The Capstone Performance Measures:

(also called Success Measures):
Cumulative Profits
Market Share
Return On Sales (ROS)
Asset Turnover
Return On Assets (ROA)
Stock Price
Return On Equity (ROE)
Market Capitalization

Let’s look at how financial structure and performance measures are intertwined by examining each measure as if they were the only one selected for the company. Examining the extremes can provide insight into the usefulness of each measure.

 Cumulative Profits:

 Generically, profits are driven by the company’s asset base and by its efficiency working those assets.

Given any two companies, if we hold efficiency constant, the company with more assets produces more profit. If we hold assets constant, the company with higher efficiency is more profitable. It follows that teams that choose cumulative profits will want a larger than average asset base, and that they will work their assets as hard as possible. A new product with an efficient plant meets those criteria. An older product with high plant utilization at high automation similarly meets the criteria. Both represent sizable investments in new assets.
          In the end, an emphasis on cumulative profit drives management towards a large asset base. Managers are willing to increase debt to get there, but because interest payments consume profits, they will prefer funding with equity. Their funding priorities will retain earnings (no dividends) , then issue stock, and finally issue bonds.
         
    To grow its assets, a company can retain all of its profits and issue all the stock it can—then leverage  the new equity with new long term debt. Presumably then the $ can buy plant improvements &/or expand the product line and/or improve the plant efficiencies.
    

In short, management’s top priority was to identify opportunities to accumulate efficient assets. When identified, managers raised the money first with equity (retained profits and stock issues) , and then with as much long term debt as needed (up to its credit limits) .
 

Note the trade-offs with other performance measures.

 We are increasing assets, equity and leverage. Dividends are zero. Stock is diluted.

The implications for other performance measures include:

1) ROE: Likely falls in the short run, may climb in the long run
2) ROA: Likely falls in the short run, may climb in the long run.
3) Asset turnover: Likely stays neutral or falls slightly
4) Stock price: Since dividends fall to zero as shares are diluted, likely falls.
5) Market cap: Stays neutral. More shares, but at a lower price.
6) ROS: Probably goes up.
7) Market share: Goes up.

Of course, the team hopes that profit growth will outpace balance sheet growth, and if it does, all of these measures will swing positive in the long run.    If the board of directors imposes other performance measures, management will feel torn. That can be a good thing. While cumulative profits is, perhaps, the most important individual measure, it does not take into consideration all of the stakeholders interests, particularly stockholders.

Market Share

Generically, market share is driven by the breadth of the company’s product line and management’s willingness to sacrifice profits.

An expanded product line implies a larger asset base. Profits fall because of price cuts, expanded inventory carrying costs (to avoid stock-outs) and increased SG&A expenditures.
          When it stands alone, market share drives managers towards destructive behaviors. Of course, demand increases, and if the company can at least break even, at some point in the future the company will be significantly larger than its competitors. Management will increase margins, sacrificing some of its demand for profits.
          Given our starting balance sheet, how would market share alone affect management behavior?

 
1) Let’s assume management wants to at least break even. Profits are close to zero. No increase in retained earnings. Management will want to expand the product line and add to existing capacity.
2) Plant and equipment expands, funded by stock and long term debt. However, because there are no profits, the stock price will fall, limiting the amount of equity that can be raised. The burden shifts to long term debt.
3) Management will expand accounts receivable (increases demand) and Inventory (avoids stock-outs) , with corresponding increases in accounts payable and current debt.
4) Plant and equipment purchases will be somewhat smaller because the emphasis will be on capacity, not automation. It will be constrained by a need to expand current assets.

         
Note the trade-offs with other performance measures. We are increasing assets, using a modest increase in equity and heavy leverage. Profits are zero. Dividends are zero. Stock is diluted.

   The implications for other performance measures include:

1) ROE: Falls because of low profits. May climb if some share is sacrificed near the end of the simulation.
2) ROA: Same as ROE.
3) Asset turnover: Likely stays neutral or falls slightly.
4) Stock price: Falls. No increased book value. EPS is zero. Dividends zero. Shares diluted.
5) Market cap: Falls. More shares at a lower price.
6) ROS: Falls to zero.
7) Cumulative profit: Falls to zero.

