Department of Economics
EC 7080: Dissertation
MSc Finance and Business Analysis
2008 / 2009
Incentives in Organization: How to measure company
performance in order to design incentive pay schemes to
executives?
Prepared by: Mhd Said Al Kabbani
ID: 089000203
University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis Table of Content
Chapter One: Introduction
1) Relationship between principal and agent …………………………………………… 6
2) The role of managers and conflict of interest between owners and executives ……. 7
3) Incentives and types of incentives …………………………………………………….. 9
3.1 What are incentives? ……………………………………………………………… 9
3.2 Incentives pay schemes ………………………………………………………….. 10
3.2.1 Annual bonus linked to accounting performance ………………………. 10
3.2.2 Stock Option ………………………………………………………………. 10
3.2.3 Long term incentive plan (LTIP) ………………………………………... 12
3.2.4 Severance arrangements …………………………………………………. 12
4) What to motivate? ……………………………………………………………………. 13
5) Incentives and current financial crisis ……………………………………………… 14
Chapter Two: Literature Review, Previous Studies and Real Examples
1) Problems of designing incentives pay schemes to executives ……………………… 17
1.1 Work effort cannot be monitored ………………………………………………. 17
1.2 Agent attitudes and bearing risk ……………………………………………….. 18
1.3 Dealing with multi agents ……………………………………………………….. 19
1.4 Problems with firms structure ………………………………………………….. 20
1.4.1 The board is relatively weak or ineffectual ……………………………... 21
1.4.2 Absence of a large outside shareholder ………………………………….. 21
1.4.3 Absence of large institutional shareholders ……………………………... 21
1.4.4 Managers are protected by antitakeover arrangement ………………… 21
1.5 Problems with performance measurement that linked to accounting profit … 21
1.5.1 Methodology of accounting ………………………………………………. 22
Page | 1 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis 1.5.2 Accounting policy …………………………………………………………. 24
1.5.3 Providing wrong incentives ………………………………………………. 25
1.6 Problems with maximizing market share price performance ………………… 26
2) Examples of measuring performance ………………………………………………. 28
2.1 Economic Value Added (EVA) ………………………………………………….. 28
2.1.1 EVA Pros ………………………………………………………………….. 29
2.1.2 EVA Cons …………………………………………………………………. 29
2.2 Simon’s Three Wheels Profit Planning ………………………………………… 29
2.2.1 Profit Wheel ………………………………………………………………. 31
2.2.2 Cash Wheel ………………………………………………………………... 31
2.2.3 ROE Wheel ………………………………………………………………... 31
2.2.4 Simon’s three wheels profit plan pros and cons ………………………… 32
3) Example of incentives pay schemes …………………………………………………. 32
3.1 Tesco’s schemes ………………………………………………………………….. 32
3.1.1 Base salary ………………………………………………………………… 33
3.1.2 Short-term incentives …………………………………………………….. 33
3.1.3 Long term incentives ……………………………………………………... 33
Chapter Three: Measuring companies’ performance
1) Non Financial elements ………………………………………………………………. 36
1.1 Corporate structure and information flow between executives, board of
directors and shareholders ……………………………………………………… 36
1.2 SWOT analysis …………………………………………………………………... 38
1.3 Balanced Scorecard ……………………………………………………………... 42
1.4 The link between SWOT analysis and the Balanced Scorecard ……………... 44
2) Financial elements …………………………………………………………………… 45
2.1 The Financial model ……………………………………………………………. 45
Page | 2 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis 2.2 Methodology of the model and data ……………………………………………. 48
2.3 The model ………………………………………………………………………… 49
2.3.1 Revenue ……………………………………………………………………. 50
2.3.2 Net profit …………………………………………………………………... 50
2.3.3 ROCE ……………………………………………………………………… 51
2.3.4 Profit Margin ……………………………………………………………… 51
2.3.5 Salaries over Revenue …………………………………………………….. 52
2.3.6 Interest Cover …………………………………………………………….. 52
2.3.7 Beaver Ratio (Net cash flow) …………………………………………….. 52
3) Results ………………………………………………………………………………… 53
Chapter Four: Conclusion, Limitation and Recommendation
1) Conclusion ……………………………………………………………………………... 54
2) Limitation ……………………………………………………………………………... 55
3) Recommendation ……………………………………………………………………... 55
Bibliography
56
Page | 3 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis List of figures and tables
Figure 1.1: Principle & agent relationship ………………………………………………….. 7
Figure 1.2: Managers & Shareholders utility ……………………………………………….. 8
Figure 1.3:Which is more important job security or dividends ……………………………... 9
Figure 1.4: Value of share option ………………………………………………………….. 11
Figure 2.1: Contract between principal and agent with perfect information ………………. 17
Figure 2.2: Contract between principal and agent with different types of agents …………. 20
Figure 2.3: Marks & Spencer stock performing …………………………………………… 27
Figure 2.4: Simon’s three wheel profit planning …………………………………………... 30
Figure 2.5: Tesco’s incentive pay scheme …………………………………………………. 32
Figure 3.1: Simon’s information needed of top managers in achieving goals and strategies 37
Figure 3.2: SWOT analysis ………………………………………………………………... 38
Figure 3.3: Tesco’s sales growth …………..………………………………………………. 40
Figure 3.4: Tesco’s number of stores growth ……………………………………………… 40
Figure 3.5: Tesco’s group space …………………………………………………………… 41
Figure 3.6: Balanced Scorecard four prospective …………………………………………. 42
Figure 3.7: Internal Value Chain …………………………………………………………... 43
Figure 3.8: Revenue Performance ……………………………………………………….… 50
Figure 3.9: Net profit Performance ………………………………………………………... 50
Figure 3.10: ROCE Performance ………………………………………………………….. 51
Figure 3.11: Profit Margin Performance ……………………………………………….….. 51
Figure 3.12: Salaries over Revenue Performance ……………………………………….… 52
Table 2.1: Three possible outcome for different state of world …………………………… 18
Table 2.2: Risk natural manager’s payoff …………………………………………………. 19
Table 2.3: Risk natural manager’s payoff in uitl …………………………………………... 19
Page | 4 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis Table 2.4: Different methods of depreciation ……………………………………………... 22
Table 2.5: Debenhams & Next assets depreciation ………………………………………... 23
Table 2.6: Inventory Treatment ……………………………………………………………. 23
Table 2.7: Inventory Treatment after increasing stocks …………………………………… 24
Table 2.8: Debenhams profit and cost of sales under two different accounting policy …… 24
Table 2.9: Three possible outcome for different state of world …………………………… 25
Table 2.10: Agent and principal outcome …………………………………………………. 25
Table 2.11: EVA performance of selected US companies (2003) ………………………… 29
Table 2.12: Tesco ROCE target …………………………………………………………… 34
Table 2.13: Share option scheme ………………………………………………………….. 34
Table 3.1: Tesco’s SWOT analysis (2004) ………………………………………………... 39
Table 3.2: example of cash ≠ profit ………………………………………………………... 48
Table 3.3: Performance model weight …………………………………………………….. 49
Table 3.4: Tesco’s Interest Cover ………………………………………………………….. 52
Table 3.5: Tesco’s Beaver Ratio ………………………………………………………...… 52
Table 3.6: Tesco’s overall performance ………………………………………………….... 53
Page | 5 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis Chapter One: Introduction
This chapter will address an important problem in economics, which is a Principal and Agent
problem and how it is related to incentive pay scheme problems for motivating executives
and CEOs to manage companies and organizations in a good way. In addition, this chapter
will shed light on the importance of the incentives problems in the current financial crisis.
1) Relationship between Principal and Agent
Large businesses and multinational companies do have hundreds of thousands of
shareholders. It is not possible for all of them to be actively involved in management, in
such cases a separation of ownership and management is necessary.
Therefore, a Principal authorizes or allocates somebody to carry out her/ his duties to
manage the firm; the agent in turn manages the firm in favour of shareholder’s interest.1
In the real world, each company has a board of directors who are elected to act on behalf
of the shareholders to monitor and appoint CEOs and top management who are involved
to manage the firm, their responsibility is to provide a report to shareholders on the
performance of the company, what its future plans and strategies are and also submit
themselves for re-election to the board. The main advantage is that the board of directors
can hire professional managers to manage the firm. The main roles for board of directors
are2:
A) Establish vision, mission and values: Determine the company's vision, mission,
company policies and review company goals.
B) Select and appoint a chief executive: whom responsible for the administration of the
organization.
C) Set strategy and structure: ensure that the company's organizational structure and
capability are appropriate for implementing the chosen strategies
D) Exercise accountability to shareholders: Understand and take into account the
interests of shareholders and publish the financial position of the firm. The board of
1 D.Schuler. (2002). Principal‐Agent Relationship, [Accessed: 8 Jun 2009 , Available at: http://www.ruf.rice.edu/~schuler/principal‐agent.html] 2 The board of directors: roles and responsibility, Brefi Group Limited [Accessed: 15 Jun 2009 , Available at: http://www.corporatedirector.co.uk/directors_roles_and_responsibilities.html ] Page | 6 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis directors should also monitor relations with shareholders to promote the goodwill and
support.
Figure 1.1: Principal & agent relationship3
2) The role of managers and conflict of interest between owners and executives:
In the previous section we have seen that firms should be managed on behalf of
shareholders and managers should act in favour of the interest of shareholders. The main
duty for executives is to review and evaluate his/her performance regularly on the basis
of a specific job description, including executive relations with the board, leadership in
the organization, and in management of the organization and its personnel.4 The problem
arises when the objectives are differs, shareholders look to maximize their utility by
maximizing wealth which is a firm’s value (shares market price and profit), but the
important question is that: why should managers increase utility for someone else?
Managers and executives utility is different to shareholders (big offices, meeting …etc).
