Chapter 12
Performance Appraisal
Performance measurement
Performance measurement and appraisal is a central
component of a management control system.
The focus of performance measurement and
appraisal is to ensure the business is following its
strategies and that each element or unit is
contributing to the overall objectives of the business.
Performance appraisal of managers is instrumental
in decisions regarding salaries, bonuses, future
assignments and career advancement.
Good performance measurement promotes goal
congruence with organisational objectives and
facilitates comparison across different subunits.
Performance appraisal techniques
Budgetary control and variance analysis
Key internal financial performance indicators
Return on investment,
Profitability and asset utilisation ratios,
Residual income.
Inter-firm comparisons or benchmarking
performance against other companies regarded as
best performers in the sector.
Various non-financial performance indicators such
as levels of innovation, customer satisfaction and
staff morale, all of which affect profitability.
Performance measurement –
factors for sucess
It must be integrated with the overall strategy of the
business.
There must be a system of feedback and review.
The performance measurement system must be
comprehensive.
The system must be owned and supported
throughout the organisation.
Performance measures must be fair and achievable.
The system needs to be simple, clear and
understandable.
CIMA Technical briefing ‘Latest Trends into Corporate Performance Measurement’
The objectives of measuring
performance
To assess and ensure that managements actions and
decisions are in line with strategic objectives.
To act as a motivational tool in providing a framework
to guide and measure managers decisions.
To help in improving decision-making across an
organisation by ensuring that decisions are informed
and based on key performance indicators.
To provide timely, relevant information on areas
needing management attention, thus acting as a
control mechanism.
To enable managers to understand the needs and
expectations of the various stakeholders in an
organisation.
Performance evaluation requires
Clearly defined and articulated strategic objectives
which are used in assessing whether a strategy or
business performance has achieved its primary goals.
Clear frameworks and performance indicators to
measure performance, assess strategy, explore
threats and weaknesses and ultimately provide
information for management to take corrective action.
Regular feedback, which ensures that management
appreciate the impact of their decisions on the overall
strategy of an organisation. It also provides early
warning to management where the objectives are not
going to be achieved.
Benchmarking
‘Establishment, through data gathering, of
targets and comparators, that permit relative
levels of performance (and particularly areas
of underperformance) to be identified’.
Benchmarking as defined by CIMA Official Terminology
Approaches to benchmarking
Competitor benchmarking is a process of
comparing ones financial performance with that
of direct competitors.
Process benchmarking where data is exchanged
between companies with similar operating and
administrative systems, with the objective of
learning from one another and improving
efficiencies.
Strategic benchmarking, which compares
businesses that possess similar organisational
structures and implement similar business
strategies.
Inter-firm comparison
Inter-firm comparison is the process of
comparing the performance of different
companies, subsidiaries and investment centres.
Performance is compared by preparing key
accounting ratios to assess the businesses that
are performing above average and those that
are not.
Realistic inter-firm comparison
require comparison with
Businesses within the same sector,
Businesses of similar size,
Businesses that employ similar accounting policies.
Ratio analysis
Financial performance measures are generally
expressed as ratios. Ratios measure the relationship
between figures and express that relationship as a
percentage or ratio. Ratios are useful in that they provide
a means of comparison of actual results with:
A budget or desired target.
Ratios of previous years in order to detect trends.
Ratios of other companies or divisions in a benchmarking and
inter-firm comparative appraisal process.
Industry norms or indices.
Ratio analysis
Profitability
Efficiency
Liquidity
Capital
Structure
Investment
The Du Pont pyramid
Profitability Efficiency Liquidity
Gross profit margin
Net profit margin
Expenses to sales
Return on capital employed
Return on owners equity
Capital
Structure
Gross profit margin
Gross Profit x 100
Sales
This indicates the margin of profit between
sales and cost of sales.
A fluctuating gross profit
percentage can be caused by
Reduction
Increase
 Reduction in selling price.
 Increase in selling price.
 Increase in the cost price of  Reduction in cost price of
stock purchases.
stock purchases.
 Changes in the product sales  Changes in the product sales
mix with the business selling
mix with the business selling
a higher proportion of goods
a higher proportion of goods
with a lower gross profit
with a higher gross profit
margin.
margin.
 Theft of cash or stock.
 Waste.
Operating profit margin
Operating Profit x 100
Sales
This shows the amount of profit after all expenses
are deducted.
A fluctuating operating profit
margin can be caused by:
Reduction
Increase
Decrease in gross profit Increase in gross profit
margin.
margin.
Increase in the expenses Decrease in the expenses
to sales percentage.
to sales percentage.
Expenses to sales
Expenses x 100
Sales
This shows the percentage of sales needing to
cover expenses. This ratio assesses the ability of
management in controlling expenses of the
business.
Breakdown of expenses to sales
Breakdown of expenses to total
costs
Return on capital employed (ROCE)
Usually net profit before interest and tax
Net Profit
x 100
Capital employed
share capital + reserves + Loans
This shows the ratio of net profit to the
investment in the business.