          Of course, the company hopes to suddenly restore profits near the end of the simulation. If they can, all of the performance measures will turn sharply upwards in the end game. Further, in destroying their own profitability, they have also destroyed their competitors. If they can get “big” while competitors stay small (possible, since competitors would seek a profit) , they can sacrifice a small amount of share in the end game for a sizeable, albeit late, profit.
          The board of directors will almost always impose other performance measures. Applying market share alone is a recipe for self-destruction. Used in concert with cumulative profit, management will feel schizophrenic, but will see a common theme of fast growth.

Return On Sales
Generically, return on sales (ROS) is an efficiency measure defined as:

 net profit / net sales.

ROS asks “How hard are we working each dollar of sales?” This is a pure income statement relationship. However, if ROS is used alone, we could infer its effect upon the balance sheet and the financial structure.

1) Profits. From the cumulative profit discussion, we know the company needs to expand its asset base to increase profits.
2) But management wants a small sales base. If they have a smaller top line, and produce average profits, they can keep ROS high.
3) Management  will likely respond with a niche strategy : a) Playing in fewer segments lets them expand assets within the segments. For example, they could concentrate their starting products in low technology segments, or they could retire the low tech products and replace them with new, high tech products with the recovered capital. b) Similarly, sales will be near the overall industry average in a niche strategy. Although they give up some segments, they have higher sales in their target segments.
4) Management will avoid debt, and move to retire existing debt to reduce interest payments.
5) Plant investments will be relatively modest.
6) Management is under no pressure to minimize assets, particularly current assets.

Regarding the trade-offs with other performance measures, we are modestly increasing assets, using a hefty increase in equity and reduction in debt. Profits are good, but not quite as good as with a pure emphasis on cumulative profit. Dividends are zero. Stock is diluted.

   The implications for other performance measures include:

1) ROE: Falls because of increased equity.
2) Asset turnover: Flat or improves somewhat.
3) ROA: Improves (ROS x Asset Turnover = ROA) therefore if ROS improves and asset turnover stays flat (worst case) , then ROA must improve.
4) Stock price: Flat. Gains in book value are offset by stock dilution and zero dividends.
5) Market cap: Increases. More shares at the original price.
6) Cumulative profit: Increases.
7) Market share: Flat. Gains in segments are offset by abandoning other segments.

 
          In a basic sense, ROS forces management to emphasize efficiency. Related measures like ROA and cumulative profit improve in concert.

A board of directors would never impose ROS alone, although the overall affect is healthy upon the company. Used alone it has two important downsides. First, stockholders will be disappointed. Although market cap goes up, it is not because stock price improved, but because additional stockholders were added. Second, the company becomes a takeover target. It has such an attractive mix of debt and equity that a corporate raider could buy the company using its own debt capacity.

Asset Turnover
Asset Turnover is defined as: Sales / Assets.

Asset turnover is another efficiency measure. It addresses the question, “How hard are we working our assets to produce sales?” Since it mixes an income statement item, sales, with the balance sheet’s assets, it should be a better predictor of general health than any of the measures we have looked at so far. Unfortunately, it suffers from one important drawback—it pays no attention to profit.
          If asset turnover stands alone, management pushes for sales growth faster than asset growth.
1) Sales must grow, but there is no incentive to make a profit. Much like market share, SG&A expenses, which increase demand, surge while prices fall. Management will stay in every segment with its starting product line.
          However, management wants to minimize assets. It avoids plant improvements, downsizes excess capacity, and minimizes current assets. Management might add new products, but it will invest as little as possible in new plant and equipment.

