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Performance Management

Chiara Demartini

[email protected]

UNIVERSITY OF PAVIA

Master in International Business and Economics 1

Lectures and Test

C. Demartini – Performance Management

• Lectures: – Tuesday hr. 11-13 Room 15 – Wednesday hr. 14-16 Room F

• Office hours:

– Mondays hr. 11-13

• Written test: – 18/01/2016 – 18/02/2016

• Tutor: Mr Davide Grillo

2

Structure of the module and materials


• First part:

– Principles of Financial Accounting – Principles of Financial Statement

Analysis

• Second part:

– Performance Management

• http://economia.unipv.it/pagp/pagine_personali/cdemartini/

Teaching notes

Teaching notes & Demartini C. (2013),

Performance Management Systems. Design, Diagnosis and Use, Springer, Berlin.

3

https://www.youtube.com/watch?v=2SN_OEXSFhM

Module grading


• Module grading:

– 30% case studies and other assessments over the module

– 30% presentation of a company’s performance management system

– 40% written test

4

Part One:

Principles of Financial Accounting



Financial Accounting


Financial Accounting provides information: 1. primarily to people outside the company

2. that would be helpful in attracting capital

– Equity and debt (useful in debt contracts) – Credit from suppliers – Customers – Employees

3. helpful in monitoring and evaluating management

performance

6

Aims of Financial Accounting


Stakeholders: Present and potential investors

Employees

Suppliers

Company

Resources flow: today

Resources flow: tomorrow

Info

rmatio

n

Economic resources, claims to those resources and changes

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Financial accounting


Financial accounting translates events into financial statements

Events Rules &

management choice

Financial statements

Accounting Principles

GAAP

IFRS

Generally Accepted Accounting Standards

International Financial Reporting Standards

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IFRS 1


The objective of this IFRS is to ensure that an entity’s first IFRS financial statements, and its interim financial

reports for part of the period covered by those financial statements, contain high quality information that:

(a) is transparent for users and comparable over all

periods presented

(b) provides a suitable starting point for accounting

in accordance with International Financial

Reporting Standards (IFRSs)

(c) can be generated at a cost that does not exceed

the benefits.

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Delivery of financial information


Demand for independence:

Accounting enters objective, verifiable information into accounting records

Information produced by managers alone is not believable. Outside investors demand independently audited financial information

In the process, accounting misses out on forward- looking information that might be valuable, but lacks objective evidence (e.g., research in progress)

10

Asymmetry in financial reporting


• Why? – Demand for bad news

Creditors with no upside, but all the downside – Investors believe bad news disclosed by management, but sceptical of

good news unless supported by objective evidence – Management incentives affect credibility of their disclosures

Faced with uncertain bad

news, accounting tends to enter it into the records

Faced with uncertain good news, tendency

to ignore it

Asymmetric treatment of good and bad

news

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International Financial Reporting The Annual Report


Management letter

Financial Statements

Auditors’ report

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The Auditors’ Report


GAAS (Generally Accepted Auditing

Standards)

Reasonable assurance that financial statements are free

of material misstatement

Assess the accounting principles used and

significant estimates made by management

Actual opinion

Financial statements present fairly the financial position, the results of operations,

etc.

Compliance with GAAP (Generally Accepted

Accounting Principles)

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The Auditors’ Report


• Management responsible for – the preparation and integrity of the financial statements,

etc. • Statements prepared in accordance with GAAP. • Estimated amounts based on management's best estimates and

judgments.

– Maintenance of an internal control system to ensure that assets are safeguarded and transactions are properly authorized, recorded and reported.

• The Board has an Audit Committee composed entirely of outside directors – This committee appoints the auditor who has direct access

to the Audit Committee.

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Financial statement auditing

“The objective of the ordinary audit of financial statements by the independent auditor is the expression of an opinion on the fairness with which they present fairly, in all material respects, financial position, results of operations, and its cash flow in conformity with generally accepted accounting principles. The auditor’s report is the medium through which he expresses his opinion or, if circumstances require, disclaim an opinion.“ (para 110.10, AICPA, SAS N. 1, codification of Auditing Standards and Procedures)

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Independence and objectivity

• «Objectivity is a state of mind, a quality that lends value to a member’s services. It is a distinguishing feature of the profession. The principle of objectivity imposes the obligation to be impartial, intellectually honest, and free of conflicts of interest.

• Independence precludes relationships that may appear to impair a member’s objectivity rendering attestation services.» AICPA.

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Audit opinion

1) Unqualifed Opinion

2) Qualified Opinion

3) Adverse opinion

4) Disclaimers of opinion

Emphasis of matter

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Basics of double entry bookkeeping: The account


• All the events related to business transactions should be entered into ACCOUNTS twice.

• Accounts are the basic founding units of the double entry bookkeeping, which is the accounting methodology to record transactions.

• Accounts can be analysed according to two main cathegories: either economic (e.g. revenues, expenses) or financial (e.g. payables, receivables) ones.

