Expanding Business Performance Evaluation: Financial and Operational Approaches, Exercises of Computer Science

Download Expanding Business Performance Evaluation: Financial and Operational Approaches and more Exercises Computer Science in PDF only on Docsity! Developments in Business Simulation and Experiential Learning, Volume 28, 2001 EVALUATION OF PERFORMANCE IN BUSINESS GAMES: FINANCIAL AND NON FINANCIAL APPROACHES Antonio Carlos Aidar Sauaia, University of São Paulo – Brazil asauaia@usp.br ABSTRACT The purpose of this paper is to propose that the system for evaluating Business Game performance be expanded. The traditional sectorial multiples, indicators of financial accounting, reflect past performance and to them must be added operational measures, vectors of future performance. INTRODUCTION Prior to Business Games it is usual for participants to formulate these questions: a) How many rounds are we going to play? b) How are we going to be rated? c) Are we supposed to plan for the continuation of the simulated company? Such questions have prompted this study. According to Kaplan and Norton (1992), any system of evaluation has a strong influence on the behavior of the managers. In Business Games, students are aware that to achieve success they must conceive strategies, implement them and properly control the results. Mature and experienced executives already understand that measures of performance directly influence the behavior of all collaborators. "That which is not measured is not managed" (Kaplan and Norton, 1997:21). Furthermore, they have perceived that return on investment and profit per share, traditional measures of financial accounting may be quite restricted when results beyond these such as continued improvement and innovation are sought. These measures may have been acceptable in the industrial age, but are outdated when new competencies and qualifications are taken into consideration. Scholars and researchers of Business Games (Keys and Biggs, 1990:71) also believe that an important part of learning is the result of a profound reflection on the part of the participants. It occurs when conceptual models that represent the simulated entrepreneurial activities are compared with the results of their experimentation. When the cause and effect relationships are drawn up. The overall performance achieved in each round of the game is shown by the sales and production reports and also by the financial statements. Real company managers as well as academic researchers have been making efforts to improve and overcome the shortcomings of the traditional performance evaluation. While some systems highlight financial measures others recommend operational ones. Included are the level of satisfaction of internal and external clients, length of process cycles and incidence of deficiencies. "The financial results will take form by themselves" (Kaplan and Norton, 1992:71). Managers and students should not be required to choose between financial or operational evaluations. This approach will never provide a clear and comprehensive picture of the business performance in its critical domains. A more complete picture will become available when assessment incorporates financial as well as operational measures. STAKEHOLDERS VS. STOCKHOLDERS For Friedman (University of Chicago) and followers, profit is the main objective. "Companies are oriented towards a maximization of the stockholders profits by means of resources cautiously managed in accordance with the current law"(SILBIGER, 1995:53). Evaluation of a company however is not restricted to the numbers. Each assessor faces a personal judgment problem taking into account past experience and the objectives of the assessment. For instance: the accounting value of a company is obtained by adding the purchase cost of all assets to calculate the Net Worth; however the economic value is established according to the potential of future performance. Included are such considerations as the business risk, financial risk and estimated growth rate. Other factors may affect company value: the long term economic outlook, the amount and frequency of dividend payments, market price of the share, asset characteristics, the nature of the business, history of the business and the intangible assets, to name a few. When attempting to identify the important performance measures, an answer is not easily found because it depends upon how the evaluation is being directed. MODELS OF FINANCIAL EVALUATION The figures shown in financial statements are of limited significance. The true picture may be obtained analyzing the performance ratios of the results of a company in comparison with others in the same economic sector. While small margins and large volumes are characteristic of some sectors, others operate with large margins and very limited volumes. The use of financial ratios makes possible comparison between companies in the same sector and between current and past performance. SECTORIAL MULTIPLES Dozens of ratios may be obtained from a company's financial statements. Such performance indicators generally relate to the past. A review of the important financial ratios permits an overall evaluation of the company in addition to identifying problem areas (Wheleen and Hunger, 1986:30-1). Most ratios come from a basic set of financial indicators – Sectorial Multiples – which may be grouped into 4 categories Liquidity ratios – measure the organization's ability to meet its financial commitments. 