Measurement of Firms Performance - Coursework Example

How do firms measure their performance? What options are available to the firm, which techniques are most commonly used and what more recent methods are some firms now using? July 23, 2014 Table of contents How do firms measure their performance? What options are available to the firm, which techniques are most commonly used and what more recent methods are some firms now using? 1 July 23, 2014 1 1. Introduction 4 2. Firm value Creation and Measurement 4 3. Conclusions 10 References 12 List of Figures Figure 2.1. Firm performance perspectives and dimensions (Carton and Hofer, 2006) 5 Figure 2.2. Indicators for dimensions of firm performance (Carrott and Jackson, 2009) 6 Figure 2.3. The Porter value chain (Porter, 1985) 8 Figure 2.4 Performance factors for value creation (Leask and Parker, 2007) 10 1. Introduction Firm performance refers to the process of evaluating the performance of a firm, in areas of its business and other activities. Traditional firm performance measures focused on accounting metrics such as sales turnover, profit, productivity, efficiency, share price, market capitalisation, and others such metrics (McKinsey, et al. 2010). However, these metrics present short-term performance measures that focus on financial results. Values for these measures are presented in the company balance sheet, filed to meet regulatory requirements, and to help investors to understand the organisation performance (Deelder, et al. 2008). Direct accounting measures do not reveal the extent to which the organisation has used its resources, the innovation capability of the staff, firm value, reputation in the market, and other such important measures. Accounting and financial ratios also do not explain the firm performance, in comparison with that of rival firms, or similar types of businesses (Chan and Mauborgne, 2002). During mergers and acquisitions, valuators look at many measures that are beyond accounting figures, and these reveal not only the financial health of a company but the future prospects, and the value creation ability of the firm (Porter, et al. 2004). This paper evaluates the methods used for firm performance by focussing on factors such as the firm value and strategy for growth, which an organisation draws. 2. Firm value Creation and Measurement Firm value creation refers to the organisation processes used to create value in the organisation. Value is much more than annual sales and covers the long-term business value created through the competitive advantage of the firm, the innovative culture in the firm, and the motivation level of the employees (Baum and Wally, 2003). This chapter evaluates the concept of firm value creation and its measurement. 2.1. Understanding firm performance perspectives Firm performance has two perspectives in which measurements are done, and these are financial performance and strategic performance (Santos and Brito, 2012). As stated in the introduction section, financial performance measure is obtained through the balance sheet, and some of the common dimensions are profitability, growth, and market value (Arnold, 1998). Strategic performance on the other hand, is more complex since the results and outputs are not directly available, but rather, these have to be derived through other methods (Stewart, 1991). The following figure illustrates the dimensions. Figure 2.1. Firm performance perspectives and dimensions (Carton and Hofer, 2006) Strategic performance measures act as the drivers for financial performance. Each of these performance measures has a number of indicators, which are used to calculate the firm performance (Farris, et al. 2008). The following figure illustrates these indicators. Figure 2.2. Indicators for dimensions of firm performance (Carrott and Jackson, 2009) 2.2. The shareholder wealth value analysis Shareholders are entities who have invested in an organisation, either by purchasing equity or through loans. The primary objective of a company is the maximisation of the shareholder wealth. One common method used for measurement is the net present value - NPV and this is the value obtained from the present value of future operating cash flows discounted at the cost of capital (Collis and Montgomery, 1998). When the business activities earn more money than the cost of capital invested, the shareholder wealth increases. Shareholder value analysis - SVA helps to measure the firm performance, and the shareholder wealth appreciation. Six important drivers are associated with the increase of shareholder wealth, and these include a positive sales growth rate and an appreciating operating profit margin; a decreasing tax rate; fixed capital investment, where flight of capital does not occur; an adequate working capital; a well defined planning horizon, and obtaining the required rate of return (Rappaport, 1986). 2.3. External value metrics While internal valuation gives the metrics for firm performance, it is important to use external metrics for a comparative assessment. Such an assessment helps the investor to evaluate the performance of a firm with reference to the performance of peers. Important metrics used include the total shareholder return - TSR, market value added - MAV, and the market to book ratio - MBR. TSR gives the total return on shares over a period, and it includes dividend returns, and share price changes. It is calculated as the ratio of dividend per share, plus the difference of final and initial share price, to the initial share price. UK firms must show the TSR in comparison with a standard index. The main drawback is that share price is decided by the market, based on many factors, which do not reflect the management performance (McTaggart, 1994). MVA is used to measure the wealth created over a period. It is market value less the capital, and the market value is the sum of the current value of debt and the shares issued. Capital refers to the cash obtained from financing or from earnings, used to fund new investment. It helps to obtain other metrics such as rate of return, and to determine the cash invested in a business (Bruckner, 1999). MBR differs from the other two valuations, and it measures the wealth created over the life of the business. It includes debt, equity, market to capital, and neutralises any leverage differences across companies. The main drawbacks are that MBR distorts with inflation, and it is difficult to estimate if rate of return on capital higher or lower relative to the cost of capital (BCG, 2000). 