Introduction

The promotion of the Chief Financial Officer (CFO) to Vice President for Overseas Operations has indeed left a knowledge gap in the owners group regarding some key finance and accounting issues. As requested, this memo sets out to explain some of these issues. The focus will be on economic value added (EVA), fixed assets turnover ratio, net profit margin, sales forecast and breakeven analysis.

Economic value added (EVA)

This is one of the performance measures of a company that tries to avoid some of the pitfalls in accounting performance measures. Behind EVA as a concept is the idea that investors must get above average returns to continue their investments in the company (Elliott & Elliott, 2011, p.758). Some organizations even rely on EVA as the basis for bonus payments to managers. EVA calculates the returns to investors after deducting a charge for the cost of capital (Brealey, Myers & Allen, 2011, p.299). This measure is sometimes called residual income and is determined by adjusting the net profit after tax (NOPAT) for the dollar return required by investors.

Unlike accounting performance measures, EVA has the advantage of encouraging managers and employees to focus on value creation as opposed to increasing earnings (p.299). Using EVA has several advantages over earnings or growth of earnings. For instance, it provides an opportunity to highlight parts of the business that may not be performing as expected. This may inform the management to employ the assets of a non performing division to other places. By making the cost of capital visible to operating managers, EVA leads to the disposal of underutilized assets.

Ratio analysis

A key role of the Accountant is to present users with financial information that would be relevant for their use in making decisions. Much as the accountant may try, the reality is that financial statements rarely make any sense for users by themselves. Shareholders of a company as one category of those who use financial statements may want to analyze them by comparing to other firms. Such a comparison is impossible unless there is some form of standardization in the relevant financial statements.  Ratio analysis is one way to standardize some information in the financial statements.

Ratios try to show how the various components of financial statements are related to one another (Elliott & Elliott, 2011, pp.696-673). Any set of financial statements can generate several ratios. An expert analyst is, therefore, that person who can tell ratios with relevant information. For example, those interested in the company may have an interest in knowing whether there will be enough profits to pay dividends. It is obvious from this that the aspect of a company’s affairs under investigation determines the relative usefulness of each ratio.

An effective use of ratios must proceed with some caution. First, one must be aware of the fact that companies use different accounting policies making comparisons valid only in cases where those policies are the same (p.698). In addition, the definition of ratios does not follow any universal pattern.  Thus, it is possible to find differences in the components that go into the computation of any ratio from one company to the other. Furthermore, over time changes in any of the two values compared by a given ratio can often be obscured. Stated differently, a financial ratio only says something about the combined effect of its individual components. One cannot assume anything about the underlying figures.

Fixed Assets Turnover Ratio

This ratio is one of those which are commonly referred to as asset management ratios or simply as asset utilization ratios. These ratios measure the ability of a firm to manage assets at its disposal (Baker & Powell, 2005, p.56). Fixed assets turnover ratio measures the efficiency with which the management is managing the fixed assets of the firm (p.60). The ratio is an indication of the effectiveness with which the management uses net fixed assets to generate sales. It can also be seen as a measure of the number of times that a dollar of fixed assets leads to a dollar of revenues. For instance, a fixed assets turnover ratio of 1.5 indicates that the business generates $ 1.5 of net revenues for each dollar invested in net fixed assets.

It appears from the above discussion that the higher the ratio, the more efficient the management is utilizing net fixed assets. There should be caution in establishing the reasons for any change in the ratio (Elliott & Elliot, 2011, p.702). For example, an increase in the ratio could be the consequence of increased revenues or a decrease in the capital asset base or even both.

An increase in fixed asset turnover ratio is a positive indicator if it is the result of increased sales provided that either the sales mix or selling prices remain the same (p.702). But sales can still increase at the expense of profit margin in situations where large discounts are given. On the other hand, an increase in the ratio resulting from a decrease in the capital asset base is not a good thing in itself.  For instance, it could be the failure to maintain capital assets which has the implication of sacrificing operating efficiency.  Bias may also arise from the historic cost accounting principle used in recording fixed assets.  Under this principle, firms with older fixed assets are likely to post relatively high fixed asset turnover ratio in times of inflation (Baker & Powell, 2005, p.60). In contrast to showing any efficiency in the utilization of fixed assets, such a high ratio may simply show that the firm should replace its old assets.