210 Developments in Business Simulation and Experiential Learning, Volume 28, 2001 Profitability ratios - measure the organization's degree of success, with respect to achieving the expected profit. Activity ratios – measures the efficient use of the organization's resources. Leverage ratios – measure the contribution of financing by the owners in comparison to that by the creditors. In spite of the severe limitations, magazines such as Forbes, Business Week, The Economist, Fortune and " Exame: Maiores e Melhores" (Brazil), have developed analyses based upon traditional financial ratios in order to rank companies in accordance with Sectorial Multiples, rewarding those with outstanding performances in each sector. DISCOUNTED CASH FLOW Only a short time ago, the value of a company used to be calculated by evaluating it's operational assets – an existing business, a factory, a production line or its position in a given market. The traditional method then was the Discounted Cash Flow – DCF still in use. However, the version of the DCF that has been accepted as a standard in the last twenty years – and uses the Weighted Average Cost of Capital –WACC as a discount factor is considered obsolete (Luehrman, 1999:3). Notwithstanding, Business Schools and textbooks continue to propose the WACC simply for the sake of tradition and not because of better results. Furthermore, alternative methods such the Adjusted Present Value have been devised to assess operations or assets in the state in which they are found. The APV method may be useful for managerial analysis of an asset, and also to identify the sources of value. All methods of Discounted Cash Flow operate with the forecast of future cash flow, discounted to a present value by rates that reflect the associated risks. In this way each financial maneuver is analyzed separately, accruing the value of each to the business as a whole.(Luehrman, 1997:3). OPTION PRICING The decision to make Research and Development investments may imply two different aspects: how much will be invested or what kind of expense will be made. Whatever the final decision, it is the opportunities that are being assessed. When such an investment is undertaken, immediate operational cash flow is not generated, but with some luck, there will be an opportunity to invest again in the future. The same thing may be observed with various types of expenses in Marketing. When an investment is made to create a new brand or to strengthen an existing one, a certain result is produced, however not immediately. Companies with new technologies, ideas for product development and positions to be defended in fast growing markets, hold valuable opportunities. For some, opportunities are the most valuable thing they have. A frequent approach to formally assess opportunities is to wait until they mature, until the decision to invest cannot be further delayed. In financial terms, an opportunity is similar to an option. "If Research and Development proves that the idea is sound, we will invest". An option is a right, not a commitment to exercise a purchase or a sale at a fixed price, today or up to a given date in the future. (Luehrman, 1997:136-8). So an option to buy in the stock market may insure the holder the right to buy the share at $10 anytime during a year. If the share is worth $11, there will be a clear valorization of the option. If the value is $9, the option still is valorized because the expiration of the option ends only after a year, and if the price of the share should go up in the next months, it still may surpass $10, before the year is over. The opportunities that arise in organizations have the same characteristics as options. "If R&D demonstrates that the investment is sound", is the analogous to "if the price of the stock goes up in the next months". The potential investment to be made corresponds to the exercise of purchasing an option. The uncertainty about the future value of the operational assets is portrayed by means of the variance of the returns on the assets: that is to say it is similar to the variance of the returns on the purchase options. The recommended tactic for this analysis is based upon a mapping that compares the real project to a simple option (LUEHRMAN, 1997:141). NON FINANCIAL MODELS To measure a company's performance, sales, profits, productivity of the assets and all the other usual financial indicators may be brought into focus. Part of the manager's work is to keep the stock price high, follow the Price Earnings ratio and monitor the Balance Sheet. It is to be expected that investors and analysts as well as the participants of the Business Games do likewise. But when the long-term health of a company is to be assessed, the traditional financial indicators do not suffice. The non- financial assessments are receiving increased attention. (LOW, 1999:3). Consider the difference between the accounting value of the share and its market value. The worth of a business cannot simply be described by traditional financial data. When considering the typical assets of a company, it may be noted that there is an increasingly larger portion of intangible assets in relation to the tangible ones. The past financial performance is no longer a good indicator of the future. A recent study by the Ernst & Young Center of Entrepreneurial Innovation reports that in equity analyses the greater the use of non-financial information, the more precise are the forecasts of future profits. For the majority of the companies studied, 35% of the items used in business evaluations by institutional investors relate to non-financial information. Among them are: Ability of the company to carry out the previously established strategy. This measure, which by itself is the most important one, indicates if the managers succeed in taking difficult decisions and in exploiting opportunities quickly; if the company reached the objectives in the time set forth and within the allocated budget. Administrative credibility. If the company carries out what it states, it scores well in this item. Quality of strategy. The view that the administrators have of the future must optimize the creation of value in 211