Monitor and Evaluate Policy

Monitor and evaluate policy

Contents

Introduction 3

Global cases of corporate downfalls 3

Monitoring corporate governance policies 5

Performance indicators 6

Summary 14

Feedback to activities 15

This learning guide is based on the following resources:
Textbook
Wilson C and Keers, B (2003) Financial Management: Principles and applications, Pearson
Adams K, Grose R and Leeson D (2004) Internal Controls and Corporate Governance (2nd edn), Pearson/Prentice Hall
(This textbook is based on the AUS 402 published in 2002. AUS 402 has been updated with the new standard ASA 315 under 2006 legislation.)
Online
Australian Government Auditing and Assurance Standards Board: www.auasb.gov.au/. Select the link Standards and Guidance which brings you to the AUASB Standards and Pronouncements to obtain all the auditing standards. You can download ASA315 Understanding the entity and its environment and assessing the risks of material misstatement.
DVD
Enron: The Smartest Guys in the Room (2005)

Introduction

Global cases represented by names such as Enron, HIH Insurance and others have become media events with the chief executive officers (CEOs), chief financial officers (CFOs) and external auditors as the main players.

In all these Australian and worldwide business failures we ask the question: did any corporate governance policies exist and if so, what was the culture that sidelined them or led to total disregard of the policies?

We’ll begin by looking at these global cases of corporate downfalls and then examine some of the tools that can be used to monitor corporate governance policies.

Global cases of corporate downfalls

There are two business failure cases worth looking at, one in Australia and the other in the United States.

HIH Insurance

/ Activity 1

Using your favourite search engine, eg Google, locate the following document by typing in its title ‘Report of the Royal Commission into HIH Insurance’. Download and read the document. Then answer these questions in the space given.

1 What are the issues raised in the third paragraph of ‘Key Findings’?

2 What actions were needed to correct those issues that may have prevented or reduced the impact of the collapse?

Check the feedback at the end of this learning guide.

Enron

The second activity looks at the biggest corporate bankruptcy in the United States history, ie the downfall of the Texas energy company Enron. There’s an abundance of resources on this corporate scandal. Apart from the websites, there are also documentaries including Enron: The Smartest Guys in the Room on DVD. Among other things, this documentary looks at the rise and fall of the personalities in the company.

/ Activity 2

Using your favourite search engine, type in the phrase ‘Enron United States’ and then locate the following three documents:

· US Department of Justice, Enron Trial Exhibits and Releases

· Findlaw Legal News Indictment (US v Arthur Andersen LLP)

· US Supreme Court Arthur Andersen LLP v The United States

Download the documents and scan the contents. Then answer the following questions and write your answers in the space given.

1. What were the central issues of this business failure?

2. What part did Arthur Andersen play in assisting the Enron executives?

3. How would you describe the culture and attitude of the Enron executives?

4. What corporate governance policies existed?

Check the feedback at the end of this learning guide.

Monitoring corporate governance policies

The boards of directors of companies set the corporate governance policies which are expected to be implemented and monitored by the management. The degree of management’s commitment to those policies is found in their monitoring programs established to review the organisation’s operational, administrative and financial performance.

Internal auditors and the internal audit section have a significant role to play in supporting and carrying out those monitoring and assessment procedures. Inextricably linked to all of this is the external auditor and the extent to which they can rely on the monitoring procedures in forming their opinion as to what is true and fair.

Tools available to management and the internal audit section include:

· performance indicators using ratio analysis

· solvency testing to prove or disprove the ‘going concern’ statement made by the directors in their annual report

· costing accuracies

· actual and budget comparisons.

Performance indicators

Analysis of financial statements by the use of ratios is useful and these can be easily calculated and understood in most situations, if expressed in plain English. There are endless computations but we will restrict ourselves to a few critical ones that should alert management to impending problems that, if not fixed, may become disasters.

