will be generated by reskilled

employees, superior information technology, and aligned organizational procedures. As

organization invest in acquiring these new capabilities, their success cannot be motivated

or measured in the short run by the traditional financial accounting model. It measures

events of the past, not the investments in the capabilities that provide value for the future.

The BSC is a new frame work for integrating measures derived from strategy. While

retaining financial measures of past performance, the BSC introduces the drivers of

future financial performance. The drivers, encompassing customer, internal-business-

process, and learning and growth perspectives, are derived from an explicit and rigorous

translation of the organization’s strategy into tangible objectives and measures. The BSC,

however, is more than a new measurement system. Innovative companies use the

scorecard as the central, organizing framework for their management processes. The real

power of the BSC occurs when it is transformed from a measurement system to a

management system. As more companies work with the BSC, they can see how it can be

used to clarify strategy and communicate strategy, to align organization with strategy, to

link strategic objectives to long term targets and budgets, to perform periodic strategic

review and to obtain feedback to learn about and improve strategy.

References:

• Anand Manoj and Sahay B S, (2005), “Balanced Scorecard in Indian companies”,

Vikalpa, Volume 30, No.2, April-June, 11-25

• Crowther David, (2002), “Understanding the Balanced Scorecard”, Effective

Executive, March, 33-41

• Kaplan R.S. and Norton, D.P. (1996a). The Balanced Scorecard – Translating

Strategy into Action, Boston ; Harvard Business School Press

• Kaplan R.S. and Norton, D.P. (2001). The Strategy Focused Organization : How

Balanced Scorecard Companies Thrive in the New Business Environment,

Boston ; Harvard Business School Press

• Kaplan R.S. and Norton, D.P. (1992). “The Balanced Scorecard – Measures that

Drives Performance,” Harvard Business Review, January-February, 71- 79 ( The

best of HBR – July- August, 2005)

• Kaplan R.S. and Norton, D.P. (1993). “Putting the Balanced Scorecard to Work”,

Harvard Business Review, September – October, 140 – 147

• Kaplan R.S. and Norton, D.P. (2000). “Having Trouble With Strategy –Then map

it’, Harvard Business Review, September – October, 167-175

• Kaplan R.S. and Norton, D.P. (2006), “How to Implement a new Strategy

Without Disturbing Your Organization”, Harvard Business Review, March 100 –

109

• Kaplan R.S., (2005), “Designing Strategy”, The Smart Manager, August-

September,53-59

• Pandey I M. (2005), “Balanced Scorecard – Myth and Reality”, Vikalpa, Volume

30, No.1, January-March, 51-66

• Pandya Pradeep. (2002), “Keeping Score on Strategy”, Indian Management,

August, 30-38

• Schneiderman, Arthur M. (1999), “Why Balanced Scorecard Fail”, Journal of

Strategic Performance Measurement, January, 6-11

• Schneiderman, Arthur M. (2004) http. //www. scheneiderman. com/ concepts/

The_First_Balanced_scorecard.htm

Chapter – 9

Value Based Management

• Introduction • Characteristics of Value Based Management

• Value Based Management Concept

• Value-Based Management Techniques and Systems

• Economic Concept of Profit

• Shareholder Value Analysis

• Cash Flow Return on Investment

• Cash Value Added

• Accounting Concept of Profit

• Residual Income

• Economic Value Added

• Economic Profit

• Marakon Approach

• BCG Approach

• BCG Matrix

• McKinsey Approach

Introduction:

The terms ‘Shareholder Value’ and ‘Value-based Management’ may be relatively new,

but the ideas behind it obviously are not, long past Smith, 1776 emphasized on

shareholder value. It realized that a company only makes a profit when all the costs are

covered, including the costs of capital (both debt and equity). It did not gain much

attention, though, until the publication of the book ‘Creating Shareholder Value’ by

Alfred Rappaport in 1986. From that time, organizations focus on shareholder value

instead of accounting profits. At that time the term ‘Value-based Management’ (VBM)

was coined to operationalize shareholder value creation. Value-based Management in a

principal-agent (i.e., capital market-firm) perspective in order to see to what extent VBM-

metrics could be helpful in this external agency relationship. Many authors defined and

described VBM (Rappaport, 1986; Stewart, 1991; McTaggert et al., 1994; Weissenrieder,

1997; Arnold, 1998; Copeland et al., 2000; Young & O’Byrne, 2001).

Definition:

Value-based Management is a managerial approach to create value by investing in

projects exceeding the cost of capital and by managing key value drivers.

Characteristics:

The following characteristics are generally shared in common:

Value Based Management takes all costs of capital into account. Where

accounting profits only include the cost of debt (interest), economic value is only

created when net profits also exceed the costs for debt as well as for equity.

Value Based Management is a managerial approach. Applying VBM takes more

than calculating a measure that includes the cost of capital. It is an approach

where techniques, concepts, and tools are used to meet the firm’s objectives,

relating to all organizational functional areas (e.g., production, logistics, strategy,

finance, accounting, and human resources) and levels.

Value Based Management is built around value drivers. This stresses the fact

again that it is not about the calculation, but about the variables that are related to

the calculation. These activities can be expressed in both financial and non-

financial terms, and involve all organizational levels. Ways to operationalize this

‘break-down’ is by using for example the Balanced Scorecard or a ‘value tree.’

Value-based Management, predominantly describes the various metrics that are used to

calculate and express value creation, or try to find empirical evidence on capital market

performance about correlations with share prices compared with the more ‘traditional’

accounting performance measures such as earnings. Value-based Management is used

and applied in organizations, and how this affects the management control system in

order to meet the shareholders’ interests. Regarding management control, Anthony &

Govindarajan’s (2001) definition, They describe the activities that are involved with

management control as follows (Anthony & Govindarajan, 2001, pp. 6–7):

(1) Planning what the organization should do,

(2) Coordinating the activities of several parts of the organization,

(3) Communicating information,

(4) Evaluating information,

(5) Deciding what, if any, action should be taken, and

(6) Influencing people to change their behavior.

Moreover, they state that ‘management controls are only one of the tools managers use in

implementing desired strategies,’ besides organization structure, human resources

management, and culture (p. 8). This leads to Anthony & Govindarajan’s definition of

management control: ‘the process by which managers influence other members of the

organization to implement the organization’s strategies’ (Anthony & Govindarajan, 2004,

p. 7).

Value Based Management Concept Organization Strategy Financial Performance Shareholders Returns

• Organizational Structure

• Strategic Management Process

• Targets Organizations

• Control Process

• Remuneration System

Input Output

Figure: Value-based Management Process (Source: Broersen and Verdonk, 2002)

Value-Based Management Techniques and Systems

To measure how Value-based Management contributes to contracting agents, several

metrics are developed, mostly by consulting firms. They all argue that their metric

correlates most closely with share price or measure shareholder value most accurately,

especially compared to traditional accounting measures. The most fundamental economic

relationship underlying Value-based Management (in countries with well-developed

capital markets) is that shareholder value (i.e., the market value of the company’s

common stock) is determined by discounting the cash flows investors (i.e., principals)

expect to receive over a long-time horizon at the minimum acceptable rate of return they

require for holding equity investments, also known as the cost of equity capital

(Rappaport, 1986; Stewart, 1991; McTaggert et al., 1994; Young & O’Byrne, 2001). The

value of the firm is subsequently a function of three major factors: the magnitude, the

timing, and the degree of uncertainty of the future cash flows resulting from executing

investment projects and stemming from decisions made with regard to the financing of

Business Unit Strategy

• Participation

• Competitive Strategy

SBU Strategy

Market Potential

CompetitivePosition

Economic Profit

Economic Value

Total Returns to shareholders

the firm (Young & O’Byrne, 2001; Brealey et al., 2004; Damodaran, 1996). The

magnitude in cash flows will vary from asset to asset – dividends for stocks, coupons

(interest) and face value for bonds, and after-tax cash flows for a real project. The

magnitude tells little about the current value unless timing is also known. Cash has a time

element, which means that we would rather have it today than have to wait for it (Young

& O’Byrne, 2001; Brealey et al., 2004). The function of the uncertainty or riskiness of

the estimated cash flows, with higher rates for riskier assets and lower rates for safer

projects, results in the discount rate. These are the elements of the ‘present value’ rule,

where the value of any asset is the present value of expected future cash flows on it (the

discounted cash flow model):

Where

n = Economic life of the asset or investment

CFt = Cash flow in period t

r = Discount rate that reflects the riskiness of the estimated cash flows.