  

Regarding the trade-offs with other performance measures, we are reducing assets slightly (at a minimum, sharply limiting asset growth) . Profits are zero. Dividends are zero. Stock and bond issues are avoided. As depreciation accumulates, we pay down debt.
The implications for other performance measures include:
1) ROE: Falls to zero.
2) ROS: Falls to zero.
3) ROA: Falls to zero.
4) Stock price: Falls.
5) Market cap: Falls.
6) Cumulative profit: Falls.
7) Market share: Increases.

          It is easy to see that when used alone, emphasizing asset turnover is destructive. A board of directors would never impose it alone, but when teamed with a profit oriented measure, it is an important indicator of company health. For example, asset turnover multiplied by return on sales determines return on assets:  Asset Turnover x ROS  = ROA

Return On Assets
Return on assets (ROA) is defined as: Profits / Assets.

 
ROA is one of the most common performance measures. It mixes the income statement’s results with the balance sheet’s results, answering the question, “How good are we at producing wealth with our assets?”
          As a measure, ROA has two drawbacks:
1) It pays little attention to sales growth.
2) It biases behavior towards the accumulation of equity.
 

When ROA is used alone, management pushes for increased profits while minimizing assets.

Because interest payments reduce profits, management avoids debt where possible.

    Management is torn about increasing the size of the asset base. On the one hand, with assets in the denominator, any increase in assets makes it difficult to improve ROA. On the other, overall profits depend in part on sales volume. If we increase sales volume while holding ROS constant, the absolute profits must increase.
    Management becomes cautious. When buying an asset, they must be confident that enough profit will flow from the investment to maintain or improve ROA. When funding the investment, they avoid debt, thereby limiting the size of the investment and increasing pressure to do stock issues.
    In the end, assets grow slowly. Debt falls. Profits are retained. Stock is issued, but because there are no dividends, stock price stays flat.

The implications for other performance measures include:
1) ROE: Falls. Equity accumulates faster than profits increase.
2) ROS: Should at least stay flat, and probably improves.
3) Asset turnover: Should at least stay flat, and probably improves.
4) Stock price: Stays flat. No dividends. Stock issues dilute stock. EPS stays flat.
5) Market cap: Increases, although stock prices stay flat, there are more shares outstanding.
6) Cumulative profit: Increases.
7) Market share: Stays flat.

ROA pressures management to avoid risk, emphasize efficiency, and to improve incrementally profits.
          Privately held companies often emphasize ROA.
          Publicly held companies, however, would never use ROA alone for the same reasons they would not use ROS alone. It disappoints stockholders, who see no appreciation in their stock price, and it makes the company a takeover target. It has such an attractive mix of debt and equity that a corporate raider could buy the company using its own debt capacity.

Return On Equity
Return on equity (ROE) is defined as: Profits / Equity.

ROE is an exceptionally popular measure with publicly held companies. It answers the question, “what rate of return is the company producing for its owners?”  The difference between ROA and ROE is the use of debt, also called leverage. Leverage is defined as: Assets / Equity.
---when a board of directors emphasizes ROE as a performance measure, managers respond by minimizing equity and maximizing profits. To minimize equity, they avoid issuing stock and they pay dividends to reduce retained earnings. They match all investments with new debt (increasing debt, or leverage) . They work the assets hard (asset turnover) .
            Therefore, if the board says, “emphasize ROE,” you can predict that the company’s financial structure will be at least 50%/50% debt to equity. It might be as high as 75%/25% debt to equity.

Put this way, leverage asks, “How many dollars of assets do we have for every dollar of equity?” If the answer is 2.15, then for every $1.00 of equity, we have $2.15 of assets, and therefore the remaining $1.15 must be in some form of debt.
Owners note that ROE can also be defined as:

Asset Turnover x ROS x Leverage = ROE ---These ratios address overlapping and vital questions.

• Asset turnover asks, “How hard are we working our assets to produce sales?”

• ROS asks, “How hard are we working the income statement to produce a profit?
  Multiplied together, ROS and asset turnover produce ROA, which asks, “How hard are we working the assets to produce a profit?”

• Leverage is such an important idea that the various stakeholders—debt holders, equity holders, and management —prefer different formulas to define it.

