A brief history or background of the Balanced Scorecard:
- Balanced Scorecard is not at all new in the market. It was initiated in 1992 with many companies especially Fortune 1000 adopting the BSC with phenomenal result.
- It was originally developed in the early 1990’s by Dr Robert Kaplan ( Prof Harvard Univ) and David Norton (Consultant). Both men researched on exploring new methods of performance measurement. They believed that financial measures of performance alone were ineffective for the modern business enterprise.
- Their study identified four areas of performance measures :
- Customer issues
- Internal business process
- Employee activities
- Shareholder concerns
Management is doing things right; leadership is doing the right things.
Leaders shouldn’t attach moral significance to their ideas: Do that, and you can’t compromise.
The leaders who work most effectively, it seems to me, never say “I.” And that’s not because they have trained themselves not to say “I.” They don’t think “I.” They think “we”; they think “team.” They understand their job to be to make the team function. They accept responsibility and don’t sidestep it, but “we” gets the credit. This is what creates trust, what enables you to get the task done.
“Erroneous assumptions can be disastrous.”
“The most serious mistakes are not being made as a result of wrong answers. The truly dangerous thing is asking the wrong questions.”
Management means, in the last analysis, the substitution of thought for brawn and muscle, of knowledge for folkways and superstition, and of cooperation for force. It means the substitution of responsibility for obedience to rank, and of authority of performance for the authority of rank.
What is the manager’s job? It is to direct the resources and the efforts of the business toward opportunities for economically significant results. This sounds trite — and it is. But every analysis of actual allocation of resources and efforts in business that I have ever seen or made showed clearly that the bulk of time, work, attention, and money first goes to problems rather than to opportunities, and, secondly, to areas where even extraordinarily successful performance will have minimal impact on results.What is the major problem? It is fundamentally the confusion between effectiveness and efficiency that stands between doing the right things and doing things right. There is surely nothing quite so useless as doing with great efficiency what should not be done at all. Yet our tools especially our accounting concepts and detail focus on efficiency. What we need is (1) a way to identify the areas of effectiveness (of possible significant results), and (2) a method for concentrating on them.
Earlier article discuss the need for managers to understand risk management. The following are the risks, the manager of a firm normally might encountered:
1.0 Market Risk which relates to business environment, industry, political situation,
2.0 Liquidity Risk which relates to cash-flow, funding, capital,
3.0 Credit Risk which relates to customers’ reputation, settlement, accounts, payment,
4.0 Operational or Process Risk which relates to the systems, policies and procedures, internal controls and management supervision
Risk management is defined as the process of analyzing exposure to risk and determining how to best handle such exposure
It is imperative that managers need to understand the importance of managing the risk in an organization. By doing so, numerous benefits are reaped like for example:
- Once we have established a sound risk management culture into the organisation’s business framework, it promote productivity in the sense that senior management and line managers can focus more on their primary responsibilities instead of squandering resources on “fire-fighting” the challenges that may arise due to the lack of such practices,
- Its strengthen the business planning processes by allowing decision-makers to make contingency plans to avert possible “ mishaps” thereby producing more realizable opportunities for the organization on the whole and leading to increased shareholder value,
- It’s enhance shareholder value as it assist in reducing expenses as there are many direct and indirect cost of risk.
- Management is able to avoid paying the direct and indirect of risk namely:
- For Direct cost of risk, it comprises: cost of replacement, loss of revenue, damages paid.
- Indirect cost of risk comprises: loss of market, loss of reputation, management time, paid absence from work, effects on insurance premiums, product or service recall, write-offs of plant or material, medical expenses and effect on morale,
- It’s provide a sort of peace of mind for senior management,
- It’s might be matter of business survival or failure,
- The reputation of the organization for social responsibility has been enhanced in relation to another organization who ignores risk management which affects the overall community or society,
- With the current emphasis on good corporate governance by outsiders like investors, it’s a must that risk management is a tool to convince outsiders that the company has what it’s take. The presence of sound and effective risk management and controls systems inspires confidence in the investing public and others.
- It safe-guard an organization’s credibility and goodwill.
About MBA:
The Master of Business Administration (MBA) is an internationally-recognized degree Currently, this course is the most popular professional degree program in the world. Today there are over 2,500 MBA programs offered worldwide. First introduced at American universities around the turn of the 20th century, MBA programs have evolved in order to keep up with the demands of the times.
