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FINANCIAL PERFORMANCE MEASUREMENT (Measuring profitability and…
FINANCIAL PERFORMANCE MEASUREMENT
Measuring profitability and productivity
measured by ROI/ ROCE, ROE, profit margin, gross profit margin or cost/sales ratio
Responsibility centre
Revenue centre
Responsible for revenues
Profit centre
Responsible for costs and revenues
Cost centre
Responsible for costs
Investment centre
Responsible for costs, revenues and assets
Return on capital employed (ROCE)
shows how much profit has been made with the amount of resources invested
PBIT/TALTL(capital employed) x%
a relative measure
the use of ROI as performance measure might not lead to goal congruent decision
Residual income (RI)
Profit- interest charge on investment
absolute measure of performance used to select proposals based on absolute increase in profits
Return on Equity (ROE)
Net income/shareholders' equity
PAT and preference dividends/Equity shareholders' funds x%
the ability of a firm to generate profits from its shareholders' investment
Return on sales
PBIT/Revenue x%
Productivity
How efficient resources are being used
Asset turnover
measure how well the assets are being used to generate sales
Revenue/TALCLL
Revenue/Capital employed
Responsibility centre
Divisionalisation
Divisional managers are given authority to make decisions
Responsibility accounting
Describe decentralisation of authority with the performance of the decentralised units or responsibility centres measured in terms of accounting results
Liquidity
Current ratio
CA/CL
ratio in excess of 1 should be expected
Quick ratio
(CA-inventory)/CL
Efficiency
Receivables collection period
average length of time for a company's receivables to pay what they owe
receivables/sales x365 days/12 months
Payables payment period
average length of time for a company to pay what they owe
(payables/purchase) x 365 days/12 months
Inventory turnover
number of days inventory are held
COS/ inventory
Inventory/COS x 365 days
Gearing or leverage
Gearing ratio
Debt/(Debt+Equity)
concerned with the amount of debts i a company's long term capital structure
Interest cover
whether company is earning enough profits before interest and tax to pay its interest cost comfortably
whether interest costs are high in relation to size of its profit
PBIT/Interest charges
Limitations
On their own, they do not provide information to enable managers to gauge performance or make control decisions
The ratios must be carefully defined
Measures compared over a period of historical cost cannot be compared when inflation in prices has incurred during the period, unless adjustment is made
Performance between different companies cannot be properly compared if they are using different accounting policy
Appraisal of Investment centres
Advantages of using RI
acceptable projects increase the RI of a division giving a simpler decision rule
Goal congruent likely to occur
RI can be more flexible as different cost of capital can be applied to investments with different risk characteristics
Disadvantages of using RI
Comparisons between divisions and projects are more difficult
RI does not relate the size of a centre's income to the size of the investment
Requires cost of capital