Because investments tie up cash, their value is based on the amount of future cash flows

that will accrue to investors. These free cash flows can be thought of as the amount of

cash flow left over from the company’s operating activities after investments have been

made. It is from this residual cash flow that companies can then return cash to their

investors (principals). In brief, free cash flow makes it possible for companies to make

(i) Interest payments,

(ii) Pay off the principal on the loans,

(iii) Pay dividends, and

(iv) Buy back shares.

These are the four ways that companies return cash to their investors, and therefore, the

expectations of such cash flows will be the ultimate determinant of a company’s value

from a capital market perspective (Young & O’Byrne, 2001).

Economic Concept of Profit

The economic concept of profit (Hicks, 1946), or economic income (Brealey & Myers,

1996), rests on the concept described above. When applying this concept, profit is

defined as the free cash flow in a specific time period (year t) plus the change in present

value between year-ends t-1 and t. In other words:

Economic Income = free cash flow + year’s change in present value

Economic Incomet = FCFt + PVt – PVt-1

Where FCF is defined as the cash flow that is left from the operating cash flow after

investments have been made and which is subsequently available to the investors.

Various value-based metrics (i.e., metrics that take costs of all capital into account) are

based on these principles, and will be discussed below.

Shareholder Value Analysis

When looking at Rappaport’s Shareholder Value Analysis (Rappaport, 1986), the basic

thought behind this concept takes the change in present value of future cash flows as

starting point to calculate Shareholder Value Created. The definition is as follows:

Shareholder Value = Corporate Value -/- Debt

Where Corporate Value is subsequently defined as (Rappaport, 1986: 51):

Present value of cash flow from operations during the forecast period

+ Residual value (which represents the present value of the business attributable

to the period beyond the forecast period)

+ Marketable Securities

For most businesses only a small proportion of value can be reasonably attributed to its

estimated cash flow for the next five or ten years. The residual value often constitutes the

largest portion of the value of the firm. Moreover, two issues should be borne in mind

regarding residual value. First, while residual value is a significant component of

corporate value, its size depends directly upon the assumptions made for the forecast

period. Second, there is no unique formula for residual value. Its value depends on an

assessment of the competitive position of the business at the end of the forecast period

(Rappaport, 1986: 60). Debt, as second component of Shareholder Value, includes the

market value of debt, unfunded pension liabilities, and the market value of other claims

such as preferred stock. In line with the economic concept of profit (or economic income),

shareholder value creation addresses the change in value over the forecast period. This is

based on the fact that the cost of capital incorporates the returns demanded by both debt

holders and shareholders because pre-interest cash flows are discounted, i.e., cash flows

on which both debt holders and shareholders have claims. Rappaport states (1986: 56)

that the relevant weights for debt and equity should be based on the proportions of debt

and equity in the firm’s target capital structure over the long-term. In calculating the

weights of the target capital structure, the conceptual superiority of market values is in

finance literature generally accepted, despite their volatility, on the grounds that to justify

its valuation the firm will have to earn competitive rates of return for debt holders and

shareholders on their respective current market values (Brealey & Myers, 1986; Copeland

et al., 1996; Stewart, 1991; Young & O’Byrne, 2001).

Measuring the cost of debt is a relatively straightforward matter once it is established that

what is appropriate is the cost of new debt and not the outstanding debt. This is so

because the economic desirability of a prospective investment depends upon future costs

and not past or sunk costs. In addition, since interest on debt is tax deductible, the rate of

return that must be earned on debt-financed instruments is the after-tax cost of debt

(Rappaport, 1986: 56).

The second component of the cost of capital, the cost of equity, is more difficult to

estimate. In contrast to the debt-financing case where the firm contracts to pay a specific

rate for the use of capital, there is no explicit agreement to pay common shareholders any

particular rate of return. Rational, risk-averse investors expect to earn a rate of return that

will compensate them for accepting greater investment risk.

Thus, in assessing the company’s cost of equity capital, it is reasonable to assume that

they will demand the risk-free rate as reflected in the current yields available in

government securities, plus an additional return or equity risk premium for investing in

the company’s more risky shares (Rappaport, 1986: 57). In the absence of a truly risk-less

security, the rate on long-term Treasury bonds serves as the best estimate of the risk-free

rate. The use of long-term Treasury bonds also accomplishes that there is consistency

with the long-term horizon of the cash flow forecast period, and in addition captures the

premium for expected inflation.

The second component of the cost of equity is the equity risk premium. One way of

estimating the risk premium of a particular stock is by computing the product of the

market risk premium for equity (the excess of the expected rate of return on a

representative market index such as the Standard & Poor’s 500 stock index [rm] over the

risk-free rate [rf]) and the individual security’s systematic risk8, as measured by its beta

(V) coefficient9 (Rappaport 1986: 57-58). The market risk premium (rm – rf) has

averaged 8.4 percent a year over a period of 69 years (Brealey & Myers, 1996: 180).

These variables are combined in the Capital Assets Pricing Model (CAPM). Sharpe

(1964) and Lintner (1965) described this model, where in a competitive market the

expected risk premium varies in direct proportion to beta. Hence, the

CAPM can be written as:

Cost of equity = rf + V(rm – rf)

Value created by strategy = shareholder value -/- pre-strategy shareholder value, or

Cumulative Present Value of cash flows

+ Present Value of Residual Value

+ Marketable Securities

- Market Value of Debt

= Shareholder Value

- Pre-strategy Shareholder Value

= Shareholder Value Created

In order to be able to manage shareholder value, Rappaport introduces the Threshold

Margin, which represents the minimum operating profit margin a business needs to attain

in any period in order to maintain shareholder value in that period, thus the level at which

the business will earn exactly its minimum acceptable rate of return, that is, its cost of

capital (Rappaport, 1986: 69). It can be expressed in two ways: either as the margin

required on incremental sales (i.e., incremental threshold margin) or as the margin

required on total sales (i.e., threshold margin). The change in shareholder value

(Shareholder Value Created) can be defined as:

(Incremental Sales)(Operating Profit Margin on Incremental Sales)

(1 - Income Tax Rate) (Cost of capital)

-/- (Incremental Sales)(Incremental Fixed Plus Working Capital Investment Rate)

(1 + Cost of Capital)

The first term represents the present value of the firm’s incremental cash inflows, which

are assumed to begin at the end of the first period and continue into perpetuity. The

second term represents the present value of the investment (also assumed to take place at

the end of the period) necessary to generate the incremental cash inflows. Consequently,

the incremental threshold margin is the operating profit margin on incremental sales that

equates the present value of the cash inflows to the present value of the cash outflows.

