University of Waterloo
Enager Industries, Inc.
Akua Acheampong, Lori Chin Suey, Kieng Iv, Tara Mathanda, Hubert Sy
Issues Summary
Enager Industries (“Enager”) is a relatively young company that has three divisions –
Consumer Products, Industrial Products, and Professional Services. Currently, the divisions are
classified as investment centres measured using return on assets (ROA). The company as a
whole has not been able to meet ROA targets despite increases in earnings per share and
return on equity over the past year. Two of the divisions in particular have not been able to
achieve the company-wide return on asset target of 12%. The purpose of this report is to
evaluate the current performance measurement system and how it has been implemented. In
addition, there is tension between divisional managers due to the performance measurement
system. Recommendations have been provided relating to the ROA targets, evaluation of
proposed projects, and the use of the balanced scorecard to evaluate divisions.
New Product Proposal
Sarah McNeil, product development manager in the Consumer Products Division of
Enager, recently proposed a new project that was rejected by Henry Hubbard, Chief Financial
Officer. Even though the project had an estimated $0.15 increase on Earnings per Share (EPS), it
was rejected because it did not show a return on assets of 15%, which is the current hurdle
rate. The project is estimated to have $390,000 in earnings before interest and taxes (EBIT) with
an incremental asset base of $3,000,000. This computes to a return on asset (ROA) of 13%,
which is lower than Henry’s required return for any new projects.
Sarah’s new project should not have been rejected, as the gross required rate of return
of the company is 12%. This takes into account the marginal cost of debt, which is fairly high
because of Enager’s recent debt financing interest rates, and the marginal cost of equity,
1
shareholders’ required rate of return. If a project has a 12% ROA then the net present value of
the project would be $0 -the 12% is the internal rate of return for Enager. If a project exceeds
12% ROA, then it should be pursued as it will increase the value of Enager. The proposed
project has a 13% ROA, which is higher than the internal rate of return, and should have been
accepted, not rejected.
Inferences from Statement of Cash Flows
Please see Appendix A for the cash flow statement and related schedules. When
analyzing the cash flow statement for 1993, a few inferences could be made. The 1993 net cash
flow from operating activities is $14,826,000 and the income quality ratio was 1.221, which
indicates that a large percentage of their net income is being realized in cash. The highly
positive number indicates strong operational performance and ability to generate cash flows
from operations.
The net cash flow from investment activities is $(28,158,000), which indicates that longterm fixed assets are being purchased for expansion of operations. Of the $28,158,000 spent,
$25,230,000 was used to purchase plant and equipment. The poor 1993 return on assets can be
partially attributed to this large increase in fixed assets, which accounted for the majority of the
increase in assets, along with the moderate increase in net income of $1,249,0002. These inputs
resulted in a gross incremental ROA of 9.1%3, which is lower than the 1992 gross ROA of 9.5%
and lower than the required 12% for projects to “breakeven”. This is why 1993 ROA was lower
than 1992 ROA.
1
Income Quality Ratio =Operating Cash Flows/Net Income =14,286/12153
Change in Net Income = 1993 Net Income – 1992 Net Income = 12,153,000-10,904,000=1,249,000
3
Gross Incremental ROA= Change in EBIT/Change in Assets=(18414+2928-16521-1728)/(226257192096)~9.1 %
2
2
The net cash flow from financing activities for 1993 is $13,257,000. This means that
they have financed about half their capital expenditures, which total $28,158,000, with external
capital. The other half of the capital expenditures was financed through operating cash flow.
The impact of the large increase in debt financing was evident in the income statement. The
income statement showed that Enager had paid an additional $1,200,000 of interest in 1993
when compared to 1992 figures. The average interest rate or cost of debt in 1992 was 4.6% and
in 1993 was 5.7%4. This substantial increase in interest rate directly affects net income which in
turns affected the ROA for 1993.There was also a large issuance of common shares, worth
$6,320,000, and this was accompanied with a large amount of cash dividends paid in 1993 of
nearly the same amount, $6,285,000.
A breakdown by division would be helpful, as it would allow for deeper analysis and
understanding of the performances of each division. In the analysis of the company-wide cash
flow statement, it was clear that there were some investments that did not have a high enough
actual ROA. By having a breakdown of each division, it would help in determining which
divisions are making poor investments and which divisions are making financially sound
investments. As well, a breakdown would help in determining which divisions are performing
the best operationally. Currently the operating section of the cash flow statement indicates
that Enager is doing well in managing its day-to-day cash flows and is able to finance its current
operations. However, it is likely that some divisions are not performing as well as others in this
portion of the cash flow statement, as company-wide ROA has dropped year over year.