Managers might shirk for their own benefit and this is how the conflict of interest arises,
this is because one party (usually the agent) has more information than the other
(Principal). When the manager is maximizing utility this is not necessarily the same as
3 Principal‐agent problem, Wikipedia, [Accessed: 8 Jun 2009 , Available at:
http://en.wikipedia.org/wiki/File:Principal_agent.png] 4 Overview of Roles and Responsibilities of Corporate Board of Directors, Free management Library Accessed: 15 Jun 2009 , Available at: http://managementhelp.org/boards/brdrspon.htm ] Page | 7 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis profit maximizing. The following diagram shows that when total revenue is increased to
the maximum (maximize shareholders utility) it does not maximize utility for managers
(conflict of interest)
Figure 1.2: Managers & Shareholders utility 5 A survey conducted in five countries showed three countries believing firms should be
managed for shareholders interest; whilst the UK and USA believe firms should be
managed for stakeholders’ interest. The following figure, 1.4 shows the importance for
employees between dividends for shareholders and job security for employees in five
countries, only in the USA and the UK are dividends more important than job security,
while in the Germany, France and Japan job security comes first.
5 M.Hoskins Economics of Organisation lectures notes 2008/2009, University of Leicester, pp.33 Page | 8 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis 120
97
100
89
89
80
60
59
60
Dividends
40
41
Job Security 40
20
11
11
3
0
Japan
Germany
France
UK
USA
Figure 1.3: Which is more important job security or dividends? 6
The conflict of interest arises when managers priority is job security and they mange the firm
to achieve this target, while shareholders priority is dividends, each one of them has a
different priority.
We conclude from previous sections, that there is a conflict of interest between the principal
and agent unless the manager has a stake in the firm, in such cases, his interest is aligned with
shareholders interest. However, the board of directors can still make managers act in favour
of shareholder’s interest even if they do not have a stake in the firm by motivating them and
offering incentives schemes. The next section identifies incentives and briefly spotlights the
different types of incentives.
3) Incentives and types of incentive:
3.1 What are incentives?
Economically, incentives can be defined as a particular factor that motivates a person (can
be CEO, manager or worker) to take an action to make a decision or choice than other
alternatives, and to behave in a certain way almost optimally. General speaking,
incentives are the motivation to take optimal decision.7
6 R.Brealey, S.Myers & F.Allen. (2005). Chapter 2: Present value, the objectives of the firm, and corporate governance – pp. 28, Corporate Finance, 8th edition. 7 Incentives, Wikipedia, [Accessed: 29Mar 2009 , Available at: http://en.wikipedia.org/wiki/Incentive ] Page | 9 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis Basically, incentive rewards can be divided into two sections: Financial incentives (direct
incentives) and non financial incentives (indirect incentives). Bonuses, commissions,
financial rewards and allowances are considered financial incentives. An example of non
financial incentives can be formed as: goods or holidays. Many companies give their
employees discount on buying company products and services. Others offer subsidies and
financial facilities.8
CEOs and top executives compensation can be formed as share options, allowances and
other types on compensation, which will be discussed in the next sections.
3.2 Incentives pay schemes:
This section looks at how companies offer incentives pay schemes to executives and top
management in order to motivate them:
3.2.1 Annual bonus linked to accounting performance:
This is one of the most common incentives schemes used by almost all firms
around the world, the main advantage of this scheme is the simplicity to
implement and it is easy to understand by everyone. General speaking, this
scheme is conditioned by achieving a certain level of profit to get the bonus,
otherwise nothing is received. The measurement of this scheme can be linked to
net profit before interest and tax, ROI (Return On Investment), ROC (Return On
Capital) or Residual Income (RI)9. On the other hand, a firm’s profit appears to be
subject to significant differences of interpretation and various measurements of
profit can be defended, such as the method of accounting (i.e. UK GAAP or
IFRS)
3.2.2 Stock Option:
Stock option or share option can be defined as the right - but not the obligation to buy a certain number of shares at an agreed price at a later date in the future10.
For example, an option contract offer to buy stock at £100 after a month, at the
end of the period (after one month) if the market price is £150, then the buyer can
8 P.Milgrom & J.Roberts, (1992). Chapter 12: Compensation and motivation, pp. 388 – 421. Economics organization and management 9 C.Emmanuel, K.Merchant & D.Otley, (1990). Chapter 9: Performance measurement and Evaluation – pp. 222 – 258, Accounting for management control. 2nd Edition 10 Set up employee share schemes, Business Link. [Accessed: 25 Apr 2009 , Available at:
http://www.businesslink.gov.uk/bdotg/action/detail?type=RESOURCES&itemId=1074480874] Page | 10 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis buy the stock at £100 (called strike price or exercise price) or discard the option
(in this case, the buyer will exercise the option as he will be better off), when the
options were given to the employee, regardless of the prevailing market price.
They can then keep the shares or, if the market price is higher, sell them at a
profit. The main advantage behind share options is aligning the interests of CEOs
to owner / shareholders, since options are valuable only if the stock price remains
above the option's strike price. Usually, the value of the option is closer to the
underlying asset price when the date of the option is about to be exercised. As I
argued in section two, managers in such a case will have a stake in the firm,
which is his interest as well as shareholders to maximize profit. Sometimes stock
option does not provide the correct incentives, the problem behind that is when
the manager is a risk lover, he is willing to take on risky projects and investments.
(This point will be discussed later in chapter two, section 1.2)
Figure 1.4: Value of share option11
The given chart illustrates share option schemes that the manager gets no benefit
if the market price is smaller than the exercise price and he only benefits when
the market price is greater than the exercise price. Clearly, this pay scheme helps
shareholders to maximize their utility by increasing share market price.
11 M.Hoskins Economics of Organisation lectures notes 2008/2009, University of Leicester, pp.51 Page | 11 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis 3.2.3 Long term incentive plan (LTIP):
Long term incentives are defined as: reward designed to improve executives, by
providing rewards tied to the company's performance. Executives must
fulfill various conditions and/or requirements that prove that he or she has
contributed to increasing shareholder value.12 For example, Tesco’s LTIP set a
target to achieve a certain growth for ROEC (Return on Capital Employed) for 5
years and EPS growth for 3 years, managers will be awarded up to 200% of their
base salary. (See chapter 2 section 3.1)
LTIP usually ranged between three to ten years. Stock option can be considered
also as LTIP, a 5 years stock option means that the manager cannot exercise his
right until the 5 years are over. The main idea behind this is to ensure that a
manager does not care only for short term profit and not perform well for long
term. The main difference between stock option incentive and LTIP is that stock
option usually holds for 1 year, while LTIP usually 5 years or more.
3.2.4 Severance arrangements:
Severance arrangement is a payment to a director, manager or executive
associated with employee’s termination of services. 13
In some cases, departing CEOs are given board payments and benefits that are
gratuitous-not required under the terms of the CEO's compensation contract. Such
gratuitous goodbye payments are common even when CEOs perform so poorly
that the board feels compelled to replace them.14
For example, L.Bebchuk & J. Fried mentioned in their article (2003), when
Mattel CEO Jill Barad resigned under fire, the board forgave a $4.2 million loan,
gave her an additional $3.3 million in cash to cover the taxes for forgiveness of
another loan and allowed her unvested options to vest automatically. These
gratuitous benefits were in addition to the consider-able benefits that she received
12 P.Milgrom & J.Roberts, (1992). Chapter 13: executives and managerial compensation, pp. 423 –443. Economics organization and management 13 The Board of Pensions of The Presbyterian Church, Q & A Severance Arrangements Under the Traditional Program. [Accessed: 9 Jun 2009 , Available at: http://web.pensions.org/Publications/pensions/Home/Forms%20&%20Publications/Booklets%20&%20Brochu
res/qa_severance_arrangements.pdf ] 14 L.Bebchuk & J.Fried ‘ Executive Compensation as an Agency problem ‘ Journal of Economic perspectives Vol. 17 No. 3, 2003 pp. 81 Page | 12 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis under her employment agreement, which included a termination payment of
$26.4 million and a stream of retirement benefits exceeding $700,000 per year.
Did he/she deserve all of these compensations?15
4) What to motivate:
First of all, it is important to know specific information about what is the business need
and what do shareholders look for in order to know how to motivate. For example,
P.Milgrom (1992) illustrates that in 1967, McDonalds manager’s base salary was tied to
their meeting corporate standard of quality, services and cleanliness. In 1974 the scheme
was revised by adding to the previous performance cost of control, revenue and training
staff. The training factor was added because in that time the restaurant chain increased
rapidly and faced a shortage of managers. This scheme was updated to meet the business
need to motivate managers to train new staff when the company faced a shortage. This
example illustrates the importance of how incentives can lead the company to be
managed in certain ways. Another example is Applied Materials Inc. The board of
directors set a percentage of the resulting sales revenues for new products; this incentive
pay scheme gives the physicist who led the team that developed a successful product
more than $800,00016
The above two examples give a clear idea of how to motivate managers in a particular
way based on the business need and the incentive schemes can be updated when a new
situation occurs. A wide range of flexibility should exist in management to give
opportunities for intellectual ideas and feedback about business plan which may help to
improve overall output.
The Times Online presented a survey conducted by the National School of Government
and Ashridge Business School. It was based on 1,394 senior and middle managers and
showed that the two most common factors for motivation were, a high basic salary and
the opportunity to learn and develop. The results illustrated that just over half, 55%, of
15 L.Bebchuk & J.Fried (2003) ‘ Executive Compensation as an Agency problem ‘ Journal of Economic perspectives Vol. 17 No. 3, 2003 pp. 81 16 P.Milgrom & J.Roberts, (1992). Chapter 12: Compensation and motivation, pp. 388 – 421. Economics organization and management Page | 13 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis public sector managers, described their leaders as effective, compared with 74 per cent of
managers in the private sector.17
To sum up, it’s important for owners to know what is the best motivation for managers
and apply the incentive scheme based on business need and company business plan.
5) Incentives and current financial crisis:
This section illustrates the importance of incentives and bonuses during the current
financial crises by demonstrating several examples.
-
In March 2009, the biggest insurance company, American International Group
(AIG), paid bonuses of around $165m after their government bailout in December
2008 ($173 Billion). AIG chiefs faced an angry US Congress, which caused
President Obama to vow to pursue “every single legal avenue” to block the $165m18.
The firm was performing badly and occured losses. How can a company pay such a
huge amount in bonuses, when at the same time it faced financial problems and
would have been bankrupt without Congress financial aid? This indicates that the
bonuses were not linked to performance.
-
An investigation by US Congress has been carried out, investigating $3.6B in
cash bonuses to Merrill executives.19 Merrill has reported a loss around $12.73
per share for 2008 and was taken over by Bank of America after liquidity
problem.20 Similarly, how do these executives deserve any bonus while the bank
reported a loss? Again bonuses did not link to performance.