The incremental threshold margin can be subsequently be defined as:

(Incremental Fixed Plus Working Capital Investment Rate)(Cost of Capital)

(1 + Cost of Capital)(1-Income Tax Rate)

While the incremental threshold margin is the ‘break-even’ profit margin on incremental

sales only, the threshold margin is equal to the ‘break-even’ operating profit margin on

total sales in any period (Rappaport, 1986: 73). The threshold margin is thus calculated as

follows:

(Prior Period Operating Profit) + (Incremental Threshold Margin) (Incremental Sales)

Prior Period Sales + Incremental Sales

Essential point that follows from the above is, that when a business is operating at the

threshold margin, sales growth does not create value.

Once the investment requirements and risk characteristics of a strategy have been

established, shareholder value creation is determined by the product of three factors:

1. Sales growth

2. Incremental threshold spread (= profit margin on incremental

sales -/- incremental threshold margin)

3. Duration over which the threshold spread is expected to be

positive (value growth duration).

This means that shareholder value creation by a strategy in a given period t can also be

defined as:

(Incremental Sales in Period t)(1 – Income Tax Rate)(Incremental Threshold Spread in Period t)

(Cost of Capital)(1 + Cost of Capital) t periods - 1

The above equations provide the essential link between the corporate objective of

creating shareholder value (which serves as the foundation for providing shareholder

returns from dividends and capital gains) and the seven basic valuation parameters or

value drivers:

• Sales Growth Rate, Operating Profit Margin and Income Tax Rate: Operational

decisions

• Working Capital Investment and Fixed Capital Investment: Investment decisions

• Cost of Capital: Financing decisions

• Value Growth Duration: Management’s best estimate of the number of years that

investments can be expected to yield rates of return greater than the cost of capital

(Rappaport, 1986: 76-77).

Shareholder Value Analysis (SVA) can be used for whole business, divisions, operating

units, projects, product lines or customers.

Cash Flow Return on Investment

An other metric that is rooted in the company’s cash flows is developed and promoted by

Holt Value Associates and the Boston Consulting Group: Cash Flow Return on

Investment (CFROI)(Madden, 1999; Damodaran, 1999). The CFROI measure was

developed to minimize accounting distortions in measuring a firms’ economic

performance; particularly distortions related to inflation (Madden, 1999: xii). In

calculating CFROI, four inputs are required (Madden, 1999: 110): (1) the life of the

assets, (2) the amount of total assets, (3) the periodic cash flows assumed over the life of

those assets, and (4) the release of non-depreciating assets in the final period of the life of

the assets. CFROI is subsequently calculated as follows:

Where:

Gross Cash Flow = earnings before interest, after taxes + depreciation

Economic Depreciation = based on replacement cost in current currency

Gross Inflation Adjusted Assets = net value of assets + accumulated depreciation,

adjusted for inflation

The inflation adjusted Gross Cash Flow conceptually seeks to capture the amount of cash

flow resulting from the company’s business operations, regardless of how financed. The

items added to accounting Net Income are Depreciation & Amortization, Adjusted

Interest Expense, Rental Expense, Monetary Holding Gain (Loss), LIFO Charge to FIFO

Inventories (subtractive item), Net Pension Expense, Special Item After Tax, and

Minority Interest (Madden, 1999: 133). Holt’s CFROI procedure organizes non-

depreciating assets into Monetary Assets (i.e., cash and short-term items are susceptible

to loss of purchasing power of the monetary unit11), and All Other Non-depreciating

Assets, which include Investments & Advances, Inventory, Land, and when appropriate,

a reduction of a portion of the firm’s Deferred Tax Assets.

Shareholder value is calculated as (CFROI * GIAA – DA)(1 – t) – (CX – DA) – ∆WC

(kc - gn)

Where:

GIAA = Gross Inflation Adjusted Assets

DA = Depreciation and Amortization

t = Tax Rate

CX = Capital Expenditures

∆WC = Change in Working Capital

kc = Cost of Capital

gn = Sustainable Growth rate

The CFROI valuation model is rooted in the previously described Discounted Cash Flow

principles (e.g., Young & O’Byrne, 2001; Brealey & Myers, 1996): (a) more cash is

preferred to less, (b) cash has a time value, sooner is preferred to later, and (c) less

uncertainty is better. The real numbers used in CFROIs, asset growth rates, and discount

rates help to make a performance/valuation model useful on a worldwide basis. Inflation

adjustments are made from the perspective of the firm’s capital suppliers, not from the

going-concern perspective. The capital suppliers’ perspective requires that all monetary

values – all cash-in/cash-out amounts – be measured in monetary units of equivalent

purchasing power (Madden, 1999: 109).

Managerial skill and competition are the fundamental determinants of the path of a firm’s

economic performance through time. The CFROI valuation model incorporates these in

the form of a competitive life-cycle framework for analyzing firms’ past performance and

forecasting future performance. The life-cycle framework postulates that over the long

term there is competitive pressure for above-average CFROI firms to fade downward

toward the average economic return and the below-average firms to fade upward. The

primary focus is on the fade patterns for forecasted CFROIs and for reinvestment rates

(asset growth), with particular attention given to the next five years (Madden, 1999: 9-10;

Stigler, 1963 in: Madden, 1999: 19). Regarding the discount rate (cost of capital)

component of DCF valuation, Madden (1999) rejects conventional CAPM and beta

procedures for estimating firms’ discount rates (cost of capital), because they are rooted

in a backward-looking estimate of a premium for the general equity market over a risk-

free rate coupled to a dubious volatility measure of risk (beta). In contrast to CAPM/beta,

CFROI does not import a discount rate determined without regard to the model’s

forecasting procedures. In this model, a firm’s discount rate is determined by the market

rate plus a company-specific risk differential.

Figure: CFROI Valuation Model Map (Source: Madden, 1999: 65)

The market’s discount rate is derived using monitored forecast data for an aggregate of

firms with known market values. This makes it a forward-looking rate, derived much in

the manner that a bond’s yield-to-maturity is calculated from a known price and a

forecast of future cash receipts from interest and principal. A firm’s risk differential is a

function of the firm’s size and financial leverage (Madden, 1999: 10). On the other hand,

the forward-looking perspective makes this rate more subjective than a rate based on

objective, historical data. For that reason, CFROI has limited use with start-up operations,

where the portfolio of projects as a whole is still being penalized by very substantial

expenses and limited revenues. In this instance, operating milestones of a non-financial

nature are crucial: e.g., getting a prototype product to meet or exceed target performance

standards, engineering the product so that manufacturing costs will not exceed a target

level, et cetera (Madden, 1999: 80).

Madden (1999: 14) states that ‘at a basic level, economic performance can be described

in terms of a completed contract … measured by the firm’s achieved ROI (return on

investment) adjusted for any changes in the purchasing power of the monetary unit. The

ROI is the internal rate of return that equates a project’s net cash receipt (NCR) stream to

its cost, where the NCR represents what the firm receives less what it gives up along the

way, which is at the heart of valuation analysis. Cash outflows and inflows are expressed

in monetary units of the same purchasing power (e.g., constant dollars) by adjusting for

period-to-period changes in the general price level. The measurement of economic

performance requires inflation adjustments; otherwise, the cash amounts reflect a

combination of economic performance and monetary unit changes. In final form, the

firm’s economic performance for that project can be expressed as a real, achieved ROI.’

To outside investors, individual projects cannot be identified from financial statements,

so the data for the separate projects would not be available. However, financial

statements do reveal the amount of total assets, total depreciating assets, total non-

depreciating assets, and total cash flow. It is reasonable to infer that the cash tied up in

non-depreciating assets (net working capital) is released over the life of the depreciating

assets (Madden, 1999: 79). Madden explains (1999: 67) that analyzing a conventional

statement of sources and uses of funds, with a focus on net working capital, helps to

identify the NCR from both the firm’s perspective and from the capital suppliers’

perspective. Since the CFROI model utilizes accrual accounting to represent economic

transactions, the funds statements based on net working capital (NWC) (not cash) are

appropriate. Capital suppliers, both debt holders and equity owners, have claims on the

firm. For a non-financial firm, the standard CFROI perspective is to value the entire firm.

