Performance Dashboards and Analysis for Value Creation

By Jack Alexander

No matter what industry your company competes in, you need to have a firm understanding of how to create a direct link between shareholder value and critical business processes in order to improve performance and achieve long-term value. Performance Dashboards and Analysis for Value Creation contains the information and expertise you need to do just this—and much more.

• Language: English
• Publisher: Wiley
• Release date: Jan 11, 2011
• ISBN: 9781118044728

Book preview

CHAPTER 1

The Management Challenge: Integrating Performance, Finance, and Value

One of the primary objectives of corporate managers and directors is to create value for the company’s shareholders. Much has been said and written on this subject over the past 15 years. Yet many managers and most employees still have difficulty in fully understanding the drivers of shareholder value and how their activities relate to these drivers. The objective of this book, and the Value Performance Framework (VPF), is to assist managers and employees in developing a comprehensive understanding of valuation and creating a direct link between shareholder value and critical business processes.

Managers face many challenges in building shareholder value in today’s business environment. They face pressure from all fronts, balancing demands from customers, suppliers, employees, regulators, and investors. In addition, they must integrate a number of available tools to build shareholder value. Many managers focus primarily on sales and earnings growth. However, many other factors will also affect shareholder value; it is a significant challenge to evaluate and incorporate them into a single management framework. Figure 1.1 presents many of these tools and illustrates the objectives of the Value Performance Framework:

• Demystify valuation.

• Identify key value drivers.

• Link value and performance.

• Identify high-leverage improvement opportunities.

• Build a comprehensive performance management system.

• Build long-term shareholder value.

FIGURE 1.1 Managers Face Many Challenges in Managing Factors That Build Long-Term, Sustainable Shareholder Value. The VPF integrates obvious and subtle tools to build value into a single framework.

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Note that we are using the verb building shareholder value, rather than creating value. It is important to recognize that building sustainable shareholder value is more akin to constructing a complex building than to a divine or mystical creation. It takes substantial effort, time, process, and a great team to lay the foundation for building long-term sustainable value. Creating also conjures up the images of the dot-com bubble and the unsustainable value created by accounting gimmickry. We will focus on those factors that lead to building and sustaining shareholder value.

WHAT IS SHAREHOLDER VALUE?

Shareholder value is defined as the market value of the firm’s stock held by shareholders. It is commonly referred to as the market cap (capitalization) of the firm. It is calculated by multiplying the number of shares outstanding times the price of the stock. For example:

We will discuss the valuation techniques commonly used by investors to establish the stock price and market value of a firm in Chapter 3. For now, we need to simply understand that the market value of both private and publicly held firms will be determined by the expectations of future performance of the firm, primarily future revenues, earnings, and cash flows.

THE MEASUREMENT CHALLENGE

The single greatest challenge in creating an effective measurement system is to ensure that it supports the organization’s objective for creating value by executing a strategic plan. Many attempts at building a performance management framework fail to achieve intended results because the context has not been created and the measures are not integrated with other key management practices and systems. Creating context builds excitement and purpose and takes performance management to a whole new level. In addition, operational, financial, and value measures must be understood, linked, and integrated. (See Figure 1.2.)

FIGURE 1.2 The Measurement Challenge: Creating Context and Effectively Integrating Value, Financial, and Operational Measures

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ABOUT THE VALUE PERFORMANCE FRAMEWORK

The basic architecture for the Value Performance Framework is illustrated in Figure 1.3. The framework recognizes that there are a number of external factors that will affect shareholder value. These factors, such as the general economy, interest rates, and market valuation factors, will impact the value of all firms. Managers need to recognize these factors and understand the impact each has on their business performance and valuation. In this book, we focus on the value drivers that are largely under management’s control:

• Sales growth.

• Relative pricing strength (competitive advantage).

• Operating effectiveness.

• Capital management.

• Cost of capital.

• The intangibles.