Published and audited financial statements are the starting point, particularly from a shareholder and stakeholder perspective. Internal reports are no less informative and provide current data that allows for comparisons to be made and trends to be plotted.

Published statements include:

· revenue

· balance sheet

· cash flow.

Internal reports include:

· sectional operating results (eg by product or division)

· production reports (materials, labour and overhead)

· inventory holdings (raw material, work in process, finished goods)

· accounts receivable (debtors ageing lists and days outstanding)

· proposals to acquire and/or replace non-current assets

· cash budgets.

Ratio calculations can be grouped into the following classifications:

· liquidity

· activity

· profitability

· leverage

· performance.

Liquidity ratios

· Current ratio: based on current assets and current liabilities, the ratio is expressed as funds available to pay debts as they fall due.

· Liquid or quick ratio: based on current assets less inventory and prepayments compared to current liabilities less bank overdraft; it is expressed as funds available to pay debts on demand.

They are both solvency tests: the current ratio tells if the firm can pay its debts in an orderly manner and the liquid or quick ratio tells if the firm has the funds to pay now without hesitation.

Monitoring

Current and liquid ratios are all about current assets and current liabilities that require daily monitoring – how much do we owe and how much are we owed. The difference is financial success or failure.

A business that cannot pay its debts as they fall due or without hesitation is technically insolvent, with the risk that creditors may appoint a receiver and manager with a view to winding up the firm, if it cannot trade out of the situation.

A similar example from an individual’s situation is one who could be owing $5000 on a credit card, and having $200 in the bank, no other assets and $600 wages after tax.

As an example of how to eliminate cash flow problems, fast food chains only accept cash or debit/credit cards, have no inventory (what comes in this morning has gone by tonight) and pay their suppliers in 30 or 60 days.

Activity ratios

· Average collection period: extending credit occurs where a company allows its customers to take thirty or forty days to pay, instead of cash on delivery. It is this granting of credit without tight credit policies and continuous staff training that could lead to the situation of insolvency.

This happens all too easily, with suppliers demanding payment, at risk delivery cut-off, and on the other hand customers ignoring the credit terms and withholding payment. It’s the classic situation of cash going out and no cash coming in.

The building industry is well known for this, with lots of sub-contractors failing when developers claim cash flow problems and stretch out or withhold payments.

Extending credit is the same as lending money to customers, if or until they pay.

Monitoring

There are two warning signs for management:

· the majority of debtors are in the 60 and 90 days column of the debtors’ ageing list

· the average number of days debtors are taking to pay their bills exceeds the days allowed under the credit policy.

The formula to calculate average number of days is:

5095_eqn1.eps

So if credit terms are 30 days and debtors are taking on average 55 days, it indicates management have taken their eye off the ball in terms of internal controls.

The cost of lending that money for an extra 25 days (55 – 30) on say $2000000 accounts receivable, @ 0.000274% per day, would be $13698. Taken over a year, that equals $164384, which could go a long way to funding an internal audit section.

Profitability ratios

Again we see a relationship, this time within the group of gross profit, net profit after tax and return on shareholders’ funds.

If we start with:

· shareholders’ funds opening balance of $50000000

· total sales of $10000000

· profits from trading (gross profit) $4000000

· then deduct operating expenses, interest payable $2571429

· and tax $428571 (at 30%)

· we are left with earnings after tax (net profit after tax) of $1000000.

We can calculate:

· gross profit margin: $4000000 ÷ $10000000 = 40%

· net profit margin: $1000000 ÷ $10000000 = 10%

· return on shareholders’ funds: $1000000 ÷ $50000000 = 2%.

Monitoring

What can management draw from these results?

Actually quite a lot, but we will highlight a few points:

1 For every $1 of sales:

(a) $0.600 goes toward the cost of the goods that were sold

(b) $0.257 goes toward operating expenses and interest payable

(d) $0.100 belongs to shareholders.