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The structure of an account

C. Demartini – Performance Management 19

Euro 100.00

DEBIT CREDIT Purchase a/c

Euro 100.00

DEBIT CREDIT Bank account

Debit or credit an account?


Balance Sheet

Income Statement

Accrual & Cash Method


• There are two main methods of accounting (or bookkeeping):

1. Accrual method

2. Cash method

• The accrual method of accounting is the preferred method because it provides: – a more complete reporting of the company's assets, liabilities, and

stockholders' equity at the end of an accounting period, and

– a more realistic reporting of a company's revenues, expenses, and net income for a specific time interval such as a month, quarter or year.

• As a result, US and Italian GAAP requires most corporations to use the accrual method of accounting.

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Accrual v Cash Method


• The following table compares the accrual and cash methods of accounting:

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http://www.accountingcoach.com/wp-content/uploads/2013/10/[email protected]

Financial statement


• The financial statements must "present fairly" the financial position, financial performance and cash flows of an entity. (IAS 1)

• It contains primarily historical information

• Assets, liabilities & owners’ equity Balance Sheet

• Revenue (-) Expenses = Net Income Income Statement

• Cumulative sum of undistributed profits Statement of changes in

equity and retained earnings

• Operating, Investing and Financing activities Statement of cash flows

• Significant accounting policies, estimates, etc. Footnotes 23

Going Concern Principle


The Conceptual Framework notes that financial statements are normally prepared assuming the entity is a going concern and will continue in operation for the foreseeable future. (IAS 1)

If management has significant concerns about the entity's

ability to continue as a going concern, the uncertainties

must be disclosed.

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Assets

Resources owned by a corporation, e.g., cash, accounts receivable, equipment, land

Liabilities amounts/services owed by the company, e.g., loans payable, accounts payable, customer advances, etc.

Stockholders’ equity

initial investment by the owners

Plus the cumulative sum of undistributed profits (retained earnings) .

Financial Statements: Balance Sheet


• Balance sheet

– Statement of the financial position of a business as of a certain date.

ASSETS LIABILITIES EQUITY ACCOUNTING

EQUATION

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Minimum line items


(a) property, plant and equipment

(b) investment property

(c) intangible assets

(d) financial assets (excluding amounts shown under (e), (h), and (i))

(e) investments accounted for using the equity method

(f) biological assets

(g) inventories

(h) trade and other receivables

(i) cash and cash equivalents

(j) assets held for sale

(k) trade and other payables

(l) provisions

(m) financial liabilities (excluding amounts shown under (k) and (l))

(n) current tax liabilities and current tax assets, as defined in IAS 12

(o) deferred tax liabilities and deferred tax assets, as defined in IAS 12

(p) liabilities included in disposal groups

(q) non-controlling interests, presented within equity

(r) issued capital and reserves attributable to owners of the parent.

ASSET SIDE

LIABILITY AND EQUITY SIDE

26

http://www.iasplus.com/en/standards/ias/ias12






Financial Statements: Income Statement


• Income statement measures the “performance” of a company over a period of time

Expenses –

A measure of economic sacrifices incurred to “earn” the revenues of a given period

Revenues –

A measure of economic benefits generated by the sale of products or providing of services over a period of time

Net income

Revenues Expenses

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Dividends


• Are dividends paid to owners considered an expense? – Owners are residual claimants

– Dividends are distributions to the owners out of the profits earned by the business

– In determining accounting profits to the “residual” owners, we only subtract the costs of all factors of production, e.g., physical capital (depreciation), human capital (salaries), debt capital (interest cost), etc.

– Dividends are not a factor of production

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Financial Statements: Retained Earnings and Shareholders’ Equity


• Retained earnings – A measure of undistributed profits of a business

– Do not include capital contributed by owners

• Retained earnings = Cumulative sum of profits earned from the inception of business (-) Cumulative sum of all “dividends” distributed to the owners from the inception of business

• Statement of shareholders’ equity describes the change in retained earnings over a period of time (e.g., a year)

Beginning balance in retained earnings

Net income earned

Dividends distribute

d

Ending balance in retained earnings

31

Financial Statements: Retained Earnings and Shareholders’ Equity


Financial Statements: Statement of Cash Flows


• The statement of cash flows details the enterprise’s cash flows.

• This operating statement reveals how cash is generated and expended during a specific period of time.

(a) operating activities

(b) investing activities

(c) financing activities

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Cash received from customers

Inventory Purchased

Cash Paid for Inventory

Cash Paid for Salaries and Wages

Cash paid for Taxes, interests and other normal business expenses

• Total Sales Minus the Increase in Net Receivables (or, plus a decrease in net receivables)

• Cost of Goods Sold Minus the Decrease in Inventory (or, plus an increase in inventory)

• Inventory Purchased Minus the Increase in Accounts Payable (or, plus a decrease in accounts payable)

• Wages Expense Plus the Decrease in Wages Payable (or, minus an increase in wages payable)



(c) financing activities 34



Cash inflows from sales of

assets

Cash outflows for purchase

of assets

• Disposal of long-term assets (Land, Building, Equipment, Brands), sales of investmnet bonds or stocks, or loans to other companies etc.

