Performance Management: University of Pavia

UNIVERSITY OF PAVIA
Performance Management
Chiara Demartini
mariachiara.demartini@unipv.it
Master in International Business and Economics
Lectures and Test

Lectures:
Tuesday
Wednesday
hr. 11-13
hr. 14-16
Office hours:
Mondays
hr. 11-13
Room 15
Room F
Written test:
18/01/2016
18/02/2016
Tutor: Mr Davide Grillo
C. Demartini Performance Management
Structure of the module and materials
First part:
Principles of Financial Accounting
Principles of Financial Statement
Analysis
Second part:
Performance Management
Teaching notes
Teaching notes &

Demartini C. (2013),
Performance
Management Systems.
Design, Diagnosis and
Use, Springer, Berlin.
http://economia.unipv.it/pagp/pagine_personali/cdemartini/
Module grading
Module grading:
30% case studies and other assessments over the
module
30% presentation of a companys performance
management system
40% written test
Part One:
Principles of Financial Accounting

Financial Accounting
Financial Accounting provides information:
1. primarily to people outside the company
2. that would be helpful in attracting capital
Equity and debt (useful in debt contracts)

Credit from suppliers
Customers
Employees
3. helpful in monitoring and evaluating management

performance
Aims of Financial Accounting

Stakeholders:
Present and potential investors
Employees
Information
Resources flow:
tomorrow
Suppliers
Economic
resources,
claims to those
resources and
changes
Resources flow:
today
Company
Financial accounting
Financial accounting translates events into
financial statements
Events
Rules &
management
choice
Financial
statements
Accounting
Principles
GAAP Generally Accepted Accounting Standards
IFRS
International Financial Reporting

Standards
IFRS 1
The objective of this IFRS is to ensure that an entitys

first IFRS financial statements, and its interim financial
reports for part of the period covered by those financial
statements, contain high quality information that:
(a) is transparent for users

and comparable over all
periods presented
(b) provides a suitable

starting point for accounting
in accordance with
International Financial
Reporting Standards (IFRSs)
(c) can be generated at a

cost that does not exceed
the benefits.
Delivery of financial information

Demand for independence:
Accounting enters objective, verifiable information
into accounting records
Information produced by managers alone is not
believable. Outside investors demand independently
audited financial information
In the process, accounting misses out on forwardlooking information that might be valuable, but lacks
objective evidence (e.g., research in progress)
10
Asymmetry in financial reporting
Faced with
uncertain bad
news, accounting
tends to enter it
into the records
Asymmetric
treatment of
good and bad
news
Faced with uncertain

good news, tendency
to ignore it
Why?
Demand for bad news
Creditors with no upside, but all the downside
Investors believe bad news disclosed by management, but sceptical of
good news unless supported by objective evidence
Management incentives affect credibility of their disclosures
11
International Financial Reporting

The Annual Report
Management letter
Financial Statements
Auditors report
12
The Auditors Report

GAAS
(Generally Accepted Auditing
Standards)
Actual opinion
Reasonable assurance that

financial statements are free
of material misstatement
Financial statements present

fairly the financial position,
the results of operations,
etc.
Assess the accounting

principles used and
significant estimates made
by management
Compliance with GAAP

(Generally Accepted
Accounting Principles)
13
The Auditors Report

Management responsible for
the preparation and integrity of the financial statements,
etc.
Statements prepared in accordance with GAAP.
Estimated amounts based on management's best estimates and
judgments.
Maintenance of an internal control system to ensure that

assets are safeguarded and transactions are properly
authorized, recorded and reported.
The Board has an Audit Committee composed entirely

of outside directors
This committee appoints the auditor who has direct access
to the Audit Committee.
14
Financial statement auditing

The objective of the ordinary audit of financial
statements by the independent auditor is the
expression of an opinion on the fairness with which
they present fairly, in all material respects, financial
position, results of operations, and its cash flow in
conformity with generally accepted accounting
principles. The auditors report is the medium through
which he expresses his opinion or, if circumstances
require, disclaim an opinion. (para 110.10, AICPA, SAS
N. 1, codification of Auditing Standards and Procedures)
15
Independence and objectivity
Objectivity is a state of mind, a quality that lends

value to a members services. It is a distinguishing
feature of the profession. The principle of objectivity
imposes the obligation to be impartial, intellectually
honest, and free of conflicts of interest.
Independence precludes relationships that may
appear to impair a members objectivity rendering
attestation services. AICPA.
16
Audit opinion
1) Unqualifed Opinion
2) Qualified Opinion
3) Adverse
opinion
4)
Disclaimers
of opinion
Emphasis of matter
17
Basics of double entry bookkeeping: The account
All the events related to business transactions should be

entered into ACCOUNTS twice.
Accounts are the basic founding units of the double entry
bookkeeping, which is the accounting methodology to record
transactions.
Accounts can be analysed according to two main cathegories:
either economic (e.g. revenues, expenses) or financial (e.g.
payables, receivables) ones.
18
The structure of an account

