Topics

 

In this section I will deal with some issues in a detailed and, at the same time, simple way about the world of controlling, its topics, both strategic and operating ones, both the current approaches and the future trends, that is the way the companies "do it" and are going to do it and, of course, my advice.

 

76. Strategic "Extra-Compensation" - Part 2

75. Strategic "Extra-Compensation" - Part 1

74. Not Only ROE and ROI!! - Part 2 (The Risk)

73. Not Only ROE and ROI!!

72. Looking at the Society as a Strategic Move

71. The Misconception of the Indirect Cost Allocation

70. The Soft Skills of the "Budgeters"

69. Praise for the Activity-Based Management - More in Fashion than Ever

68. The Crisis of Net Present Value

67. The Correct Framework of a Cost Center's Manager Performance Evaluation

66. Valuation of a Company? Which Approach Makes Sense Today?

65. OKRs and their Strategic Use in the Finance Dpt

64. Flexibility in Real Investments, its Financial and Strategic Value

63. When Depreciation Does Make Sense for the Operating Decision Making

62. Variable Costing vs Full Costing for the Profit Center Assessment

61. The New Evolution of the Performance Indicators

60. Management Accountant Profession in the Spotlight - The Last Song

59. Digital Assets and Customer Data: How to Evaluate Them as Fixed Assets

58. How to link the Capital-Investment Decisions to the Strategy

57. A full view on the use of the Value Chain Analysis

56. Labor-Intensive Businesses and the Learning Impact on Cost Estimation

55. Strategic Reporting Adherence: Lean, from the processes to the accounting

54. Zero-Based Budgeting and its Strategic Sides

53. How Many Kinds of Overhead Variance Analysis!

52. Project Control and some Risk Assessment Methodologies

51. When  the Operating Leverage is used as an excuse

50. A Common Manufacturing Accounting "Misundertanding"

49. Make the Right Price.

48. The Choice of the Kind of Bonus: Advantages and Risks

47. How Well is Your Company Using Its Money?

46. ROI: Some Strategic Sides about it and other financial performance metrics

45. Value Creation or Value "Invention"?

44. The Strategic Cost of Quality

43. The Rule of Thumb doesn’t exist

42. Why is the  Healthcare Cost Accounting so peculiar?

41. The strategic sides of Target Costing 

40. The great implications of the true Capacity Costs (PART TWO)

39. Which is the Most Profitable Customer? 

38. The Game of the Ending Inventory

37. How the "work" of the Support dpts affects the Cost Accounting Settings

36. Only Just In Time?

35. The "Way" to spot the real profitability by product

34. Risk Management: some important metrics

33. Another useful "piece" of variance analysis for the BU

32. Budgeting process: not only a numerical issue 

31. The great implications of the true Capacity Costs (PART ONE)

30. How does the Lean Accounting support the decision making?

29. The strategic interpretation of the productivity measurement (PREVIEW)

28. How deep you can dig and some strategic aspects in the variance analysis

27. Strategic distortions in the capital-budgeting project evaluation

26. Some errors in the capital-budgeting analysis

25. How and why to try to understand the real trend of the overheads

24. The cost variance analysis in the project control (INTRODUCTION)

23. The cost management and the customer-driven value model (PREVIEW)

22. What if you compete on timeliness and speed to customers?

21. The Strategic Fixed Overheads

20. The assessment of the State of the Work according to the activities

19. The choice of an appropriate costing system

18. How to deal with the uncertainty in the estimation process

17. The importance of the Product/Service Life Cycle costs

16. Resource Consumption Accounting: a comprehensive management accounting system

15. Strategic Transfer Pricing: Cost-based and Negotiated Price Methods

14. Motivation and other strategic factors in the Transfer Pricing: Market Price

13. Strategic sides of ROI

12. SBU's manager evaluation: - Nonfinancial measures and strategic structure

11. How can you evaluate your business? 

10. How do you deal with the indirect costs? 

9. A very useful "piece" of variance analysis for the BU  

8. Are you getting right about the estimation of the overheads? 

7. Constraints? Here is the way to make decisions 

6. Are you customer-oriented? Here's how you can know about that 

5. Global succes indicator

4. Which kind of standard cost is it convenient to set? 

3. Joint products: how the  contribution margin is calculated  

2. ABC: - Great difference in calculating the financial variances versus the traditional costing systems 

1. The cost of the complexity

 

In a turbulent industry and turbulent times, where the uncertainty and volatility reigns, the most appropriate way to assess the business manager performance of any kind of responsibility center (cost center, revenue center, profit center, investment center) is the benchmark approach we have seen in the previous paragraph.