  •     Equity holders prefer: Assets / Equity, “how much assets do we have for every dollar of equity?” Equity holders prefer bigger values, provided that the investments are good ones. Their reasoning goes, “management’s job is to identify high return investments. For example, if they find investments for my money that return 25%, they should invest my money, and they should borrow as much as they can at 10%, so that I get the other 15% on the lender’s money, too.”

  •     Debt holders prefer: Assets / Debt, “how much assets do we have for every dollar of debt?” They also prefer bigger numbers. At $1 assets for every $1 of debt, or 1.0 the entire company is funded by debt. At 2.0, then there is a dollar of equity for every dollar of debt, and their risk falls. Their reasoning goes, “sure, I want to lend money, but there is a chance the company will fail. If so, we can sell the assets and recover our principal. Unfortunately, we will be lucky to get some fraction for each dollar of assets, say $.50 for each dollar of assets. In that case, we get the $.50, and the equity holder gets nothing.”

  •     Managers prefer: Debt / Equity. At 1.0, there is a dollar of debt for every dollar of equity. At 2.0, there are two dollars of debt for every dollar of equity. Managers want to keep their jobs, and in that regard they face two risks. If the company cannot meet its interest obligations, debt holders can force the company into receivership and fire management. On the other hand, if a public company has little leverage, it becomes a takeover target.
    
    The key questions are, “who gets the wealth that is being created?”, and “who takes the risk of failure?”
    
    Looking For Wealth

Traditionally, wealth is found at the EBIT line on the income statement. Looking at the income statement we can see that the wealth is split between lenders (interest) , government (taxes) , and owners (profits) .

However, managers capture wealth before the EBIT line in form or salaries, buried in period costs. In recent times this has become a major issue in strategy, expressed in two parts, executive compensation and management turnover. Although that discussion is far broader than we can discuss here, we can note that if the company is publicly held, management will seek moderate levels of leverage, neither too low (risk of take-over) nor too high (risk of bankruptcy) . In privately held companies, management will prefer ROA to ROE and reduce leverage to more modest levels.

From this discussion we can see that leverage is the key issue in the financial structure of the firm. We can make a few generalizations for publicly held companies.

Using stockholder’s assets / equity as the definition, a leverage of 1.0 means the company is entirely funded by equity. Stockholders, including potential stockholders like a corporate raider, will ask, “Why can’t management borrow, invest the money, and make profits on the borrowed funds?” Management can expect trouble at a leverage of 1.0.

    At a leverage of 2.0, for every dollar of equity, there is a dollar of debt. Management and bankers will be happy, although stockholders might pressure for more debt.
    At a leverage of 3.0, for every dollar of equity, there are two dollars of debt. If the investments are good, stockholders will be delighted. Management and debt holders will be modestly uncomfortable.
    At a leverage of 4.0, for every dollar of equity, there are three dollars of debt. Even stockholders are likely to be uncomfortable. Management will feel pressure to bring down the leverage, and are at some risk of losing their jobs if they do not.

How would applying ROE alone likely affect the balance sheet?

Management will buy assets. The assets will produce higher sales volume. The higher sales volume will increase profits. Management will minimize stock issues, and they will pay dividends to get rid of any excess (non-leveraged) retained earnings.

The implications for other performance measures include:
1) ROS: Should at least stay flat, and probably improves.
2) Asset turnover: Should at least stay flat, and probably improves.
3) ROA: Should at least stay flat, and probably improves.
4) Stock price: Increases. EPS increases. Excess working capital is returned to stockholders as dividends. There are few stock issues to dilute stock.
5) Market cap: Increases as stock price goes up.
6) Cumulative profit: Increases.
7) Market share: Hard to predict. Often there is some tradeoff in the short run between profits and market share. Management is reluctant to reduce profits, but knows that increasing sales volume while holding ROS constant must increase asset turnover, and therefore improve ROA and ROE. At best, we see modest improvements in market share.

