Measuring and Controlling Assets Employed
The purpose of measuring assets employed are analogous to the purposes for profit centers. The purpose being to provide information that is useful in making sound decisions about assets employed and to motivate managers make these sound decisions that are in the best interests of the company. Also , to measure the performance of business units as an economic entity.
Long Term Investment
Long term investments can be a strategic and control issue:
Long term investment decisions are made after long term strategy is decided (not the other way around). Also, strategic leverage affects how much investments in long term assets are necessary. Consequently, if decisions about long term investments are made incorrectly, strategy and strategic leverage are less likely to be accomplished. Long term investments are generally huge in their monetary and non-monetary impact. As such, if managers and others do not take all precautions when investing and later, in measuring the usefulness of the assets and their contribution, it will have significant adverse impact. Therefore, measuring long term assets is also a control issue of great importance
Measuring assets employed:
what practice will induce business unit managers to use their assets most efficiently?
1. Cash: central control, most companies control cash centrally because central control permits use of a smaller cash balance than would be the case if each business unit held the cash balances it needed to weather the unevenness of its cash inflows and outflows. \
2. Receivables: Business Unit managers can influence the level of receivables by their ability to generate sales and directly by establishing credit terms and approving individual credit accounts and credit limits and by their vigor in collecting overdue amounts.
whether to include accounts receivable at selling prices or at cost of goods sold is debatable. One could agree that the business unit's real investment in account receiveable is only the cost of good sold and that a satisfactory return on this investment is probably enough. The business unit could reinvest the money collected from accounts receiveable and it should be included at selling price.
3. Inventories: recorded at end-of-period amount. treated in a manner similar to receiveable, that is recorded at the end-of-period amounts even though intraperiod averages would be preferable conceptually. ex: advance payments and accounts payable.
4. Working capital: Sound from a motivational standpoint if the business units cannot influence accounts payable or other current liablities. (eg: Gross working capital and net working capital
5. Fixed Assets: Initially recorded at their acquisition cost, and this cost is written off over the asset's useful life through depreciation. (acquisition of new equipment, Gross book value, disposition of assets, annuity depreciation, other valuation methods). Leased assets, Idle assets, Intangible assets, non current liabilities, the capital charge.
Performing investment analysis
Unless an organization is a 100% service organization, profits are generated ONLY if you have investments. Therefore, earning a satisfactory return on the investments employed is necessary. The investors in stock compute such a return routinely (e.g. Ford and G.M.). To compare two units, A and B, without considering the investment made in each is meaningless.
First, a manager should invest in assets only if the assets will produce adequate returns. Second, when an asset is not providing adequate return (the expected return could change over the years), it is time to "disinvest" or reduce further investments into this asset. Two ways to relate profits and investments and to compare investment alternatives: 1) Return on Investments (ROI) and 2) Economic Value Added (EVA)
ROI
A performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments. To calculate ROI, the benefit (return) of an investment is divided by the cost of the investment; the result is expressed as a percentage or a ratio.
The return on investment formula:
ROI = (Gain from Investment – Cost of Investment) / Cost of Investment
In the above formula "gains from investment", refers to the proceeds obtained from selling the investment of interest. Return on investment is a very popular metric because of its versatility and simplicity. That is, if an investment does not have a positive ROI, or if there are other opportunities with a higher ROI, then the investment should be not be undertaken.
EVA
A measure of a company's financial performance based on the residual wealth calculated by deducting cost of capital from its operating profit (adjusted for taxes on a cash basis). (Also referred to as "economic profit")
EVA = Net Operating Profit After Taxes (NOPAT) - (Capital * Cost of Capital)
Cost of Capital
The minimum return an organization must earn on its investments to meet investor expectations. Cost of capital is specific to each organization and depends on several factors such as the type of industry in which it operates, how risky the organization is, the rate at which it can borrow from outside and more (borrowing, in this context, refers to both debt and equity). If an investment returns more than the cost of its capital, the investment is positive and if not, it is negative and as well not invested.
ROI can lead to poor decisions:
Encourages division managers to retain assets beyond their optimal life and not to invest in new assets which would increase the denominator. Can cause corporate managers to over- allocate resources to divisions with older assets because they appear to be relatively more profitable. Capital may be allocated towards least profitable divisions, at the expense of the most profitable divisions. So, when computing ROI or EVA, don't use net book value of the asset but use gross book value (original purchase price ignoring depreciation).
Advantages of using EVA
EVA ranks project on profits in excess of the cost of capital (EVA increases).
With EVA, all business units have the same profit objective for comparable investments.
EVA permits the use of different interest rates for different investment projects.
EVA has greater correlation with a firm's market value (it optimizes shareholder value).
ROI versus EVA
In practice, most businesses use ROI because it is simpler to compute and understand.
It is also comprehensive in the sense that it considers the entire balance sheet and income statement.
Unlike ROI – a percentage, EVA is a dollar amount and does not allow for intra and inter company comparisons.
There is considerable debate about the right approach to management control over fixed assets .Reporting on the economic performance of an investment center is quite different from reporting on the performance of the manager in charge of that center. ROI and EVA are two ways of relating profits to assets employed. Focusing on profits without considering the assets employed to generate those profits is an inadequate basis for control.
Return on investments (ROI) is a ratio. The numerator is income as reported on the income statement. The denominator is assets employed.
Economic value added (EVA) is a dollar amount, rather than a ratio. It is found by subtracting a capital charge from the net operating profit. This capital charge is found by multiplying the amount of assets employed by a rate. This rate is set by the corporate headquarters. The rate should be higher than the one used for debt financing, because the funds used are a mix between debt and higher-cost equity. It is usually set somewhere below the company's cost of capital so that the EVA of an average business unit will be above zero.
EVA = Net profit – Capital charge = Capital employed(ROI – Cost of capital)
Capital charge = Cost of capital*Capital employed
If annuity is determined by annuity rather than the straight line method, the business unit profitability calculation will show the correct economic value added and return on investments. With annuity depreciation, the annual amount of depreciation is low in the early years and increases each year. Note that the rate of remains constant. In practice however, the annuity method is seldom used.
There are three apparent benefits with ROI:
It is a comprehensive measure in that anything that affects financial statements is reflected in this ratio.
It is simple to calculate, easy to understand and meaningful on an absolute scale.
It is a common denominator regardless of size or type of business. The performance of different business units may be compared directly to one another. Also, ROI is available for competitors and may be used a basis for comparisons.
There are four compelling reasons to use EVA over ROI however:
With EVA, all business units have the same profit objective for comparable investments. ROI on the other hand, provides different incentives for investments across business units.
Decisions that may increase a units ROI might decrease its profits.
With EVA, different types of interest rates may be used for different types of assets.
EVA has a stronger correlation to changes in the company's market value than ROI.
Creating shareholder value in the company is crucial; as it measures the worth of the company as a whole, it is difficult to use as a performance criterion in responsibility centers. The best proxy for shareholder value at the business unit level is to ask business unit managers to create and grow EVA.
EVA has the issue of no solving the problem of how to account for fixed assets unless the annuity method is used, which is rarely the case.
Evaluating the Economic Performance of the Entity
Economic reports are made as the basis for arriving at the value of the company as a whole. The breakup value is the estimated amount that the shareholders would receive if individual business units were sold separately.