Net Profit Margin

The ratio falls within the wider category of profitability ratios. They gauge the ability of the firm to manage its expenses in relation to sales (Baker & Powell, 2005, p.62). They are also a reflection of operating performance, riskiness and leverage. As a part of this group of ratios, the net profit margin is a measure of the percentage of sales that results into net income. It is calculated as shown below:

As with fixed asset turnover ratio, a higher net profit margin should generally mean well for the company for two main reasons. In the first place, it may suggest that the firm is able to control its costs. The conclusion stems from an understanding that costs, by way of expenses, is a key component in the computation of net income (Baker & Powell, 2005, p.62). Secondly, it could also be the indication of the competitive strength of the firm within its industry. Uncompetitive firms in any industry are always vulnerable to cost-cutting measures from competitors. In contrast, a low net profit margin indicates the inability of the firm to control costs. It may also be an indication of declining competitiveness of the firm as other firms in the industry offer lower prices.

Knowledge of the industry in which the firm operates is important as net profit margins vary with industry. For instance, industries in with high sales volumes can accommodate even low net profit margins (Baker & Powell, 2005, p.62). This is actually the case in most retail businesses where net profit margins are not very high.  The high turnover of total assets allows firms in such industries to operate profitably even with low net profit margins.

Sales Forecast

Planning is important to the success of any organization. The whole organizational plan would normally consist of three components: goals of the organization, the strategic long range profit plan and the master budget.  The master budget outlines how the organization intends to achieve its goals in the next year (Maher, Stickney & Weil, 2008, pp.304-310). Although the process of developing a master budget varies from one place to the other, there is evidence that sales revenue is one of the most important measures in many places. This makes sales forecasting a very important component of budget preparation.

The level of subjectivity inherent in the process makes sales forecasting a particularly difficult exercise (p.305). There is no single source of information for making sales forecast. Given their proximity to customers, sales staff may have very useful information for forecasting. Sales staff are, however, prone to bias their forecasts if performance evaluation depends on them. To avoid this bias, the management can also turn to market researchers for forecasts (p.306). Forecasts from this group are more likely to be objective as they have no incentive to bias their forecasts.

Bias in sales forecast can also be reduced by using the Delphi technique. Members of the forecasting group submit anonymous estimates to each other (p.310).  These are then discussed and the process is repeated until the different estimates are reconciled to a single reasonable one. Besides these three methods, an organization can also employ trend analysis and econometric models in forecasting sales.

Breakeven Analysis

This kind of analysis falls under the wider category of Cost-Volume- Profit (CVP) analysis. CVP analysis investigates the relationship between the various cost components. When conducting a break-even analysis, managers are simply seeking to know what would happen if both sales and cost forecasts turned out to be worse than was expected(Brealey, Myers & Allen, 2011, p.246).

The break-even point becomes very important in conducting such analyses. It is the point at which the business neither makes a profit nor a loss. Production above this point would see the business make a profit. On the other hand, production below the point results into a loss. Any business intent on success must, therefore, strive to at least break even. The ability to break-even can see a firm remain in business in the short run even if it is thought that there will be opportunity to make profits in the long run.  At break-even:

Conclusion

It is my hope that the above information will prove useful for making some key decisions in the management of the company.

References

Baker, H.K., & Powell, G.E. (2005). Understanding Financial Management: A Practical Guide.   Malden, A: Blackwell Publishing.

Brealey, R.A., Myers, S.C., & Allen, F. (2011). Principles of Corporate Finance (10^th        Edn.).Avenue of the Americas, New York: McGraw-Hill Irwin.

Elliott, B., &Elliott, J. (2011). Financial Accounting and Reporting (14^th Edn.). New York:           Pearson.

Maher, M.W., Stickney, C.P., & Weil, R.L. (2008). Managerial Accounting: An Introduction to     Concepts, Methods and Uses (10^th Edn.). Mason, OH: Thomson Higher Education.

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