Traditionally a MBA program normally takes two-years to complete( USA is quite prevalent). Presently, one-year program, part-time and distance-learning programs are also widely available. Most MBA programs are taught in English, and are therefore attractive to international students wishing to study abroad. Many institutions in non-English speaking countries offer MBA programs in English, as well as in the country’s native language.
When enrolling for a MBA program, the student should take into account factors like location, duration of program, areas of specialization offered by an institution and more important that the business school have been accredited by the proper authorities.
It is interesting to note that there is no one uniform MBA curriculum, but rather a vast range of different kinds of programs to choose from.
Purpose of MBA program:
- Designed to prepare students and further develop the skills required for careers in business and management.
Benefits derived from pursuing MBA program:
- The value of the MBA, however, is not limited strictly to the ‘business’ world.
- Also useful for those pursuing a managerial career in the public sector, government, private industry, and other areas.
- MBA programs provide graduates with the preparation and practical skills needed to excel in management and leadership positions.
As head of the Finance Function, the main role of the Finance Manager is to manage the company’s funds in such a way so as to ensure their optimum utilization and their procurement in a manner that the risk, cost and control considerations are properly balanced in a given situation.
Some of the functions, nature and scope of the Finance Manager are listed below:
Financing Decision
- Helps to decide what type of Capital structure the company needs to have re: whether these funds would be raised re: from loans/borrowings or from internal source(share capital)
- To raise sufficient long term funds to finance fixed assets and other long term investments and to provide for the needs of working capital
Investment Decision
- In projects using the various capital budgeting tools like Payback method, accounting rate of return, internal rate of return, net present value.
- Assets management policies are to be laid down regarding the various items of current assets like accounts receivable by coordinating with the sales personnel, inventory with production
Dividend Decision
Taking into consideration, earnings trend, share market price trend, fund requirement for future growth, cash flow situation and others.
Cash Management
- The finance manager needs to ensure the supply of adequate, timely and cheap fund to the various parts of the organization
- That there is no excessive cash idling around
Forecasting and Planning
- The need to estimate/forecast the requirement of funds for both the short term(working capital requirements) and the long term purpose(capital investments).
- Forecasting the requirements of funds involves the use of budgetary control and long-range planning
Dealing with relevant parties in the Financial Markets
- Where the company is a listed entity, the need to interact with the Stock Exchange
- To deal with money markets and capital markets for financing or investment of idling funds
- To foster relationships with bankers, investors, underwriters of equity and bond issuances and other government regulatory bodies.
Evaluating financial performance
- To need to constantly review the financial performance of the various units of organization generally in terms of ROI(return on investment. Such review assists management in seeing ow the funds have been utilized in the various divisions and what can be done to improve it.
Financial negotiation
Plays a very important role in carrying out negotiations with the various financial institutions, banks and public depositors for raising funds on favourable terms
Earlier article, we see many benefits when deploying the Economic value added computation. However, like any analytical tool, there are still some limitations/ pitfall(s) of EVA namely:-
EVA is still based on an accounting based concept, hence it still suffers the following:
- like other accounting rate of returns for example like the ROI. Using the normal accounting convention of the historical costs concept, asset values are quoted on historical costs unaffected by inflation, the true rate of return is not able to be properly ascertained,
- EVA is distorted by the fact of the upfront normal depreciation being small at the beginning of a project and big at the end of the project. Therefore companies with a lot of new investments have lower EVA than their true profitability would imply and companies with a lot of old investments have bigger EVA than their true profitability would imply. The extent of this challenge depends on the asset structure (the relative proportions of current assets, depreciable assets, un-depreciable assets) and on the length of the investment period. This pattern is similar to the ROI where when we examine a single project the ROI is a poor estimator or the true rate of return, since at the beginning of the project when the capital base is big, the ROI is small and then at the end when the capital base is small then the ROI is big.
Some of the major advantages of using this economic value added methodology are:
- In my earlier article, we have compared EVA with earnings per share and return on investment/assets and found that both the traditional ratios do not reflect the true cost of capital- there is no hinge whether shareholders value have been created or destroyed,
- EVA is extremely easy to compute- just extract the data from both the income statement and the balance sheet and put in some adjustments to derive the EVA,
- EVA is easy to understand like the net present value (NPV) concept wherein EVA( particularly future EVA) if positive, increases shareholders’ wealth and a negative EVA is vice versa,
- EVA is easy for layman besides accountants to understand its concept as it is logical and comply with the economic terms of “economic profit” ,
- EVA is part of Return on Investment re deploys assets turnovers and utilization which ordinary managers can easily relate to,
- EVA is also really the discounted free cash flows of a business,
- EVA is an all round performance metric which measures the operating profit, business investment and the cost of capital as a financing cost .
