www.aqhuman.com Key performance indicators Aqhuman financial training & coaching
Jun 11, 2015
Aqhuman financial training & coachingwww.aqhuman.com
Key performance indicators
Aqhuman financial training & coachingwww.aqhuman.com
Key performance indicators:operating margin
Operating margin = operating profit % revenue
Aqhuman financial training & coachingwww.aqhuman.com
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)
Aqhuman financial training & coachingwww.aqhuman.com
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
Aqhuman financial training & coachingwww.aqhuman.com
Key performance indicators:return on 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”)
Liabilities:Trade payables (Creditors)Short term debtLong term debtShareholders’ Equity
-Trade payablesCapital employed
Capital employed
Aqhuman financial training & coachingwww.aqhuman.com
Key performance indicators:return on 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”)
Liabilities:Trade payables (Creditors)Short term debtLong term debtShareholders’ Equity
-Trade payablesCapital employed
Capital employed
Now the left hand side is our
operational assets (“above the line”) and the right just
the funding
Aqhuman financial training & coachingwww.aqhuman.com
Key performance indicators:return on capital employed
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”)
Aqhuman financial training & coachingwww.aqhuman.com
Key performance indicators:return on capital employed
A tidied up version: The total of both sides is called the capital employed
Property, plant and equipmentCash at bankReceivables Inventories - Payables
DebtShareholders’ Equity
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
Aqhuman financial training & coachingwww.aqhuman.com
Key performance indicators:return on capital employed
A tidied up version: The total of both sides is called the capital employed
Property, plant and equipmentCash at bankReceivables Inventories - Payables
DebtShareholders’ Equity
So the yield of the operational side is
operating profit/capital
employed
Aqhuman financial training & coachingwww.aqhuman.com
Key performance indicators:return on capital employed
Property, plant and equipmentCash at bankReceivablesInventories - payables
DebtShareholders’ Equity
Every pound taken into the company as
funding; either as debt or equity...
Costs WACC per £
Aqhuman financial training & coachingwww.aqhuman.com
Key performance indicators:return on capital employed
Property, plant and equipmentCash at bankReceivablesInventories - payables
DebtShareholders’ Equity
Remember this is a balance sheet
so...
Is represented by a pound on
the operational
side
Must yield ROCE per £
Costs WACC per £
Aqhuman financial training & coachingwww.aqhuman.com
Key performance indicators:return on capital employed
Property, plant and equipmentCash at bankReceivablesInventories - payables
DebtShareholders’ Equity
And that pound needs to yield at
least the wacc
Must yield ROCE per £
Costs WACC per £
Aqhuman financial training & coachingwww.aqhuman.com
Return on capital employed
To summarise:
Return on capital = operating profit %employed (roce) capital employed
Where capital employed = debt + equity
Aqhuman financial training & coachingwww.aqhuman.com
Gearing
Gearing is a measure of how we finance our business.
There are two standard definitions:
Gearing = Debt % or Debt %Equity Debt + equity
Aqhuman financial training & coachingwww.aqhuman.com
Gearing
Which is more expensive, debt or equity?For a given company it is equity. Why?
Return
RiskEquityDebt
Aqhuman financial training & coachingwww.aqhuman.com
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
Aqhuman financial training & coachingwww.aqhuman.com
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
Aqhuman financial training & coachingwww.aqhuman.com
Gearing
So why do companies not have huge gearing ratios if debt is cheaper?
Because life is not that simple!
Return
RiskEquityDebt
Aqhuman financial training & coachingwww.aqhuman.com
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
Aqhuman financial training & coachingwww.aqhuman.com
Gearing
Look what happens to the risk return graph when you increase gearing:
Return
RiskEquityDebt #1
before
Aqhuman financial training & coachingwww.aqhuman.com
Gearing
Look what happens to the risk return graph when you increase gearing:
Return
RiskEquityDebt #1
One more loan
#2
Each loan is more
expensive as the chance of getting paid is
lowered
Aqhuman financial training & coachingwww.aqhuman.com
Gearing
Look what happens to the risk return graph when you increase gearing:
Return
RiskEquityDebt #1
One more loan
#2
Equity gets more expensive as the
shareholders are now at the back of a longer
queue
Aqhuman financial training & coachingwww.aqhuman.com
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.
Aqhuman financial training & coachingwww.aqhuman.com
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
Aqhuman financial training & coachingwww.aqhuman.com
Free cash flow
Cash from operationsLess interestLess taxLess depreciation= Free cash flow
But why depreciation?
Aqhuman financial training & coachingwww.aqhuman.com
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 & coachingwww.aqhuman.com
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.