DEBIT
Purchase a/c
CREDIT
Euro 100.00
DEBIT
Bank account
CREDIT
Euro 100.00
19
Debit or credit an account?
Balance Sheet
Income
Statement
20
Accrual & Cash Method

There are two main methods of accounting (or bookkeeping):
1. Accrual method
2. Cash method
The accrual method of accounting is the preferred method because
it provides:
a more complete reporting of the company's assets, liabilities, and
stockholders' equity at the end of an accounting period, and
a more realistic reporting of a company's revenues, expenses, and net
income for a specific time interval such as a month, quarter or year.
As a result, US and Italian GAAP requires most corporations to use

the accrual method of accounting.
21
Accrual v Cash Method

The following table compares the accrual and cash methods
of accounting:
22
Financial statement
The financial statements must "present fairly" the financial position,
financial performance and cash flows of an entity. (IAS 1)
It contains primarily historical information
Balance Sheet
Assets, liabilities & owners equity
Income Statement
Revenue (-) Expenses = Net Income
Statement of changes in
equity and retained earnings
Statement of cash flows
Footnotes
Cumulative sum of undistributed profits

Operating, Investing and Financing activities
Significant accounting policies, estimates, etc.
23
Going Concern Principle

The Conceptual Framework notes that financial statements are
normally prepared assuming the entity is a going concern and
will continue in operation for the foreseeable future. (IAS 1)
If management has significant
concerns about the entity's
ability to continue as a going
concern, the uncertainties
must be disclosed.
24
Balance sheet
Financial Statements:
Balance Sheet
Statement of the financial position of a business as of a certain date.
Assets
Resources owned by a
corporation, e.g., cash, accounts
receivable, equipment, land
Liabilities
amounts/services owed by the
company, e.g., loans payable,
accounts payable, customer
advances, etc.
Stockholders equity
initial investment by the owners
Plus the cumulative sum of
undistributed profits (retained
earnings) .
ACCOUNTING
EQUATION
ASSETS
LIABILITIES
EQUITY
25
Minimum line items

(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
(i)
(j)
(k)
(l)
(m)
(n)
(o)
(p)
(q)
(r)
property, plant and equipment

investment property
intangible assets
financial assets (excluding amounts shown under (e), (h), and (i))
investments accounted for using the equity method
biological assets
inventories
trade and other receivables
cash and cash equivalents
assets held for sale
trade and other payables
provisions
financial liabilities (excluding amounts shown under (k) and (l))
current tax liabilities and current tax assets, as defined in IAS 12
deferred tax liabilities and deferred tax assets, as defined in IAS 12
liabilities included in disposal groups
non-controlling interests, presented within equity
issued capital and reserves attributable to owners of the parent.
ASSET SIDE
LIABILITY AND EQUITY
SIDE
26
27
Income Statement
Income statement measures the performance of a company over a
period of time
Expenses
Revenues
A measure of
economic sacrifices
incurred to earn
the revenues of a
given period
A measure of
economic benefits
generated by the
sale of products or
providing of services
over a period of time
Net
income
Revenues
Expenses
28
29
Dividends
Are dividends paid to owners considered an
expense?
Owners are residual claimants
Dividends are distributions to the owners out of the
profits earned by the business
In determining accounting profits to the residual
owners, we only subtract the costs of all factors of
production, e.g., physical capital (depreciation),
human capital (salaries), debt capital (interest cost),
etc.
Dividends are not a factor of production
30
Retained Earnings and Shareholders Equity
Retained earnings
A measure of undistributed profits of a business
Do not include capital contributed by owners
Retained earnings = Cumulative sum of profits earned

from the inception of business (-) Cumulative sum of all
dividends distributed to the owners from the inception
of business
Statement of shareholders equity describes the change
in retained earnings over a period of time (e.g., a year)
Beginning
balance in
retained
earnings
Net
income
earned
Dividends
distribute
d
Ending
balance in
retained
earnings
31
Retained Earnings and Shareholders Equity
32
Statement of Cash Flows