The total-firm warranted value less debt provides the warranted equity value. The firm’s

NCR stream thus represents receipts to which both debt and equity suppliers have a claim.

From the firm’s perspective, a NCR is gross cash flow less reinvestment, consisting of

gross capital expenditures and change in net working capital. From the capital suppliers’

perspective, cash in their pockets takes the form of interest payments, debt principal

repayments, dividends, and share repurchases. The NCR of this group is these cash

receipts less new debt and sale of additional equity shares (Madden, 1999: 67). In

working with aggregate financial statements, investors need to assess likely ROIs on

future projects in relation to the firm’s cost of capital. This is the language of discounted

cash flow: internal rates of return and discount rates. This is not the language of

accounting-based ratios derived from financial statements and often loosely referred to as

‘ROIs’ (Madden, 1999: 14). Madden continues (p. 15): ‘Holt’s CFROI valuation model is

particularly rigorous in its inflation-adjustment procedures, i.e., in calculating ‘real’

magnitudes. This added complexity is necessary in order to better observe patterns and

important relationships in time-series data and to better judge the plausibility of forecast

data.’

The CFROI is a much more informative performance measure compared to the historical

cost accounting earnings/book ratio. CFROI is a cross-sectional return measure derived at

a point in time from aggregate data contained in conventional financial statements. ‘ROI’,

in CFROI lexicon, denotes an internal rate of return for a project. Displayed as a time-

series track record, CFROI is a measure with which to judge levels of and trends in a

firm’s economic performance, which then can be used to help forecast ROIs on future

projects. Madden further says (1999: 21) that ‘a significant advantage of the CFROI

valuation model is that firms’ track records of CFROIs and real asset growth rates

provide a visual display of past performance which corresponds exactly with the key

drivers of forecasted future performance. This is not to say that the future must be much

like the past. Rather, the point is that if performance for established firms is forecasted to

be substantially improved, the business plans for doing it would be expected to break

with business-as-usual. The better one understands the past, the better equipped one is to

deal with the future.

Cash Value Added

Cash Value Added is a measure that is used by different authors in explaining different

concepts, but by using one similar name. Conceptually, its calculation varies in using

cash based variables or accounting-based variables.

The first CVA-concept to explain is from Ottoson & Weissenrieder (1996) and

Weissenrieder (1997).

In their definition, CVA is calculated as:

Operating Cash Flow -/- Operating Cash Flow Demand

Where Operating Cash Flow = Sales -/- Costs +/- Working Capital Movement -/-

Non-strategic Investments

Operating CF Demand = Cash Flow needed for Strategic Investments

Where the NPV of that investment equals zero

given the investor’s cost of capital

Shareholder value is defined as the cumulative present value of future CVAs, while the

shareholder value added equals the annual CVA.

Like Rappaport’s Shareholder Value Analysis, this metric is also explicitly built around

value drivers. These are:

• Operating surplus (sales -/- costs)

• Working capital movement

• Non-strategic Investments

• Operating Cash Flow Demand

The CVA-analysis can be done at each level of the company, like the other metrics,

where the CVA for the company is the aggregate CVA of its Strategic Investments. It

makes in that respect a distinction between investments that are supposed to create value

(strategic investments) and investments required to maintain the value created by those

strategic investments (non-strategic investments).

The Boston Consulting Group (BCG) describes Cash Value Added (or its financial

services equivalent AVE—Added Value to Equity), as an absolute measure of operating

performance contribution to value creation. It provides a strong directional indication of

when and how value creation is being improved. CVA reflects operating cash flow minus

a cost of capital charge against gross operating assets employed (BCG, 2003).

According to the BCG, CVA is an accurate tool for determining priority value drivers

and assessing value-driver trade-offs. In particular, it is a useful strategic indicator that

allows managers to balance the high level trade-offs between improving profitability

versus growing the business. Because its measurement is based on cash flow and original

cash investment, it avoids the key accounting distortions that cause profit-oriented

measures to give misleading trends in capital-intensive businesses (BCG, 2003). In

BCG’s view, CVA is an effective measure for annual incentives at the business-unit and

operational levels. Moreover, CVA can be disaggregated into a value-driver tree of

practical measures, beginning with cash flow return on investment (CFROI) and its

appropriate value levers, cash flow margin and capital turnover, as well as profitable

growth in terms of gross investment increase. For that matter, CVA can also be

interpreted as the spread between CFROI and the cost of capital, multiplied by the asset

base. When further broken down into operational value drivers for each business unit, it

provides insight into how value is created in different areas and levels of responsibility

throughout a company. This breakdown into the key performance indicators (KPIs)

which are relevant to each management area, form the basis for internal or external

performance benchmarking and for establishing annual incentive targets (BCG, 2003).

Table: shows how these metrics relate with aligning shareholders’ (principals) and

management’s (agents) interests, and to which extent they are applicable regarding data.

Principal-Agent Compliance Cash Flows Data Availability

Shareholder Value Analysis

• Uses market values of debt and equity

• Cost of equity includes equity risk premium

• Uncertainty about residual value, which constitutes largest portion of value

• Estimates of cash flow

implications on strategy

• Linked with value drivers

Data not readily

available to outsider

investors

Cash Flow Return on Investment

• Minimize accounting distortions, particularly inflation, from capital supplier’s perspective

• Managerial skills and competition are fundamental determinants of value

• Relative rate (internal rate of return) reflecting market rate plus company specific risk differential.

• Forecasted data used in

determining variables

• Linked with CFROI

valuation model map

• Limited use for start –up

operations

• Data not readily

available outside

investors

• Annual CFROI data

extractable from

annual accounts, not

firm value

Cash Value Added (Ottoson and Weissenrieder)

• Distinct between strategic and non-strategic investments

• Discount rate future CVAs is investor’ cost of capital (using CAPM for equity)

• Forecasted cash flows of

non-strategic investments

• Linked with value drivers

• Data not readily

available outside

investors

Cash Value Added (BCG)

• Related to CFROI • Accurate tool for determining

priority value drivers trading off profitability Vs. growth

• Effective measure for annual incentives at Business Unit and operational levels

• Useful for internal and external performance benchmarking

• Forecasted cash flows

• Linked with value drivers

• Data not readily

available outside

investors

Table: Compliance of cash flow-based metrics with capital markets

Accounting Concept Of Profit

Data on cash flows are often not as easily and readily available as accounting data (as a

result of the legal and regulatory requirements; see below), making cash-based Value-

based metrics less easily applicable. Besides, cash flows by themselves are not by

definition required for purposes of performance measurement and management

compensation (see previous section).

Financial statements created under cash basis normally postpone or accelerate recognition

of revenues and expenses long before or after goods and services are produced and

delivered (when cash is received or paid). They also do not necessarily reflect all assets

or liabilities of a company on a particular date. For these two considerations, measures

have been developed which are based on accounting data, but take the inefficacies of

traditional accounting measures (like profits, Return On Investment, or Return On Sales)

as discussed in a previous section to some or a major extent into account. Either way,

they include the cost of both equity and interest-bearing debt in order to express a

company’s economic value created.

Finally, failing capital markets (judging the numerous newspaper articles and news

reports published over the past few years) result in a fading reliance on finance-based

measures, i.e., cash flows, to the benefit of measures based on accounting figures.