The critical element of the VPF is to link these value drivers to specific processes, activities, and improvement programs that resonate with managers and employees. Many managers and most employees do not under-stand how their activities relate to shareholder value. For example, engineering groups may understand that their activities affect sales growth, but they may not fully understand the impact the activities have on working capital requirements of the firm. In most companies, a significant driver of inventory levels is the extent to which the products are designed for manufacturability (i.e., the design process has a focus on developing products that can be efficiently manufactured) and use common components. If the engineering group is sensitized to the impact of their practices on downstream business processes such as manufacturing, they have a context for more effective design decisions. If the firm establishes an effective set of performance measures—for example, to track the use of common components and product assembly steps—the future impact of design decisions on the supply chain process and inventory requirements can be measured. We cover more on this subject in Chapter 5.

FIGURE 1.3 Building Shareholder Value Requires Performance across All Key Value Drivers

Source: Reprinted by permission of Value Advisory Group, LLC.

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FIGURE 1.4 Value Performance Framework Overview

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Linking critical business processes to value drivers and financial performance in this manner can have a profound impact on the firm. Employees are more engaged if they feel connected to the company’s overall performance and shareholder value. It becomes easier to choose between competing initiatives or projects when we can evaluate the potential contribution of each to long-term shareholder value. One of the great aspects of this link between shareholder value and process is the realization that shareholder value is not at odds with satisfying customers or employees. To the contrary, the framework underscores the need to attract, retain, develop, and motivate a competent workforce that exceeds customers’ expectations. This in turn will lead to building long-term sustainable value for shareholders.

The key to implementing sustainable performance improvements and building long-term shareholder value is to integrate valuable business tools including value drivers, benchmarking, quality and process initiatives, and performance management into a cohesive management framework. This integrated framework is illustrated in Figure 1.4. Supported by research covering over 125 companies, the framework emphasizes the importance of linking shareholder value to critical business processes and employee activities. Key elements of the VPF include:

• Understanding key principles of valuation.

• Identification of key value drivers for a company.

• Assessing performance on critical business processes and measures through evaluation and external benchmarking.

• Creating a link between shareholder value and critical business processes and employee activities.

• Aligning employee and corporate goals.

• Identification of key pressure points (high-leverage improvement opportunities) and estimating potential impact on value.

• Implementation of a performance management system to improve visibility and accountability in critical activities.

• Development of performance dashboards with high visual impact.

The integrated framework allows managers to ask and answer the following questions:

• What impact will my quality initiatives have on shareholder value?

• How do we compare to best practice companies on key performance measures?

• Given limited financial and human resources, should we pursue a program to reduce working capital or warranty expense?

• How do acquisitions affect shareholder value?

• What is the full potential value of this firm?

We begin with a review of key financial concepts and build a common vocabulary in Chapter 2.

PART One

Creating Context and Covering the Basics

CHAPTER 2

Fundamentals of Finance

A key building block in our foundation for utilizing the Value Performance Framework is the ability to understand and evaluate financial statements and financial performance. This chapter presents a brief introduction (or refresher) to financial statements and financial ratios. Many of these financial ratios will be used as overall measures of a company’s performance or as overall measures of performance on a particular driver of value.

BASICS OF ACCOUNTING AND FINANCIAL STATEMENTS

There are three primary financial statements: income statement, balance sheet, and the statement of cash flows. We need all three statements to properly understand and evaluate financial performance. However, the financial statements provide only limited insight into a company’s performance and must be combined with key ratios and ultimately an understanding of the company’s market, competitive position, and strategy, before evaluating a company’s current performance and value.

Financial statements are based on generally accepted accounting principles (GAAP). A key objective of financial statements prepared under GAAP is to match revenues and expenses. Two significant conventions arise from this objective: the accrual method of accounting and depreciation. These two conventions are significant in our intended use of financial statements for economic evaluation and valuation purposes, since they result in differences between accounting income and cash flow.

Accrual Accounting

Financial statements record income when earned and expenses when incurred. For example, the accrual basis of accounting will record sales when the terms of the contract are fulfilled, usually prior to collection of cash.

TABLE 2.1 Comparison of Common P&L Measures

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Similarly, expenses are recorded when service is performed rather than when paid for.

Depreciation

Generally accepted accounting principles require that an expenditure for such things as property, plant, and equipment with long lives be recorded as an asset and depreciated over the expected useful life of the asset. As a result, when a firm spends cash to purchase equipment, it records it as an asset on the balance sheet and depreciates the cost of that asset each year on the income statement.