-
The federal bailout to car makers in the USA prohibits bonuses to senior
executives. Car makers such as Ford and GM have been given 60 days to prepare
a restructure plan, Congress does not want car makers more than 80 years old to
17 C.Lewis (2008). What motivates managers? Times Online [Accessed: 10 Jun 2009 , Available at: http://business.timesonline.co.uk/tol/business/industry_sectors/public_sector/article4916162.ece ] 18 A.Andrew (2009), Obama vows to fight AIG bonuses. Financial Times [Accessed: 10 Jun 2009 , Available at:http://www.ft.com/cms/s/0dd26124125d11deb8160000779fd2ac,Authorised=false.html?_i_location=http
%3A%2F%2Fwww.ft.com%2Fcms%2Fs%2F0%2F0dd26124125d11deb8160000779fd2ac.html&_i_referer=http
%3A%2F%2Fsearch.ft.com%2Fsearch%3FqueryText%3DObama%2Bvows%2Bto%2Bfight%2BAIG%2Bbonuses%
26aje%3Dtrue%26dse%3D%26dsz%3D ] 19 S.Connor (2009), Merrill’s $3.6bn bonuses under fire. Financial Times [Accessed: 10 Jun 2009 , Available at: http://www.ft.com/cms/s/0/ea5bfba6‐1d7e‐11de‐9eb3‐00144feabdc0.html ] 20 Merrill Lynch & Co. Inc. Analyst Estimates. Yahoo! Finance, Accessed: 10 Jun 2009 , Available at: http://finance.yahoo.com/q/ae?s=MER ] Page | 14 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis bust out and at the same time they want efficient management and a restructure
plan so they can compete in the market especially after new countries have
entered the market such as China and India. Until then, Congress will prevent
bonuses until they see a real improvement in companies performance.21
All these examples and many other cases have been raised after the current financial
crisis which indicate those executives’ incentives are controversial issues. The
problem is that many firms are paying millions of dollars in bonuses and incentives
regardless how the firm performs and in many cases firms have big losses.
Executives should only be paid for strong performance and hard efforts and not when
they shirk their responsibilities. Another point should be considered, who authorizes
all of these payment to executives? It is not logical for executives to authorize
bonuses to themselves.
The problem of incentives linked to performance is also important in the normal economic
climate. For example, Marks and Spencer increased revenue in 2008 by 5.1% in comparison
with 200722.
Do executives deserve a bonus based on these figures (let’s assume an
incentives schemes based on revenue)? Several questions should be asked before giving an
answer to that question: What is the industry average revenue? Is the growth of revenue real
(increasing sold goods) or nominal “price inflated“ (sold the same goods but increasing the
price)? Does increasing revenue indicate successful management? Although, revenue
increased, it might be the total cost increased by more than 5.1% and the extra gain is wiped,
this is the problem with financial statements. (Will be discussed in depth in chapter two,
section two)
In conclusion, this chapter explained the relationship between Principal and Agent and the
causes of conflict of interest. Shareholders look to maximize a firm’s value, while managers
look to maximize their own benefit (shirking). The solution to this problem is either,
managers possess a stake in the firm or by offering an incentive pay schemes to induce
managers to manage the firm in favour of shareholders. As discussed above, it is optimal to
shareholders to decide how they want the firm to be managed as a starting point, then
discover what the business need is in order to motivate managers. Finally, incentive problem
21 D.Milmo. The Guardian, Bail‐out bill for car makers nears passage [Accessed: 19 Apr 2009, Available at:
http://www.guardian.co.uk/business/2008/dec/08/gm‐chrysler‐bail‐out]
22 Marks and Spencer annual report 2008 [Accessed: 19 Apr 2009, Available at http://corporate.marksandspencer.com/investors/reports_publications/2008] pp.57
Page | 15 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis is important in any economic situation. However, the biggest concern with regards to
incentives is during a recession.
Page | 16 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis Chapter Two: Literature Review, Previous Studies and Real Examples:
After defining the problem in the first chapter, this chapter will focus on the following issues:
Firstly, problems that owners face in designing incentives pay schemes to executives, after
that I will demonstrate examples of performance measurement, then examples of how
companies design incentive schemes. Finally, shed light on the elements of how to measure
CEO performance.
1) Problems with designing incentives pay schemes to executives:
When owners design incentive schemes for managers to act on their behalf, they face
several problems which make designing these schemes difficult.
1.1 Work effort cannot be monitored:
In the case of perfect information, the principal can monitor every single effort, the
contract between agent and principal can be easily formed. When a principal observes
low effort, an agent is paid a low wage, when high effort is observed, an agent is paid
a high wage.
When the principal employee an agent to manage the firm, he/she depends on the
available information, past performance and experience of the agent which indicates
that agent is talented and hard working if the past experience was good.
Figure 2.1: Contract between principal and agent
Figure 2.1 shows when the principal can distinguish between high and low efforts; it
is easily to set up a contract and determine the wage for an agent. However, this is a
theoretical case; in the real world work effort cannot be monitored. It is impossible for
owners to monitor every single thing in the firm. When the owners of the firms are
Page | 17 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis thousands of shareholders, there is no way for all of them to be involved in daily
tasks; the principal does not know if the manager is either working hard or shirking,
he can only observe results, output and financial statements which could indicate the
effort of the managers. The problem of salaries and wages should be made known to
the agent before they start working (the agent might accept or reject the work if the
salary does not cover ‘Reservation Pay’ which is the minimum amount that the agent
is willing to work). The principal cannot say to the agent “your salary will be
determined when the result or output observed is to a high or low effort”
1.2 Agent attitudes and bearing risk:
If risk neutral managers can be motivated by particular incentives scheme, the same
scheme might not motivate risk averse managers, the following example illustrates the
idea23:
Assume there are two managers; one is risk neutral he needs:
£16,900 to stay in job and shirk,
and £22,500 if he works hard
The other manager is risk averse with the following utility function:
.
if he shirks
.
and
if he works hard
(R is total remuneration: basic salary and any performance related pay, the manager
requires 130 utils to stay in job), suppose the following outcomes with equal
probability
Outcomes
Expected
Revenue
1
2
3
Not Shirk
60,000
60,000
30,000
50,000
Shirk
30,000
60,000
30,000
40,000
Table 2.1: Three possible outcome for different state of world
Suppose that two managers are offered the same contract: no basic salary but allowed
to keep all cash earned in excess of £27,500
23 M.Hoskins Economics of Organisation lectures handout notes 2008/2009, University of Leicester, pp.18 Page | 18 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis Risk neutral manager’s payoff:
Outcomes
Agent’s
Exp. Inc.
Agent’s
Surplus
Pri. Inc.
1
2
3
Not Shirk
32,500
32,500
2,500
22,500
0
27,500
Shirk
2,500
32,500
2,500
12,500
-4,400
-
Table 2.2: Risk natural manager’s payoff
It is clear that the manager will not shirk, as his surplus is better than shirking (if he
shirks he does not cover reservation pay 12,500 < 16,900).
Risk averse manager’s payoff:
Outcomes
Not Shirk
Agent’s
Exp. Util
Agent’s
Surplus
Pri. Inc.
1
2
3
160.29
190.29
30
116.85
-13.43
-
50
180.29
50
83.43
-36.43
-
Shirk
Table 2.3: Risk natural manager’s payoff in uitl
It is clear that the agent does not cover reservation pay in both cases and he will not
work.
The above example illustrates clearly how the risk averse manager will not work if he
is offered the same contract as the risk neutral manager. Designing incentives differs
when the agent: risk averse than risk neutral, to be more precise, risk averse agent
costs more to employ when monitoring is no longer possible to induce him to accept
the job. One of the disadvantages for risk averse is he costs more to hire than risk
neutral. 24
On the other hand, risk lover agent might undertake risky investments in order to
maximize profit (high risk, high profit) and increase his pay off as a consequence to
give the illusion his effort levels are high.
1.3 Dealing with multi agents:
In the previous case, the principle cannot monitor the agent but he knows that he is
dealing with one agent. The situation will be more complicated when the principle
24 R.Gardner, (1995). Chapter 10: Games between a principal and an agent. pp. 288 – 291. Games for Business and Economic Page | 19 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis deals with many types of agents. In reality, owners assign more than one agent, for
example, high effort on the part of a good agent is different than high effort on the
part of mediocre agent (the output for a good manager is higher than mediocre), and
the same thing as low effort on the part of a good agent is different than low effort on
the part of mediocre agent. The Principal cannot distinguish and he almost offers the
same contract for both of them, the good agent tends to be more professional more
than the mediocre agent, thus incurring an additional agency cost. It is not easy to
know the types of agent before the contract is drawn up; usually the Principal relies
on the agent’s experience in previous work. 25
Figure 2.2: Contract between principal and agent with different types of agents
According to figure 2.2, the Principal cannot distinguish between good and mediocre
agent as the same contract will be offered if high effort is observed (the same offer but
good manager gives higher outcome) and similarly, another contract for low effort
(good manager gives higher outcomes).
1.4 Problems with firms structure:
L.Bebchuk and J.Fried (2003) in their article “Compensation as Agency Problem“
pointed out that the managerial power approach predict that pay will be more and / or
less tied to performance in firms in which managers have relatively more power.
25 R.Gardner, (1995). Chapter 10: Games between a principal and an agent. pp. 291 – 296. Games for Business and Economic Page | 20 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis However, there are many factors that affect managers and executives’ power, some of
them are:
1.4.1
The board is relatively weak or ineffectual: The board tends to be weak when
the board is large and especially when many of the outside directors have been
appointed by the CEO, which could cause them to feel a sense of obligation to
the CEO. Cyert, Kang and Kumar, 2002; Core, Holthausen and Larcker,
(1999) found that CEO compensation is higher by 20% - 40% if the CEO is
the chairman of the board. 26 This makes the board weaker as the CEO acts as
chairman and CEO at the same time. Corporate governance suggest to separate
the role of chairman to be played be the CEO.
1.4.2
Absence of a large outside shareholder: With large outside shareholders this is
likely to result in closer monitoring and it can reduce executives influence
over their compensation. L. Bebchuk and J. Fried pointed out in an
examination of Standard & Poor's 500 firms between 1992 and 1997, that a
higher concentration of shareholders results in a significantly smaller amount
of share options grants to CEOs. This means when outside shareholders are
large, CEO’s compensation is linked more to their performance.
