Financial Perfomance Measurement

Ahalik, SE, Ak, M.Si, M.Ak, CMA,CPMA,CPSAK

Financial Performance Measures

Financial Performance Measures

Indicate the economic impact of diverse physical activities within an organization. Examples include: Revenue Costs Income

Designing Accounting-Based Performance Measures

Requires a six-step design process:
1.
2.

3.

4.

5.
6.

Choose among different performance measures Choose the time horizon of each Performance Measure Choose a definition of the components in each Performance Measure Choose a measurement alternative for each Performance Measure Choose a target level of performance Choose the timing of feedback

Step 1: Choosing among Different Performance Measures

Four common measures of economic performance:
1. 2. 3. 4.

Return on Investment Residual Income Economic Value Added Return on Sales

Illustration :
Hospitality Inns owns and operates three hotels-one each in San Fransisco, Chicago, and New Orleans. Financial data for Hospitality Inns for 2010 (in thousand) are as follow :

San Fransisco Hotel

Chicago Hotel

New Orleans Hotel

Total

Hotel Revenue

1,200,000

$1,400,000

$ 3,185,000

$5,785,000

Hotel Variable Cost

Hotel Fixed Cost Hotel Operating Income Interest Costs on long term debt at 10% Income before income taxes Income taxes at 30% Net Income

$
$ $

310,000
650,000 240,000

$ 375,000
$ 725,000 $ 300,000

995,000

$1,680,000
$3,055,000 $1,050,000 $ 450,000 $ 600,000 $ 180,000 $ 420,000

$ 1,680,000 $ 510,000

Net Book Value at the end of 2006 : Current Assets Long-term assets Total Assets Current Liabilities Long-term debt $ $ $ $ 400,000 600,000 1,000,000 50,000 $ 500,000 $1,500,000 $2,000,000 $ 150,000 $ 660,000 $1,560,000 $4,440,000 $6,000,000 $ 500,000 $4,500,000

$ 2,340,000 $ 3,000,000 $ 300,000

Stockholder's Equity
Total liabilities and SE

$1,000,000
$6,000,000

Additional Information :
Suppose that the company has two sources of longterm funds, 50% financed by long-term debt and 50% by stockholders equity. Long term debt with a market value and book value of $4.5 million issued at an interest rate of 10% Equity capital that also has market value of $4.5 million (but a book value of $1 million), it has a cost of 14% per year. This 14% represents the opportunity cost to equity investors of investing in Hospitality Inns the return forgone by not investing in other equity securities of similar risk.

Return on investment (ROI)

ROI is an accounting measure of income divided by an accounting measure of investment

ROI =

Income Investment

Return on investment (ROI)

ROI =
Income

Investment
= Income Revenues X X Revenues Investment Investment Turnover

= Return on Sales

* Variations in the definition of both profit and investment will influence ROI calculations

Return on investment (ROI)

One of the more popular approaches to performance measurement for two reasons:
1.

2.

Blends all the ingredients of profitability (revenues, costs, and investment) into a single percentage May be compared to other ROIs both inside and outside the firm

Also called the Accounting Rate of Return (ARR) or the Accrual Accounting Rate of Return (AARR)

Residual Income (RI)

Residual Income (RI) is an accounting measure of income minus a dollar amount for required return on an accounting measure of investment

RI = Income (RRR x Investment)

RRR = Required Rate of Return
* Variations in the definition of both profit and investment will influence RI calculations

Residual Income (RI)

Some companies favour RI because managers will concentrate on maximizing an absolute amount rather than a percentage, such as ROI Goal congruence is more likely to be achieved by using RI rather than ROI

Economic Value Added (EVA)

EVA is a specific type of residual income calculation that has recently gained popularity

EVA =

After-tax Operating Income

Weighted-Average Cost of Capital

X(

Total Current Assets Liabilities

)}

Weighted-average cost of capital equals the after-tax

average cost of all long-term funds in use

Return on Sales (ROS)

Return on Sales is simply income divided by sales one of the components of ROI Simple to compute, and widely understood