Income Statement (aka Profit and Loss)

The income statement, or what is frequently referred to as the profit and loss (P&L) statement, is a summary of all transactions completed during the period (year, quarter, etc.). Typical captions and math logic for a basic income statement include:

Many different measures, terms, and acronyms are used in practice to describe various elements of the P&L. Table 2.1 illustrates how some of these common measures are determined as well as how they relate to one another.

Following are definitions of some key terms used in Table 2.1:

• Net income. Residual of income over expense. Sometimes referred to as profit after tax (PAT).

• Earnings before interest and taxes (EBIT). This measure reflects the income generated by operating activities (generally equals or approximates operating income) before subtracting financing costs (interest) and income tax expense.

• Earnings be fore interest a fter taxes (EBIAT). Also known as net operating profit after taxes (NOPAT) or operating profit after taxes (OPAT), this measure estimates the after-tax operating earnings. It excludes financing costs but does reflect income tax expense. It is useful in comparing and evaluating the operational performance of firms, excluding the impact of financing costs.

• Earnings before interest, taxes, depreciation, and amortization (EBITDA). EBITDA adjusts EBIT (operating income) by adding back noncash charges, depreciation, and amortization. This measure is used in valuation and financing decisions, since it approximates cash generated by the operation. It does not reflect capital requirements such as working capital and expenditures for property and equipment.

• Economic pro fit (EP). Economic profit measures, including Economic Value Added (EVA™) developed by Stern Stewart & Company,¹ subtract a capital charge from the earnings to arrive at an economic profit. The capital charge is computed based on the level of capital employed in the business.

Balance Sheet

The balance sheet is a critical financial report. It is a summary of the company’s assets, liabilities, and owner’s equity and represents a snapshot of all open transactions as of the reporting date. For example, the inventory balance represents all materials delivered to the company, work in process, and finished goods not yet shipped to customers. Accounts payable represents open invoices due vendors that have not been paid as of the balance sheet date.

The balance sheet can be a good indicator of the efficiency of an operation. A firm with a very effective manufacturing process will have lower inventory levels than a similar firm with less effective practices.

The balance sheet is constructed as shown in Table 2.2.

Another way to look at the balance sheet is to reorder the traditional format (Table 2.2) to identify the net operating assets and the sources of capital provided to the organization. This presentation is more useful in understanding the dynamics of the balance sheet. The net operating assets are those assets that are required to operate and support the business. The net operating assets must be funded (or provided to the firm) by investors, either bondholders or shareholders, as illustrated in Table 2.3.

TABLE 2.2 Balance Sheet: Assets = Liabilities + Shareholders’ Equity

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TABLE 2.3 Net Operating Assets/Invested Capital Illustration

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Statement of Cash Flows

The statement of cash flows (SCF) summarizes the cash generated and utilized by the enterprise during the specific period (year, quarter, etc.). Since cash flow will be a focus of our economic valuation and is an important business measure, we will pay particular interest to cash flows in the VPF framework. The statement of cash flows starts with the net income generated by the company over the period, as reported on the income statement.

Since net income is based on various accounting conventions, such as the matching principle, the SCF identifies various adjustments to net income to arrive at cash flow. In addition, we also will have to factor in various cash flow items that are not reflected in net income, such as working capital requirements, dividends, and purchases of equipment.

A simplified format for a statement of cash flows is shown in Table 2.4.

TABLE 2.4 Cash Flow Statement

The three primary financial statements just discussed are interrelated. Understanding these relationships is critical to evaluating business performance and valuation and is presented in Figure 2.1. For example, net income (or PAT) flows from the income statement to increase shareholders’ equity in the balance sheet. Net income for the period is also the starting point for the statement of cash flows. Other elements on the statement of cash flows are the result of year-to-year changes in various balance sheet accounts, including capital expenditures, changes in working capital, and reductions or increases in borrowings. Finally, financial ratios look at the relationship of various line items both within each financial statement and across all financial statements (e.g., return on assets).

