1. © Unitec New Zealand 1 CONS 7820Professional Business Management ENGG 7021 Professional Engineering Management ENGG 7050 Engineering Management Performance Measurement and Evaluation

2. © Unitec New Zealand 2 Financial Analysis and Evaluation Decision makers include all users of financial information who will evaluate such information in order to understand better an organisation’s situation. They are interested in: –financial performance, –range of activities, –liquidity, –indebtedness, –long-term commitments and other investment criteria. Financial information includes both internally generated information that is processed through an organisation’s accounting information systems and financial data from external sources such as industry averages and other economic indicators.

3. © Unitec New Zealand 3 Percentage analysis and Ratio analysis The user of these techniques can: –Identify important relationships between items in the same financial statements, previous financial statements, planned performance, or related items of a similar enterprise within the same industry, –Compare the relationships in terms of expectations and or trends, –Use the information to reveal those operational transactions which should be further investigated and/or which require managerial attention.

4. © Unitec New Zealand 4 Financial Ratio analysis Financial Ratios are used to provide an insight into financial reports and draw logical conclusions from financial statements Financial ratios are measures, often expressed as percentages or ratios or periods of time, that relate one financial figure to another. Typically, the two financial figures come from the same set of financial reports. The objective of calculating such ratios is to enable users to arrive at meaningful comparisons so that insights into past performance and present conditions can be gained.

5. © Unitec New Zealand 5 Stakeholder interests Owners & shareholders are interested in: Profitability, Activity, Gearing, and Investor ratios. Why? –Shareholders are particularly interested in what profits have been made and what prior claims there may be on these profits before shareholders can participate. They are also interested in how effectively management has used the resources at their command.

6. © Unitec New Zealand 6 Stakeholder interests Government are interested in Profitability ratios. Why? –The government is interested in the amount of tax to be accurately calculated and collected

7. © Unitec New Zealand 7 Stakeholder interests Management are interested in Profitability, Activity, Liquidity and Gearing ratios. Why? –Management needs to know the overall financial position and performance of the business so that their attention tends to be drawn to areas of improvement and other related strategic issues

8. © Unitec New Zealand 8 Stakeholder interests Customers are interested in Liquidity ratios. Why? –Customers are interested in the ability of the business to survive in the short term and to continue to supply the goods and services they need

9. © Unitec New Zealand 9 Stakeholder interests Suppliers are interested in Liquidity ratios. Why? –Suppliers are also most interested in the ability of the business to survive in the short term and meet its obligations

10. © Unitec New Zealand 10 Stakeholder interests Creditors are interested in Liquidity and Gearing ratios. Why? –Short-term lenders are particularly concerned with the ability of the business to meet its financial obligations. Long term lenders are interested in the extent to which the business is financed by long term lenders

11. © Unitec New Zealand 11 Stakeholder interests Employees are interested in Profitability, Activity and Liquidity ratios. Why? –Employees are suppliers of labour and human resources. They are interested in their job security and their pay and promotion prospects.

12. © Unitec New Zealand 12 Financial Ratios - Profitability Return on total assets= Profit before tax X 100% average Total assets Return on equity= Profit after tax X 100% Average ordinary equity Gross profit ratio=Gross profit X 100% Sales Net profit ratio=Profit X 100% Sales

13. © Unitec New Zealand 13 Financial Ratios - Activity Net asset turnover= Sales Net assets Age of debtors = Accounts receivable X 365 (in days) Credit sales Inventory turnover period = average Inventory held X 365 (in days) Cost of goods sold

14. © Unitec New Zealand 14 Financial Ratios - Liquidity Working capital ratio = Current assets (or current ratio) Current liabilities Liquid ratio = Current assets less inventory (or Quick asset ratio) Current liabilities

15. © Unitec New Zealand 15 Financial Ratios - Gearing Debt to equity ratio = Debt capital X 100% Total owners’ equity Debt ratio= Total liabilities X 100% Total assets Equity ratio= Total shareholders’Eqx100% Total assets

16. © Unitec New Zealand 16 Comments on Financial Ratios The following comments can only be applied to the comparison of one year with the previous year’s figures or The comparison of a business’s financial ratios with budget or the industry norm.

17. © Unitec New Zealand 17 The Gross Profit Ratio A falling Gross Profit ratio may be due to: –A decrease in the mark-up % –Theft –Problems with inventory such as carrying inventory that is out of date causing management to hold cut-price sales –Reducing prices at the end of the season.

18. © Unitec New Zealand 18 The Net Profit Ratio A falling net profit ratio indicates that the proportion of the sales dollar spent on expenses has risen. Individual expenses need to be studied to indicate which particular expenses have caused the rise (advertising, marketing, rent?). Many expenses tend to be fixed over a particular level of activity and therefore a small rise in sales should not cause any increases in this area.