Therefore, most countries’ generally accepted accounting principles require accrual basis

accounting for financial reporting purposes (e.g., Libby et al., 2004). In accrual

accounting, revenues and expenses are recognized when the transactions and other events

that cause them occur, not necessarily when cash is received or paid. That is, revenues are

recognized when they are earned and expenses when they are incurred (Libby et al.,

2004). The accrual accounting adjusting entries affect net income on the income

statement, and they affect profitability comparisons from one accounting period to the

next. They also affect assets and liabilities on the balance sheet and thus provide

information about a company’s future cash inflows and outflows. This information is

needed to assess management’s short-term goal of achieving sufficient liquidity to meet

its need for cash to pay ongoing obligations. The potential for abuse arises because

considerable judgment underlies the application of adjusting entries. One must be careful,

though, that misuse of this judgment can result in misleading measures of performance

(Needles & Powers, 2004). Auditors’ reports prevent this to a certain extent.

Residual Income

Residual income (RI) is based on the premise that a firm must earn more on its total

invested capital than the cost of that capital (Hicks, 1946, 1979; Ittner & Larcker, 1998;

Bromwich & Walker, 1998; Dechow et al., 1999; Young & O’Byrne, 2001). Where

DuPont developed the Return On Investment (ROI) measure around 1910 in order to

assess the return on their capital-intensive activities, in the 1920s Alfred Sloan

implemented a Residual Income-like system for General Motors’ operating divisions.

The Japanese company Matsushita established a similar system in the 1930s, as did

General Electric in the 1950s in order to assess the return on their widely diversified

activities which required different use of capital (Sloan, 1996; Lewis, 1955; Solomons,

1965; Young, 1999; Young & O’Byrne, 2001).

Residual Income can be calculated in two ways (Young & O’Byrne, 2001):

1. Invested Capital x (RONA - WACC)

2. NOPAT - (Invested Capital x WACC)

Where

Invested Capital = Total Assets - Non-interest-bearing current liabilities

(at beginning of the year, at book value)

RONA = NOPAT / Invested Capital

NOPAT = (Operating Income + Interest Income) x (1 - Tax Rate)

In 1965 Wharton Professor David Solomons devoted a large portion of his influential

work on divisional performance measurement to residual income (RI), helping to fuel an

interest in the topic among finance and accounting academics in the 1960s and 1970s

(Young & O’Byrne, 2001). However, RI has never been widely used. A study by Reece

& Cool (1978) showed that only 2 percent of their respondents measured an investment

center’s performance using RI, compared to 65% using Return on Investment. However,

28% were measuring both ROI and RI (out of in total 459 respondents). According to

Young & O’Byrne (2001: 105), the reason for this rare implementation can be found in

that only few corporate executives really understood it or felt that they needed to. Even

those who did understand the concepts, could not figure out how to estimate the ‘interest’

on the equity portion of a company’s capital base. According to Kaplan & Atkinson

(1998: 507-8): ‘Despite the appeal of the residual income calculation and its apparent

theoretical superiority over the ROI measure, virtually no company used it extensively

for measurement of business unit performance. But a revolution in thinking occurred

starting in the late 1980s, when several financial consulting firms published studies that

showed a high correlation between the changes in companies’ residual incomes and the

changes in their stock market valuation. These correlations were significantly higher than

the correlations between changes in ROI and stock price changes. The move toward the

RI measure received even greater publicity when it was renamed into a far more

accessible and acceptable term – Economic Value Added – by the Stern Stewart

consulting organization, a prime advocate for the Economic Value Added concept’.

With RI, a company’s accounting policies are taken as given, without adjusting for

potential biases or distortions caused by the application of generally accepted accounting

principles (GAAP).

Economic Value Added

Stern Stewart & Co. claim that (Stewart, 1991: 2-3) ‘Management should focus on

maximizing a measure called economic value added (EVA), which is operating profits

less the cost of all the capital employed to produce those earnings. EVA will increase if

operating profits can be made to grow without tying up any more capital, if new capital

can be invested in projects that will earn more than the full cost of the capital and if

capital can be diverted or liquidated from business activities that do not provide adequate

returns.’ Young & O’Byrne (2001) add that EVA will also increase if the company can

achieve longer periods over which it is expected to earn a RONA greater than its WACC

and by reductions in the cost of capital. According to Stewart (1991: 3), EVA is the only

performance measure that is entirely consistent with the standard capital budgeting rule:

accept all positive and reject all negative net present value investments. They continue

that ‘Earnings per share, on the other hand, will increase as long as new capital

investments earn anything more than the after-tax cost of borrowing, which is hardly an

acceptable return’. It is also Stewart’s claim that however important cash flow may be as

a measure of value, it is virtually useless as a measure of performance (p. 4). The more

management invests in rewarding projects, the more negative the immediate cash flows

will be, but at the same time the more valuable the company will be. It is only then when

cash flows become significant if they are considered over the life of the business, instead

of for any given year.

Economic Value Added (EVA) (Stewart, 1991) can also be calculated in two ways,

similar to RI:

1. Adjusted invested capital * (Adjusted return on Capital - WACC)

2. Adjusted operating profits after tax - (Adjusted invested Capital * WACC)

The first calculation is known as the ‘spread’ method, while the second is known as the

‘capital charge’ method.

Shareholder value can subsequently be defined as the Adjusted Book Value plus the

cumulative present value of EVAs. The shareholder value added equals EVA.

For determining ‘capital’, two approaches can be followed: the Operating Approach,

which adds Net Working Capital to Net Fixed Assets, and the Financing Approach,

which adds Debt to Equity. Both are taking Equity Equivalents (EEs) into account, that

gross up the standard accounting book value into what Stewart (1991: 91) calls

‘economic book value’. EEs eliminate accounting distortions by converting from accrual

to cash accounting, e.g., with respect to deferred income tax reserve, the LIFO inventory

valuation reserve, the cumulative amortization of goodwill, a capitalization of R&D and

other market-building outlays, and cumulative unusual write-offs (less gains) after taxes

(Stewart, 1991: 91). Stern Stewart & Co. suggest over 150 possible adjustments to

invested capital and profits to arrive at the ‘economic book value.’

As the equations show, EVA is basically a variant of residual income, but it attempts to

overcome some of the problems outlined before regarding traditional accounting

measures by means of the adjustments as suggested by Stewart (1991). As residual

income came to be resurrected and repackaged as EVA, three distinctive features began

to emerge (Young & O’Byrne, 2001):

1. EVA draws on advances in capital market theory unavailable to the early users of

residual income, to derive credible estimates for the cost of equity, e.g., by means

of the Capital Assets Pricing Model or the Arbitrage Pricing Theory.

2. Conventional measures of residual income accept operating profit as given. With

EVA, perceived biases or distortions inherent in GAAP are corrected, providing

presumably more credible measures of performance than unadjusted residual

income, therefore approaching an Economic Concept of Profit.

3. As EVA is applicable to any level in an organization, EVA is seen as a way of

offering divisional management value-creating incentives similar to stock options

and other equity-based schemes set aside for top management.

Economic Profit

In McKinsey’s economic profit model (Copeland et al., 1996), the value of a company

equals the amount of capital invested plus a premium equal to the present value of the

value created each year going forward. The concept of economic profit dates back at least

to the economist Alfred Marshall.

Economic Profit is defined as follows:

Economic Profit = Invested Capital x (ROIC -/- WACC)

EP therefore also follows the principles of RI, as the equation shows. The Net Operating

Profits Less Adjusted Taxes (NOPLAT) represents the after-tax operating profits of the

company after adjusting the taxes to a cash basis, making taxes the only adjustment to the

profit and loss account (Copeland et al., 1996). The latter is the consequence of the fact

that the provision for income taxes in the income statement generally does not equal the

actual taxes paid in cash by the company due to differences between financial accounting

and tax accounting. The adjustment to a cash basis can generally be calculated from the

change in accumulated deferred income taxes on the company’s balance sheet (the net of

long- and short-term deferred tax assets and long- and short-term deferred tax liabilities)

(Copeland et al., 1996).