FIGURE 2.1 Financial Statement Interrelationships

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FINANCIAL RATIOS AND INDICATORS

Financial ratios can be very useful tools in measuring and evaluating business performance. Ratios can be used as tools in understanding profitability, asset utilization, liquidity, and key business trends and in evaluating overall management performance and effectiveness.

Usefulness

Using financial ratios can provide a great deal of insight into a company’s performance, particularly when combined with an understanding of the company and its industry. In addition to providing measures of performance, financial ratios can be used to monitor key trends over time and in comparing a company’s performance to peers or best-practice companies.

Variations

There are a number of different financial terms and ratios, and variations of each of these are in use. This leads to potential confusion when similarsounding measures are computed differently or used interchangeably. It is important to clearly define the specific ratio or financial measure used.

Key Financial Ratios

To illustrate key financial ratios we will use the information in Table 2.5 for Simple Co. Unless otherwise indicated, the ratios will be computed using the estimated results for 2006 (2006E).

OPERATING MEASURES

Operating measures include ratios that provide insight into the operating performance of the company. These measures typically utilize the information presented in the income statement.

TABLE 2.5 Simple Co. Historical and Estimated 2006 Financials

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Sales Growth

Sales growth is an important determiner of financial performance. Based only on information in the income statement, we are limited to measuring the sales growth rate over periods reported. Two key sales growth measures are year-over-year growth and the compound annual growth rate.

Year-over-Year Growth Simple Co.’s sales are expected to grow from $92,593 in 2005 to $100,000 in 2006. This represents a growth of 8 percent in 2006:

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Compound Annual Growth Rate This measure looks at the growth rate over time (n years). The compound annual growth rate from 2003 to 2006 is computed as follows:

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Revenue growth contributed by acquisitions has significantly different economic characteristics. As a result, total revenue growth is frequently split between acquired and organic growth.

Gross Margin % Sales

How Is It Computed? Gross margin % is simply the gross margin as a percentage of total revenues.

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What Does It Measure and Reflect? Gross margin % is an important financial indicator. Gross margins vary widely across industries, ranging from razor-thin margins of 10 to 15 percent to very high margins approaching 70 or even 80 percent.

The gross margin % will be impacted by a number of factors and therefore will require substantial analysis. The factors affecting gross margin include:

• Industry.

• Competition and pricing.

• Product mix.

• Composition of fixed and variable costs.

• Product costs.

• Production variances.

• Material and labor costs.

Research and Development (R&D) % Sales

How Is It Computed?

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What Does It Measure and Reflect? This ratio determines the level of investment in research and development (R&D) compared to the current period sales. This ratio will vary significantly from industry to industry and from high-growth to low-growth companies. Some industries, for example retail, may have little or no R&D. Other firms, such as pharmaceuticals or technology companies, will likely have large R&D spending. Firms in high-growth markets or investing heavily for future growth will have very large levels of R&D, occasionally exceeding 20 percent of sales.

Selling, General, and Administrative (SG&A) % Sales

How Is It Computed?

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What Does It Measure and Reflect? Since this measure compares the level of SG&A spending to sales, it provides a view of spending levels in selling and distributing the firm’s products and in supporting the administrative aspects of the business. The measure will reflect the method of distribution, process efficiency, and administrative overhead. In addition, SG&A will often include costs associated with initiating or introducing new products.

Operating Income (EBIT) % Sales

How Is It Computed?

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What Does It Measure and Reflect? This is a broad measure of operating performance. It will reflect operating effectiveness, relative pricing strength, and level of investments for future growth.

Return on Sales (Profitability)

How Is It Computed?

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What Does It Measure and Reflect? This is an overall measure of performance. In addition to the factors described under Operating Income (EBIT) % Sales, this measure reflects taxes and other income and expense items.

ASSET UTILIZATION MEASURES

Asset utilization is a very important element in total financial performance. It is a significant driver of cash flow and return to investors.

Days Sales Outstanding (DSO)

How Is It Computed?

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What Does It Measure and Reflect? Days sales outstanding (DSO) is a measure of the length of time it takes to collect receivables from customers. It will be impacted by the industry in which the firm participates, the creditworthiness of customers, nature of distribution channels, and even the countries in which the firm does business. In addition, DSO is affected by