At a big picture level, assets are some multiple of equity. If equity is kept small, the asset base must be small. Therefore, in the long run, emphasis on ROE can stunt a company.

Stock Price
Literally millions of man-hours have gone into the study of stock price in the real world, and many correlations between factors as varied as “fundamentals” like profits and “psychologicals” like news stories have been identified.

Capstone®, however, is an educational tool. It takes a simple approach to stock price, highlighting the basic drivers. In Capstone®, stock price is a function of:
1) Book value = Equity / Shares outstanding
2) Earnings per share = Profits  / Shares outstanding
3) Dividend per share
4) Emergency loans penalties Book Value

There are only four ways to affect book value:
1) Issue stock
2) Retire stock
3) Retain profits
4) Pay dividends

Generally, book value climbs if management keeps the profits as retained earnings and does not pay dividends. Historically, in the days when a balance sheet reflected the wealth producing assets like land and factories, book value was a fair estimate for the value of stock. In today’s world, off balance sheet assets like customer lists, brand equity, or access to markets swamp book value.

Earnings Per Share
Earnings per share (EPS) looks at the wealth that is being created on each share of stock. It is a somewhat useful predictor of future earnings. The EPS will either wind up in the stockholders hands directly as a dividend, or it will be retained and used to enhance the wealth creation capabilities of the company. Therefore, one school of thought says that a stock price should reflect the present value of a future EPS stream, and if we can somehow predict that stream we can predict the stock price.

Dividends
Dividends are usually a portion of the earnings per share. Therefore, let us look at the limits first, a dividend of zero and a dividend greater than the EPS.

When management doesn’t pay a dividend, it is saying, “Let’s keep the profits. We will invest it at a high return, and we will leverage it to against additional new debt. The company will get bigger and better at producing future earnings.” This makes sense to investors, but it is not quite the same as having cold hard cash placed in an investor’s palm. If management is correct, EPS will go up in the future, and the stock price will rise. However, if dividends fall, stockholders must consider the possibility that management will do worse with the money than the stockholder, and stock price will fall.

Above the EPS, management is extracting excess equity and giving it stockholders. This may be appropriate, but it cannot be sustained. Eventually all of the equity would be paid out. Therefore, a stockholder does not reward the company with a higher stock price.

A good dividend policy might look like this:
1) Management determines the financial structure of the firm. For example, they decide upon a leverage (assets / equity) of 2.5. This translates into 60% debt and 40% equity.

2) Management looks at the investments it wishes to make, and at its requirements for working capital growth. For example, suppose it needs to grow current assets by $5 million and buy $20 million of new plant. To maintain its 60/40 structure, it needs 40% x ($5 + $20) million = $10 million in new equity.

3) It can get the equity by retaining profits or by issuing stock. If profits are expected to be $10 million or more, management can use profits alone to grow the company. There is one complication to consider, “did we pay dividends last year?” If so, it may wish to maintain the past dividend. Suppose that 2 million share are outstanding. $10 million divided by 2 million shares produces an EPS of $5.00. If last year’s dividend were $2.00 per share, that would leave $3.00 time’s 2 million shares or $6 million for new, retained earnings. The remaining $4 million would be raised in a stock issue. Of course, this is a policy decision. Management could choose to cut the dividend and avoid the stock issue.

In short, dividends should represent the “excess” profits that are not required for growth in working capital and new plant. Consider the alternative. If you keep the profits and do not put them to use, your financial structure must change. Idle assets, especially cash, will accumulate. You will feel pressure to do something with the cash. Teams often pay down debt, which further affects the financial structure. Instead of making financial policy, they observe it.

Returning to stock price, a dividend can be compared to the interest payment on a bond. Given the payment and the interest rate, we can easily determine the principal. Since dividends can be volatile, Capstone® stockholders look at last year’s dividend (up to last year’s EPS) and this year’s dividend (also up to this year’s EPS) and calculate an average dividend.