Inferences from Comparative Balance Sheet and Income Statement
4
Average interest rate=Interest expense/Long-term debt
3
Please see Appendix B for comparative balance sheets, income statements, and financial
ratios.
Balance Sheet inferences
•
Investments in plant, equipment and other assets that are significantly higher than
depreciation have been made suggesting that Enager is investing in new assets to generate
more revenue rather than just replacing old assets. However, this had a negative impact on
ROA since the percentage increase in net income is much lower than the percentage
increase in total assets. This suggests that the additional assets may not have generated as
much revenue as expected.
•
The accounts receivable increased 14% from 1992 to 1993, which suggests that Enager has
been more willing to extend credit in order to attract more customers. The accounts
receivable as a percentage of total assets (~21%) also indicates that credit sales is a
significant part of Enager’s business.
•
The significant increase (15%) in inventory suggests that Enager is anticipating higher sales
in the future or was unable to sell its entire budgeted inventory.
•
Enager took on 22% more long-term debt in 1993, which may have been used to finance its
plant, equipment and other assets. From the year-over-year change in interest expense in
the income statement, the new long-term debt has a very high (~9%) interest rate. This
suggests not only higher interest rate levels in the economy but possibly a negative change
in Enager’s fundamentals that the market has priced into its debt.
•
Enager has also issued more equity, to possibly finance its capital expenditures.
•
Deferred income taxes also increased substantially as a percentage of total assets from
4
1992 to 1993. This is negligible, however, since it is only about 1.3% of total assets.
Income Statement inferences
•
Sales had a mediocre rise when compared to the increase in capital expenditures.
Profitability ratios showed only a little positive change except for ROA, which fell.
•
COGS rose by a smaller percentage than sales, which contributed, to the positive change in
gross margin.
•
Total expenses rose by a smaller percentage than gross margin, which contributed, to the
rise in net income.
•
Additional debt did not seem to have lowered Enager’s effective tax rate.
Overall, Enager as a firm seems to rely more on smaller expenses, lenient credit policies
and cost cutting rather than growth in order to maintain profitability. Also, the Consumer
Products and Industrial Products divisions may be weighing down the explosive growth in the
Professional Services division.
Investment Centre Implementation Issues and Solutions
In implementing the investment center concept, Randall and Hubbard decided to
measure each of the division’s performance based on its return on assets, which is calculated as
the division’s net income divided by its total assets. Also, Hubbard demanded that each division
try to provide a return of 12% on its assets for 1992 and 1993. He also decided that all new
investments must have a 15% return in order for it to be approved as the firm’s current ROA
was only 9.4%.
5
Implementation Issues
Solutions
Require a minimum 15% ROA to
accept a project
Accept any projects with a positive net present value in
order to help increase firm value – meaning any project
with a return on investment higher than the cost of
capital.
Management should use residual income (or EVA) to
analyze the profitability and return of projects, in
addition to, or in replacement of, ROA. This is aligned
with only accepting positive net present value projects.
This also leads to better goal congruence, as divisions are
not rejecting projects that are lower than their historic
return on assets that may be good for the performance
of the firm but bad for the performance of the division.
EVA as a performance measurement would also lead to
less perceived unfairness between the divisions. Since
different EVAs are not very comparable across divisions,
managers will be more focused on its operating
efficiencies.
Example. The Consumer Products proposal for a new product with a calculated ROA of 13%
should be accepted as it is above the firm’s internal rate of return of 12%. As well, using
residual income (or EVA) would result in the acceptance of this project, as it would yield a
positive EVA or residual income.
Each division is required to
Different costs of capital can be used for each division
attain the same target ROA of
depending on the risk of each project and nature of
12%, even though they are
business. The cost of capital can be obtained by
engaged in diverse business
observing the cost of equity capital of equivalent public
activities and each division has
companies that engage in similar business activities as
a different level of risk.
each of the divisions.
Example. Consumer Products division is probably less risky than the Industrial Products division
as they are the most mature whereas the Industrial Products division is very sensitive to the
success of individual projects. Therefore, a higher return on investment will be required for
projects in the Industrial Products division to offset this risk.
The calculation of company Calculate both the company-wide ROA and the divisional
wide ROA is based on EBIT,
ROA based on EBITDA for the performance measurement
while the calculation of
purposes. As senior management focus divisional
divisional ROA is based on net
managers on operational issues rather than corporate
income. This creates an
headquarter planning, such as tax and debt financing.
inconsistency in performance
measurement.