19. © Unitec New Zealand 19 Return on Equity This ratio should be measured against the current bank rate or other investment alternatives available to the owner. If the ratio is too low, the owner may: –Wind down the business –Change the type of business –Expand the business

20. © Unitec New Zealand 20 Working Capital (Current) Ratio This ratio indicates whether a business is able to pay their debts when they fall due. A business that cannot pay their debts is unlikely to survive. However this ratio gives only a limited indication of a business’s liquidity as they may have easy access to further funds, particularly if they are a large company. Also, it is not good business practice to have too much finance tied up in inventory or accounts receivable. An ideal Current ratio is 2:1 for a small business but may be less for a large one

21. © Unitec New Zealand 21 Liquid (acid test or quick asset) Ratio This ratio indicates a business’s ability to pay their debts without disrupting normal trading, in about 2 or 3 months. (If a business must sell stock to pay their debts, they end up without a going concern as they have nothing left to sell.) An ideal liquid ratio is 1:1 but again may be less for a large firm. If this ratio is too low, the business will shortly cease trading and go into liquidation. A general comment that may be made about a falling liquid ratio is that it may have been caused by overtrading or expanding too quickly but this may not apply.

22. © Unitec New Zealand 22 Inventory Turnover period If this ratio is falling it may indicate that the business is carrying too little stock, too much stock, out of date stock or that stock has been stolen.

23. © Unitec New Zealand 23 Age of Debtors If the debtors are taking longer to pay their debts and particularly if the collection period is more than 45 days or 1.5 months, it means that the business does not have good credit control and must take immediate steps to collect debts more quickly. –Visit or telephone the debtor –Check the debtor’s ability to pay before allowing them credit –Make sure all credit sales are promptly recorded as well as sending them reminder letters as soon as they become over due.

24. © Unitec New Zealand 24 Class Example 1

25. © Unitec New Zealand 25 Class Example 2

26. © Unitec New Zealand 26 Small changes in profits can have big effects The consequences of not paying interest to a bank can be catastrophic. A receiver may be appointed. High gearing can make it much harder to cope with small downturns in business. “Gearing” - ratio of debt to equity (funding). It is a measure of risk. The higher the gearing, the higher the proportion of profit that must be paid out to creditors. Interest must be paid. shareholder dividends need not be paid. “Interest Cover” - ratio of operating profits to interest costs. The higher the ratio (10:1), the less the degree of risk. The lower the ratio (1: 1.5) the higher the degree of risk. “Acid Test” - compares interest charges to the assets that the business can liquidate at short notice (its liquid assets - cash, debtors, inventory??, marketable securities). A ratio of 1:1 is fairly safe, whereas anything less is risky.

27. © Unitec New Zealand 27 Hedging to smooth out profits Hedging - a form of insurance (to reduce/eliminate risk) which a business can take out against variations in factors that affect profits but which management cannot influence. This should ensure that profits actually reflect the quality of the business rather than simply good or bad luck with matters outside management’s control. Common hedges are for fixing prices, interest rates and exchange rates.

28. © Unitec New Zealand 28 The main concerns Measure profits by quality not just quantity Discover the difference between trading profits and one- off gains Compare returns against real asset values Acknowledge risk The risks of single suppliers or customers What is the appropriate Debt / Equity ratio? Interest cover and availability of cash Factors outside control of management

29. © Unitec New Zealand 29 The Balanced Scorecard The balanced scorecard is a management approach that leads a company or business unit to focus both on achieving current financial results and on creating future value through strategic activities. Kaplan and Norton argue that senior managers need this balanced approach because management’s traditional emphasis on financial measures alone cannot motivate, predict or create future performance. With the scorecard, an organisation measures performance from four different perspectives – financial, customer, internal operations and innovation and improvements activities. The balanced scorecard examines some new thinking about how businesses measure and manage performance.

30. © Unitec New Zealand 30 Overview Financial – “How we look to our shareholders?” Customer – “How do we become our customers’ most valued supplier?” Internal Processes – “ What processes – both long and short term – must we excel at to achieve our financial and customer objectives?” Innovation and Improvement – “How can we continue to improve and create value, particularly in regard to employee capabilities and motivation and the rate of improvement of existing processes?’

31. © Unitec New Zealand 31 Benefits of using the Balanced Scoreboard It makes strategy operational by translating strategy into performance measures and targets It helps focus the entire organisation on what must be done to create breakthrough performance It can act as an integrating device, an umbrella, for a variety of diverse, often disconnected corporate programs such as quality, re- engineering, process redesign, and customer service Corporate level measures can be broken down to lower levels in the organisation so that local managers, operators, and employees can see what they must do well in order to improve organisational effectiveness. It improves a comprehensive view that overturns the traditional idea of the organisation as a collection of isolated, independent functions and departments.

32. © Unitec New Zealand 32 The Key questions Do the problems and issues of relying solely on financial performance indicators apply to us? If so, should we consider adopting the balanced scorecard in our organisation?

33. © Unitec New Zealand 33 At the highest level in the business, do we assess overall performance by using primarily financial results? Do we tend to focus on one or two numbers that we think tell the story about the business’ performance? If we do, are we entirely comfortable with that focus? Do we systematically convert our strategies into measures that are tracked regularly throughout the year?

34. © Unitec New Zealand 34 Do we systematically track our performance in non-financial dimensions, critical to our future success? Are we certain that we are actually managing to build future value? Can we identify exactly how we are building future value? Is the company, or each business units within the company, clearly focused on carrying out its specific strategies for building competitive strength and future value? Does each employee understand his or her role in helping the business achieve its strategic objectives? (Have we been able to translate our mission and strategies into meaningful objectives for employees?).