 

Following this method you can compare your revenue, your profit, many of your costs to those of the competitors without a doubt. Of course  this is easier to be done when we refer to large-sized firms that have a most immediate way to benchmark their numbers  through, for instance, internet info services always available.

 

SMEs have some trouble to have a fast benchmark as reliable as possible.

 

In these realities the most recurring methods are often the Static Budget or the period-against-previous period method that compares the reference values of the lapse of time just passed to those of the same period of the previous year.

 

The latter, used also by many large-sized companies, serves to monitor the succes of the continuous improvement strategy that fits very well any sort of industry and business center.

 

Thererefore it is habitual to see Revenue vs Previous Year's Revenue, Trade Profit vs Previous Year's Trade Profit as the comparison put in place to assess the performance of the managers/employees.

 

If the advantage of this way is the congruengy goal achievement that makes the manager's actions converge towards the company's objectives, on the other hand it is not sometimes very fair with regards to the same center managers that are made accountable for some factors not under their control.

 

That is the case of the uncertain and volatile periods when, for instance, the commodity prices fluctuate a lot, the supply-side bottlenecks happen, etc...

 

At this point the best way to hit both a congruent and a fair evaluation method could be to adopt a mixed approach.

 

Imagine to benchmark the difference between the company's  ROI and the previous period's ROI against the same difference of the top "peers" in the reference industry.

 

In my opinion the mixed method could be the best way to go along when comparing businesses at the same stage of their life.

 

In fact it's clear how a firm that kicks off a large investment policy will have financial results not comparable to those of the competitors that instead is living another stage of its life.

 

This aspect is always to be taken into account both with the mere benchmark approach and with the mixed one. 

 

Other methods exist and depend on some strategic factors, stage of the business' life and kind of responsibility center. The issue is to be dealt with by using professionale expertise and a genuine attitude both to the achievement of the goals of the organizaion and to the respect for the managers doing their best when working.

 

If are interested in going deep into this topic, don't hesitate to get in touch with me.

 

As we all know most companies are accustomed to rewarding their managers and other employees based on the difference between Actual results and Budget targets.

 

This old approach is something that is to be reviewed more than ever because of at least two reasons.

 

The first of these is nothing new but it looks as if may organizations aren't aware of it.

 

The above model might cause some consequences that impact the trust relationship between managers and the "business" in a dangerous way for the profitability of the business itself.

 

As a matter of fact, linking the compensation to a fixed target my lead some managers to set biased numbers in the budget where they come into play, in a sense that they push to make some easy goals, in terms of cost savings, revenue/profit results, look motivating and hard to achieve.

 

Once these targets are accomplished at the end of the reference period nothing advantageous is obtained for the organization, that is held to pay the undeserved bonus to the managers.

 

This void of interest congruency is called "budgetary slack".

 

The second reason concerns the fairness aspect in consideration that the accomplishment of the budget goals, particularly in the current times characterized by the volatility and uncertainty of many external factors, could be affected by macroeconomics events that would make the performance assessment unfair or undeserved.

 

In other terms the extent either of the achievement or of the failure of the targets fixed on the static budget session would depend on noncontrollable factors, beyond the influence of the people to be "rewarded".

 

These considerations together with those concerning the development of new forms of planning would lead us to think of other ways to measure and assess the performance of the managers/employees.

 

These ways will depend also on the kind and size of business as well as the industry where the business operates.

 

Just to mention one of these approaches I like to highlight how the comparison of the actual results of the business units with those of the business' peers in the industry concerned could deprive the evaluation of undeserved or penalizing assessments described in the lines above.

 

This way is also the best measure of the success of the company in the market and sounds without a doubt as a strong motivation tool for the whole business that wants to improve and improve.

 

Nonetheless, it's clear how this method is more appropriate to be applied by large-sized organizations whose benchmarcks are easily "on hand".

 

Then which method is most strategic for SMEs?