2.4. Firm performance and the value chain The value chain considers the value generated through strategic alliances for a business. An organisation, large or small, is a part of a value chain, and it must add value to the network through value drivers, else it is pushed out of business. Value drivers are important processes and capabilities, which help a firm to generate and sustain high value strategies. The value chain looks mainly at the value drivers, influenced by the cost drivers. The objective is to find network nodes where value or cost is created, and use this information to increase the sustainable competitive advantage. The following figure illustrates a typical value chain, with all the important processes and capabilities. Key processes are the primary activities while support activities are the capabilities (Porter, 1985). Figure 2.3. The Porter value chain (Porter, 1985) Considering the value chain, it becomes obvious that firm performance, depends on the performance of the primary and support activities. Metrics for primary activity performance measurement include productivity, throughput time, efficiency, and accounting measures. Metrics for support activities must be derived using other analytical methods such as value invested and returns obtained, the number of mismatch or errors, etc. The firm value appreciates only after the value chain becomes efficient (Lorange and Roos, 1992). 2.5. Using Benchmarking standards to measure firm performance A very important test for performance measurement is to assess the performance with standard industry best practices. A number of websites are available that provide results of studies on best practices for different sectors. The databases provide indicators, their benchmarked values, and these can be compared with the firm performance metrics (Benchmarking, 2014). 2.6. Defining firm strategy and firm performance The previous sections explained different methods to assess the firm performance, and several financial measures were discussed. As mentioned in section 2.1, it is also important to evaluate the firm performance from the strategic perspective. Strategy refers to the integrated set of actions that leads to a sustainable competitive advantage. Strategic factors for firm performance include market economic factors, the competitive position, the financial determinants, and these lead to value creation (Hamel and Prahalad, 1990). The following figure illustrates the factors that lead to value creation. Figure 2.4 Performance factors for value creation (Leask and Parker, 2007) From the above figure, it becomes obvious that measuring the strategic firm performance depends on the strategy implementation. Strategy is designed and implemented using tools such as the Porters Five Force analysis, PESTLE, SWOT, McKinsey 7 S Framework, and others. Measuring the firm performance therefore depends on the quality of inputs used in the initial analysis. The analysis tools help to position the firm in the competitive landscape. This positioning is determined by the ranking given to various indicators such as market share, quality of customer, strengths, and competencies in the business areas, the strength of the competitive advantage, inter alia. Once these metrics are understood and classified, the firm strategy needs to drawn up, implemented, and measured, to gauge the effectiveness of the strategy. These activities then become a part of the firm performance measurement. 3. Conclusions The paper discussed various methods to measure firm performance, covering financial and strategic methods. Measuring firm performance helps the organisation, and investors to understand and evaluate the extent to which shareholder wealth appreciates. Internal financial metrics include a number of accounting ratios such as sales, productivity, efficiency, operating margins, etc. External metrics that were examined include TSR, MAV, and MBR. An interesting theme that was discussed was to measure the performance of the value chain, and to use data from benchmarking databases. Such methods help to understand the firm performance in reference to the performance of industry peers. References Arnold, G., 1998. Corporate Financial Management. London: Financial Times Baum, J. R., and Wally, S., 2003. Strategic decision speed and firm performance. Strategic Management Journal, 24(11), pp: 1107-1129. BCG, 2000. New Perspectives on Value Creation. NY: Boston Consulting Group. Benchmarking, 2014. Benchmarking Network, Inc - Business Process Best Practices. 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NY: Free Press. Leask, G., 2012. Lecture 2. Internal Value Metrics. Lecture Notes, Aston Business School Leask, G., and Parker, D., 2007. Strategic groups, competitive groups and performance within the U.K. Pharmaceutical industry: Improving our understanding of the competitive process. Strategic Management Journal, 28(7), pp: 723-745. Lorange, P. and Roos, J., 1992. Strategic alliances: formation, implementation and evolution. MA: Blackwell. McKinsey & Company Inc., Koller, T., Dobbs, R. and Huyett,B. 2010. Valuation. NY: John Wiley & Sons. McTaggart, P., 1994. The Value Imperative. NY: Free Press Porter, M., 1985. Competitive Advantage. NY: Free Press. Porter, M, E., Lorsch J. W. and Nohria, N., 2004. Seven Surprises for New CEO’s. Harvard Business Review. Oct. pp: 62-72. Rappaport, A., 1986. Creating Shareholder Value. New York. Free Press. Santos, J. B. and Brito, L. A., 2012. Toward a subjective measurement model for firm performance. 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