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Performance Management
Chiara Demartini
UNIVERSITY OF PAVIA
Master in International Business and Economics 1
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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
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Structure of the module and materials
C. Demartini – Performance Management
• 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.
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Module grading
C. Demartini – Performance Management
• Module grading:
– 30% case studies and other assessments over the module
– 30% presentation of a company’s performance management system
– 40% written test
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Part One:
Principles of Financial Accounting
C. Demartini – Performance Management
Master in International Business and Economics 5
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Financial Accounting
C. Demartini – Performance Management
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
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Aims of Financial Accounting
C. Demartini – Performance Management
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
C. Demartini – Performance Management
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
C. Demartini – Performance Management
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
C. Demartini – Performance Management
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)
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Asymmetry in financial reporting
C. Demartini – Performance Management
• 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
C. Demartini – Performance Management
Management letter
Financial Statements
Auditors’ report
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The Auditors’ Report
C. Demartini – Performance Management
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
C. Demartini – Performance Management
• 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
C. Demartini – Performance Management
• 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
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Debit or credit an account?
C. Demartini – Performance Management 20
Balance Sheet
Income Statement
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Accrual & Cash Method
C. Demartini – Performance Management
• 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
C. Demartini – Performance Management
• The following table compares the accrual and cash methods of accounting:
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Financial statement
C. Demartini – Performance Management
• 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
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Going Concern Principle
C. Demartini – Performance Management
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
C. Demartini – Performance Management
• 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
C. Demartini – Performance Management
(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
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C. Demartini – Performance Management 27
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Financial Statements: Income Statement
C. Demartini – Performance Management
• 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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C. Demartini – Performance Management 29
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Dividends
C. Demartini – Performance Management
• 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
C. Demartini – Performance Management
• 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
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Financial Statements: Retained Earnings and Shareholders’ Equity
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Financial Statements: Statement of Cash Flows
C. Demartini – Performance Management
• 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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Financial Statements: Statement of Cash Flows
C. Demartini – Performance Management
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)
(a) operating activities
(b) investing activities
(c) financing activities 34
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Financial Statements: Statement of Cash Flows
C. Demartini – Performance Management
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
(a) operating activities
(b) investing activities
(c) financing activities 35
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Financial Statements: Statement of Cash Flows
C. Demartini – Performance Management
Cash inflows
Cash outflows
• Stock or bonds issuing, borrowing under loans
• Repayment of borrowings, acquisition of treasury stock, dividend distribution
(a) operating activities
(b) investing activities
(c) financing activities 36
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C. Demartini – Performance Management 37
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C. Demartini – Performance Management 38
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Financial Statements Linkages
C. Demartini – Performance Management
• 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
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Part One:
Principles of Financial Statements Analysis
C. Demartini – Performance Management
Master in International Business and Economics 42
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Financial Statements Analysis
C. Demartini – Performance Management
• 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
C. Demartini – Performance Management
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
C. Demartini – Performance Management
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?
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Turnover Ratios
C. Demartini – Performance Management
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
C. Demartini – Performance Management
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
C. Demartini – Performance Management
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
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Other Indicators
C. Demartini – Performance Management
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
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Horizontal Analysis
C. Demartini – Performance Management
• 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
C. Demartini – Performance Management
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
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Vertical Analysis
C. Demartini – Performance Management
• 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
C. Demartini – Performance Management
• 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
C. Demartini – Performance Management
• 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
C. Demartini – Performance Management
• 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
C. Demartini – Performance Management
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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C. Demartini – Performance Management 63