Emergency Loan Penalties
Emergency loans are issued to companies that run out of cash during the year. Typically, these companies produce too much inventory or allow purchases of capacity and automation to go unfunded. Emergency loans are a shock to stockholders. To cover the cash shortfall, management was forced to seek funding with above-market interest rates. Clearly this will affect the stockholder’s valuation of the stock. Capstone® addresses this as follows:

1) Generally, an emergency loan penalty will be equal to the amount of the emergency loan divided by shares outstanding. For example, with 2 million shares outstanding, a $6 million emergency loan will reduce share price by $3.00.
2) An emergency loan can cut the stock price to as much as half the book value, but no more.
3) Any emergency loan, no matter how small, drops stock price by at least 10%.

To determine stock price, Capstone uses the four factors listed above.

Book value + (A x EPS) + (B x Ave. Dividend) – Emerg. Loan Penalty
“A” is a constant with a value between 2 and 3; “B” is a constant with a value between 5 and 8.

At a big picture level, emphasizing stock price has much the same effect as ROE. Managers are reluctant to issue stock and accumulate earnings, but feel pressured to grow the company. In the long run, emphasizing stock price can stunt a company because of limits placed on reinvestment--

Thus implications on performance measures include:
1) ROS: Management wants to improve ROS.
2) Asset turnover: Difficult to predict. Management wants to avoid stock issues and pay dividends, so there is downward pressure on the asset base. However, management wants to increase ROS, so there is pressure to increase the asset base.
3) ROA: Improves.
4) ROE: Improves.
5) Market cap: Increases as stock price goes up.
6) Cumulative profit: Increases.
7) Market share: Hard to predict. Often there is some tradeoff in the short run between profits and Market Share. Management is reluctant to reduce profits, but knows that increasing sales volume while holding ROS constant must increase asset turnover, and therefore improve ROA and ROE. At best, we see modest improvements in market share.

Market Capitalization
Market capitalization (market cap) is defined as: stock price x shares outstanding.

To explore market cap, let’s use an example. Suppose that your team wants to expand the asset base by $40 million.

You begin by answering the question, “What is our financial structure?” You decide upon a Leverage (assets / equity) of 2.0, or 50% debt 50% equity. Therefore, you need $20 million in new equity.

When you look at your projected earnings, you believe you can retain $5 million in profits. It follows you must raise $15 million from the sale of new stock. If the stock price is $30, you must issue $15M/30 = 200 thousand shares.

The implications for other performance measures include:
1) Stock price: With more shares outstanding, it will be more difficult to grow EPS and dividends. Therefore stock price will grow more slowly.
2) Market share: Depends on the type of investment. Since you can match new debt with the new equity, you can grow the asset base quickly. If used to expand the product line, the company gets big faster than if you use retained earnings alone. However, if the company investments are intended to reduce costs (probably via automation) , then market share will stay flat or even fall.
3) ROS: Also depends upon the type of investment. Product line expansions tend to hold ROS constant. Productivity improvements improve ROS.
4) Asset turnover: Likely falls somewhat. The asset base grows, but depending on the type of investment, sales could stay flat. Either way, there are more assets.
5) ROA: Can grow, but because of the larger asset base, will grow slowly at best and could fall.
6) ROE: Can grow, but will grow slowly at best.
7) Cumulative profits: Grows. The larger asset base produces wealth, but producing it efficiently is not a concern.

At a big picture level, issuing stock quickly raises capital and makes it easier and quicker to achieve strategic goals. Differentiators can introduce new products. Cost leaders can improve productivity more quickly.
 

Linking Financial Structure and Performance Measures to Strategy and Tactics
Financial structure and performance measures are intertwined. Suppose you were given these performance priorities:

Compared with an average company, how would your tactics be affected?

Over time, the financial structure these measures tend to produce --will create a large, relatively inefficient company. The struggle between management and owners varies from company to company. A major factor in the outcome is the degree to which ownership is concentrated. Your situation in the simulation would be comparable to a wholly owned subsidiary or to a company with a very large voting block of conservative stockholders. You cannot do any of the things managers love to do. Instead, you must maximize the present and future wealth of the owners.