1.4.3
Absence of large institutional shareholders: A survey conducted to examine
almost 2000 CEO’s pay in L.Bebchuk and J.Fried (2003) showed that large
institutional shareholders can result in better monitoring and compensation is
more sensitive to performance.
1.4.4
Managers are protected by antitakeover arrangement: When managers feel
more secure, they attempt to get higher compensation. A case study in the
same article showed that when CEOs are protected by antitakeover, they tend
to reduce their holdings of shares by 15%, because the shares were not
necessary for maintaining control.
1.5 Problems with performance measurement that linked to accounting profit:
This section discusses one of the most important and controversial issues in designing
incentive schemes. As I discussed earlier in chapter 1 section 3.2.1, bonuses linked to
accounting profit is one of the most common schemes and it is used by almost all
26 Cyert, Richard, Sok‐Hyon Kang & Praveen Kumar. 2002. Corporate Governance, Take‐ overs, and Top‐
Management Compensation: Theory and Evidence. Management Science. 48:4, pp. 453. Page | 21 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis firms all over the world. The question that arises is how owners (the board of
directors) can determine the key indicators to measure company performance?
However, financial statements such as income statement, balance sheet, cash flow
statement, profit and loss account and financial ratios give a good overview about the
firms position, it is insufficient to evaluate the business and the effort of executives
because accounting profit does not reflect their performance correctly because of the
following problems:
1.5.1
Methodology of accounting:
Net profit may significantly change for a company for one period based on the
method used in accounting; the way that accountants treat assets may differ in
the same company which follows the same accounting procedure and policy.
Calculating depreciation is a famous example, each company uses different
method for each asset. In some cases the same asset for two different
companies might not be treated in the same way. For instance, Debenhams
uses “A Straight-Line basis” for depreciation assets,27 while Next uses
estimated residual values, based on current prices at the balance sheet date.28
Straight Line
p.a.
Straight Line
(full year)
Reducing
balance
p.a
Reducing
balance (full
year)
Cost 1.7.08
100,000
100,000
100,000
100,000
31.12.08 Dep.
10,000
20,000
10,000
25,000
31.12.09 Dep.
20,000
20,000
22,500
18,750
31.12.10 Dep.
20,000
20,000
16,875
14,063
B Val. 31.12.10
50,000
40,000
50,625
42,187
Table 2.4: Different methods of depreciation 29
The example above assumes a life of 5 years and a reducing balance of 25%
for the assets worth 100,000. It is clear how the book value for the same asset
differs based on the method used in depreciation.
27 Debenhams annual report 2008 [Accessed: 19 Apr 2009, Available at: http://www.debenhamsplc.com/deb/ir/report/2008re/ ] pp.66 28 Next annual report 2008 [Accessed: 23 Apr 2009, Available at: http://www.investis.com/reports/nxt_ar_2007_en/report.php?type=1&page=50 ] pp.45 29 J.O’Hare, Financial Statement Analysis lecture notes. 2008/2009, University of Leicester. Lecture 1 pp. 19 Page | 22 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis Moreover, numbers of years may also differ from one company to another for
the asset.
Asset
Debenhams
Next
4 – 5 Years
6 – 15 Years
Office Equipments
10 Years
10 – 25 Years
Vehicles
4 Years
2 – 6 Years
3 – 6 Years
2 – 6 Years
Fixtures and Fittings
IT and Computers
Table 2.5: Debenhams & Next assets depreciation
The above table shows similar assets with different years to depreciate, there
is a significant difference between Debenhams and Next for depreciating
fixtures and fittings.
Depreciation affects the profit and loss account which means it affects the net
profit value, not because of how managers perform, therefore, executives’
compensation which is linked to accounting profit may change based on the
method of depreciation (can be higher if assets depreciated for long period).
Another controversial issue in accounting is inventory evaluation. According
to accounting principles, the cost of inventories should reflect all costs and the
share of factory overheads in bringing the items to selling the location, this
leads to another problem. For example, let’s assume a firm sells 10,000 units
(£10 per unit), the cost is £5/unit item and the factory cost (fixed cost) is 40:
100,000
Sales (10,000 @ £10)
Cost of goods manufactured (10,000 @ £5)
(50,000)
Other factory costs (e.g. rent)
(40,000)
(90,000)
Total cost
Profit
10,000
Table 2.6: Inventory Treatment
Now assume that an incentives pay scheme allows the manager to get a bonus
if he achieved a profit equal to or more than 25,000.
Simply, the manager manufactures 20,000 units instead of 10,000 and the
financial statement will show the following:
Page | 23 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis 100,000
Sales (10,000 @ £10)
Cost of goods manufactured (20,000 @ £5)
(100,000)
Other factory costs (e.g. rent)
(40,000)
Total cost of 20,000 units
(140,000)
70,000
Still in stock (not sold)
cost of goods SOLD
(70,000)
Profit
30,000
Table 2.7: Inventory Treatment after increasing stocks
30
Table 2.6 showed a different method to deal with inventory which tripled the
profit, the surprising point is that this method is legal, the manager increases
profit three times by manufacturing more units.
Although the manager
receives a benefit when manufacturing more units because the fixed cost does
not change, this might lead to inefficient management if the manager keeps
increasing inventory levels and later on will face a problem when selling large
stocks beside the cost of holding stocks increases.
1.5.2
Accounting policy:
A major problem arising with a financial statement is that whatever
accounting policy the firm is following, be it UK GAAP (Generally Accepted
Accounting Principles) or IFRS (International Financial Reporting Standards).
For example, the annual report 2008 for Debenhams showed two income
statements for 2005, one under UK GAAP and the second under IFRS for the
same year31.
UK GAAP
IFRS
1,270.9
1,293.4
Operating Profit
300.7
341.3
Profit before taxation
50.7
87.6
Cost of Sales
Table 2.8: Debenhams profit and cost of sales under two different accounting policy
30 Table 2.3 & Table 2.4 are from the same source: J.O’Hare, Financial Statement Analysis lecture notes. 2008/2009, University of Leicester. Lecture 2 pp. 56‐59 31 Debenhams annual report 2008 [Accessed: 19 Apr 2009, Available at: http://www.debenhamsplc.com/deb/ir/report/2008re/ ] pp.91 Page | 24 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis The above table shows clearly how cost of sales and profit vary in 2005
between UK GAAP and IFRS. The board of director should be aware of this
when they change accounting policy from one system to another. When a firm
changes to a new policy it is better in the first year to present both policies.
Assume a CEO’s bonus was based on profit before taxation, his compensation
would change by doing nothing related to his effort, it would be because of
changing the policy of accounting.
1.5.3
Providing wrong incentives:
In some specific cases, owners provide wrong incentive schemes, the
following example illustrates the idea, assume there are three states of worlds
and each one has equal probability:
Outcomes
Expected
Revenue
1
2
3
Not Shirk
60,000
60,000
30,000
50,000
Shirk
30,000
60,000
30,000
40,000
Table 2.9: Three possible outcome for different state of world
The agent needs an expected income of at least 16,900 (reservation pay) to
stay in the job and shirk, if monitoring were possible, he would requires
22,500 to stay and work hard (not shirk).
If an incentive scheme is offered a basic salary of 10,000 plus 20% of the cash
outcomes, the agent and principal income will be the following:
Outcomes
Agent’s
Exp. Inc.
Agent’s
Surplus
Pri. Inc.
1
2
3
Not Shirk
22,000
22,000
16,000
20,000
-500
30,000
Shirk
16,000
22,000
16,000
18,000
1,100
22,000
Table 2.10: Agent and principal outcome
It is clear that the agent maximizes his surplus by shirking and the principal
income is 22,000 (if the agent does not shirk principal income will be higher,
but agent will not work because his surplus is negative). 32
32 M.Hoskins Economics of Organisation lectures handout notes 2008/2009, University of Leicester, pp.18 Page | 25 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis There are several drawbacks to this model, firstly, no one can determine what
the reservation pay is for each industry and even if the agent knows he will not
tell the principal, but usually there is a range or average salary for each
industry. Another point is that no one knows what the state of world will be.
However, this model is a theoretical example; it is very similar to what
happened in reality and it is widely common in business. Many firms offer a
salesman or marketing team a basic salary lower than the average (i.e. in our
example 10,000 is lower than reservation pay) plus percentage of sales (i.e. in
our example 20%). This example shows clearly that the incentive scheme does
not make the agent work harder, it motivates him to shirk.
1.6 Problems with maximizing market share price performance:
One of the major tasks that managers should perform, is to maximize the market value
of the firm. The stock market valuation of a firm is considered the present value of
future expected cash flows to its shareholder. N. Jayaraman, A.Khorana, E.Nelling &
J.Covin (2000) argue in their article that “unlike performance measures based on
accounting data, stock-based performance measures are not influenced by firmspecific financial reporting rules which is consistent with an important principle in
corporate finance-that is, a firm's manager should act in order to maximize the
market value of the firm “33 Although the idea is true, to some extent I disagree with
them, it is wrong to measure long term performance based on market share price for
several reasons: first of all, as they argued, market price is not influenced by a firms
accounting data, so how do we compensate managers on something they have not
contributed? Moreover, market prices are influenced by many other factors that
managers cannot control such as economic situations, market risks, market fluctuation
…etc. However, stocks prices should reflect a firms performance, many other factors
influenced the movement of the stock regardless of the company’s performance.
Finally, stocks that go up and down are subject to demand and supply theory, which
also out of the managers control.
Stock prices are not only influenced by a firm’s financial position, as I discussed
external factors affect the prices.
33 N. Jayaraman, A.Khorana, E.Nelling & J.Covin (2000), CEO Founder Status and Firm Financial Performance. Strategic Management Journal, Vol. 21, No. 12 (Dec., 2000), pp. 1215‐1224 [Accessed: 7 May 2009, Available at: http://www.jstor.org/stable/3094454 ] Page | 26 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis It does not make sense to compensate someone who has no continuation or control of
the stock price. Executives are required to maximize shareholders wealth by assessing
how they perform in their management roles and how this contributes to shareholders’
wealth.
Figure 2.3 shows stock performance for Marks & Spencer between 2007 and
beginning of 2009.
