Key Performance Indicators

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Key performance indicators


Key performance indicators:operating margin

Operating margin = operating profit % revenue


Key performance indicators:operating margin

Operating margin = operating profit % revenue

It is a measure of “value added”: the

party that does most should earn

most

Building up brand strength often

enhances operating margin (hence the large ad. spend on

branded goods)


Key performance indicators:return on capital employed

To understand roce we first need to look at a 3rd version of the balance sheet. First the asset=liability version:AssetsProperty, plant and equipmentCash at bankReceivables (“debtors”)Inventories (“stocks”)

Liabilities:Trade payables (Creditors)Short term debtLong term debtShareholders’ Equity



We keep the funding on one side and move the operational stuff to the other:AssetsProperty, plant and equipmentCash at bankReceivables (“debtors”)Inventories (“stocks”)


-Trade payablesCapital employed

Capital employed



We keep the funding on one side and move the operational stuff to the other:AssetsProperty, plant and equipmentCash at bankReceivables (“debtors”)Inventories (“stocks”)


-Trade payablesCapital employed

Capital employed

Now the left hand side is our

operational assets (“above the line”) and the right just

the funding



A tidied up version: The total of both sides is called the capital employed

Property, plant and equipmentCash at bankReceivables Inventories - Payables

DebtShareholders’ Equity

This side comes at a cost; the weighted

average cost of capital (“wacc”)






Leaving this side to pay for that wacc. So the yield of the

operating side has to cover the wacc. “Above the line”

produces OPERATING PROFIT






So the yield of the operational side is

operating profit/capital

employed



Property, plant and equipmentCash at bankReceivablesInventories - payables


Every pound taken into the company as

funding; either as debt or equity...

Costs WACC per £





Remember this is a balance sheet

so...

Is represented by a pound on

the operational

side

Must yield ROCE per £

Costs WACC per £





And that pound needs to yield at

least the wacc

Must yield ROCE per £

Costs WACC per £


Return on capital employed

To summarise:

Return on capital = operating profit %employed (roce) capital employed

Where capital employed = debt + equity


Gearing

Gearing is a measure of how we finance our business.

There are two standard definitions:

Gearing = Debt % or Debt %Equity Debt + equity


Gearing

Which is more expensive, debt or equity?For a given company it is equity. Why?

Return

RiskEquityDebt


Gearing

Equity is more expensive because shareholders take more of a risk; they are the last to get a share of the profits each year and they are the last to get a pay out of assets in the event of a liquidation

Return

RiskEquityDebt


Gearing

In other words because equity investors have taken more of a risk they expect a higher return and so the company must find more profit to accommodate that expectation

Return

RiskEquityDebt


Gearing

So why do companies not have huge gearing ratios if debt is cheaper?

Because life is not that simple!

Return

RiskEquityDebt


Gearing

As your gearing increases so does the risk profile of your company increase; investors are getting nervous that their interest or dividends are not going to be paid because of the extra loans that need to be serviced

Return

RiskEquityDebt


Gearing

Look what happens to the risk return graph when you increase gearing:

Return

RiskEquityDebt #1

before


Gearing


Return

RiskEquityDebt #1

One more loan

#2

Each loan is more

expensive as the chance of getting paid is

lowered


Gearing


Return

RiskEquityDebt #1

One more loan

#2

Equity gets more expensive as the

shareholders are now at the back of a longer

queue


Gearing

But despite the previous analysis, we find that by increasing the gearing we do lower the cost of capital. Why?

Because the cost of debt, interest, is tax deductible. In other words the payment is effectively subsidised by the government.

This subsidy has the effect of lowering WACC until gearing gets so high as to cancel the “tax shield” effect.


Free cash flow

Let us consider the key elements of the cash flow statement:First...

Cash from operations

This is the “engine room” of the business. Your customers need to be

paying you more in cash than you are paying your suppliers – or else

where how is the deficit to be funded? But we also need

to take account of those items that are non-discretionary


Free cash flow

Cash from operationsLess interestLess taxLess depreciation= Free cash flow

But why depreciation?


Free cash flow

Cash from operationsLess interestLess taxLess depreciation= Free cash flow

It gives us an estimate of how much we need to spend each year just to replace

existing fixed assets (we take the replacement of old assets as non-

discretionary otherwise our business becomes non-productive)


Aqhuman Financial Training

Aqhuman’s principal is Kevin Amor, FCA. Kevin qualified as a chartered accountant with PWC. He spent 12 years working in commerce at financial controller/director level. Kevin now has more than 12 years experience in financial training. He trains managers at all levels and gives 1 to 1 financial coaching to senior executives.He also teaches corporate finance andaccounting for a number of business schools’ MBA programmes.

Key Performance Indicators

Economy & Finance

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