Financial performance measurement

Financial measures appear throughout the APM exam, usually with a claim you are expected to test: a chief executive celebrating record earnings per share, a manager whose return on investment has "never been higher", a board judging a strategy on EBITDA. The study guide names gross and operating profit, ROCE, ROI, EPS and TSR, EBITDA, RI, NPV and EVA. You must calculate each and, more importantly, say whether it is the right measure for the purpose. This lesson starts from the shareholder objective, works through the measures, then covers liquidity, gearing, benchmarks and divisions. The worked example takes one company through them all and shows how different measures tell different stories.

Why shareholders come first

A company is owned by its shareholders. They provide the risk capital, are paid last, and bear the losses if things go wrong; the directors run the company as their agents. The primary financial objective is therefore to maximise shareholder wealth: the value of the dividends and share price growth they receive. Other stakeholders matter, but mainly as constraints and as means: a company that mistreats employees, customers or the environment will not create value for long.

Accounting profit is not the same as value created for shareholders. It ignores the cost of equity (shareholders' capital looks free), the timing and risk of cash flows, and spending such as research or brand building that is expensed now but creates value later. The measures below differ in how far they correct for these gaps.

Profit and return measures under IFRS 18

These notes present profit under IFRS 18 Presentation and Disclosure in Financial Statements (mandatory from 1 January 2027), as ACCA now does. Its statement of profit or loss shows gross profit (revenue less cost of sales), operating profit, then profit before financing and income taxes (operating profit plus income from investments, such as interest and dividends received or the share of an associate's profit), then profit before income taxes after finance costs, and profit for the year. With no investment income, operating profit and profit before financing and income taxes are equal. Follow any definition the question gives.

You know ROI and RI from PM. The APM point is that both use accounting profit and book values, so they share the weaknesses that EVA tries to correct.

Measures for shareholders: EPS and TSR

Earnings per share (EPS) is profit for the year attributable to ordinary shareholders divided by the weighted average number of ordinary shares in issue. It is widely watched and easy to understand, but it can grow while value is destroyed: a company that borrows to invest in projects earning less than the cost of capital can still increase EPS. It ignores risk and the capital used, and can be lifted by share buy-backs or accounting choices.

Total shareholder return (TSR) measures what a shareholder actually gained over a period:

TSR = (dividends paid in the period + closing share price − opening share price) ÷ opening share price

TSR is the shareholder's own measure of wealth created, and it reflects the market's view of the future, not only the past year. It is best compared with a peer group or the market index over several years. Its weaknesses are that it depends on share price movements outside management's control (interest rates, market sentiment), it can be volatile, it exists only for listed companies, and it cannot be measured for divisions.

EBITDA

EBITDA (earnings before interest, tax, depreciation and amortisation) is not a subtotal IFRS 18 requires. Calculate it from operating profit by adding back depreciation and amortisation, unless the question defines it differently. It is used as a rough proxy for operating cash flow, it removes the effect of different depreciation policies and asset ages, and lenders often set covenants on net debt as a multiple of EBITDA.

Its weaknesses are serious for a capital-intensive business. It ignores the cost of the assets the business consumes and must replace; it ignores working capital and tax, so it is not cash flow; and because no standard defines it, companies choose what to add back. A strategy judged on EBITDA can look successful while it destroys value through overinvestment.

Net present value

NPV discounts the expected cash flows of a project or strategy at the cost of capital. A positive NPV means the investment is expected to increase shareholder wealth by that amount, so NPV is the decision measure most consistent with the shareholder objective. As a performance measure it is limited: it covers a whole life, so it cannot judge one year, and it depends on forecasts and a chosen discount rate. Use it to appraise strategies and to review them afterwards against the cash flows actually achieved.

Economic value added

Economic value added (EVA) is a residual income measure built to approximate value created for shareholders. It charges the business for all the capital it uses, debt and equity, and adjusts accounting profit and capital so that they reflect economic reality.

EVA = NOPAT − (WACC × capital employed at the start of the year)

Market value added (MVA), a related measure, is the market value of a company's debt and equity less the capital invested in it. It is the market's verdict on how much value management has created, and in theory it equals the present value of the EVAs investors expect in future. It is a whole-company measure and moves with the share price.