34
We can see clearly that M&S stock prices declined gradually
between 2007 and 2009. Does this mean executives management was bad and they
did not maximize shareholders wealth? In fact, Marks & Spencer’s financial position
was better off in 2008 compared with 2007: increasing revenues, gross profit and net
profit which means executives performed very well as financial ratios are better off.
This indicates that the market price can be affected by external factors that cannot be
controlled.
Figure 2.3: Marks & Spencer stock performing 35
Between 1999 and 2000 (where the revolution of technology and internet sectors took
place) many firms such as Yahoo and Microsoft reached their highest stock price ever.
Did managers at that time manage the firm efficiently?
I believe share prices are affected by economic environment (external factors) more
than company financial performance (internal factors) and I therefore think measuring
performance based on market price does not provide good incentives.
34 Marks and Spencer annual report 2008, M&S [ Available at http://corporate.marksandspencer.com/investors/reports_publications/2008 ] pp. 57 ‐ 59 35 Marks & Spencer (MKS.L), Yahoo! Finance [Accessed: 12 Jun 2009, Available at: http://finance.yahoo.com/echarts?s=MKS.L#chart4:symbol=mks.l;range=20061218,20090302;charttype=line;c
rosshair=on;ohlcvalues=0;logscale=off ] Page | 27 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis 2) Examples of measuring performance:
This section discusses two performance measurement models, the first one is EVA
(Economic Value Added) and the other is Simon’s three wheels of profit planning.
2.1 Economic Value Added (EVA):
A.Ehrbar (1998) defines EVA: ‘is a measure of corporate performance that differs
from most others by including the charge against profit for the cost of all the capital
a company employs’.
36
Actually, EVA is considered as a framework for a financial
management and incentives compensation system that can guide every decision a
company makes. The idea behind EVA is the capital charge, what economists call an
opportunity cost. While accounting profit calculates income, they start with revenue
and then deduct costs (wages, material, tax …etc), they do not deduct “Cost of
Capital”; EVA does. EVA calculates the net income after deducting the return
required by investors, which is also called “Residual Income” 37
%
38
Where NOPAT is the Net Operating Profit After Tax (income earned), C% is the
Cost of Capital and I is the investment (Total Capital). EVA recognizes the amount
of capital employed and the amount of additional wealth created because, when the
return on investment is equal to the cost of capital, EVA is equal to zero.
For example, suppose an investment is worth 1,000 million dollars and generates
$130 million profit, if the cost of capital is 10%, then it is equal to $100 million, in
this case EVA will be 130 – 100 = $30 million. This is in addition to shareholders
wealth. EVA only considers earnings after ducting the cost of capital, in other words,
the importance of EVA is that the firm must cover operating costs and cost of capital,
while accounting profit such as earnings per share measure only operating costs.
EVA measures the change in shareholder wealth and not how much profit the firm
generates.
EVA has been used commonly in firms; the following table shows EVA’s for
selected US companies:
36 A.Ehrbar (1998), Chapter 1: The EVA Revolution, pp 1 – 24. EVA The Real Key to Creating Wealth. 37 R.Brealey, S.Myers & F.Allen. (2005). Chapter 12: Agency problems, management compensation and the measurement performance – pp.299 ‐ 321, Corporate Finance, 8th edition. 38 A.Ehrbar (1998), Chapter 1: The EVA Revolution, pp 3. EVA The Real Key to Creating Wealth. Page | 28 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis Company name
EVA
Capital
Invested
Return On
Capital
Cost of
Capital
Wal-Mart
$ 4,525
$ 79,17
12.3 %
6.6 %
Microsoft
4,027
24,577
29.8
13.5
Coca-Cola
2,729
20,503
20.1
6.7
Intel
(57)
31,216
15.6
15.8
Dow Chemical
(1,503)
44,158
3.6
7.0
Viacom
(5,508)
96,515
3.5
9.2
IBM
(7,505)
108,926
4.6
11.5
Table 2.11: EVA performance of selected US companies (2003) 39
The above table shows that the highest ROC is not necessarily the highest EVA,
Microsoft is the highest ROC, but Wal-Mart has the Highest EVA. This is because
Wal-Mart has more capital invested, while Microsoft ROC is 29.8% to small capital
24,577 another reason is that Wal-Mart’s cost of capital tends to be lower than
Microsoft.
2.1.1 EVA Pros:
EVA suggests investing if, and only if, increase in earnings is enough to cover
the cost of capital. Another advantage of EVA is that it makes the cost of
capital visible, as EVA can improve by either, increasing earnings or reducing
capital employed.
2.1.2 EVA Cons:
The First drawback is that, how can you judge whether a low EVA caused bad
management or stems from outside factors that are out of a manager’s control.
Another disadvantage is that which data and on which basis should be used. For
example, a start up venture, where there may be heavy capital used to start the
project which gives low or negative earnings in the first years, this leads to
negative EVA even when the net present value might be positive.
2.2 Simon’s Three Wheels Profit Planning:
Robert Simon (1999) suggests that managers should consider three points in order to
build a profit plan. Firstly, a firm’s strategy should create economic value (this
39 R.Brealey, S.Myers & F.Allen. (2005). Chapter 12: Agency problems, management compensation and the measurement performance – pp. 313, Corporate Finance, 8th edition. Page | 29 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis assumption is convenient with EVA). Secondly, the firm should have enough cash to
fund their strategy and pay expenses (wages, factory cost…etc) and finally, the firm
should satisfy and create enough value providing the financial resources that which
needs to fund long term investment. The model that Simon suggests was based on:
Profit wheel, Cash wheel and ROE wheel, the following diagram illustrates the
model:
Figure 2.4: Simon’s three wheel profit planning
40
40 R. Simon (1999), Chapter 5:Builiding a Profit Plan, pp. 79, Performance measurement and control systems for implementing strategy Page | 30 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis 2.2.1 Profit Wheel:
The profit plan summarizes the expected revenue inflows and expenses
outflow for a specified future accounting period (usually one year). The First
step is estimating roughly the level of sales because profit is determined by
revenue growth and the level of operating expenses is a function of sales
volume.
The second step is forecasting operating expenses which is divided into two
categories: Variable cost, which varies proportionally with levels of
production such as raw materials, factory overheads … etc, while fixed costs
do not vary directly with the level of production such as wages.
The third factor is calculating expected profit by deducting operating expenses
from sales. To close the profit wheel circle, the firm could reinvest in assets to
generate more sales and profit.
2.2.2 Cash Wheel:
The cash wheel circle shows sales of product and services generate cash and
accounts receivable (which also turned into cash), this cash is used to produce
inventory, which in turn is used to generate more sales. Depending on a firm’s
industry and its business plan, it might need more or less operating cash.
Usually, a high level of inventory requires more operating cash.
One of the most common problems with cash is when the cash needed to
finance the business, it exceeds cash reserves or maximum borrowing capacity,
and then the profit plan is not feasible. Such cases in fast growing businesses
or at the beginning of new businesses is known as “Overtrading”. Basically,
managers estimate operating cash needed by deducting cash paid to suppliers
and operating expenses from cash received from clients (generated from
selling goods).
2.2.3 ROE Wheel:
When a firm earns more profit, it will be better off to have more resources to
invest, it will be able to generate more profit in future and pay high dividends
to shareholders. Shareholders look to maximize their wealth, so they care
⁄
about return on equity.
Page | 31 ′
University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis The shareholder’s equity portion of the balance sheet shows the total original
investment by shareholders, plus accumulated business profit that occur.41
2.2.4 Simon’s three wheels profit plan pros and cons:
The main advantage of this model is that the three wheels are linked together;
sales generate cash which in turn produce more inventory, profit comes after
deducting expenses which can be reinvested in assets to generate more profit
and increase the ROE for shareholders. This model takes into account profit
and cash in calculation (profit and cash is not the same thing, firm can generate
more profit by selling goods on credit). Another positive point is that this
model considers economic value and ROE to shareholders where EVA does
the same.
On the other hand, this model is using a forecasting basis to estimate sales,
revenue, cash inflow and outflow, which are sometimes out of manager
control. For example, estimating sales and revenue are subject to external
factors such as: macroeconomic factors, client demand and competitors
actions.
3) Example of incentive pay schemes:
This section will illustrate an example for Tesco’s incentive pay scheme. Tesco is one of
the biggest chain of supermarkets all over the world.
3.1 Tesco’s schemes:
Tesco’s schemes categorize as the following figure
Figure 2.5: Tesco’s incentive pay scheme 42
41 R. Simon (1999), Chapter 5:Builiding a Profit Plan, pp. 77 ‐ 109, Performance measurement and control systems for implementing strategy 42 Tesco annual report 2008, Tesco Plc [Accessed: 13 Jun 2009, Available at: http://www.tescoreports.com/] pp. 26 Page | 32 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis 3.1.1
Base salary:
Base salaries are determined by the responsibilities, skills and experience of the
individuals against a benchmark determined by reference to other large retailers,
major FTSE 100 companies and international comparator companies.
3.1.2
Short-term incentives:
The Company operates an annual bonus scheme, which is delivered part in cash
and part in shares. The Remuneration Committee has typically made awards of
up to 100% of salary paid in cash at the end of the year and a maximum of
100% of salary paid in shares with compulsory deferral for three years. The
cash element is earned through achievement of EPS growth targets and specific
corporate objectives. The share element is also based on an assessment of
shareholder returns. The Committee considers performance against the FTSE
100 and a comparator group of international retailers that includes Ahold,
Carrefour, J Sainsbury, Metro, Morrisons, Safeway Inc, Target and Walmart.
3.1.3
Long term incentives:
A) Performance Share Plan (PSP):
This scheme provides the opportunity to earn rewards for achieving superior
long-term performance, by ensuring a focus on long-term business success.
