Financial Performance Measurement for ACCA Advanced Performance Management

What this chapter covers

Financial performance measurement: topics in the order to study them

1. 1Financial Performance Measures and Ratio AnalysisIt gives you the basic toolkit of profitability, liquidity, efficiency and gearing ratios that every later topic builds on.
2. 2Limitations of Financial Performance MeasuresOnce you can calculate ratios, you need to criticise them, since this sets up the reasons for the other measures.
3. 3Divisional Performance: ROI, Residual Income and EVAThese are the most calculation-heavy measures, and they show how the choice of measure changes manager behaviour.
4. 4Shareholder Value Measures: MVA, TSR and Value-Based ManagementIt moves from divisions to the whole company and its owners, and builds on the idea of economic profit from EVA.
5. 5Cash-Based Measures: Cash Flow ROI and Free Cash FlowCash measures answer the profit-based weaknesses you have already studied, so they make most sense after those topics.
6. 6Public Sector and Not-for-Profit Financial MeasuresIt applies the same ideas where profit is not the main aim, so study it last, when the commercial measures are clear.

How to prepare Financial performance measurement

1. Learn each formula from memory, along with what goes in each term, such as which profit and which capital figure are used.
2. Do short calculation drills on ratios, ROI, residual income and EVA until the arithmetic is quick and correct.
3. For every measure, write three points on its strengths and three on its weaknesses, with a short example of the behaviour it could encourage.
4. Compare measures on the same data, for example ROI against residual income, and note when they give different decisions.
5. Practise reading a scenario and picking the measures that suit it, rather than computing every ratio you know.
6. Answer past-style written questions under time. State your calculation, interpret it, then give a clear recommendation.
7. Review your answers for professional skills: did you show scepticism about the data, and was your advice practical and well communicated?

Common mistakes in Financial performance measurement

• Listing ratios and numbers without explaining what they mean for the organisation.

  Fix: After each figure, write what it shows, why it changed and what the business should do about it.

• Mixing up how ROI and residual income affect decisions.

  Fix: Remember that ROI is a percentage that can discourage good projects, while residual income is a money amount that rewards any return above the required rate.

• Using inconsistent profit and capital figures, such as profit after interest with capital that includes debt.

  Fix: State the definition you use, keep profit and capital on the same basis, and show the workings so marks can be given.

• Giving generic limitations of financial measures that ignore the scenario.

  Fix: Link each limitation to a fact in the scenario, such as a manager's short-term behaviour or an asset-light business.

• Applying profit-based thinking to public sector and not-for-profit bodies.

  Fix: Focus on objectives, funding limits and value for money, and note that outputs and outcomes are harder to measure in money.

• Forgetting professional skills marks in the written answer.

  Fix: Use a clear layout, show scepticism about the data, keep advice commercial and address the audience named in the requirement.

Last-day revision: Financial performance measurement

• ✓ROI = profit ÷ capital employed, and it can lead managers to reject projects that are good for the company but lower their ROI.
• ✓Residual income = divisional profit − (capital employed × required rate of return).
• ✓Residual income supports goal congruence better than ROI because accepting any project that earns above the required return increases it.
• ✓EVA is an economic profit measure that uses adjusted accounting figures, such as NOPAT and capital, and a cost of capital charge.
• ✓MVA is the market value of the firm less the capital invested in it.
• ✓TSR combines dividends and share price change over a period, compared with the starting share price.
• ✓Value-based management focuses decisions and rewards on creating shareholder value.
• ✓Free cash flow is cash generated after investment needed to keep and grow the business, and is available to the providers of finance.
• ✓Profit measures can be manipulated by accounting choices, while cash is harder to alter but can be timing-sensitive.
• ✓Financial measures look backward, are short-term and may ignore quality, customers and innovation.
• ✓Ratios are only useful when compared with a trend, a budget, a competitor or an industry benchmark.
• ✓Public sector bodies often use value for money: economy, efficiency and effectiveness.

Financial performance measurement practice questions

• Orion Foods uses residual income (RI) with a notional capital charge of 10% to assess divisions. Division Z has operating profit of $1.5m an…
• A charity, Brightpath, funds literacy programmes. Its trustees want to judge performance but note that, unlike a listed company, it has no s…
• Kestrel Components plc evaluates its divisional managers solely on annual return on investment (ROI). The Fabrication division currently ear…
• Division Alpha of Brightwell Group earns operating profit of $360,000 on divisional capital employed of $2,400,000. Brightwell's cost of cap…
• Kestrel Co's board uses profit after tax as its main performance measure. Profit is $8m, but free cash flow has been negative for three year…
• Kestrel Ltd reports operating profit of $2.4m, capital employed of $12m and a cost of capital of 8%. Its divisional manager rejects a projec…
• Dunmore Telecom is comparing two divisions. Division A has net assets of $10m, mostly old equipment with a net book value that is 80% deprec…
• Kestrel Division has an ROI of 20% and capital employed of $5,000,000. The group's required return is 14%. The divisional manager, whose bon…

Financial performance measurement in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

• ACCA Applied KnowledgePerformance measurement - application
• ACCA Applied SkillsFinancial objectives and relationship with corporate strategy
• CMA FinalPerformance Measurement, Evaluation and Improvement Tools
• CMA IntermediateResponsibility Accounting