Liquidity and gearing alongside profitability

Profit does not pay bills. A profitable company can fail if its cash is tied up in inventory and receivables, often through rapid growth (overtrading), or if it borrows more than it can service. So read profitability with:

• Liquidity: current ratio, quick ratio, the cash operating cycle (inventory days + receivables days − payables days) and operating cash flow.
• Financial gearing: debt ÷ (debt + equity), interest cover, and net debt ÷ EBITDA, which lenders often use in covenants.
• Operational gearing: the proportion of fixed costs in the cost structure, measured as contribution ÷ operating profit. A business with high operational gearing sees its operating profit rise and fall much faster than its revenue.

Operational gearing is 20 ÷ 8 = 2.5, so a 10% fall in volume cuts operating profit by 25%. Financial gearing magnifies it again by 8 ÷ 5 = 1.6, so profit before income taxes falls by 2.5 × 1.6 × 10% = 40%. A business that combines high fixed costs with high debt is the riskiest for shareholders and lenders, which is why an organisation should monitor all three areas together, not profit alone.

Choosing benchmarks

A measure means little without a comparison. The appropriate benchmark depends on the question being asked:

Divisions: managerial and divisional performance

In a divisionalised company, judge the manager on what the manager controls and the division on everything traceable to it. Head office costs apportioned to divisions should be left out of both. The figures below are for Division East, with a cost of capital of 12%.

The manager's ROI is 6.0 ÷ 30.0 = 20.0% and RI is 6.0 − (30.0 × 12%) = $2.4m: a good performance. The division's ROI is 4.5 ÷ 40.0 = 11.25% and RI is 4.5 − (40.0 × 12%) = −$0.3m: as an investment, it does not cover its cost of capital. The first answer decides the manager's reward; the second, whether the group should keep investing in the division. EVA can be applied to divisions in the same way, with a cost of capital that reflects each division's risk.

Worked example

Scenario. Sokoto Cables Co (fictional) is a listed manufacturer. Its chief executive's statement says: "20X6 was a record year: earnings per share rose by over 10%, ROCE was 20%, well above our 12.6% cost of capital, and EBITDA reached $24 million." Extracts for the year ended 31 December 20X6 ($m):

Other information: profit for 20X5 was $9.5m; 50 million shares were in issue throughout both years. The share price was $2.40 on 1 January 20X6 and $2.25 on 31 December 20X6, and a dividend of 8 cents a share was paid during the year. At 1 January 20X6 equity was $60.0m and borrowings $30.0m, at 10% interest. Tax paid equals the tax charge. The cost of equity is 14%, and market values at the start of the year were equity $120.0m (50m × $2.40) and debt $30.0m.

Operating expenses include: development spending of $4.0m (the programme began in 20X6 and will benefit four years); an increase of $0.2m in the allowance for doubtful receivables (opening allowance $0.6m); and depreciation of $6.0m. Economic depreciation is estimated at $7.5m, and the replacement cost of non-current assets at 1 January 20X6 exceeded their carrying amount by $9.4m.

Step 1: the conventional measures.

Step 2: the WACC. Weights: equity 120 ÷ 150 = 80%, debt 30 ÷ 150 = 20%. After-tax cost of debt = 10% × (1 − 0.30) = 7%. WACC = (14% × 0.8) + (7% × 0.2) = 11.2% + 1.4% = 12.6%.

Step 3: NOPAT.

Step 4: capital employed and EVA.

The development spending was all incurred during 20X6, so none of it is in opening capital; the unamortised $3.0m will join the capital base for 20X7. MVA at the start of the year was (120.0 + 30.0) − 100.0 = $50.0m. During the year, the market value of the equity fell from $120.0m to $112.5m (50m × $2.25).

Model answer extract (report to the board).

The chief executive's figures are correct, but they overstate how much value was created in 20X6. Comparing a pre-tax ROCE of 20% on book values with an after-tax cost of capital of 12.6% is not comparing like with like. On an economic basis, the company earned NOPAT of $14.3m on adjusted capital of $100.0m, a return of 14.3%, so it beat its cost of capital by 1.7 percentage points. EVA was positive at $1.7m: value was created, but far less than the headline figures suggest.

Skill: analysis and evaluation. The appropriate measure is chosen, and the misleading comparison is explained.

EBITDA of $24.0m is the least reliable of the three headline figures for a capital-intensive business like ours. It ignores the cost of the assets we consume, and the gap between accounting depreciation of $6.0m and economic depreciation of $7.5m, with replacement cost $9.4m above book value, suggests an ageing asset base that will soon need significant reinvestment.