 

See you at the next publication.

  

 

In the previous articles we have disserted about many profitability rates concerning different assets and different kinds of info a manager needs from their calculation.

 
What if we want to navigate the risk incoporated into the assets analyzed?

When usually does it happen?

The ratio that comes up at once is RORAC and usually it is used in the management of banks, insurance companies and other financial enterprises for risk analysis and investment evaluation.

More precisely it is a rate of return  commonly used when various projects and investments are evaluated based on capital at risk and when the projects/investments have with different risk profiles.

 
This work is easier to do if their individual RORAC values have been calculated.

 

How do we get to this profitability rate?

 

Return on risk adjusted capital is an adaptation of the concept of ROCE (Return on capital Employed) used by industrial and commercial businesses and it is obtained by placing in the numerator the expected results of transactions relating to a financial instrument, a project, or a certain operational activity and in the denominator the capital to be used adjusted to take into account the associated risks.

 

Formula

 

Return on Risk Adjusted Capital (RORAC) = Net Income (or Expected Return)/Risk-Weighted Assets (RWA)

 

At this point we have to clear what we mean by Risk-Weighted Assets.

Risk-Weighted Assets are the allocated risk capital, economic capital, or value at risk.

 

Allocated risk capital is the firm's capital we adjust for a maximum potential loss calculated once we have estimated future earnings distributions or the volatility of earnings.

In other terms, it's the amount of capital that a company needs to ensure that it is "at ease" given its risk profile.

Risk-weighted assets (RWA) are calculated by multiplying a bank's assets by their respective risk weights.

​
....And what about RAROC (Risk-adjusted return on capital)?

 

 
See you soon!!!

 

The business' Profitability is monitored and estimated in different ways, both through intermediate results and ratios, both with regard to the whole business and with regard to its pieces (units, projects..).

 
The range is as large as fascinating and many finance people cannot know all of them.

 

You have heard of ROE (Return on Equity) and ROI (Return on Investment) and seen the "path" to get them thanks to your basic study courses, but in addition to these you have learned or experienced that other ratios are used to explore how efficient and profitable the use of the business assets is or will be within the different specific organization they belong to and according to the specific goal the analysis is intended for.

 

At this point we could ask ourselves what RONA, ROIC, ROA, ROCE and others are like and why they are used!

 

Let's kick off with RONA.

 

 

RONA

 

It is the Acronym for Return on Net Assets.

It measures the efficiency at which a company utilizes its net assets, i.e. fixed assets and net working capital (NWC); in particular its goal is determining whether the allocation of business' net assets is generating earnings or not.

 

There are three inputs we need to calculate the return on net assets (RONA):

Net Income
Fixed Assets
Net Working Capital (NWC)

 

RONA = Net Income/Fixed assets + Net Working Capital

 

It gives us the net profits per dollar of fixed assets and net current assets owned.

It's clear how the higher the RONA the more efficient the company is at generating profits .

 

In order to understand this profitability metrics better, let's focus on the terms at the denominator:

 

- Fixed Assets : In this metrics we consider the long-term tangible assets belonging to a company such as property, plant and equipment.

- Net Working Capital: it is the difference between operating current assets and operating current liabilities; cash and cash equivalents, as well as debt and any interest-bearing securities, are not not taking into account.

 

In order to make numerator and denominator consistent about timing, it would be very advisable to use the average for the period under scrutiny with regards to the fixed assets and net working capital (NWC) calculation.

 

As to the Net Income the bottom line of the Income Statement can be considered but in my opinion the best suitable metrics for this use is NOPAT (Net Operating Profir After Tax) that is the Net Income minus Financial Interests plus the Fiscal Savings from Financial Interests.

 

RONA = NOPAT/Fixed assets + Net Working Capital

In so doing you have the maximum "Operating" consistency between numerator and denominator.

 

One profitability ratio that makes use of NOPAT, just as it could be advisable for the calculation opf RONA, is the ROIC.

 

 

ROIC

 

What is ROIC like?

 
The Return on Invested Capital (ROIC) measures the percent return earned by a company using the capital contributed by equity and debt providers.

In practice, ROIC is commonly used to determine the efficiency at which capital contributed by shareholders and lenders is allocated, because the generation of a positive value is perceived as a necessary attribute of a quality business.