The calculation of ROA for
performance measurement
includes corporate
Senior management should focus divisional managers on
operational issues rather than reducing corporate
headquarter expenses, these items should not be
6
administrative expenses
arbitrarily allocated based on
divisional revenue.
included in the calculation. If included, it should be
allocated based on another metric that more closely
measures use of administrative expenses by each
division.
Example. Professional Services division most likely utilizes more administrative services, such as
human resources, as they employ more human capital. Therefore they should be allocated
more of the corporation administrative services expenses.
The calculation of ROA for
The gross book value should be used for the ROA
performance measurement
calculation to prevent some from continuing to use old
includes the net book value of
machines for the purposes of increasing their ROA.
property, plant, and equipment.
This incorporates depreciation,
which decreases asset value
overtime.
Example. If the net income is held constant, ROA will be higher as the assets reach the end of its
useful life because of the decrease in the asset base due to depreciation. This reduces the ability
to compare one division to the other, since the asset base will differ depending on the useful
life of those assets. This may provide incentive for managers to keep old machines and sacrifice
quality in order to have a higher ROA.
Tension created between the
From making the above changes, divisional managers
three divisions.
should perceive the performance measurement system
to be more equitable and fair. This will reduce tension
between the divisional mangers.
Also measuring managers based on the balance
scorecards created will also reduce tension, as the
system would be perceived as more equitable since they
are division specific.
Example. The Industrial Products divisional manager would not be only concerned with ROA,
but many other measures, in which the purchase of fixed asset is looked at in a positive light.
7
The Balanced Scorecard for Each Division
Customer
Products Division
Innovation and
learning
Perspective
Internal Business
Perspective
Customer
Perspective
Financial
Perspective
Measures
Importance of Measure
• Innovation measured by the
number of new product
released in the year and the
percentage of sales spent on
research and development.
• Employee growth measured
by number of training days
per employee in the
manufacturing area in the
year and number of creative
workshops for entire
division
• Quality measured by
number and frequency of
product returns, and first
pass yields on products
produced.
• Given that the housewares and kitchen items
are a mature industry, the need for new
differentiating products that spark renewed
demand is vital.
• The number of days that an employee trains
and is able to better perform their
manufacturing job, will reduce inefficiencies
and cost, which is also key in a mature
industry
• Creativity is key to the design of new
products, and it can come from any member
in the division, not just the design team.
• Quality is very important to the long run
profitability of the company, especially with
products that are used on a daily basis such
as housewares and kitchen items. Product
returns show customer dissatisfaction with
the product that may be quality related.
• Producing a high quality product the first
time will reduce inefficiencies in the
production line and avoid the suck costs
embedded within defect products.
• The higher the market share, the more
profitable the company. This metric will
enable Enager to thwart any threats to
market share early on.
• Given the medium life of a more houseware
and kitchen items, customer loyalty is key
because it will result in numerous purchases
over the customer’s lifetime. This is
especially true given the fact that houseware
and kitchen items are often given as gifts.
• Long term earnings and the survival of a
corporation in the long run is largely
dependant on its ability to earn a return on
its investment.
• Sales growth is important to measure the
quantitative effects that the other qualitative
measures have on profitability.
• Market Share of
household/kitchen products
• Customer loyalty measured
by repeat purchases of
kitchen products, customer
referrals, and sales to
customers as percentage of
total requirements for the
same product/similar type
products.
• Return on investment
measured residual income
• Sales revenue growth
measured by percentage
increase from the prior
year.
8
Industrial
Measures
Importance of Measure
Products
Division
Innovation • Innovation measured as • The ability to develop one of a kind product to
and
percentage of sales
customer specifications lies in the division ability to
Learning
spent on capital
purchase cutting edge technology to do so. A lack
Perspective
expenditures for
of investment in this area will lead to an inability to
cutting edge machinery
cater to customer needs.
for tool manufacturing
• Given the constant investment in new equipment, it
• Employee growth
is important to ensure that employees are trained
measured by # of
adequately to use the equipment, in order to ensure
training days per
timely production and reduce error.
employee in the year
• Capacity Utilization,
• Considering there are high fixed costs in this
Internal
Business
considering the fixed
division due to the constant capital expenditure
perspective
costs (ex. Capital
investments, utilization rates are important to
expenditure) are high in
ensure that the division is working at an efficient
this division
pace to offset those fixed costs.
• Number of times
• With contracts spanning several months, it is
production and delivery
important that the job be finished quickly in order
schedules were not
to be able to take on new contracts as they arise.
met.