• Payment for acquiring long-term assets (Land, Building, Equipment, Brands, etc.) or long-term investments in other firms






Cash inflows

Cash outflows

• Stock or bonds issuing, borrowing under loans

• Repayment of borrowings, acquisition of treasury stock, dividend distribution




Financial Statements Linkages


• Income statement, statement of retained earnings, and balance sheet articulate.

• The income for the period ties into the statement of retained earnings

Income statement

• … the ending retained earnings ties into the balance sheet.

Statement of retained earnings •…This final tie-in

causes the balance sheet to balance.

Balance Sheet

41

Part One:

Principles of Financial Statements Analysis



Financial Statements Analysis


• Investors must be very thorough in examining the financial statements of companies in which they are considering making an investment.

• Sometimes, the evaluation of complex situations can be assisted by utilization of key metrics or ratios.

LIQUIDITY RATIOS

DEBT SERVICE RATIOS

TURNOVER RATIOS

PROFITABILITY RATIOS

OTHER INDICATORS

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Liquidity Ratios


CURRENT

Ability to meet near time obligations

Current Assets

Current Liabilities

QUICK

Narrower than Current Ratio

(Cash+Short-term investment+Receivables)

Current Liabilities

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Debt Service Ratios


Debt to Total Assets

Percentage of TA financed by long-term and short-term debts

Total Debt

Total Assets

Debt to Total Equity

Proportion of financing that is

debt related

Total Debt

Total Equity

Times Interests Earned

Ability to meet interest obligations

Income before Income taxes and

Interests Interest charges

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

debt financing?


Turnover Ratios


ACCOUNT RECEIVABLE TURNOVER

Frequency of collection cycle

Net Credit Sales

Average Net Accounts Receivable

INVENTORY TURNOVER

Frequency of inventory rotation

Cost of goods sold

Average inventory

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Profitability Ratios


Net Profit on Sales

Profitability on sales; for

comparison and trend analysis

Net income

Net sales

Gross Profit Margin

Gross Profit Rate

Gross Profit

Net sales

Return on Assets

Assets utilisation in

producing returns

Net income + interest expense

Total Assets

Return on Equity

Efffectiveness of equity invested

in producing returns

Net income – Preferred Dividends

Avg common E

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Other Indicators


EPS

Amount of earnings attributable to a single

common share

Income

N. Of common shares

P/E

Price of stock in relation to EPS

Market price PS

EPS

Dividend rate yield

Yield to investors through dividend

payments

Annual Cash Dividend

Market price PS

49

Other Indicators


Dividend Payout Ratio

Proportion of earnings distributed as dividends

Annual Cash Dividend

EPS

Book Value

The amount of shareholders’

equity per common share outstanding

Common Equity

Common share

outstanding

50

Horizontal Analysis


• Horizontal analysis, also called trend analysis, refers to studying the behavior of individual financial statement items over several accounting periods.

• These periods may be several quarters within the same fiscal year or they may be several different years.

ABSOLUTE VALUE ANALYSIS PERCENTAGE VALUE ANALYSIS

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Absolute v Percentage Analysis


Absolute Analysis

• Financial statement users with expertise in particular industries might evaluate amounts reported for research and development costs to judge whether a company is spending excessively or conservatively.

• Users are particularly concerned with how amounts change over time.

Percentage Analysis

•It involves computing the percentage relationship between two amounts. •Percentage analysis sidesteps the materiality problems of comparing different size companies by measuring changes in percentages rather than absolute amounts.

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Horizontal Analysis


Vertical Analysis


• Vertical analysis uses percentages to compare individual components of financial statements to a key statement figure.

•compares items over many time periods

Horizontal analysis

•compares many items within the same time period.

Vertical analysis

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Vertical Analysis of the Income Statement


• Vertical analysis of an income statement (also called a common size income statement) involves converting each income statement component to a percentage of sales.

• Although vertical analysis suggests examining only one period, it is useful to compare common size income statements for several years.

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Vertical Analysis of the Balance Sheet


• Vertical analysis of the balance sheet involves converting each balance sheet component to a percentage of total assets.

• Even small individual percentage changes, however, may represent substantial dollar increases.

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Limitations of Financial Statement Analysis


• External users can rely on financial statement analysis only as a general guide to the potential of a business. They should resist placing too much weight on any particular figure or trend.

• Many factors must be considered simultaneously before making any judgments.

• The analysis techniques discussed are all based on historical information. Future events and unanticipated changes in conditions will also influence a company’s operating results.

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Sources of Limitations of Financial Statement Analysis


Different Industries

Different industries may be affected by

unique social policies, special

accounting procedures, or

other individual industry attributes.

Changing Economic

Environment

When comparing firms, analysts must be alert to changes

in general economic trends from year to

year.

Accounting Principles

Two particular concepts,

conservatism and historical cost, have

a tremendous impact on financial

reporting.

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Groupwork


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