ROIC stands for “Return on Invested Capital”.

It ultimately determines the long-term sustainability of the business model since it represents the rate of return earned by a company from reinvesting the funds contributed by its capital providers, i.e. equity and debt investors.

The formula to calculate ROIC is NOPAT divided by the average invested capital, i.e. the company’s fixed assets and net working capital (NWC).

 

ROIC = NOPAT/Average Invested Capital

 

NOPAT (Net Operating Profir After Tax) is the Net Income minus Financial Interests plus the Fiscal Savings from Financial Interests-

NOPAT is the most suitable numerator because even more than the cash flow metric because the latter captures the core operating profits and is an unlevered measure (i.e. unaffected by the capital structure).

 
Instead NOPAT is a company’s tax-affected operating profit  and thus represents what is available for all equity and debt providers.

 

Average Invested Capital represents the sources of funding raised to grow the company and run the daily operations.

As we know these sources of funds for the businesses are debt and equity.

 

Debt Financing is the capital raised by a company in exchange for the interest to be paid periodically throughout the borrowing term and the return on the principal at maturity.

Equity Financing consists of the capital a company gets by issuing ownership stakes allocated to institutional investors (i.e. venture capital and/or growth equity firms) or the secondary markets if the company is publicly traded.

 

Having said that here is the formula.

Invested Capital = Fixed Assets + Net Working Capital (NWC) + Acquired Intangibles + Goodwill

 

In any case the simplest way to calculate the denominator is to add the net debt (i.e. subtract cash and cash equivalents from the gross debt amount) and equity values from the balance sheet.

in fact cash and cash equivalents (e.g. marketable securities) are not considered as operating assets and as a result the line item is excluded.

As to the uses that a company makes of ROIC, the main one is comparing the business' ROIC at different points in time and together with that making comparisons to peer companies.

 

 

ROA

 

Let's turn our attention to another much used profitability ratio concerning the business' "ability" to use its assets: Return on Assets (ROA).

It indicates how profitable a company is making use to its total assets.

 

Its formula is:

 
ROA = Net Income/Total Assets

 

ROA factors in a company's debt unlike ROE.

In fact the total assets are the sum of the total liabilities of a company and shareholder equity and this consideration exists since both types of financing are used to fund a company's operation and try to generate profits.

 

ROE comes out as a percentage using a company's net income and its assets.

 
The higher ROA the more efficient and productive the business at managing its balance sheet to generate profits.

It tells you what earnings are generated from the business' assets.

ROA target for a company depends on the industry in which they work; that's why it is best to compare it against a previous ROA or a similar company's ROA.

A particular use of ROA is the one financial companies do; at the denominator they put the average value of assets instead of the current value and that's done to gauge financial performance.

 

 

ROCE

 

What is Return on Capital Employed (ROCE) like?

Return on Capital Employed (ROCE) is a ratio that in addition to measuring how efficiently a company is using its assets to generate profits is often used by investors to assess whether a company is good to invest in or not.

 

ROCE = EBIT/ Capital Employed

 

Earnings before interest and tax (EBIT) is, as we know, the company’s profit, including all expenses except interest and tax expenses.

My opinion is to use instead the Net Operating Profit After Tax (NOPAT) since it excludes the non-operating income such as Lease, Dividend and Investment Income, Foreign exchange transaction income.

 
Capital employed is commonly derived from total assets less current liabilities.

 

About the ROCE meaning, its calculations shows how much operating income (or EBIT) is generated for each monetary unit of capital invested.

 
The higher the better since it tells us that more profits are generated per dollar of capital employed.

As we said above ROCE is used to understand whether a company can be a good investment or not and as a result the comparison of its ROCE with other companies' ROCE of the same industry is the best way to hit this goal.

Some appropriate considerations should be done when comparing these companies' ROCE, just as you shoul do when taking into account other profitability ratios to be used in conjunction with ROCE in order to decide whether to invest in that company or not.

 

In the end we have seen four Financial Ratios accounted for to determine whether a company is efficient in using its capital or not, each of them with their own use, individually or together with other indexes.

We have seen also the best ways to compute these ratios for every component of their formula.

Further in-depth analyses about use and computation methods can be dealt with by writing on page Contacts of this website.