Purposes of performance measurement

There are three different major functions for the use financial performance measurement and measures developed for different purpose. The three main functions involved are as follows:

1) The use of financial measures of performance as a tool of financial management. This is concerned with efficient provision and use of financial resources to support the aims of company, and to manage the affective and efficient operation of cross-border operation.

2) The performance of finance as major objective of a company. Some financial measure, such as profit, return on investment (ROI) or (EVA), is used to signify the achievement of the most important firm objective.

3) The function of financial performance measures as a system for motivation and monitoring within company. Here the financial information provides financial manages to control of company outflows and inflows.

Any companies have to live within financial constraints and to deliver perceived value for money to its stakeholders. Thus, financial monitoring and control is an essential part of the overall finance management process. Financial monitoring can be seen as the process by which such systems are controlled and necessary corrective action proposed when significant is detected. The single most powerful tool of reporting on these matters is the so-called “pyramid of ratios”.

Return on invest = (4.1)

Figure 4.2[6]

This pyramid can be provided by considering the purpose of calculating each ratio. Thus, if the concern is with cash flows and liquidity, a range of ratios based on working capital are appropriate. Thus, five key ratios are commonly calculated, namely:

1) Current ratio, equal to current assets divided by current liabilities;

2) Quick ratio (or acid test), equal to quick assets (current assets less inventories) divided by current liabilities;

3) Inventory turnover period, equal to inventories divided by cost of sales, with the result being expressed in terms of days or months;

4) Debtor to sale ratio, with the result again being expressed as an average collection period;

5) Creditors to purchases ratio, again expressed as the average payment period.

Each of these ratios addresses a different aspect of the cash collection and payment cycle.

EVA, Book ROI, and EP

The top executive of company usually has compensation packages which is included a bonus that depends on increases in earnings or on other accounting measures of performance. But for lower-level manager’s packages depend more on accounting measures. Accounting measures have two advantages:

- They are based on absolute performance, rather than on performance relative to owner’s expectation.

- They make it possible to measure the performance of junior managers which is responsible only for a single division.

Tying compensation to accounting profit also has some problems. First, accounting profit is partly within the control management. Second, accounting earnings and rates of return can be severely biased measures of true profitability. Third, growth in earnings does not mean that owners are better off. Any investment with positive rate of return will eventually increase earning but owners want only positive-NPV investment.

There are two methods for judging whether the management of company has increased owners value.

The first, book return on investment (ROI) is the ratio of after-tax operating income to the net book value of assets. Managers frequently assess the performance of a division by comparing its ROI with the cost of capital.

The second, method is the tool which is provides to calculate a net money return to owners. This is the Residual Income or Economic Value Added (EVA). EVA is the term used by the consulting firm Stern-Stewart, which has done much popularize and implement this measure of residual income. Net income after deducting the money return required by investors is called residual income, economic value added, or EVA. The formula is:

EVA = Residual income = income earned – income required =

= income earned –cost of capital x investment (4.2)

The consulting firms Stern-Stewart has been popularized the term EVA, but the concept of residual income has been around. Other consulting firms have their own versions of residual income. Company uses Economic Profit (EP), defined as capital invested multiplied by the spread between return on investment and the cost of capital.

Economic Profit (EP) = (ROI – r) x capital invest (4.3)[7]

If we want stimulate interest of managers we could give the managers common stock or stock option .But now it is does not working completely. The performance of the stock depends on manager’s strategy and stock price already reflects investor’s expectations. Since the scandal at Enron, WorldCom, and other companies, many worry that the award of executive stock options may tempt unscrupulous managers to pump up the price of their stock and disguise the true state of the firm.

The accounting measure of profitability EVA and book ROI, depends on accurate measures of earnings and capital employed the adjustments are made to accounting data, these measures may underestimate the true profitability of new assets and overestimate that of old assets.