Decisions based on past performance misleading

People make many decisions based on the past performance of a company, but fail to understand the risk as they do not use the proper tools for performance measurement; these are the reasons for companies to fail, said Professor of the Indian Institute of Management P.C. Narayan at a breakfast meeting organised by the Institute of Chartered Accountants of Sri Lanka.

He said the traditional method of performance measurement is Return on Investment (ROI) or Earnings Per Share (EPS) . ROI is easy to calculate but it is sensitive to choice of accounting method and is backward looking while it also fails to consider the risk. Using EPS as a performance management tool, may cause management to refrain from issuing equity at times when the company needs it, possibility of fabricating EPS gains by using more debt than prudent and accepting weak projects that happen to be financed with debt.

According to the Harvard Business Review until a business returns a profit that is greater than its cost of capital it operates at a loss.

Professor Narayan said that just because a company has an accounting profit it does not mean the company has an economic profit. Therefore the best performance measurement tool is Economic Value Add (EVA). It is the financial performance measure that comes closer than any other to capturing the true economic profit of an enterprise.

It is also the performance measure that is directly linked to the creation of shareholder wealth over time.

EVA based financial management and incentive compensation system gives managers superior information and superior motivation to make decisions that will create the greatest shareholder wealth in any publicly owned or private enterprise.

Professor said put most simply EVA is net operating profit minus an appropriate charge for the opportunity cost of all capital invested in an enterprise.

He said that implementation of EVA shows whether the company has created or destroyed wealth and it is a consistent way to improve the firms financial performance as well as the stock price.

Permanent EVA improvement has to be a constant management pursuit while changes in EVA has to be analysed and actioned on an ongoing basis and most importantly identify where returns are below the capital cost divest them if improvement in return is not feasible, said professor Narayan.