It is also important to customer satisfaction, that
customers are getting the machine tools when they
need them by.
• Customer satisfaction
• Given the nature of the industry, the division is
Customer
Perspective
measured by customer
likely to have a few large customers rather than
surveys and complaints.
many small ones. As such, customer satisfaction is
important because it means that if they have other
needs for specific machine tools in the future they
will use Enager again, and they may refer our
company to others.
• Return on investment
• Long-term earnings and the survival of a
Financial
Perspective
measured by return on
corporation in the long run is largely dependent on
investment ratio.
its ability to earn a return on its investment. This
• Net Income as
ratio for this division is important because of the
compared to prior
heavy capital expenditures requirement. It needs
to be monitored to ensure that the purchased
years
assets are earning an adequate return.
• Given the demand of customers for our services
can vary immensely, net income needs to be
monitored to ensure that division is still able to
cover its own costs as an independent division.
9
Professional
Measures
Services
Division
Innovation and • Employee growth
learning
measured by number of
Perspective
professional
development days per
employee in the year
Internal
Business
perspective
•
•
•
Customer
Perspective
•
Financial
Perspective
•
•
Capacity Utilization, in
terms of sold time
relative to available
professional hours
On-time deliver
measured by percentage
that deadlines set by
clients for services were
met
Quality measured by
customer complaints
Customer loyalty
measured by the sales to
the customer as a
percentages of the
customers total
requirements for the
same produce or services
Return on investment
measured by residual
income
Sales revenue growth
measured by percentage
increase from the prior
year.
Important of Measure
• Given that the nature of the services
provided depend on employees technical
skills and knowledge, keeping up to date up
new technologies regarding planning,
engineering’s, as well as laws and regulations
is key to the quality of the division’s offerings
• Important to measure that the talent base
acquired through employees is be utilized to
full potential, and it also serves to provide
disincentives for shirking.
• Given the legal nature surrounding the
“environmental impact” studies, prompt
delivery of reports and services is important
to customer satisfaction.
• Quality of service is vital especially in a
service industry.
• There is a high profit potential in being the
only provider of professional services for
planning, architecture, and engineering for a
given corporation. This loyalty should be
measured in order to recognize if it is ever
decreasing.
• Long-term earnings and the survival of a
corporation in the long run are largely
dependent on its ability to earn a return on
its investment. This ratio for this division is
important because of the heavy capital
expenditures requirement. It needs to be
monitored to ensure that the purchased
assets are earning an adequate return.
• Sales growth is important to measure the
quantitative effects that the other qualitative
measures have on profitability.
10
The following represents cause and effect relationships between the measures within each
balance scorecard.
Customer Products Division
• Fostering manufacturing skills
Innovation
and Leaning
Internal
Business
• High first pass yield rates
• High quality products that are not returned by customers
• Customer satisfaction
Customer
• Customer loyalty to brand
• Sales revenue growth
Financial
Innovation
and Learning
• Fostering creativity
• Creation of new products
• Increased customer loyalty and satisfaction
Customer
Financial
• Sales revenue growth
• Increased return on investment
11
Industrial Products Division
Innovation
and Learning
• Training for Manufacturing Skills
• Spending on cutting edge technology
Internal
Business
• Full capacity utilization for machinary
• Delivery schedules meet
• Customer satisfaction increased
Customer
Financial
• Return on assets increased through higher utilization
• Net income increased
Professional Services Division
Innovation
and Learning
Internal
Business
• Increase technical abilities employees through training
• Increse quality of work produced
• Increase customer satisfaction and loyalty
Customer
• Increase sales revenue growth
Financial
Other recommendations for Randall and Hubbard
1. Investigate into why the cost of debt has increased substantially from 4.6% to 9%.
2. Investigate other forms of financing that may be cheaper than the current long-term
long
debt.
3. Due to the increase in account receivables, look into determining the collectability of
the receivables and calculating allowance for doubtful accounts.
4. Tightening credit terms in order to prevent potential future cash flow problems.
5. Evaluate managers based on proposed balanced scorecards.
6. Consider expansion/contraction of business divisions based on new performance
measures and the balanced scorecard.
7. Proceed with the one-day
day company off
off-site retreat in order to foster knowledge sharing
and cooperation and to boost morale
morale.
12
Appendix A
ENAGER INDUSTRIES, INC.