Skill: scepticism. The answer questions the measure itself and draws out what the adjustments reveal.

Shareholders did not share in the record year. TSR was −2.9%: the 8 cent dividend did not offset the 15 cent fall in the share price, and the equity lost $7.5m of market value. Because the share price reflects expected future EVA, investors appear to expect lower returns ahead, perhaps because of the reinvestment the assets need.

Skill: commercial acumen. The answer connects the internal measures to how investors see the company.

I recommend that the board adopts EVA as its main measure of value creation, reported alongside TSR against a peer group over three years, and that the development programme is treated as an investment, not a cost to be cut when profit is under pressure.

Skill: communication. A clear recommendation for the board.

Common mistakes

• Deducting finance costs before calculating NOPAT. The capital charge already covers the cost of debt, so starting after interest counts it twice.
• Using the tax charge without adding back the tax relief on interest, or using the closing instead of the opening capital employed when the question says otherwise.
• Comparing a pre-tax ROCE with an after-tax WACC.
• Treating EBITDA as cash flow, or praising EPS growth without asking whether the investment behind it earned its cost of capital.
• Calling profit before income taxes "profit before tax", or using operating profit for ROCE when the question, or IFRS 18, points to profit before financing and income taxes.
• Judging a manager on traceable profit, or a division on controllable profit only.

Exam technique

Lay out an EVA calculation as two short tables, NOPAT and capital employed, each adjustment on its own labelled line, so a marker can follow your method even if one figure is wrong. State assumptions, such as tax paid equalling the tax charge. Calculate only what the requirement needs, then spend most of your time on what the measures mean: which is most appropriate, why they disagree, and what the board should do. Where a claim rests on one measure, test it with another.

Study with AI

I am studying ACCA Advanced Performance Management (APM), financial performance
measurement. Give me a company's statement of profit or loss under IFRS 18, its
opening capital, cost of equity, cost of debt, tax rate, share prices and dividend,
and three EVA adjustments. Ask me to calculate EPS growth, TSR, EBITDA, NOPAT, WACC
and EVA, then to evaluate the chief executive's claims. Check every figure and mark
my evaluation.

AI assistants often make arithmetic slips in EVA and may use outdated profit labels: recompute every figure and follow these notes, including the IFRS 18 terms.

Lecturer's note: Every financial measure answers a slightly different question, and most exam traps come from using one to answer another's question. EPS answers "how much profit per share?", not "was value created?". ROCE answers "what return on book capital?", not "did we beat the cost of capital?". EBITDA answers "how much did operations earn before the cost of assets?", not "how much cash?". EVA and TSR come closest to the shareholder's real question, "did I get richer?", one from inside the company and one from the market. Ask which question the board is really asking, then choose the measure.

Key points

• The primary financial objective is to maximise shareholder wealth; accounting profit ignores the cost of equity, risk, timing and expensed investment.
• Under IFRS 18, use profit before financing and income taxes for ROCE and as the starting point for NOPAT; EBITDA adds depreciation and amortisation back to operating profit.
• EPS can rise while value is destroyed; TSR shows what shareholders gained, including the market's view of the future.
• EVA = NOPAT − WACC × opening adjusted capital; NPV is the decision measure consistent with shareholder wealth, and MVA is the market's view of future EVA.
• Read profitability with liquidity, financial gearing and operational gearing; choose benchmarks that fit the question; judge managers on controllable and divisions on traceable profit.

Quick check

1. A share price rises from $4.00 to $4.30 during a year, and a dividend of 20 cents is paid. What is the TSR?
2. NOPAT is $8.0m, opening adjusted capital employed is $60.0m and the WACC is 11%. What is EVA?
3. A company's contribution is $15m and its operating profit is $5m. If revenue falls by 4% with no change in the cost structure, by how much will operating profit fall?

Answers

1. (0.20 + 4.30 − 4.00) ÷ 4.00 = 0.50 ÷ 4.00 = 12.5%.
2. $8.0m − ($60.0m × 11%) = $8.0m − $6.6m = $1.4m.
3. Operational gearing = 15 ÷ 5 = 3, so operating profit falls by 3 × 4% = 12%, or $0.6m (contribution falls by 4% × $15m = $0.6m).