Invested Capital represents the amount invested in the operations of the business, and is

calculated as the sum of operating working capital, net property, plant, and equipment,

and net other assets (net of non-current, non-interest-bearing liabilities). Working capital

is defined as operating current assets minus non-interest bearing current liabilities, such

as accounts payable. With reference to the operating current assets, specifically excluded

are excess cash and marketable securities, since these generally represent temporary

imbalances in the company’s cash flow. Excess cash and marketable securities are

defined as the short-term cash and investments that the company holds over and above its

target cash balances to support operations. The target balances can be estimated by

observing the variability in the company’s cash and marketable security balances over

time and by comparing these against similar companies (Copeland et al., 1996).

Net property, plant, and equipment is the book value of the company’s fixed assets.

Copeland et al. (1996: 169) ‘disagree with using replacement cost and believe that market

values should be used only in certain situations.’ They argue that replacement costs

should not be used ‘for the simple reason that assets do not have to be and may never be

replaced.’ According to Copeland et al. (1996: 170) ‘using the market values of assets is

appropriate when the realizable market value of the assets substantially exceeds the

historical cost book value.’ In this case, NOPLAT must be adjusted to reflect the annual

appreciation of the value of the assets. According to Copeland et al., analysts often ignore

the economic profit associated with the write-up. This way, they can analyze whether the

company makes the best use of its assets. However, by ignoring the NOPLAT-adjustment

it is not possible to analyze the company’s actual performance. Net other assets relate to

the operations of the business, excluding special investments.

Whether an item is operating or non-operating, depends on the consistency in treatment

of the asset and any associated income or expense in calculating NOPLAT. Industry

norms also prevail in order to achieve consistency with the company’s peers (Copeland et

al., 1996). Copeland et al. recommend as a practical matter to use invested capital

measured at the beginning of the period or the average of beginning and ending capital.

Technically, they argue, for the economic profit valuation to exactly equal the DCF

valuation, one must use beginning capital. If average capital is used, the variance will

generally be very small.

Another way of defining EP is as after-tax operating profits less a charge for the capital

used by the company:

Economic Profit = NOPLAT -/- Capital Charge

= NOPLAT -/- (Invested Capital x WACC)

The value of the company is subsequently calculated as:

Value = Invested Capital + Present Value of Projected Economic Profit

The present value consists of the present value of the forecasted economic profits during

an explicit forecast period plus the present value of the forecasted economic profit after

the explicit forecast period (or ‘continuing value’ - CV). According to Copeland et al.,

the recommended economic profit formula for the continuing value is as follows

(Copeland et al., 1996: 291):

Where Economic Profit T+1 = the normalized economic profit in the first year after the

explicit forecast period

NOPLAT T+1 = the normalized NOPLAT in the first year after the

explicit forecast period

g = the expected growth rate in NOPLAT in perpetuity.

If therefore a company earns exactly its WACC every period, then the discounted value

of its projected free cash flow should exactly equal its invested capital. Or, the company

would be worth exactly what was originally invested. A company is worth more or less

than its invested capital only to the extent it earns more or less than its WACC. Hence,

the premium or discount relative to invested capital must equal the present value of the

company’s future EP (Copeland et al., 1996). Economic profit is an important measure

because it combines size and ROIC into a single result. According to Copeland et al.

(1996: 178) ‘too often companies focus on either size (often measured by earnings) or

ROIC. Focusing on size (e.g., earnings or earnings growth) could destroy value if returns

on capital are too low. Conversely, earning a high ROIC on a low capital base may mean

missed opportunities.’

It is important to realize that economic profit measures realized value creation, while the

increase in the market value of a company is represented by the Total Shareholder Return,

defined as share price appreciation plus dividends. The change in market value will equal

economic profit only if there is no change in expected future performance and if the

WACC remains constant during the year.

The philosophy behind the MfV concept is that an organization develops the right

strategies to realize an improved financial performance that leads to an increasing share

price. Marakon thus assumes that an increase in EV is related to a higher value for the

shareholder, which leads to an increase in TRS. With the emphasis on building a superior

organization, conditions are created to develop the right strategies. These are formulated

by means of a bottom-up process that contribute to meeting the corporate objectives.

The implementation trajectory was divided into three phases.

Phase 1 Involved setting up a trajectory for the SBU and approval of this plan by

the Managing Board. Subsequently, the plan was communicated into the

organization. Concepts were developed and described, while the

underlying ideas and foundations were explained that were necessary to

maximize the value of ABN AMRO. Last step in this phase was preparing

the organization, in terms of both management and structure, to adopt

VBM as of January 1, 2001.

Phase 2 Was characterized by setting up the internal and external fact-sheets,

management agendas, the training of top management in using the new

concepts and improving communication by introducing management

dialogues. In addition, considerable time and effort had been devoted to

designing performance contracts. These were rooted in financial

projections based on EP and were designed for SBU and BU level. In

strategic planning, these financial projections were followed by the

strategy on how these financial ambitions were expected to be realized by

means of explicit initiatives and actions.

Phase 3 Started executing the concepts of VBM. In addition, managers were more

and more confronted with and held responsible for their performance. As

will be described later, to align management’s attitude and behavior with

VBM the remuneration structure was changed in accordance with VBM

principles. Much attention was paid to train employees in changing their

mindset and to act upon it. Of the utmost importance in this phase was

also the implementation of a new bottom-up strategic management process.

Marakon Approach:

Marakon Associates, an international management-consulting firm founded in 1978, has

done pioneering work in the area of value-based management. This measure considers

the difference between the ROE and required return on equity (cost of equity) as the

source of value creation. This measure is a variation of the Economic Value (EV)

measures. Instead of using capital as the entire base and the cost of capital for calculating

the capital charge, this measure uses equity capital and the cost of equity to calculate the

capital (equity) charge. Correspondingly, it uses economic value to equity holders (net of

interest charges) rather than total firm value. According to Marakon model shareholder

wealth creation is measured as the difference between the market value and the book

value of a firm's equity. The book value of a firm's equity, B, measures approximately the

capital contributed by the shareholders, whereas the market value of equity, M, reflects

how productively the firm has employed the capital contributed by the shareholders, as

assessed by the stock market. Hence, the management creates value for shareholders if M

exceeds B, decimates value if m is less than B, and maintains value is M is equal to B.

According to the Marakon model, the market-to-book values ratio is function of the

return on equity, the growth rate of dividends, and cost of equity. For an all-equity firm,

both EV and the equity-spread method will provide identical values because there are no

interest charges and debt capital to consider. Even for a firm that relies on some debt, the

two measures will lead to identical insights provided there are no extraordinary gains and

losses, the capital structure is stable, and a proper re-estimation of the cost of equity and

debt is conducted.

A market is attractive only if the equity spread and economic profit earned by the average

competitor is positive. If the average competitor's equity spread and economic profit are

negative, the market is unattractive.

For an all-equity firm, both EV and the equity spread method will provide identical

values because there are no interest charges and debt capital to consider. Even for a firm

that relies on some debt, the two measures will lead to identical insights provided there

are no extraordinary gains and losses, the capital structure is stable, and a proper re-

estimation of the cost of equity and debt is conducted.

