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. It is a key measure of how hard the business is making its money work, says press officer David Nicholas. He adds, however, that other measures such as net income per barrel of oil are used in tandem with ROCE, and will vary according to the business in question.
Such a combination of measures is widespread, concludes the survey. Many companies tend to mix and match performance yardsticks, some contradictory, says Braxton consultant Peter Dixon. He fears that by employing different measures to reflect different aspects of the company, there is a risk of managers misdirecting the business.
Yet it has to be a matter of horses for courses, argues Norman Lyle, general manager of finance with bio-science company Zeneca; the appropriate measure will depend on whether the period under consideration is short, medium or long term. 'In the short term, return on sales is important for us and we also look at asset turnover,' says Lyle. ROCE is employed on a monthly and quarterly basis. However, for long-term strategic planning, the use of measures becomes more complicated. 'For the longer term, we operate a value-based management approach which aims to sustain and optimise total shareholder returns over time.' Here, Zeneca concentrates attention on CFROI and on cash generation. CFROI, says Lyle, is a good measure of earnings performance within the business. 'The question asked is, "Does CFROI exceed the cost of capital?" If it does then we are optimising investor value.'
Zeneca's faith in a combination of ROCE and cash flow is endorsed by Andrew Stack of the City-based investment management firm Henderson Administration. 'As an investment fund manager with highly mobile capital, I look for companies which can deliver exceptional return on capital for as long as possible. In that respect, ROCE and some measure of cash flow provide my two most valuable yardsticks of how a company is performing.' All other measures, he says, ultimately come back to those two yardsticks.
'If a company is doing well with these two then the rest looks after itself,' he explains.
Not all company well-being, however, can be judged by the commonly used measures. ROCE or cash flow, for example, are inappropriate for pharmaceutical research and development group British Biotech which is currently a loss-making venture. Although two of its drugs are nearing the end of their clinical trial stage, British Bio-tech has no saleable product. The company raised £143 million in its rights issue in June and has £200 million in the bank. 'The analysts are not looking at our figures, but at the drugs,' says a company spokesperson. 'At present probably our most relevant measure is cash burn - how much cash we are using over a particular period.'
Keith Ward, consultant and visiting professor of financial strategy at Cranfield School of Management agrees that more traditional measures would be useless in any attempt to measure the performance of a company in British Biotech's situation. 'The measures used depend on the stage of development of the company and its major objectives,' he says. 'Putting performance measures up without understanding objectives is a nonsense. For example, measuring time to market is probably most pertinent for a biotech company while market share makes sense for a drinks company and order book measures work for the likes of British Aerospace.
'Monitoring profit is obviously important,' he continues, 'but, as measures go, it may be a long way down the road. In a growth market, for example, it is brand building and awareness, not profitability, which require measurement.
I am a total believer that profit follows, not leads, and that by monitoring profit exclusively, you can destroy a business in the long term.'
Instead Ward points to the advice given by Jack Welch of General Electric.
'Welch advises getting away from measurement based on profit to monitoring three things: customer satisfaction, employee satisfaction and cash flow.' It sounds fairly straightforward but the familiar terms mask a shift more dramatic even than the growing adoption of cash-based financial measures: of the three factors Welch believes to be crucial, two are non-financial.
Ward's own three categories of what chief executives should monitor take in external market performance, competitor performance and internal performance.
'In the latter category, cash flow is a marginally better measure than profit as it is more objective,' he believes. But, he continues, 'I would prefer to see a measure chosen which is driven by the environment in which the company finds itself. If the strategy changes then the performance measures must change too.'
The chosen measures, emphasises Glen Peters, future trends director at Price Waterhouse, must link to the drivers which have the greatest influence on enhancing shareholder value. Those drivers will differ for each organisation and may not fit into a traditional accounting framework. 'Take the mobile telephone business or building societies which have high customer churn,' he says. 'For them, customer retention is the key measure of their ability to grow the top line and is, therefore, arguably the major influence on shareholder value.' In a people-intensive industry, he continues, staff morale may prove the critical indicator of a company's health.
So the simple question of which performance measure to trust receives no simple answer. Astute chief executives must cherry pick their measures to reflect moving organisational targets. Financial measures themselves must lose ground to non-financial metrics. Measuring the drivers of shareholder value should replace overreliance on backward-looking measures of outcome. No wonder Pearce's sigh was so heartfelt.
Return on Capital Employed
ROCE can damage your health in the long term
For many years, companies like GEC and Hanson stole a march on their less sophisticated competitors by focusing their business units on return on capital employed (ROCE).
Business units knew how much capital they were using and were set target returns on this capital. As long as these targets were achieved by the individual units, the parent company would qualify as an effective user of capital and enjoy a high stock-market rating.
It also helped business unit managers to become highly conscious of the importance of minimising working capital.
But the long-term effects of such a policy can be highly debilitating. Shrewd managers quickly realise that it is unwise to invest in projects with a lengthy lead time. Far better to stick to old, heavily depreciated equipment where the low level of capital employed makes the achievement of higher returns far easier.
And the problem is exacerbated by the fact that ROCE calculations take profits rather than cash flow as the basis for calculating return: as machinery is written down in the books, the depreciation charge falls and profit rises - even though the cash generated may remain unchanged or even fall. Thus can the exclusive use of ROCE strangle the businesses whose performance it is measuring.