- As EVA is a performance metric principally for gauging the creation or not of the shareholder value, it therefore should complements very greatly the Value-based management (VBM) methodology.
Earlier articles described the limitation of traditional financial performance metrics like earnings per share and return on assets and understanding some of the limitations of EVA.
This article looks at the Economic value added formula and computation and how to further improve the performance of same.
To improve EVA, let’s re-look at its formula:
EVA=Net Operating profits after tax – (Capital Employed x Cost of capital)
Hence, we can improve EVA by reviewing the components or drivers of EVA:
NOPAT IMPROVEMENT:
- NOPAT is involves with revenue and profit growth. So to improve EVA we need to try to improve the returns with no or with only minimal capital investments.
We should try to improve the business gross margin and looks at areas for effective cost spending or reduce costs where wastage might exist.
- Also don’t forget that the effective tax rate (ETR%) is also very important as the higher the overall ETR compare to the normal corporate tax rate , the more cash flow would have being drained off from the business.
Some areas to look at :- various tax incentives offer like re-location, export incentives, industrial building allowances, free trade zone to reduce the overall business effective tax rate.
CAPITAL EFFICIENCY IMPROVEMENT:
- Capital employed is essentially the total assets minus any non-interest bearing liabilites
In Economic value added calculation, we notice that the higher the capital employed, the higher will be the capital charge which relates to the inefficiency of the capital employed. Hence, we need to re-look into areas pertaining to the returns versus quantum of capital investments and the utilization or turnover of the assets (capital).
Like the way to improve return on assets ratio, we should turn to improving higher assets turnover whether in terms of stocks, debtors and also by making fixed assets more productive will enhance EVA. This is again assuming that there is no or with only minimal capital investments.
To improve capital efficiency hence improving EVA, we should attempt to:
- Invest new capital only in projects, equipment, machines able to cover capital cost while avoiding investments with low returns
- Identify where capital employment can be reduced
- Identify where the returns are below the capital cost;
- Divest those investments when improvements in returns are not feasible
COST OF CAPITAL
The next driver in EVA calculation is the Cost of Capital. Cost of capital is a barometer to measure the financing efficiency. Normally, most companies would have certain level of gearing. Hence, by optimizing gearing with the right instruments, rates and quantum should to a certain extent lower the weighted average of cost of capital.
Earnings per share, Returns on Assets are normally used as the key performance metric/indicators for measuring the financial performance of an organization.
However, Economic value-added (EVA) as a financial performance indicator is showing encouraging support amongst many top-notched organization. Using the EVA analysis, management particularly the Board of Director are able to know whether shareholders value has been increased or decreased. ONLY with the increase in shareholders value, wealth has been created for the shareholders/investors.
Incidentally, EVA as a performance metric for creating shareholders wealth is closely tied in with the Value-based management (VBM) as they share the same principle of realigning business practices towards increasing shareholders wealth.
In simple term, the economic value added definition is:
=after-tax operating profit remaining after deducting a charge for the capital employed in the business:
EVA=Net operating profit after tax(NOPAT)-(Capital employed x Cost of capital)
[ NOPAT is a measure of the operating profit of an organization whilst capital employed is a measure of its business investment and cost of capital is the financing cost similar but not identical to borrowing costs.]
As this represents real profit, positive EVA enhances shareholder value whilst negative EVA reduces shareholder value.
Economic value added (eva) is a better performance metric as it can overcomes the following limitations presently affecting the traditional earnings per share and return on assets:-
- Earnings per share tell us nothing about the cost of generating those profits. If the cost of capital (loans, bonds, equity) is, say, 17 percent, then a 16 percent earning is actually a reduction, not a gain, in economic value. These profits also increase taxes, thereby reducing cash flow, which drain economic value of the company.
- Return on assets is a more realistic measure of economic performance as it attempts to relate how much profit a business generates relative to its asset lives, but again this metric ignores the cost of capital. A company might have a high profitable year with high return on assets but it might not be a surprise if its cost of capital can be higher than its ROA %.
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