Management Accounting Update

1. Management Accounting Update Paul Gillion www.kaplanfinancial.co.uk

2. Objectives • By the end of this session you will: • Understand how the role of the management accountant has changed from scorekeeper to business partner • Be aware of how shareholder value performance can be measured • Be aware of how an integrated ‘value-based’ forecast is constructed • Be aware of how some businesses have moved beyond the traditional budget model to manage their businesses via a more flexible approach – the ‘beyond budgeting’ model • Be aware of how the balanced scorecard can help support the beyond budgeting model

3. Agenda • The changing role of finance – the need to ‘add value’ • Measuring value performance • Adding value with forecasting • Adding value with ‘Beyond Budgeting’ • Adding value with the Balanced Scorecard

4. Agenda • The changing role of finance – the need to ‘add value’ • Measuring value performance • Adding value with forecasting • Adding value with ‘Beyond Budgeting’ • Adding value with the Balanced Scorecard

5. Self Assessment Exercise Please chose one statement from each pairing which is closest to the way you think about you and your role in the business: • I am aware of my organisation’s mission statement / objectives • I didn’t know we had a mission statement / objectives • I know who our top five customers are • I’m fairly sure we do have some customers • I spend most of my time in the finance department • I spend most of my time outside the finance department

6. Self Assessment Exercise Please chose one statement from each pairing which is closest to the way you think about you and your role in the business: • Most of my discussions are with other finance team members • Most of my discussions are with other departments • I know what each person does with the reports I send them • I just send them the reports I always have • I am working in a way which is in line with our strategic goals and I am happy to suggest change / improvements • I do the job the way I was told to – is it Friday yet?

8. Number of pictures taken • Time between taking picture and seeing photograph • Ability to delete incorrect image and re-take • Opportunities to alter image to suit requirements • Picture sharing capabilities • WHAT ARE OUR EXPECTATIONS FOR £100 • NOW AND 5 YEARS AGO?

9. The changing role of the finance function • Faculty of Finance & Management, ICAEW • October 2003 – survey of members • ‘How will the finance function within business change over the next five years?’ • 567 responses

10. Qualities and skills sought in finance personnel Traditional accounting skills Marketing People management Business acumen Knowledge of IAS Integrity Interpersonal skills Taxation IT skills Strategic thinking Legal knowledge Leadership

11. Other results from the survey • A trend towards outsourcing • A move away from standard finance processes and towards strategy and business development • Corporate governance came across as a major concern • The drive to identify value is a continuing trend

12. A cautionary note – the finance swing-o-meter Biased business partner Independent business partner Traditional score keeper Source: The role of the finance function post Enron, Atos KPMG Consulting, May 2003

13. ENRON Collapsed 2nd December, 2001, destroying $60bn in market value Year 2000 accounts reveal: 96% of reported net income and 105% of reported funds flow were attributed to accounting violations Debt reported as $10bn v. $22bn actual Source - Malcolm Salter, Harvard Business School

14. Independent business partner strengths • Strong financial controls • Independent view providing appropriate challenge • Commercial approach • Appropriate interaction with the business • Direct links with external stakeholders

15. Analysis of traditional finance function activities Source: Redesigning the finance function, CMA, 1999

16. Management objectives for finance function redesign • Increased control • Better information • Better integration • Improved quality • Increased profitability • Competitive advantage • Competitive necessity • Market positioning INFORMATIONAL STRATEGIC TRANSACTIONAL INFRASTRUCTURAL Source: Redesigning the finance function, CMA, 1999

17. ICAEW – 2005 business member survey FINANCE Budgeting DEVELOPMENT Financial Modelling & Forecasting NEEDS Finance Function Effectiveness Financial Management Performance Measurement/Management Management Accounting Financial Reporting (inc IFRS) MANAGEMENT Managing People & Teams DEVELOPMENT Strategic Planning NEEDS Personal Skills Risk Management

18. Agenda • The changing role of finance – the need to ‘add value’ • Measuring value performance • Adding value with forecasting • Adding value with ‘Beyond Budgeting’ • Adding value with the Balanced Scorecard

19. What is Shareholder Value? “Is it any wonder we have seen the recent stock market bubble burst when it was originally inflated by management who believed that share price was driven by growing earnings per share? How wrong could they be? The real value is the economic value, which is the net present value of future cash flows discounted at the weighted average cost of capital”. Ken Lever, Finance Director, Tomkins.

20. Profit v Value Does increasing profit always add value?

21. Value is a relative concept CREATING VALUE DESTROYING VALUE Free Cash Flow Free Cash Flow Expected Actual Actual Expected Time Time

22. How do shareholders get returns? • Dividends • Share price growth

23. Total Shareholder Return % Dividends + Change in Share Price Initial Share Price = Total Shareholder Returns (TSR) ‘The ultimate measure of value performance for shareholders’

24. Next plc TSR February 2005 – January 2006 44p 1592p 1733p Value will only be have created if ‘relative’ improvement is achieved

25. Value v performance • In principle, we should measure value creation performance via the change in the value of a business over a period plus the value of dividends. • For example, a business is valued at £100m at the start of the year, pays a dividend of £5m, is valued at £120m at the end of the year and has a cost of capital of 10%. How much value has the business created in the year?