For all the Executive Directors, bonuses are awarded up to 100% of salary
(divided in two settlements) will vest subject to the achievement of Group
ROCE (Return On Capital Employed) targets. The first 75% of the awards
will vest on a straight-line basis at the end of the three-year performance
period based on maximum performance against target. The remaining 25% of
the award will vest for superior Return on Capital performance. The
Committee will take into account a number of factors including: the level of
ROCE achieved, the expected ROCE sales growth and underlying profit
growth; and whether this reflects on other developments in the marketplace
and finally based on whether capital spends is in line with strategic
objectives. The following table shows the target of ROCE till 2014. 43
43 Tesco annual report 2008, Tesco Plc [Accessed: 14 Jun 2009, Available at: http://www.tescoreports.com/ ] pp. 28 Page | 33 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis ROCE
Max. performance
Target performance
2010/2011
6%
4%
2011/2012
9%
6%
2012/2013
11%
8%
2013/ 2014
12%
10%
Table 2.12: Tesco ROCE target 45
B) Share option:
Share option is offered with a value of 200% of salary granted to the
executive directors on an annual basis. Share option schemes are divided in
two sections as the following table based on EPS growth over three years:
Share Option
First 100%
Second 100%
Target EPS growth
9%
15%
Table 2.13: Share option scheme 44
C) US Long-Term Incentive Plan:
This scheme is designed for US CEOs and management only, the Tesco
Group is seeking to build a substantial presence in the US. US CEOs will
vest a maximum of 2 million shares, and another 1.5 million shares to any
other participant. This scheme will be conditional on the financial
performance of the Company’s US business, based on the achievement of
stretching earnings before interest and tax (EBIT) and return on capital
employed (ROCE) targets set by reference to the US long-term business
plan. The Remuneration Committee has the responsibility to review the
targets in light of the scale and scope of the US business in order to ensure
that they remain appropriate and challenging.
D) Group New Business Incentive Plan:
A key part of the Group’s long term strategy is to consider new business
ventures which have the potential for significant long term value creation for
shareholders. This scheme offers 2.5 million shares to the Group CEO and 2
million shares to any other participant. The Remuneration Committee has the
responsibility to determine achievement against Group and international
performance conditions.
44 Tesco annual report 2008, Tesco Plc [Accessed: 14 Jun 2009, Available at: http://www.tescoreports.com/ ] pp. 29 Page | 34 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis Although, this scheme gives a good overview of how companies motivate their
executives, it still does not give information on how the Remuneration Committee
determines the target and how these targets set up. Tesco considers these details
confidential information and they cannot not be published because of commercial
sensitivity.
To sum up this chapter, owners (or board of directors who take on the role of owners to set up
executive’s pay) face many difficulties in designing incentive pay schemes. While, some
incentives might provide the wrong schemes, others provide good ones, but even then it only
takes financial performance into account taken from financial statements, which are subject
to several determining factors which affect the means of measurement.
There is no doubt that financial performance is critical, specifically to know how the firm is
doing in respect of profitability, liquidity and overall financial position. On the other hand, I
strongly believe that to evaluate any business it is not enough to look only to financial
factors. Non financial factors also play an important role which board of directors should be
aware of.
Page | 35 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis Chapter Three: Measuring companies’ performance:
I can derive from the first two chapters that the owners (or the board of directors) face many
problems in designing incentive pay schemes, and encounter great problems measuring
accounting profit. Moreover, most incentives schemes measure only financial elements. I
believe that to measure performance, a firm should cover two elements, which will be
discussed in this chapter. The first will discuss SWOT analysis and Balanced Scorecard to
assess non financial elements, whilst the second part will design a financial model based on a
combination of financial ration to assess the financial position of the firm.
A case study will be conducted in this chapter, which will examine Tesco in comparison to
the Food and Drinks sector in the UK.
1) Non Financial elements:
1.1 Corporate structure and information flow between executives, board of directors
and shareholders:
It is important to build correct structures between executives, board of directors and
shareholders. To do so; there should be a high level of transparence to ensure all
information (or at least most of the information) is available for all parties. The
problem that arises here is that; executives do not like to publish all the information
because of competitive sensitivity and confidentiality. I believe one of the tasks that
the board of directors should handle is to manage what information should be released
to the public.
First of all, when the board of directors meets with executives to discuss business
plans and strategies, it is preferable that they run a survey beforehand determining
what shareholders look for? Do they look for high growth, long term profit, growth in
dividends …etc? and based on that, they build business plans and create incentives
schemes for executives. Another idea could be that the board of directors and top
management levels create two different business plans (including management
salaries and incentives) and let shareholders decide which plan they want by election.
The main idea behind that is to let shareholders know what the executives are going to
do in the next three to five years. At the end of each year, the board of directors meet
with executives and discusses what has been achieved from the plan? What
difficulties they faced? Compare between the actual that has been achieved and
Page | 36 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis business plan and determine the reasons of deviation. They should review the plan and
make adjustments if needed, then publish the information to shareholders.
Another point to be considered is financial control and how the financial sources
should spend. The board of directors should determine a limit amount for executives
to spend, any expenses above the limit should get an approval from the board. In this
way, the board can reduce management shirking. (i.e. Enron executives have a private
jet, do they deserve it?). Executives used to publish the minimum of disclosure of the
information that satisfy and meet regulation and authorities; they claim that an
increased level of information is sensitive and critical to competitors. Some
information considered as secret to the business should not be known to everyone.
The following diagram was suggested by R. Simon (1999), these data is essential to
conduct SWOT analysis which will be discussed in the next section.
Figure 3.1: Simon’s information needed of top managers in achieving goals and strategies 45
45 R. Simon (1999), Chapter 4: Using information for performance measurement and control, pp. 58. Performance measurement and control systems for implementing strategy Page | 37 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis 1.2 SWOT analysis:
This section will focus on SWOT analysis and the intended benefit from this analysis.
SWOT analysis is a strategic planning method for assessing projects or business ventures
and understanding of decision-making used to evaluate the Strengths, Weaknesses,
Opportunities, and Threats involved, it is identifying the internal and external factors that
are favorable and unfavorable to achieving that objective. 46
The usefulness of SWOT can be seen in how we can use and capitalize on Strengths, the
possibilities of improving Weaknesses, the available Opportunities and how a firm can
exploit and benefit, and finally avoid and eliminate Threats and how a firm can deal with
them.
SWOT analysis is also useful in determining two factors; the first one is internal factors,
which contribute to strengths and weaknesses, the other is external factors which are
opportunities and threats, external environments to the firm. Figure 3.2 illustrates the
concept of SWOT analysis.
Figure 3.2: SWOT analysis 47
However, a SWOT analysis is not required by the authorities. I believe it must be
disclosed to shareholders. Executives should clarify how they deal with each part of the
46 SWOT Analysis, Wikipedia. [Accessed: 17 Jun 2009, Available at: http://en.wikipedia.org/wiki/SWOT_analysis ] 47 SWOT Analysis, EXCELSIA Consulting Resources. [Accessed: 17 Jun 2009, Available at: http://www.excelsia.ch/htmlgb/blog/index.php?entry=entry090108‐234052 ] Page | 38 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis elements in the SWOT analysis. For example, executives should show how they
capitalize on strengths, how they improved weakness and what action was taken in order
to control and reduce threats.
Shareholders can have a better overview about a company performance when they know
what the Strengths, Weaknesses, Opportunities, and Threats are and how executives
contribute to deal with each factor. The board of directors should assess and review
executive’s contribution and take this into account for overall performance.
Datamonitor (2004) conducted a SWOT analysis about Tesco; the report shows the
following details:
Strengths
Weaknesses
Increasing market share: it holds a 13%
share of the UK retail market
Insurance: in 2003 Tesco Personal Finance
reached one million motor
insurance policies
Tesco Online: one of the world’s biggest
online supermarket
Brand Value
UK market leadership reinforced
Opportunities
Increasing debt: Tesco is not expected to
reduce its debt meanwhile
Reliance upon the UK market: 73.8% of
2003 revenues dependent on the UK
market
Signs point to serial acquisitions
Non-food retail: it has sales of £7 billion in
non-food, some 23% of the total. Its aim to
be as strong in non-food as we are in food
Health and beauty: Tesco’s UK health and
beauty ranges continue to grow, and it is
currently the fastest growing skincare
retailer in the market
Further international growth: Tesco now
operates in 6 countries in Europe and in 5
countries in Asia
UK structural change could spark a price
war with its competitor
Threats
Overseas returns could fall: economic
conditions, competitor action, or failure in
Tesco’s business model in overseas
Competitors merge challenge: Since the
US shopping giant Wal-mart purchased
Asda, Tesco’s rank as the top UK
supermarket has been threatened
International expansion: International
growth is expensive. Entering new
markets with a new brand requires heavy
investment, operation expense and
marketing, as well as land prices
Table 3.1: Tesco’s SWOT analysis (2004) 48
48 Tesco Plc (2004), Datamonitor [Accessed: 18 Jun 2009, Available at: http://people.exeter.ac.uk/wl203/BEAM011/Materials/Lecture%204/TESCO%20Company%20Profile.pdf ] Page | 39 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis The above SWOT analysis was conducted by an outsourcer, who has the advantage of
fairness instead of being conducted by the company, thereby lending itself to bias. It
seems that Tesco management was successful for the following reasons:
Figure 3.3: Tesco’s sales growth
Figure 3.3 shows that Tesco increased sales gradually between 2004 and 2008, and
doubled their international sales (capitalize on strength “Increasing market share” and
get benefit out opportunities “further international growth”)
Figure 3.4: Tesco’s number of stores growth
Page | 40 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis The above figure shows how Tesco has tripled the number of stores in the international
markets, whilst enjoying a slight growth in the UK market. (They turn a threat
“International expansion” to opportunities).
Figure 3.5: Tesco’s group space 49
The final figure illustrates how Tesco increased more than doubled the space of retail
chain in the international markets; again this shows how they capitalize on strengths and
improve weaknesses (Reliance upon the UK market) by relying on international markets
and not only UK markets.
To summarize this section, we can clearly see the benefits of a SWOT analysis and how it
can help executives to assess their performance when improving each part of the SWOT. In
our example, executives improved weaknesses, turned threats to opportunities. Shareholders
should be aware of all information and know how executives are managing the firm.
Moreover, executives become more eligible for more compensation when they show their
contribution and reaction for SWOT analysis.
I believe that the board of directors should conduct a SWOT analysis by using an external
outsourcer to tackle all research, information and analysis, and then report the result of the
analysis to executives.
49 All figures 3.3, 3.4 and 3.5 are from the same source. Tesco annual report 2008, Tesco Plc [Accessed: 14 Jun 2009, Available at: http://www.tescoreports.com/ ] pp. 4 Page | 41 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis The main advantage of SWOT analysis is to summarize to shareholders the firm’s position
from different aspects in order to take an action to focus on strengths and available
opportunities, and to improve weakness and threats.