Return on owners equity (ROOE)
Can be before or after interest and tax
Net Profit
x 100
Shareholders funds
Should only relate to ordinary shareholders
This ratio assesses the return (profit) for
the ordinary (equity) shareholders alone.
Performance guide
Percentage return
< 5 per cent
Comment
Poor
Between 5 and 10 per cent Fair
Between 10 and 15 per cent Good
Greater than 15 per cent Excellent
Profitability
Efficiency
Liquidity
Fixed asset turnover
Total asset turnover
Stock Turnover
Stock days
Debtors days
Creditors days
Capital
Structure
Fixed asset turnover
Sales
_
Fixed Assets
This shows the number of times that the fixed
assets are turned over in the period. A high rate
of return indicates that a business is operating
efficiently and is making the best possible use of
assets. A low rate suggests inefficient use of
assets.
Total asset turnover
Sales _
Total assets
This shows the number of times that the total
net assets are turned over in the period. A high
rate of return indicates that a business is
operating efficiently and is making the best
possible use of assets. A low rate suggests
inefficient use of assets.
Stock turnover
Cost of sales
Average stock
Stock turnover is the average number
per year that the whole value of
purchased and resold. The quicker
sold the quicker profit will be made
item. A low rate of turnover shows
stock is being left on the shelves.
of times
stock is
stock is
on that
that old
Stock days
Stock can also be measured by examining the
number of days on average that stock is held.
Average stock
Cost of sales
x 365
Debtors days
Trade Debtors x 365
Credit Sales
Indicates how quickly debtors pay. This
ratio can be expressed as the number of
days
credit
taken
by
debtors.
Creditors days
Trade Creditors x 365
Credit Purchases
Indicates how long before creditors are
paid. This ratio can be expressed as the
number of days credit taken before
payment.
Return on capital employed (ROCE)
Note: the combination of net profit margin and the
asset turnover gives the return on capital employed.
Profit Margin
Sales
Capital Employed
x
x
Asset Turnover
Net Profit
Sales
x 100 =
Net Profit
x100
Capital Employed
Profitability
Efficiency
Liquidity
Capital
Structure
Current ratio
Quick Ratio
Current ratio
Current Assets
Current Liabilities
This is a measure of the short term
solvency of a business.
Current ratios – sector norms
Industry Type
Manufacturing
Wholesalers
Retail/Supermarkets
Hotels, restaurants, fast
foods
Current
Ratio
2.5 – 4.5 : 1
2:1
0.8 : 1
0.4 : 1
Acid-test ratio
Current Assets - Stock
Current Liabilities
Also know
ability of a
liabilities
liquidation
as quick ratio. Indicates the
business to pay off short term
without
resorting
to
the
of stock or the sale of fixed
assets.
Profitability
Efficiency
Liquidity
Capital
Structure
Gearing
Interest cover
Capital structure
Capital structure measures the funding
mix of a business.
Financing
Through debt
Through equity
Interest must be paid on the debt
Dividends will be paid to
shareholders
Interest is tax deductible
Dividends are not tax deductible
Debt generally cheaper
Equity requires higher returns to
compensate for risk
Debt is risky because interest
must be paid
Dividends are at discretion of
management and may be
deferred
Loan must be repaid
Equity does not require
repayment
Gearing
Preference shares and long term loans
All shareholders funds and long term loans
This is the ratio of fixed interest debt and capital
to ordinary share capital.
Gearing
The higher the ratio of debt to equity, the more
dependent the organisation is upon borrowed
funds, and the greater the risk that it will be
unable to meet interest payments on these funds
as they fall due.
Low gearing = where debt is less than capital & reserves.
Neutral gearing = debt = capital & reserves.
High gearing = debt is greater than capital & reserves.
< 100%
= 100%
> 100%
Interest cover
Profit before interest
Interest payable
The ability of a company to meets its interest
commitments, measured by expressing the profit
before interest as a multiple of the interest paid
and payable.
Key operating ratios
Hospitality Sector
Key operating ratios
Hospitality Sector
Key operating ratios
Hospitality Sector
Key operating ratios
Hospitality Sector
Key operating ratios
Hospitality Sector
Key operating ratios
Retail Sector
Key operating ratios
Retail Sector
Setting the context
The age of the business
The size of the business
The economic and political environment
Industry Trends
Company performance – number
of years
Have sales increased or decreased and by what percentage?
Has operating profit increased or decreased and by what
percentage?
Has loan interest increased or decreased and by what
percentage?
Check the long-term loans in the balance sheet to see if they
have increased/decreased.
Compare profit after tax to see if it has increased or decreased.
Calculate percentage increase/decrease in fixed assets.
If assets have been increased, has this been financed through
increased loans or issued share capital?
Check to see if the business has cash or an overdraft, and is this
increasing or decreasing?
Check current assets and liabilities for any major increases.
Check the percentage increase/ decrease in long-term loans.
Company comparison
Check both businesses are in the same
industry/sector
Compare the size of each business. This is normally
done, by comparing the total asset levels in the
balance sheet (fixed assets + current assets- current
liabilities).
Compare sales and profit levels.
Compare financing. For example is one company
highly geared and the other low geared?
Compare cash balances/overdraft levels.