The statement of cash flows details the
enterprises cash flows.
This operating statement reveals how cash is
generated and expended during a specific
period of time.
(a) operating
activities
(b) investing
activities
(c) financing
activities
33

Cash received from customers
Total Sales Minus the Increase in Net

Receivables (or, plus a decrease in net
receivables)
Cost of Goods Sold Minus the

Decrease in Inventory (or, plus an
increase in inventory)
Inventory Purchased
Cash Paid for Inventory
Inventory Purchased Minus the

Increase in Accounts Payable (or, plus
a decrease in accounts payable)
Cash Paid for Salaries and Wages
Wages Expense Plus the Decrease in

Wages Payable (or, minus an increase
in wages payable)
Cash paid for Taxes, interests and

other normal business expenses
(a) operating
activities
(b) investing
activities
(c) financing
activities
34
(a) operating
activities
Cash inflows
from sales of
assets
Disposal of long-term
assets (Land, Building,
Equipment, Brands),
sales of investmnet
bonds or stocks, or loans
to other companies etc.
Cash outflows
for purchase
of assets
Payment for acquiring

long-term assets (Land,
Building, Equipment,
Brands, etc.) or longterm investments in
other firms
(b) investing
activities
(c) financing
activities
35
Cash
inflows
Cash
outflows
(a) operating
activities
(b) investing
activities
Stock or bonds
issuing, borrowing
under loans
Repayment of
borrowings,
acquisition of
treasury stock,
dividend distribution
(c) financing
activities
36
37
38
Financial Statements Linkages

Income statement, statement of retained
earnings, and balance sheet articulate.
The income for the

period ties into the
statement of
retained earnings
Income statement
Statement of
retained earnings
the ending
retained earnings
ties into the balance
sheet.
This final tie-in

causes the balance
sheet to balance.
Balance Sheet
41
Part One:
Principles of
Financial Statements Analysis

42
Financial Statements Analysis

Investors must be very thorough in
examining the financial statements of
companies in which they are considering
making an investment.
OTHER
INDICATORS
PROFITABILITY
RATIOS
Sometimes, the evaluation of complex

situations can be assisted by utilization of
key metrics or ratios.
TURNOVER
RATIOS
DEBT SERVICE
RATIOS
LIQUIDITY
RATIOS
43
Liquidity Ratios
CURRENT
Ability to meet near time
obligations
Current Assets
Current Liabilities
QUICK
Narrower than
Current Ratio
(Cash+Short-term
investment+Receivables)
Current Liabilities
44
Debt Service Ratios

Debt to
Total Assets
Debt to
Total Equity
Percentage of TA
financed by long-term
and short-term debts
Times Interests
Earned
Proportion of
financing that is
debt related
Total Debt
Total Debt
Total Assets
Total Equity
Ability to meet
interest obligations
Income before
Income taxes and
Interests
Interest charges
45
Based on this information alone, which company would

likely obtain the less favorable interest rate on additional
debt financing?
46
Turnover Ratios
ACCOUNT
RECEIVABLE
TURNOVER
Frequency of
collection cycle
INVENTORY
TURNOVER
Frequency of
inventory
rotation
Net Credit Sales
Cost of goods sold
Average Net Accounts

Receivable
Average inventory
47
Profitability Ratios
Net Profit
on Sales
Gross Profit
Margin
Profitability on
sales; for
comparison and
trend analysis
Gross Profit
Rate
Net income
Gross Profit
Net sales
Net sales
Return on
Assets
Return on
Equity
Assets
utilisation in
producing
returns
Efffectiveness of
equity invested
in producing
returns
Net income +
interest expense
Total Assets
Net income
Preferred
Dividends
Avg common
E
48
Other Indicators
EPS
P/E
Amount of earnings
attributable to a single
common share
Income
N. Of common
shares
Dividend
rate yield
Yield to investors
through dividend
payments
Price of stock in
relation to EPS
Market price PS
Annual Cash Dividend
EPS
Market price PS
49
Other Indicators
Dividend
Payout Ratio
Proportion of earnings
distributed as dividends
Annual Cash
Dividend
EPS
Book Value
The amount of
shareholders
equity per common
share outstanding
Common Equity
Common share
outstanding
50
Horizontal Analysis
Horizontal analysis, also called trend analysis, refers
to studying the behavior of individual financial
statement items over several accounting periods.
These periods may be several quarters within the
same fiscal year or they may be several different
years.
ABSOLUTE VALUE ANALYSIS
PERCENTAGE VALUE ANALYSIS
51
Absolute v Percentage Analysis