1.3 Balanced Scorecard:
R. Kaplan & D. Norton (1996) who originate Balanced Scorecard (BSC) in 1960s
define it: “BSC translates an organization’s mission and strategy into a comprehensive
set of performance measures that provides the framework for a strategic measurement
and management system, it provides managers with the instrumentation they need to
navigate to future competitive success”. 50 The strength of BSC is not only emphasizing
on achieving financial objectives; but also focuses on the performance drivers of the
financial objectives. BSC measure firms’ performance among four balanced
perspective: financial, customers, internal business process and; learning, innovation
and growth. The above figure explains the concept of BSC:
Figure 3.6: Balanced Scorecard four prospective 51
50 R. Kaplan & D. Norton (1996). Chapter 1: Measurement and Management in the Information Age, pp. 2, The Balanced Scorecard. 51 The balanced scorecard application for the learn centre platform, Learn.com [Accessed: 19 Jun 2009, Available at: http://www.learn.com/learncenter.asp?id=178441&page=16 ] Page | 42 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis A) Financial perspective:
Financial perspective can be summarized by measuring performance to indicate
whether the implementation of plans and strategies is contributing to growth and
improvement in the financial position by growing in ROCE or EVA. Another
financial measurement can be implemented such as Simon’s three wheels profit, but
I will discuss a model in the second part of this chapter.
B) Customer perspective:
Customer perspective mainly focuses on two elements: the first is Customer
Satisfaction which can be measured by either, through letters of complaint,
feedback from salesmen and service representatives, or by market research tools
such as customer response and questionnaires. The second one is Customer Loyalty
which measures the number of existing customers return again to buy from the
firm and numbers of new customers referred by existing customers.
It is very important that the firm keeps their clients satisfied because clients
generate profit for the firm when they buy goods or services. R. Simon (1999)
shows that an increase in customer loyalty by 5% can produce profit increases
between 25% and 85%
52
C) Internal Business Process perspective:
This perspective allows managers to know how well their business is running, and
whether its products and services conform to customer requirements. This can be
done by “Internal Value Chain” through innovation cycle, operation cycle and post
sale service cycle; the following diagram illustrates the concept
Innovation cycle Customer Need Identified Operation cycle Identify Create the Build the Deliver the Products / Products the Markets Services Services Products Offering Services
Post sale service cycle Service the Customer Customer Need Satisfied Figure 3.7: Internal Value Chain 53
52 R. Simon (1999), Chapter 9: Building a Balanced Scorecard , pp. 188, Performance measurement and control systems for implementing strategy 53 R. Simon (1999), Chapter 9: Building a Balanced Scorecard , pp. 192, Performance measurement and control systems for implementing strategy Page | 43 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis -
Innovation cycle: managers research the needs of customers and then create the
products or services that can meet their needs, moreover as part of innovation;
managers should also research the market to indentify the size of the market,
prices, economic risks and nature of customers.
-
Operation cycle: the second step in the cycle represents the process of build and
delivers products and services. The phase of building product and services
managers should take into account what qualities the customers look for and the
cost of the services to make sure a firm’s product and services meet customer’s
needs.
-
Post sales service cycle: this includes after sales services such as warranty, free
maintenance and repair; and treatment of defects and return. For example,
software and programming firms provide free training for the system to use the
software efficiently. When the firm keeps in touch with customers after a sale
this can lead to increased loyalty.
D) Learning & growth perspective:
Although, customers and internal process perspectives identify the most critical
factors, firms are unlikely to be able to create long term growth without learning
and improving. In the recent two decades, technology revolution and information
have been played a major role in business world growth, every single day there is
something new, therefore managers and employees are required to keep updating
their knowledge, education, system, internal process, firm infrastructure, the level
of technology used in the company. They should also keep their eye close on
changes in the customer’s needs to be able to meet them in future. Measuring
employee’s skills, empowerment and training are essential for future growth.
1.4 The link between SWOT analysis and the Balanced Scorecard:
Before implementing a balanced scorecard it’s advised to clarify and determine the
company vision, strategy and plans. This can be done through SWOT analysis to deal
with strengths, weaknesses, opportunities, and threats that might face business plan,
after that, the balanced scorecard can be widely applied in corporate performance
Page | 44 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis management to extend strategic planning. In other words, balanced scorecard looks
like executive for SWOT analysis.54
We can clearly see the advantages of SWOT and BSC and how they can contribute
widely to assess manager’s efficiency.
2) Financial elements:
The first stage in measuring an executive’s performance is the non financial elements, it
is important to measure the actual achievement compared with planned strategy. This can
be done through financial performance. For example, if the firm capitalizes on their
strengths, improves weaknesses and gets benefit from opportunities as in our example
Tesco, this should reflect their financial performance by increasing revenue and profit.
Moreover, if the measurement indicates that clients are satisfied and loyal to the firm,
this also reflects an increase in revenue, if the internal process, learning and growth has
been observed positively, this should reflect in either, reduce the cost or expenses (such
as implanting new technology, reducing human effort and mistake).
The question is how to measure financial performance? The previous sections suggests
that can be through growing in ROCE or profit (such as Tesco incentive schemes) or by
calculating EVA or return on investment. I will suggest in this section a combination of
financial ratios to measure financial performance with comparisons using a benchmark
(industry average).
The main idea behind comparing a firm’s performance with the market because it is not
enough to measure firm performance with last year or last quarter, it is also important to
know how the firm is performing in the industry. The model will examine Tesco’s
performance in comparison with the food and drinks industry in the UK.
2.1 The financial model:
The model is basically based on six financial ratios divided into two sections: the
first one will compare Tesco’s performance with the market which are: Revenue,
Net Profit, Profit Margin, ROCE and Salaries over Revenue. The second sections
will calculate the firm only and is not compared to the markets which are Interest
54 S. F. Lee & A. Sai On Ko (2000) Building balanced scorecard with SWOT analysis, and implementing ``Sun Tzu's The Art of Business Management Strategies'' on QFD methodology. Managerial Auditing Journal. Vol. 15 issue 1/2, 2000. pp. 68 – 76 [Accessed: 21 Jun 2009, Available at: http://www.emerald‐
library.com/Insight/viewPDF.jsp?contentType=Article&Filename=html/Output/Published/EmeraldFullTextArtic
le/Pdf/0510150109.pdf ] Page | 45 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis Cover and net cash flow. There is no benefit to compare the last two ratios with the
market, for example, interest cover ratio needs to be measured with company debt
and not with the market debt; because the firm might have a bigger debt than the
market. Another reason is that, it is possible the market has low interest cover which
is not satisfied (will be explained later on).
-
Revenue:
Revenue (Turnover) defined is the amount of money that a company actually
receives during a specific period, including discounts and deductions for returned
merchandise.55
In other words, it is the amount of money that is brought into a company by its
business activities. Revenue is the major key element of measurement because it
shows the firm’s ability to sell products and services.
-
Net Profit:
Net profit is the money a business makes after accounting for all the expenses. In
other words, it is the difference between revenue and total expenses (cost,
overheads and wages). Net profit can measure how the firm is efficient, for
example, if two firms have the same revenue but one of them has higher net
profit, this mean it has a lower expenses which indicates greater efficiency in
managing costs, such as higher technology levels might reduce the cost, or lower
wages.
-
Profit Margin:
It is a profitability ratio calculated as net profit divided by revenues. Profit
margin is very useful when comparing companies in similar industries.56 For
example, a company has a net profit of $10 million from sales of $100 million,
the profit margin is 10%, now imagine in the next year net profit jumped to $15
million and sales to $300 million, the profit margin drops to 5%. Although profit
increased by half, the profit margin declined because of increased revenue, which
means profit per dollar declined. Firms can be more efficient if the growth in net
profit is more than the growth in revenue, in this case profit margin increased.
55 Revenue, Investopedia. [Accessed: 21 Jun 2009, Available at: http://www.investopedia.com/terms/r/revenue.asp ] 56 Profit Margin, Investopedia. [Accessed: 21 Jun 2009, Available at: http://www.investopedia.com/terms/p/profitmargin.asp] Page | 46 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis -
Salaries by revenue :
This ratio calculates the percentage needed from revenue to cover salaries,
dividing total wages and salary by total revenue. This ratio tends to indicate if the
wages paid is over price or under price. It can be justified if a firm has high wages
and salaries if they performing better than the market, otherwise, salaries should
be reviewed if the firm is not performing well.
-
Interest Cover:
This ratio is used to determine the ability of a company to meet payment interest
on outstanding debt. The ratio calculated by dividing a company's earnings
before interest and taxes (EBIT) of one period by the company's interest
expenses of the same period. The main idea of choosing interest cover for this
model is that, debt holders are the only one who can drive the firm into
liquidation when they cannot pay interest on the debt. Executives tend to use debt
more than equity because the cost of debt is lower than the cost of equity, but this
increases the risk of the firm. The main point for shareholders is not how big the
amount of debt is, it is important to know the ability to pay debt service (interest).
For example, the balance sheet for Marks & Spencer 2008 showed that half of the
total equity was financed by debt, but the interest cover was more than eight
times.57 Many economists and accountants suggest the following ranking for
interest cover (2 = bad, 3 = minimum, 4+ = ok). 58
-
Net Cash flow (Beaver Failure Ratio):
It is not enough for the firm to make profit on paper, in other words, a firm can
sell products and services on credit not in cash, the following example illustrates
the idea:
Suppose a firm buys a machine for £60k and raw materials are purchased for
£30k (both of them in cash), goods are manufactured incurring further costs of
£30k and these goods are sold on credit for £120k. Cash does not mean profit.
The income statement and cash at the bank will be as the following:
57 Marks and Spencer annual report 2008, M&S, pp. 57 – 58 [ Available at http://corporate.marksandspencer.com/investors/reports_publications/2008 ] 58 J.O’Hare, Financial Statement Analysis lecture notes. 2008/2009, University of Leicester. Lecture 5 pp. 30 Page | 47 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis Income Statement
Sales
120K
Materials
(30)
Other costs
(30)
Depreciation
(1)
Profit
59
Cash at Bank
Capital
Machine
Materials
Other costs
Balance
100
(60)
(30)
(30)
(20)
Table 3.2: example of cash ≠ profit 59
The above example shows how the firm makes profit but at the same time it is
running out of cash because of sales on credit. This problem is very common in
business; it is therefore important to measure net cash flow generated from
operations in order to determine the solvency (liquidity) position of the firm.