A market is attractive only if the equity spread and economic profit earned by the average

competitor is positive. If the average competitor's equity spread and economic profit are

negative, the market is unattractive. The consultants of Marakon who were hired to

implement Value Based Management (VBM) emphasized that VBM is a management

approach rather than a calculus exercise using VBM metrics. Therefore, not only strategy

is involved, but also the organizational structure and processes. MfV will be much more

than just a financial exercise for us. Companies which practice MfV adopt a holistic

approach which combines three fundamentals of business: organisation, strategy and

finance.

It is a necessary condition for the success of so major an initiative as MfV that its

progress be reflected in management incentives.

In this respect it is noteworthy to show how VBM is related to shareholder value, which

could conflict with a stakeholder approach of managing a firm (Freeman, 1984;

Donaldson & Preston, 1995; Jones & Wicks, 1999; Friedman & Miles, 2002). Various

authors (Cools & Van der Ven, 1995; AICPA, 2000b; Copeland et al., 2000; Jensen,

2001; Wallace, 2003) explain that by trying to serve multiple stakeholders, as suggested

with the stakeholder approach, they will all end up being inadequately served. Without

the clarity provided by a single-value objective, ‘companies embracing stakeholder

theory will experience managerial confusion, conflict, inefficiency, and perhaps even

competitive failure’ (Jensen, 2001: 9). However, the same authors (Cools & Van der Ven,

1995; AICPA, 2000b; Copeland et al., 2000; Jensen, 2001; Wallace, 2003) admit that

other stakeholders cannot be ignored either. As Jensen (2001: 9) puts it (in line with

Atkinson et al. (1997) and Wallace (2003)): ‘In order to maximize value, corporate

managers must not only satisfy, but enlist the support of, all corporate stakeholders—

customers, employees, managers, suppliers, local communities. Top management plays a

critical role in this function through its leadership and effectiveness in creating,

projecting, and sustaining the company’s strategic vision.’ This is what Jensen (2001)

calls enlightened stakeholder theory and Wallace (2003) enlightened value maximization.

Wallace (2003: 127) states: ‘Through correlation analysis, and then through regression

analysis, I provide evidence supporting enlightened value maximization and suggesting a

complementary relationship between VBM and stakeholder theory. Companies must

create shareholder value in order to satisfy their stakeholders. At the same time, my

findings also suggest that, up to a certain point, increasing stakeholder benefits helps

create additional shareholder value. In other words, companies generally do well by

doing good – but at the same time, they must do well to be able to do good. The research

also showed that a focus on shareholders’ interests, as residual claimants, serve all other

stakeholders interests as well. Srivastava et al. (1998) relate to the marketers’ perspective

that customers and channels are market-based assets that arise from the mingling of the

firm with entities in its external environment. These assets increase shareholder value by

accelerating and enhancing cash flows, lowering the volatility and vulnerability of cash

flows, and increasing the residual value of cash flows.

Leveraging the market-based assets expands the external stakeholders of marketing to

include explicitly the shareholders and potential shareholders of the firm and requires

broader input into marketing decisions making by other functional managers.

Boston Consulting Group (BCG) Approach

The Boston Consulting Group (BCG) is a management consulting firm founded by

Harvard Business School alum Bruce Henderson in 1963. The growth-share matrix is a

chart created by group in 1970 to help corporation analyze their business units or product

lines, and decide where to allocate cash. It was popular for two decades, and is still used

as an analytical tool. To use the chart, corporate analysts would plot a scatter graph of

their business units, ranking their

relative market shares and the growth rates of their respective industries. To ensure long-

term value creation, a company should have a portfolio of products that contains both

high-growth products in need of cash inputs and low-growth products that generate a lot

of cash. The BCG matrix is a tool that can be used to determine what priorities should be

given in the product portfolio of a business unit. It has 2 dimensions: market share and

market growth. The basic idea behind it is that the bigger the market share a product has

or the faster the product’s market grows the better it is for the company. The portfolio

approach is a historical starting point for strategic analysis and choice in multi-business

firms Boston Consulting Group (BCG) pioneered an approach called portfolio techniques

that attempted to help managers “balance” the flow of cash resources among their various

businesses while identifying their basic strategic purpose within the overall portfolio.

This led to a categorization of four different types of businesses:

Relative Market Share

High Low

Stars

Question

Marks

Cash Cows

Dogs

• Cash cows Units with high market share in a slow-growing industry. These units

typically generate cash in excess of the amount of cash needed to maintain the

business. They are regarded as staid and boring, in a "mature" market, and every

corporation would be thrilled to own as many as possible. They are to be "milked"

continuously with as little investment as possible, since such investment would be

wasted in an industry with low growth.

• Dogs More charitably called pets, units with low market share in a mature, slow-

growing industry. These units typically "break even", generating barely enough

cash to maintain the business's market share. Though owning a break-even unit

provides the social benefit of providing jobs and possible synergies that assist

other business units, from an accounting point of view such a unit is worthless,

not generating cash for the company. They depress a profitable company's return

on assets ratio, used by many investors to judge how well a company is being

managed. Dogs, it is thought, should be sold off.

• Question marks Units with low market share in a fast-growing industry. Such

business units require large amounts of cash to grow their market share. The

corporate goal must be to grow the business to become a star. Otherwise, when

the industry matures and growth slows, the unit will fall down into the dog’s

category.

• Stars Units with a high market share in a fast-growing industry. The hope is that

stars become the next cash cows. Sustaining the business unit's market leadership

may require extra cash, but this is worthwhile if that's what it takes for the unit to

remain a leader. When growth slows, stars become cash cows if they have been

able to maintain their category leadership.

As a particular industry matures and its growth slows, all business units become either

cash cows or dogs.

The overall goal of this ranking was to help corporate analysts decide which of their

business units to fund, and how much; and which units to sell. Managers were supposed

to gain perspective from this analysis that allowed them to plan with confidence to use

money generated by the cash cows to fund the stars and, possibly, the question marks. As

the BCG stated in 1970:

Only a diversified company with a balanced portfolio can use its strengths to truly

capitalize on its growth opportunities. The balanced portfolio has:

• Stars whose high share and high growth assure the future;

• Cash cows that supply funds for that future growth; and

• Question marks to be converted into stars with the added funds.

Practical Use of the Boston Matrix

For each product or service the 'area' of the circle represents the value of its sales. The

Boston Matrix thus offers a very useful 'map' of the organization's product (or service)

strengths and weaknesses (at least in terms of current profitability) as well as the likely

cash flows.

The need which prompted this idea was, indeed, that of managing cash-flow. It was

reasoned that one of the main indicators of cash generation was relative market share, and

one which pointed to cash usage was that of market growth rate.

Relative market share

This indicates likely cash generation, because the higher the share the more cash will be

generated. As a result of 'economies of scale' (a basic assumption of the Boston Matrix),

it is assumed that these earnings will grow faster the higher the share. The exact measure

is the brand's share relative to its largest competitor. Thus, if the brand had a share of 20

per cent, and the largest competitor had the same, the ratio would be 1:1. If the largest

competitor had a share of 60 per cent, however, the ratio would be 1:3, implying that the

organization's brand was in a relatively weak position. If the largest competitor only had

a share of 5 per cent, the ratio would be 4:1, implying that the brand owned was in a

relatively strong position, which might be reflected in profits and cash flow. If this

technique is used in practice, it should be noted that this scale is logarithmic, not linear.

On the other hand, exactly what is a high relative share is a matter of some debate. The

best evidence is that the most stable position (at least in FMCG markets) is for the brand

leader to have a share double that of the second brand, and treble that of the third. Brand

leaders in this position tend to be very stable - and profitable

The reason for choosing relative market share, rather than just profits, is that it carries

more information than just cash flow. It shows where the brand is positioned against its

main competitors, and indicates where it might be likely to go in the future. It can also

show what type of marketing activities might be expected to be effective.