2 Some conclusions:

(a) Either the mark-up on cost is too low, costs were incorrectly calculated, trading costs are too high or all of these apply. Even with increasing gross profit from 40% to 45%, shareholders receive $0.135 for every $1 of sales (compared with $0.100).

(b) Then if the company is able to reduce operating expenses and interest payable by 10% ($257143), shareholders receive $0.118 for every $1 of sales without increasing gross profit margin.

(c) If the company is able to do both, the shareholders receive $0.153 for every $1 of sales compared to $0.100 per $1 of sales.

(d) On current figures, shareholders are receiving 2% return on funds invested in the business. They would be better off investing in government securities at 6.25% with little or no risk.

Leverage ratios

Leverage is another word for borrowing funds from financial institutions or the public with the objective of increasing earnings per share.

Three basic issues face management if they borrow funds:

· Are there sufficient earnings before interest and tax (EBIT) to pay the additional interest?

· Will investors expect a higher return on their investment in the company for the increased level of risk?

· What proportion of total assets will the total borrowings represent?

Monitoring

1 Secured creditors, such as mortgagees or debenture holders, have strict payment deadlines that, if not met, have far-reaching effects:

· mortgagees may take possession of the real estate with a view to selling the property and recovering the outstanding debt

· trustees for the debenture holders act immediately on notice of payment breaches and appoint a receiver manager to take control of the business, which usually requires the directors to stand down until the issue is resolved.

2 Investment principles dictate that the higher the risk, the higher the expected return.

3 When total borrowings compared to total assets represent 50% or more, this indicates the lenders’ control the company.

Ratios for management to monitor include:

· debt to equity

· debt to total assets

· debt to operating cash flow

· times interest coverage.

Performance ratios

This revolves around earnings after tax (EAT) and:

· how we use those funds effectively. This is called dividend policy

· what levels of return or yield on investment accrue to existing and/or potential investors

· how the company rates against similar organisations.

Monitoring

The dividend payout ratio is how much of the EAT will be distributed to the shareholders.

The ratio is set by the board of directors and is expressed as a percentage ofEAT.

This will vary where the company has preference shareholders who have preference when it comes to dividend payments. This amount is deducted from EAT, with the balance belonging to ordinary shareholders.

Once the preference shareholders have been paid their specified percentage, the dividend payout ratio applies to that amount belonging to the ordinary shareholders.

Dividend policies vary from company to company depending on whether the directors wish to pay out a high percentage of EAT as dividends or use the funds to invest in new projects.

Boards of directors need to be conscious in making dividend payments of how this affects cash flow and the solvency ratios (current and liquid).

Two initial ratios need to be calculated before we can calculate the return or yield performance indicators:

1 earnings per share (EPS):

earnings after tax – preference dividend ÷ the number of ordinary shares

2 dividend per share (DPS)

total ordinary dividends ÷ the number of ordinary shares

Now we can calculate the yield indicators:

3 earnings yield (as a %)

earnings per share ÷ current market price per ordinary share

4 dividend yield (as a %)

dividend per share ÷ current market price per ordinary share

5 price/earnings ratio (P/E ratio) (the reverse of earnings yield but expressed as ‘times’).

Example:

current market price = $4.50 per ordinary share

earnings per share = $0.50

Calculation:

$4.50 ÷ $0.50 = 9 times

If you look at the banks’ P/E ratios in the financial pages, they range from 11 to 14 times. Banks are considered conservative investments.

It is possible to compare companies using P/E ratios within their industry groupings, the difference being how the market views each company’s ability to maintain or grow their EPS in the current and future economic climate.

Costing accuracies – additional information

In the discussion on low gross profit margins (profitability), we raised the possibility that the company may not have sufficient mark-up on cost or the cost may be incorrectly calculated.

Monitoring

This is true for industries where each job attracts its own materials, labour and overhead expenses and particularly so where the mark-up is based on cost. Any cost not picked up reduces gross profit (motor vehicle panel beating and mechanical repairs are prime examples).