Section B – TWO questions ONLY to be attempted
Chicory operates a chain of depots in Deeland, supplying and fitting tyres and other vehicle parts to lorries, buses and agricultural vehicles. Chicory’s objective is to maximise shareholder wealth. Due to a slowdown in the Deeland economy, Chicory’s recent performance has been weak. An unsuccessful acquisition has also caused cash flow problems and a write-off of goodwill of $24·7m in the year to 30 June 2017.
The board has commissioned a benchmarking exercise to help improve Chicory’s performance. This exercise will involve comparison of a range of financial and other operational performance indicators against Fennel, a similar business in Veeland. Fennel has agreed to share some recently available performance data with Chicory as they operate in different countries. The reason Fennel was chosen as a benchmark is that as well as supplying and fitting tyres and parts to heavy vehicles, a large part of Fennel’s business involves supplying electricity to charging points to recharge electric cars. Fennel installs and operates the charging points in public places, and users pay Fennel for the electricity they use. The board of Chicory intends to follow a similar business model as the use of electric cars is increasing in Deeland.
The Veeland economy is growing strongly. Electric car use there has increased rapidly in the last two years, encouraged by tax incentives for businesses, like Fennel, to install and operate charging points. The Veeland government has also underwritten loans taken out by businesses to finance this technology, which has enabled Fennel to borrow funds for the significant capital investment required. The cost of components used in the charging points is falling rapidly. Capitalisation of development costs related to this technology is permitted in Veeland, but not in Deeland. In 2015, Fennel invested heavily in IT systems which significantly improved performance by increasing the availability of parts in its depots, and reducing inventories.
Chicory uses return on average capital employed (ROCE) as its main financial performance indicator, and this is to be benchmarked against Fennel. One board member suggested that, though it may have some disadvantages, EBITDA (earnings before interest, tax, depreciation and amortisation) could have advantages as a performance measure over the existing measure, and should also be included in the benchmarking exercise.
You have been given the most recently available financial data for both businesses in Appendix 1, with the data for Fennel being converted into $ from its home currency.
Evaluate the relative financial performance of Chicory against Fennel using the two financial performance measures identified in the benchmarking exercise and evaluate their use as performance measures in this situation.
(i) ROCE. (6 marks)
(ii) EBITDA. (10 marks)
(i) ROCE
As can be seen in working 1, Chicory’s ROCE is 13·6% and Fennel’s ROCE is 14·9%. Fennel has apparently performed better than Chicory. One benefit of using ROCE as a performance measure in this benchmarking exercise is that it gives a percentage figure and can compare businesses of different sizes. ROCE does not, however, give the absolute level of return. In this case, Fennel has both a higher capital employed and a higher percentage return.
ROCE is easy to calculate and will be familiar to Chicory’s management as it is currently one of Chicory’s main financial performance indicators. The figures required to calculate ROCE are readily available from published data, which makes this a good financial performance measure for benchmarking.
ROCE shows a weak correlation with Chicory’s objective to maximise shareholder wealth, which may limit ROCE’s usefulness as a performance measure in this benchmarking exercise. ROCE may be distorted by accounting policies or where different businesses have different levels of intangible assets. This may lead to drawing incorrect conclusions from the exercise. A big disadvantage of using ROCE in this benchmarking exercise is that it may encourage managers not to invest in new non-current assets, which contradicts Chicory’s strategy of investing in charging points.
Working 1
Chicory:
(ii) EBITDA
Using Chicory’s main financial performance indicators of ROCE, Fennel has performed better than Chicory. When depreciation of non-current assets and the write-off of goodwill in Chicory are added back to operating profit to calculate EBITDA, Chicory’s performance, with an EBITDA of $52·0m, is slightly better than that of Fennel, which has an EBITDA of $51·0m.
EBITDA as a proxy for cash flow
EBITDA is easy to calculate from published data, and easy to understand. It is a measure of underlying performance, as it is a proxy for cash flow generated from operating profit. As Chicory is having cash flow difficulties following the unsuccessful acquisition, EBITDA would be a relevant measure for this benchmarking exercise. EBITDA does not, however, take into account the cash flow effect of working capital changes, for example, by Chicory negotiating longer payment terms with its suppliers.
Excludes items which are not relevant to underlying performance of the business
Tax and interest are distributions from profits, unrelated to the underlying performance of the business. Excluding them from measures of performance, therefore, gives a better understanding of the underlying performance of Chicory and Fennel. This is important for the benchmarking exercise since Fennel appears to suffer much lower rates of tax, probably due to the tax incentives given by the Veeland government. Loans underwritten by the Veeland government may be at artificially reduced rates of interest and should also be excluded when measuring performance.
Similarly, depreciation, amortisation and write-offs such as goodwill are not relevant to the current year’s underlying performance and may relate to previous years. For example, adding back the write-off of goodwill in Chicory means the two businesses have identical EBITDAs, albeit that Fennel has much greater capital employed.
EBITDA affects comparability of the benchmarking data
Using EBITDA as a performance measure in the benchmarking exercise makes the data for the two businesses more comparable and removes one element of subjectivity, such as in determining useful economic lives of non-current assets. EBITDA does, however, ignore the replacement costs of these assets. This might limit the usefulness of comparisons between Chicory and Fennel if one were to lease non-current assets and the other to purchase them. The introduction of a new accounting standard on the treatment of leases may, however, remove this limitation.
Unlike Chicory’s existing measure of ROCE, which is a percentage measure, EBITDA is an absolute measure and so makes it difficult to compare businesses of different sizes. As a profit based measure, its usefulness is also limited by subjective assumptions made in the calculation of profit, or by inconsistent accounting policies. Development costs may be capitalised in Veeland, but not in Deeland, which may make a comparison against the benchmark difficult
Advise Chicory on the problems of using the benchmarking exercise with Fennel as a way to improve performance.
Benchmarking the performance of Chicory against a similar business implies that there is a best way to operate. Though Fennel may be similar to Chicory, there is no indication that it is best in class and benchmarking against it may be inappropriate.
For example, Fennel has taken advantages of tax incentives and loan guarantees to finance new investments. These do not exist in Deeland, so Chicory may be unable to fund investment in this way. It may have to consider leasing assets instead, or accept a slower rate of growth if it wishes to set up charging points in Deeland.
Benchmarking is a catching up exercise. The financial data for Fennel is 18 months older than that for Chicory and may already be out of date. In 2015, Fennel improved operational performance by investment in IT. The effect of this is not reflected in the financial data given. Benchmarking performance against historical data may not be relevant for current or future performance. The electric car market in Veeland has grown rapidly in the last two years. This growth is not reflected in the financial performance data given for Fennel, nor is the falling price of components for the charging points.
Though Fennel has agreed to share data, this data may be inaccurate or misleading. Though initially the benchmarking exercise is only against Fennel, it may be difficult to find other comparable businesses to benchmark against in the future. The data required for calculation of the three financial performance indicators used in the benchmarking exercise is likely to be readily available and audited, however, which means it is reliable
A large part of Fennel’s business relates to providing charging points for charging electric cars. Though this is a business model Chicory intends to follow in the future, it is very different to its existing business, and so benchmarking against Fennel may be misleading unless more detailed data relating to the two activities can be obtained.
Similarly, Fennel operates in a different country, where the economy is much stronger. Performance targets set following the benchmarking exercise may be unachievable for Chicory. Fennel’s financial data has been converted into $ from its home currency. Movements in exchange rates may make the benchmarking data less comparable, especially if the economies in Deeland and Veeland are growing at different rates.