Beaver failure ratio is derived from the cash flow which measures the ability for
the cash to meet long and short term loans.
Beaver Ratio = Operating cash flow / Short and Long term loans
William Beaver shows 70% of the firms fail if the ratio is less than 0.3, the
healthy ratio should bigger than 0.3.
-
Return On Capital Employed (ROCE):
This ratio measures the profit that a company made from its capital employed,
this ratio considers as efficiency and profitability measure of a company's capital
investments.60
ROCE = Profit Before Interest and Tax / Capital Employed 61
Capital Employed = Equity + Debt Or Net Assets (Total Assets – Current Assets)
2.2 Methodology of the model and data:
The model conducted in this section examines the UK food and drinks sector. The
intended benefit from this empirical analysis is just to explain clearly the idea of the
model; this model can be applied for any other sector or in the same firm, if it has
many divisions and groups with separate financial statements to determine
performance for each division. The following points illustrate criteria and
methodology of the model that I followed in order to be accurate and consistent:
59 J.O’Hare, Financial Statement Analysis lecture notes. 2008/2009, University of Leicester. Lecture 5 pp. 35 60 Return On Capital Employed – ROCE, Investopedia. Accessed: 23 Jun 2009, Available at: http://www.investopedia.com/terms/r/roce.asp ] 61 J.O’Hare, Financial Statement Analysis lecture notes. 2008/2009, University of Leicester. Lecture 3 pp. 19 Page | 48 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis A) All the data taken from Fame data base on 26 March 2009
B) All companies report are under UK SIC (2003) category with primary code 5211
which is retail sale in non-specialized stores with food, beverages or tobacco
predominating.62
C) All companies report following UK GAAP. 63
D) All data taken for live companies between 2003 and 2008.
E) All companies’ size classified as Very Large companies.
Unfortunately, the number of companies that matched the above criteria was only
twenty seven. I will assume for simplicity that the market performance is based on
the twenty seven firms and compare Tesco’s performance with that market.
To calculate market performance I took the average for Revenue, Net profit, Profit
Margin and Salaries over Revenue for each year and drew a chart from 2003 to
2008, after that I calculated separately interest cover and Beaver Ratio.
2.3 The model:
The model that I suggest gives a weight for each ratio in order to calculate the
overall financial performance, the following table shows ratios weights:
Ratio
Weight
15%
15%
15%
15%
10%
15%
15%
100%
Revenue
Net Profit
ROCE
Margin Profit
Salaries over Revenue
Interest Cover
Beaver Ratio
Total Performance
Table 3.3: Performance model weight
For example, if Tesco’s Revenue performed better than the market in the period
between 2003 and 2008, it gets 15%. If Tesco’s performed better for only one year
in that period, it gets 12.5% (2.5% for each year) and so on
The assessment for interest cover and Beaver Ration as the following table:
62 UK Standard Industrial Classification of Economic Activities 2003, UK National Statistic.pp.36 [Accessed: 23 Jun 2009, Available at: http://www.statistics.gov.uk/methods_quality/sic/downloads/UK_SIC_Vol1(2003).pdf ] 63 Generally Accepted Accounting Principles (UK), Wikipedia. [Accessed: 23 Jun 2009, Available at: http://en.wikipedia.org/wiki/UK_GAAP ] Page | 49 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis The reason behind giving the ratios 15% weight except Salaries over Revenue is
that, it could be justified if a firm is performing better than the market, but the wages
and salaries are higher than the market because they employ skilled people.
2.3.1 Revenue:
40,000
35,000
30,000
Tesco
25,000
Market 20,000
15,000
10,000
5,000
0
2003
2004
2005
2006
2007
2008
Figure 3.8: Revenue Performance
The above chart shows Tesco’s revenue is massively bigger than the market
with gradual growth, the market performance shows tiny growth during the
period. Tesco gets 15%
2.3.2 Net profit:
2000
1500
Market 1000
Tesco
500
0
2003
2004
2005
2006
2007
2008
Figure 3.9: Net profit Performance
Page | 50 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis Figure 3.9 shows that Tesco’s net profit is massively bigger than the market.
Although a spike took place in 2007, it still performs better than the market, it
gets 15%
2.3.3 ROCE:
60.00
50.00
40.00
30.00
Market Tesco
20.00
10.00
0.00
2003
2004
2005
2006
2007
2008
Figure 3.10: ROCE Performance
The above figure shows Tesco performing 15 %better than the market.
2.3.4 Profit Margin:
10.00
9.00
8.00
7.00
6.00
5.00
Market 4.00
Tesco
3.00
2.00
1.00
0.00
2003
2004
2005
2006
2007
2008
Figure 3.11: Profit Margin Performance
Tesco’s profit margin performed better than the market except in 2008; in this
case Tesco gets 12.5%.
Page | 51 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis 2.3.5 Salaries over Revenue:
14.00
12.00
10.00
8.00
Market Tesco
6.00
4.00
2.00
2003
2004
2005
2006
2007
2008
Figure 3.12: Salaries over Revenue Performance
We can clearly see that Tesco salaries over revenue is less than the market
which mean better off when the market performing better than Tesco this
means the market pays more salaries in respect to revenue, while Tesco’s pay
less which indicate more efficiency than market average. Tesco gets 10%.
2.3.6 Interest Cover:
As discussed before in section 2.1 good interest cover is when it is equal or
bigger than 4, the next table shows Tesco’s interest cover:
2003
Tesco’s interest cover 7.93
2004
6.76
2005
4.73
2006
7.33
2007
11.8
2008
2.47
Table 3.4: Tesco’s Interest Cover
In 2008, Tesco’s interest cover was below 3, it seems that the firm increased
debt because profit increased, while interest cover fell. (Table 3.1 pp.33,
SWOT analysis in 2004 pointed out that weakness in the increase in debt).
Tesco gets 12.5%.
2.3.7 Beaver Ratio (Net cash flow):
Tesco’s Beaver ratio
2003
0.44
2004
0.56
2005
0.60
2006
0.47
Table 3.5: Tesco’s Beaver Ratio
Page | 52 2007
0.45
2008
0.41
University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis The above table shows Beaver ratio for Tesco, all periods is bigger than 0.3,
Tesco gets 15%
3) Results:
Ratio
Revenue
Net Profit
ROCE
Profit Margin
Salaries over Revenue
Interest Cover
Beaver Ratio
Total Performance
Weight
15%
15%
15%
12.5%
10%
12.5%
15%
90%
Table 3.6: Tesco’s overall performance
The result for the model in our example shows Tesco’s overall financial performance is
90%.
When Tesco form incentive schemes they should consider non financial elements beside
the financial model. It is not easy to measure in numbers the non financial elements but it
can be determined by the board what is the acceptable achievement. For example, as we
have seen above (Chapter 2, section 3, page 27 – 30) Tesco’s Long Term Incentives
Schemes was based on ROCE and EPS growth, managers get 200% of annual salary if
they achieved a certain growth in EPS or ROCE. Instead of that, Tesco can use the above
model with SWOT and Balanced Scorecard and based on that, can offer incentives.
Page | 53 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis Chapter Four: Conclusion, Limitation and Recommendation:
1) Conclusion:
The most striking feature behind this model is that the non financial elements (SWOT
analysis and Balanced Scorecard) and financial (the model discussed above) is that they
all complement each other, in other words, each one explaining the other. What does this
mean?
Let’s consider the following example, if the firm’s plan is to reduce the cost and increase
revenue and net profit, the only way to know how managers achieved this plan is to look
to the financial statement or conduct a model. Another example is Debenhams’s
statements show increased debt level because they opened twelve new branches in the
UK (company’s plan or SWOT analysis explain the increase in debt in the financial
statement).
Tesco SWOT analysis warns the firm against increasing debt and the following year’s
financial statements show a great decrease in debt. These examples show the important
link between financial elements and non financial elements.
Although some factors might not appear clearly in financial statements such as learning,
growth and internal business process or what level of technology the firm has
implemented, the financial statement might at least indicate that in one way or another.
For example, when financial statements show big amounts spent on new IT systems, new
equipments or implanting new technology this should indicate that the firm is considering
new technology.
The financial model has many advantages; first of all, the example above examined the
performance between 2003 and 2008 which is suitable to design a long term incentive
plan, the model can also be applied for short term incentive schemes, for example the
firm can design incentives compared to the market for one year only (i.e. 2008) . Another
advantage is that this model is customized, which means the board of directors can add,
replace or change any financial ratio to the model based on the business plan. For
example, if the board of directors is looking at how to efficiently use their assets, they can
add Asset Turnover ratio, or if they want to measure debt level, they can add Gearing
Ratio.
Page | 54 University of Leicester Mhd Said Al‐ Kabbani Economics Department ID: 08900203 EC 7080 – Dissertation MSc Finance and Business Analysis 2) Limitation:
This above paper discussed the non financial elements, the problem with this is that it is
not easy to measure SWOT or Balanced Scorecard in numbers, or determine what the
acceptable level is, this will be determined by the board of directors or sometimes by
executives themselves (will be subject to bias or manipulation). It is always preferable not
to let executives determine the scale of measurement. This paper helps board of directors
to control and measure executives but not to give a solution to design incentives schemes.
However, the board of directors can create the best way to design incentives schemes
after conducting a SWOT analysis, Balanced Scorecard and financial model.
Another major problem is information; first of all, to compare a firm’s performance with
the market, it is important to have access to get all of the information you need about the
market. In our example, I only found twenty seven companies that have data between
2003 and 2008, the problem might be greater in other countries where information is not
easily available.
3) Recommendation:
I strongly recommend PhD students or MSc students who are interested in economics and
finance investigate incentives further especially using non financial elements such as
SWOT analysis or Balanced Scorecard or any other new method to assess manager’s
performance. I believe that when more of the non financial elements can be monitored
and controlled, executive’s performance can be easily measured and suitable incentive
schemes designed.
It is important for any company to pay attention to the information flow between
managers and board of directors and ensure the correct and necessary information is
given to them.
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