Statement of Cash Flows
For the Year Ending December 31st 1993
Operating Section
Net Income (Loss)
Add/Deduct Non-cash items
Amortization
Increase in Accounts Receivable
Increase in Inventory
Increase Accounts Payable
Decrease in Taxable Payable
1
Increase in Deferred Income Taxes
Net Cash from Operating Activities
$
12,153
$
$
$
$
$
$
9,864
(5,757)
(9,915)
7,698
(495)
1,278
Investing Section
2
Purchase of Property, Plant and Equipment
Purchase of Long-term Investments
Net Cash from Investing Activities
$
$
Financing Section
Issuance of Common Shares
3
Issuance of Long-term Debt
4
Cash Dividends Paid
Net Cash from Operating Activities
$
$
$
$
14,826
$
(28,158)
$
13,527
$
$
$
195
4,212
4,407
(25,230)
(2,928)
6,432
13,380
(6,285)
Change in Cash for 1993
Beginning 1993 Cash Balance
5
Ending 1993 Cash Balance
1
Assuming Deferred Income Taxes is a Current Liability
Assuming no disposition of long-term assets
3
Please see Schedule 1 and assuming no early retirement of debt
4
Please see Schedule 2
5
Matches 1993 Balance Sheet Cash Amount
2
Schedule 1 - Change in Long Term Debt
1993 Long-Term Debt Balance
$ 46,344
Add: Current Portion of Long-Term Debt
$ 4,902
Less: 1992 Long-Term Debt Balance
$ 37,866
Change in Long-Term Debt
Beginning Retained Earnings
Add: 1993 Net Income
Less: Ending Retained Earnings
1993 Cash Dividends Paid
$
13,380
$
6,285
Schedule 2 - Cash Dividends Paid
$ 67,659
$ 12,153
$ 73,527
13
Appendix B
ENAGER INDUSTRIES, INC.
Comparative Balance Sheets
For 1992 and 1993
(thousands of dollars)
As of December 31
1992
1993
Change
% Change
Assets
Current assets:
Cash and temporary investments
Accounts receivable
Inventories
$4,212
41,064
66,486
$4,407
46,821
76,401
$195
$5,757
$9,915
4.63%
14.02%
14.91%
Total current assets
111,762
127,629
$15,867
14.20%
Plant and equipment:
Original cost
Accumulated depreciation
111,978
38,073
137,208
47,937
$25,230
$9,864
22.53%
25.91%
Net
Investments and other assets
73,905
6,429
89,271
9,357
$15,366
$2,928
20.79%
45.54%
$192,096
$226,257
$34,161
17.78%
$29,160
3,630
0
$36,858
3,135
4,902
$7,698
($495)
$4,902
26.40%
-13.64%
32,790
1,677
37,866
44,895
2,955
46,344
$12,105
$1,278
$8,478
36.92%
76.21%
22.39%
72,333
94,194
$21,861
30.22%
52,104
67,659
58,536
73,527
$6,432
$5,868
12.34%
8.67%
119,763
132,063
$12,300
10.27%
$192,096
$226,257
$34,161
17.78%
Total assets
Liabilities and Owners’ Equity
Current liabilities:
Accounts payable
Taxes payable
Current portion of long-term debt
Total current liabilities
Deferred income taxes
Long-term debt
Total liabilities
Common stock
Retained earnings
Total owners’ equity
Total liabilities and owners’ equity
14
ENAGER INDUSTRIES, INC.
Comparative Income Statement
For the years ending 1992 and 1993
(thousands of dollars, except earnings per share figures)
Year Ended December 31
Sales
COGS
Gross margin
Other expenses:
Development
Selling and general
Interest
Total
Income before taxes
Income tax expense
Net income
Earnings per share (1,500,000 and 1,650,000
shares outstanding in 1992 and 1993,
respectively)
1992
1993
Change
% Change
$212,193
162,327
$222,675
168,771
$10,482
$6,444
4.94%
3.97%
49,866
53,904
$4,038
8.10%
12,096
19,521
1,728
12,024
20,538
2,928
($72)
$1,017
$1,200
-0.60%
5.21%
69.44%
33,345
35,490
$2,145
6.43%
16,521
5,617
18,414
6,261
$1,893
$644
11.46%
11.47%
$10,904
$12,153
$1,249
11.45%
$7.27
$7.37
$0.10
1.38%
Financial Ratios
1992
Accounts receivable turnover*
2.58
AR/Total assets
21.38%
Deferred income taxes/Total assets
0.87%
Gross profit margin
23.50%
Net profit margin
5.14%
ROA
5.68%
ROE
9.10%
* Assumes that approximately 50% of sales is on credit
1993
2.38
20.69%
1.31%
24.21%
5.46%
5.37%
9.20%
15