Absolute Analysis
Percentage Analysis
Financial statement users

with expertise in particular
industries might evaluate
amounts reported for
research and development
costs to judge whether a
company is spending
excessively or conservatively.
Users are particularly
concerned with how
amounts change over time.
It involves computing the

percentage relationship
between two amounts.
Percentage analysis sidesteps
the materiality problems of
comparing different size
companies by measuring
changes in percentages rather
than absolute amounts.
52
Horizontal Analysis
53
Vertical Analysis
Vertical analysis uses percentages to compare
individual components of financial statements
to a key statement figure.
Horizontal
analysis
compares items
over many time
periods
Vertical
analysis
compares many
items within the
same time period.
55
Vertical Analysis of the Income Statement
Vertical analysis of an income statement (also

called a common size income statement)
involves converting each income statement
component to a percentage of sales.
Although vertical analysis suggests examining
only one period, it is useful to compare
common size income statements for several
years.
56
57
Vertical Analysis of the Balance Sheet

Vertical analysis of the balance sheet involves
converting each balance sheet component to
a percentage of total assets.
Even small individual percentage changes,
however, may represent substantial dollar
increases.
58
59
Limitations of Financial Statement Analysis

External users can rely on financial statement analysis only as a
general guide to the potential of a business. They should resist
placing too much weight on any particular figure or trend.
Many factors must be considered simultaneously before making

any judgments.
The analysis techniques discussed are all based on historical

information. Future events and unanticipated changes in
conditions will also influence a companys operating results.
60
Sources of Limitations of
Financial Statement Analysis
Different
Industries
Different industries
may be affected by
unique social
policies, special
accounting
procedures, or
other individual
industry attributes.
Changing
Economic
Environment
When comparing
firms, analysts must
be alert to changes
in general economic
trends from year to
year.
Accounting
Principles
Two particular
concepts,
conservatism and
historical cost, have
a tremendous
impact on financial
reporting.
61
Groupwork
62
63

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UNIVERSITY OF PAVIA

Master in International Business and Economics

Lectures and Test

Structure of the module and materials

Teaching notes &

C. Demartini Performance Management

Master in International Business and Economics

Equity and debt (useful in debt contracts)

3. helpful in monitoring and evaluating management

Aims of Financial Accounting

GAAP Generally Accepted Accounting Standards

International Financial Reporting

C. Demartini Performance Management

The objective of this IFRS is to ensure that an entitys

(a) is transparent for users

(b) provides a suitable

(c) can be generated at a

C. Demartini Performance Management

Delivery of financial information

Asymmetry in financial reporting

Faced with uncertain

International Financial Reporting

C. Demartini Performance Management

The Auditors Report

Reasonable assurance that

Financial statements present

Assess the accounting

Compliance with GAAP

C. Demartini Performance Management

The Auditors Report

Maintenance of an internal control system to ensure that

The Board has an Audit Committee composed entirely

Financial statement auditing

Independence and objectivity

Objectivity is a state of mind, a quality that lends

Basics of double entry bookkeeping: The account

All the events related to business transactions should be

The structure of an account

C. Demartini Performance Management

Debit or credit an account?

C. Demartini Performance Management

Accrual & Cash Method

As a result, US and Italian GAAP requires most corporations to use

Accrual v Cash Method

C. Demartini Performance Management

Assets, liabilities & owners equity

Revenue (-) Expenses = Net Income

Cumulative sum of undistributed profits

C. Demartini Performance Management

Going Concern Principle

C. Demartini Performance Management

Statement of the financial position of a business as of a certain date.

C. Demartini Performance Management

Minimum line items

property, plant and equipment

C. Demartini Performance Management

C. Demartini Performance Management

C. Demartini Performance Management

C. Demartini Performance Management

Retained earnings = Cumulative sum of profits earned

C. Demartini Performance Management

C. Demartini Performance Management