Magazine article Management Today

Which Numbers Count

Magazine article Management Today

Which Numbers Count

Article excerpt

Companies are increasingly using cash-based measures of performance, both internally and externally. But for many, non-financial metrics are just as important.

The question addressed to Christopher Pearce, finance director of Rentokil Group seems straightforward enough. 'Of the myriad financial measures available to assess the well-being of a company, which one or two would you select as the most trustworthy guide to corporate performance?' To be greeted by Pearce's derisive snort-cum-sigh of ennui does not, therefore, augur well.

'It's never so easy as that,' suggests the man in charge of figures for the world's largest business services group. 'Put it this way,' Pearce elaborates, 'financial analysts, pundits and reporters may look at just a few financial measures to give them their view of how you are doing. But if I'm going away for the weekend and want to mull over the financials, then it's a pretty large pack of information that I take with me.'

To judge performance Pearce begins by asking three key questions. 'Are we wasting money? Are we running the company efficiently in terms of our objective which is to grow profits by 20% per annum? What is the quality of our investments?' While no single measure provides all the answers, Rentokil puts particular emphasis on cash flow which, Pearce judges, is an excellent touchstone for the quality of profits.

Rentokil's emphasis on cash flow reflects a growing consensus that some kind of cash-based measurement should be used to gauge a company's performance. Yardsticks such as economic value added (EVA) or cash-flow return on investment (CFROI) have become increasingly popular in the City, and companies are in turn looking at such systems to monitor their internal business units. The trend is late recognition that profits are a matter of opinion while cash is a matter of fact.

Motor components group LucasVarity is just one in a long line to express its belief in EVA: in its mission to become one of the world's top 10 automotive component suppliers, the newly merged company is to adopt EVA as its key performance criterion.

Developed in the US as a stock-market tool to calculate scientifically what a company's share price should be, EVA is based on working out the cost of equity, with the cost of debt - if there is any - factored into the equation. Once the overall cost of capital has been established, it is measured against the free cash-flows generated by the company. The surplus of cash over cost of capital represents the additional wealth created by the company; any shortfall represents an erosion in the value of the firm. The share price should then reflect a company's ability (or inability) to add value to shareholders' capital.

For his part, Terry Smith, author of Accounting For Growth and an analyst with Collins Stewart, argues that CFROI - a similar measure of how much cash flow is generated compared to. capital invested which stops short of extrapolating the results into a putative share price - is the single most important measure available to companies. 'CFROI measures what a company is meant to be doing in a way which we can all understand,' he argues. 'It measures managers' success or failure in achieving returns from the capital which is entrusted to them.' In an aside, he adds that, 'It is also a most difficult measure to fix'. CFROI is particularly useful as an internal measurement since it requires, for example, replacement capital to be distinguished from growth capital, an analysis which can prove tricky for outsiders.

While cash-based measures are gaining ground in the UK, a recent survey of 200 public companies by consultants Braxton Associates indicates that even now only 40% of respondents use such methods to judge business unit performance. More popular measures, for the time being at least, are the more traditional metrics of return on capital employed (ROCE) or growth in sales or profits.

British Petroleum is one company which relies on ROCE as a gauge of performance at a business level. …

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