26. The problem with profit as a measure of value performance • Historic focus rather than future focus • Tenuous link to cash flow • Accounting policy differences can distort underlying performance • Positive profits are achieved with no adequate risk hurdle

27. Economic profit • Re-branding of ‘residual income’ • Surplus operating profit after tax & after deducting a charge for capital employed • EVA® = EP with up to 164 adjustments (trademarked by Stern Stewart & Co.) • Boots, Cadbury Schweppes, Diageo & Siemens

28. Economic profit 150 50 100 40 150 50 100 60 0 Tax Charge Capital Economic Profit less Operating Operating Profit Net Profit Adjusted Tax

29. Economic profit illustration: Royal Mail Holdings plc year ending March 2004 Source: Shareholder Executive Annual Report 2004/5

30. Economic profit – the interpretation • Although successful from an accounting profit perspective, the cost of using investors’ funds is ignored by just focusing on operating profit • Once the full cost of investors’ funds is included (the capital charge) then we have a true indication of the underlying economic profit of an entity

31. Economic profit – the inputs • Operating profit – excluding gains and losses arising from non-operating assets • Capital charge, being: • Invested capital – being equity plus net debt, multiplied by… • Cost of capital – calculated using quoted comparables from relevant sectors

32. Economic profit insights – lessons from Diageo

33. Economic profit insights – lessons from Diageo As a result of analysis like this, the business switched funds from lower value-added brands (whisky) to the higher ones (vodka) and diverted advertising expenditure accordingly

34. ECONOMIC PROFIT – THE “PROOF”? .

35. The ultimate objective The stock market measure used at corporate level The internal short-term performance measure Generic financial value drivers Operational measures Maximise shareholder value Total Shareholder Returns (TSR) Economic profit Growth, margins, efficiency, cost of capital Financial and non-financial kpi’s Cascading the measures

36. Agenda • The changing role of finance – the need to ‘add value’ • Measuring value performance • Adding value with forecasting • Adding value with ‘Beyond Budgeting’ • Adding value with the Balanced Scorecard

37. Principles of Value-Based Forecasting • Proposition : a robust financial forecast should be based on the economic reality that the business operates within and should be driven from the fundamental value drivers • These fundamental value drivers are: • Return on Invested Capital (ROIC) • Weighted Average Cost of Capital (WACC) • Growth • Free Cash Flow (FCF)

38. Linking the value drivers Bad growth destroys value Growth in capital invested Good growth creates value ROIC – WACC spread Missed opportunities sacrifice value Divestment can create value

39. A general model of value creation Strategy Competition Projected ROIC Peak ROIC Sustainability WACC Time

40. The key questions to consider when forecasting • Can the company charge a price premium for its products or services? • Does the company have lower unit costs than its competition? • Can the company sell more products or services per pound of capital invested? • How intense is the competition? (increases ROIC decay) • How likely is it that the strategy will continue to sustain competitive advantage? (decreases ROIC decay)

41. The analysis of historical performance • Reorganise the financial statements to reflect economic instead of accounting performance. Create new numbers such as Net Operating Profit Less Adjusted Tax (NOPLAT), Invested Capital and Free Cash Flow (FCF) • Measure and analyse the company’s ROIC to obtain a value-based understanding of margin management and capital efficiency • Break down revenue growth into its four components: organic, currency effects, acquisitions, accounting changes

42. Reorganising the financial statements - definitions • NOPLAT = the total after tax operating income available to all financial investors • Invested capital = the operating assets of the business minus the operating liabilities • ROIC and FCF both rely on NOPLAT and Invested Capital

43. Reorganising the financial statements – invested capital example

44. Reorganising the financial statements – NOPLAT example

45. Reorganising the financial statements – Free Cash Flow 75 50 125 (25) 25 (100) (100) 25 9 (10) 24

46. ROIC analysis • Good profit performance • Efficient use of capital • Lower taxes • Poor profit performance • Inefficient use of capital • Higher taxes

47. Decomposing ROIC into its constituent parts The equation above demonstrates that a company’s ROIC is driven by its ability to maximise profitability (operating margin), optimise capital efficiency (capital turn), or minimise taxes

48. Decomposing ROIC via Dupont analysis

49. Analysing revenue growth • We have established that a value-based forecast focuses on ROIC, WACC and growth • Long-term revenue growth can be converted to long-term cash flow growth via an analysis of the decomposition of ROIC • A historical analysis of revenue growth will allow an assessment of the potential for growth going forward

50. Analysing revenue growth