Financial Performance Measurement - Essay Example

FINANCIAL PERFORMANCE MEASUREMENT Introduction Capital has been proved to be the driving force of every business organization. The amount of capital available to an organization usually comes as a determinant of the level that the organization has to operate. A company with large amount of capital will be able to operate at a high level of activity. At this level the company can purchase in large quantities and also carry out promotional services hence increasing the viability of the business. The organization management therefore should do a good planning for the organization capital. The planning of capital by the management should put in mind the following aspects. The activities to be carried out by the organization and need financing. The amount of financing required by the organization in relation to each activity to be carried out. The available sources of capital. The cost of capital. The cost of capital aspect is usually a main area of focus. The reason for cost of capital to be taken care of seriously is to ensure that the capital used does not exceed the expected returns from activities of the organization. There is also need to ensure that the cheapest type of capital is used to finance the company. The company therefore considers the cost of each type of capital to compute a general cost of capital referred to as weighted average cost of capital. This incorporates costs such as cost of equity and also cost of debt. The weighted average cost of capital method allocates weights to each component cost of capital. This weighted average cost of capital is usually the rate of return that the company should not operate under in order to be operating at a safe point. Weighted average cost of capital is the best measure of a company's cost of capital. Its measure gives weights to the components of a company's capital structure. Usually shareholder's equity and debt create a company's capital (Brealey, & Richard 2000p.66-67). The formula for computing weighted average cost of capital can be presented as follows (Keown, Arthur, Petty, Scott, Jr. & Martin, 1998p.56-67): - WACC = EQ . RRR + D . K (1 - TR) TC TC TC = EQ + D WWAC = This represents the weighted average cost of capital EQ = This represents the shareholder's equity and equity equivalents TC = This represents the total capital RRR = This is the required rate of return, usually cost of equity capital D = This represents debt capital K = This represents the cost of debt capital TR = This represents the tax rate Using the figures of the group company the British Associates Foods plc the shareholder's equity for the year 2005 = 3,696,000 This is at required rate of return of 12% The group's debt as at 17/09/05 was at the tune of 150,000,000. This debt was at a cost of 10% Therefore the weighted cost of capital can be computed as follows: - Total capital = Equity capital + debt Therefore Equity capital = 3,696,000,000 Debt = 150,000,000 Total capital = 3,746,000,000 Therefore WACC = 3,696,000,000 x 12% + 150,000,000 10% (1.28%) 3,746,000,000 3,746,000,000 Note: the tax rate = 28% WACC 0.118 + 0.02 WACC 0.138 = 13.8% Therefore the WACC = 13.8% The company's share price as in the financial times is recorded as 876.50 being the last price. This represents an increase in the company's share price as compared to last one week by 2.2%. 876.50 being the last share price also represent a decrease in share price as compared to 3 months earlier. At the earlier three months the share price was 5.4% higher than the current share price of 876.50. Six months ago, the company's share prices are recorded to have been 16.4% higher than 876.50. This represents a large fall in the company's share price. Upto these six months ago, the trend seems to be moving in the same direction as that of the sector. A difference in the trend of the company's share prices emerges when the comparison of the past 52 weeks is done. The company's share price seems to report as being higher than the present value by 3.8%. The percentage 3.8% is lower than the percentage for the last six months from now which breaks the trend of increasing share price as time increases from now. The first 100 percentage of 10.8% continues the trend. The sector Food producers' trend of change moves just like that of Associated Food public. The percentage for the past 52 weeks is 6.5% which is lower than the 13.2% change of the past 6 months just like that of Associated Food public which is 3.8% lower of 16.4%. They post the same trend. The market share prices show that 52 weeks ago the prices were higher than today by 3.8%. This shows that 52 weeks ago the share price was 103.8%. 108 x 876.50 100 = Kshs. 909.807 Having the trend of the company moving in the same direction with that of the sector, this represents a situation that the company is operating favourably (Hampton, 1989p.43-46).This represents a situation whereby the company is affected by just the normal factors in the sector (Nagle, Thomas & Holden, 1994p.80-82). There are no much deviations in terms of the changes in share values of the company to the changes in the sector's figures. Financial Gearing This is a term which is used to help in the explanation of a company's capital structure (Van Horne, 1989p.123-129). Financial gearing explains the matters between equity shareholders funds and debt in a company. To get gearing, you have to divide the debt by equity of a company. The gearing is usually a percentage of debt in respect to equity. Financial gearing is usually ranked as either high or low. When there is a low proportion of debt with respect to equity, such a situation represents a lowly geared company (Rejda, George & McNamara, 1998p.76-87).. In a situation where the proportion of debt to equity is high the company is said to be highly geared. The amount of gearing in a company represents how safe a company is. When the company financial gearing is high, there is usually risk of the company being unable to pay its debts, hence operating indebted or ends up dissolved. Financial gearing is computed as follows: - FG = Debt x 100 Shareholder's equity in shares The company is operating at a debt level of 150,000,000. The shareholder's equity in shares = 3,696,000,000 The group's financial gearing = 150,000,000 x 100 3,696,000,000 = 4.05% The company is operating at a financial gearing ratio of 4.05%. This is a low gearing. The company's gearing represents a situation whereby the company does not rely much on debt for its financing. The low financial gearing shows that this is an investment which is not risky to continue engaging in. it also assures that the company is capable of paying its debts. At this position, the shareholders are at a good position of gaining from the company in the long run. The low gearing ratio at the company shows that the capital management in the company is good. At this point the company is away from risk of operating highly indebted and clears the doubt of possible insolvency. This gearing ratio can assure lenders of the company that incase the company borrow; it will be able to pay back. This is an advantage to the company since it will increase its capital. Conclusion. Performance of a company is usually the determinant of its existence. A good performance gives an assurance that the company is there to stay. A poor performance is an indicator of a sinking company, and indicates that the company may cease its operations. There are several methods of performance appraisal. Companies usually use financial ratios to determine their performance. Some of these ratios include acid test ratio and current ratio among others. However for an overall debt level appraisal, financial gearing is usually the best. Reference: Brealey, Richard A, (2000p.66-67). Principles of Corporate Finance. NY: McGraw Hill. Gitman, (1991p100-103). Principles of Financial Management. 6th edition. Harper/Collins. Hampton. Financial Decision Making (1989p.43-46): Concepts, Problems, and Cases. 4th edition. Prentice Hall. Keown, Arthur, J. William Petty, David F. Scott, Jr. and John D. Martin, (1998p.56-67). Foundations of Finance: The Logic and Practice of Financial Management. 2nd ed. NJ: Prentice Hall. Nagle, Thomas T. and Reed K. Holden, (1994p.80-82) . The Strategy and Tactics of Pricing: A Guide to Profitable Decision Making. NJ: Pearson. Rejda, George E. and Michael J. McNamara, (1998p.76-87). Personal Financial Planning. NJ: Prentice Hall. Van Horne, (1989p.123-129). Financial Management and Policy. 8th edition. Prentice Hall. Read More