BCG’s Strategic Environments Matrix

• Volume businesses are those that have few sources of advantage, but the size is

large—typically the result of scale economies

• Stalemate businesses have few sources of advantage, with most of those small

• Fragmented businesses have many sources of advantage, but they are all small

• Specialization businesses have many sources of advantage and find those

advantages potentially sizable

Limitations

1. Viewing every business as a star, cash cow, dog, or question mark is overly

simplistic.

2. Many businesses fall right in the middle of the BCG matrix and thus are not easily

classified.

3. The BCG matrix does not reflect whether or not various divisions or their

industries are growing over time.

4. Other variables besides relative market share position and industry growth rate in

sales are important in making strategic decisions about various divisions.

5. It does not address how value is being created across business units

6. Truly accurate measurement for matrix classification was not as easy as the

matrices portrayed

7. The underlying assumption about the relationship between market share and

profitability varied across industries and market segments

8. The limited strategic options came to be seen more as basic strategic missions

9. It ignored capital raised in capital markets

10. It typically failed to compare the competitive advantage a business received from

being owned by a particular company with the costs of owning it

Boston Consulting Group (BCG) Matrix

The Internal-External (IE) Matrix

This is also an important matrix of matching stage of strategy formulation. This matrix

already explains earlier. It relate to internal (IFE) and external factor evaluation (EFE).

The findings form internal and external position and weighted score plot on it. It contains

nine cells. Its characteristics is a s follow

• Positions an organization’s various divisions in a nine-cell display.

• Similar to BCG Matrix except the IE Matrix:

• Requires more information about the divisions

• Strategic implications of each matrix are different

• Based on two key dimensions

• The IFE total weighted scores on the x-axis

• The EFE total weighted scores on the y-axis

• Divided into three major regions

• Grow and build – Cells I, II, or IV

• Hold and maintain – Cells III, V, or VII

• Harvest or divest – Cells VI, VIII, or IX

Steps for the development of IE matrix

1. Based on two key dimensions IFE and EFE.

2. Plot IFE total weighted scores on the x-axis and the EFE total weighted scores on

the y axis

3. On the x-axis of the IE Matrix, an IFE total weighted score of 1.0 to 1.99

represents a weak internal position; a score of 2.0 to 2.99 is considered average;

and a score of 3.0 to 4.0 is strong.

4. On the y-axis, an EFE total weighted score of 1.0 to 1.99 is considered low; a

score of 2.0 to 2.99 is medium; and a score of 3.0 to 4.0 is high.

5. IE Matrix divided into three major regions.

Grow and build – Cells I, II, or IV

Hold and maintain – Cells III, V, or VII

Harvest or divest – Cells VI, VIII, or IX

Conclusion

After discussion, the BCG matrix is an important matrix regarding strategy adopted by

firm. Still this matrix concern four strategy first growth or build strategy enhance market

share, second is hold strategy (hold existing position), third Harvesting strategy (no

further growth or select other opportunity), fourth is diversity (sell out the part of

business)

McKinsey’s Approach

GE Planning Grid

General Electric (or McKinsey) matrix uses market attractiveness as not merely the

growth rate of sales of the product, but as a compound variable dependent on different

factors influencing the future profitability of the business sector. The important steps in

the McKinsey approach to value maximization are as follows:

• Emphasis on value maximization

• Finding value drivers

• Establishing appropriate managerial processes

• Implementing value based management properly

In the early 1980s, McKinsey came up with the famous 7-S framework. The 7-S referred

to the seven variables involved in an intelligent approach to organizing. These 7 variables

are: strategy, structure, systems, staff, style, skills and shared values. The 7 variables

covered the hardware and the software.

Structure

Strategy Systems

Shared

Values

Skills Systems

Staff

Fig.: The McKinsey 7-S Framework

The frame suggests that there is a multiplicity of factors that influence an organization’s

ability to change and its proper mode of change.

Shared values:

The values and beliefs of the company. Ultimately they guide employees towards 'valued'

behavior. Shared values are commonly held beliefs, mindsets, and assumptions that shape

how an organization behaves – its corporate culture. Shared values are what engender

trust. They are an interconnecting center of the 7Ss model. Values are the identity by

which a company is known throughout its business areas, what the organization stands

for and what it believes in, it central beliefs and attitudes. These values must be explicitly

stated as both corporate objectives and individual values.

Strategy:

The direction and scope of the company over the long term. Strategy are plans an

organization formulates to reach identified goals, and a set of decisions and actions aimed

at gaining a sustainable advantage over the competition.

Structure:

The basic organization of the company, its departments, reporting lines, areas of expertise

and responsibility (and how they inter-relate). The way the organization's units relate to

each other: centralized, functional divisions (top-down); decentralized (the trend in larger

organizations); matrix, network, holding, etc. These relationships are frequently

diagrammed in organizational charts. Most organizations use some mix of structures -

pyramidal, matrix or networked ones - to accomplish their goals. The design of

organizational structure is a critical task of the top management of an organization.

Organizational structure performs four major functions:

• It reduces external uncertainty through forecasting, research and planning in the

organization.

• It reduces internal uncertainty arising out of car variables, unpredictable, random

human behaviour within the organization through control mechanism.

• It undertakes a wide variety of activities through devices such as

departmentalized, specialization, division of labour and delegation of authority.

• It enables the organization to keep its activities coordinated and have a focus in

the mindset of diversity in the pursuit of it objectives

Organizational structure must be designed in accordance with the needs of the strategy.

Systems:

Formal and informal procedures that govern everyday activity, covering everything from

management information systems, through to the systems at the point of contact with the

customer (retail systems, call center systems, online systems, etc). Systems define the

flow of activities involved in the daily operation of business, including its core processes

and its support systems. They refer to the procedures, processes and routines that are used

to manage the organization and characterize how important work is to be done. Systems

include:

Business System

Business Process Management System (BPMS)

Management information system

Innovation system

Performance management system

Financial system/capital allocation system

Compensation system/reward system

Customer satisfaction monitoring system

Skills:

The capabilities and competencies that exist within the company. What it does best.

These are developed over a period of time and are a result of the interaction of a number

of factors; performance certain tasks successfully over a period of time, the kind of

people in the organization, the top management style, the organizational structure, the

management style, the external environmental influences, etc. Hence, when organizations

make a strategic shift it becomes necessary to consciously build new skills.

Staff:

The company's people resources and how they are developed, trained and motivated.

According to Waterman and his colleagues the term “staff” refers to the way

organizations introduce young recruits into the mainstream of their activities and the

manner in which they manage their careers as the new entrants develop into future

managers.

Style:

The leadership approach of top management and the company's overall operating

approach. "Style" refers to the cultural style of the organization, how key managers

behave in achieving the organization's goals, how managers collectively spend their time

and attention, and how they use symbolic behavior. How management acts is more

important that what management says.

Conclusion:

In this chapter, we discuss various strategic analysis options at corporate level to maintain

its market value.

References:

• Boston Consulting Group, Perspectives on Experience, BGC, 1972

• Hill Charles W.L. Jones Gareth R., (2001): Strategic Management Theory – An

Integrated Approach, All India Publishers & Distributors – New Delhi

• Indira Gandhi National Open University , School of Management Studies, (1996):

Corporate Policies and Practices – Strategic Choices, IGNOU

• Pearce II John A, Robinson Jr. Richard B. (2005): Strategic Management –

Formulation, Implementation & Control, Tata McGraw -Hill Publishing, New

Delhi

• W. Thomas L., Hunger David J., (1983): Strategic Management and Business

Policy, Addison Wesley Publishing Company, London.