Finance Performance Tools

In order to effectively evaluate a company’s financial performance, analysts must take into consideration transfer pricing and performance measurement tools. Large multinational businesses with separate acting divisions can approach transfer pricing as a business strategy to increase profitability. This can be achieved through the analysis of different country’s taxation policies, accounting guidelines, and international finance law. In addition to transfer pricing, economic measurements such as residual income and economic value added are important metrics that can be used to expand upon the sometimes boring and incomplete set of ratios used by stakeholders for a company’s financial health analysis. Economic considerations are vital to a complete analysis toolbox because they take into account the importance of issues such as taxation, opportunity loss or gain, and the profitability expectation among shareholders.

As the global economy converges and businesses are looking to expand operations into emerging markets, the issue of transfer pricing policy is becoming an important consideration. Transfer pricing defines how a business’s transactions are recorded internally – when various divisions engage in business with each other. In large multinational firms, in particular, managers are responsible for the division’s return on capital. According to Hiemann and Reichelstein (2012)” In vertically integrated firms, transfer prices play a central role for both managerial accounting and tax reporting purposes. Common to these purposes is that transfer prices ultimately determine the distribution of reported income across different segments (divisions) of the firm.” In order to allocate costs effectively, the transfers between two divisions must be accounted for in an equitable fashion. When divisions make a transaction, a transfer price is established to show the allocation of costs. This policy is very important to large scale operations in which profitability must be measured by each business unit. As such, there are different methods of allocating the transfer of assets and costs inside every business. The transactions can include the flow of assets, labor, and cash. The decision has to be made by leadership in terms of which method must be employed in accounting for these transactions.

Different countries deal with transfer pricing differently. According to PWC (2013), many companies are adopting the “end-2-end” transfer pricing strategy. This strategy provides an added level of transparency while being mindful of local taxation and legal issues. Companies can approach transfer pricing as a means to reduce tax liability depends upon the local government’s level of taxation, accounting law, and its enforcement strategy. Consulting firms that understand the relationship between these dynamics can help multinational businesses adjust their transfer pricing strategy in order to achieve additional overall profitability. The measure of an effective policy will be driven by the overall processing of company profitability versus the individual gain of a single business division.

There are many performance measurement tools. Measures for performance evaluations include ratio analysis, return on investment, economic value-added, and residual income calculations. These tools are important to investors and managers for several reasons. Investors use performance measurement tools in the decision-making process – to buy, hold, or sell. While the use of any single metric is important, a single measurement cannot illustrate the full economic picture of a company. It is advisable for investors, as well as managers, to effectively use a broad array of performance evaluation tools in order to process the full scope of financial health within a company. While investors are primarily driven by the capacity of a business to raise capital and provide dividends for owning stock or drive an increase in stock price, managers must also have an accurate pulse of the company to increase profitability. Measurement tools are used for various purposes; however, the application of the tool should be consistent over time in order to be effective for the user.

For added decision-making value, economic driven metrics are also good for any performance measurement toolbox. Residual income and economic value added measurements show the true economic gain or loss of a company. Residual income is important because it compares the income to expectations. It’s important to remember that businesses have a responsibility to meet the expectations of investors. Residual income compares performance to expectation in a way that allows management to determine if those needs are being met, and if not, what strategies need to be adopted to adjust. The result is the ability for stakeholders to gauge economic gain or loss. Economic value added is important economically because it takes into consideration the real cost of taxation (Value-Based Management, n.d.). Of course, paying taxes is a real cost of doing business that many other performance measures ignore. Net income, for example, is a good indicator of financial gain; however, it totally ignores the real cost of taxation. Due to corporate tax rates being between 30 and 36% of net income, this is a significant expense that is not factored.

Performance ratios are arguably the most popular financial performance tools. They are relatively easy to process and also provide a set of core measures that can be used by any stakeholder. Using ratios is an effective approach, but ratios alone cannot address the full range of concerns that may need to be addressed by management or investors. Ratios, by nature, provide a comparison and contrast between two or more single financial metrics. For example, the quick ratio shows the ability for a business to meet its short term debt obligations. This ratio is a simple calculation of current assets to current liabilities (quick ratio = current assets/current liabilities). Mathematically, any value over 1 indicates the level of capacity for the firm to meet all of its short term debt immediately. In order for financial analysis to be effective, economic measurements such as EVA and RI must be used in conjunction with ratios.

References

Hiemann, M. and Reichelstein, R. (2012). The dual role of transfer prices in multinational firms: Divisional performance measurement and tax optimization. The EuropeanFinancial Review. http://www.europeanfinancialreview.com/?p=5741

PWC. (2012). Transfer pricing. PWC. Retrieved from http://www.pwc.com/gx/en/tax/transfer-pricing

Slideshare. (2011). Global management accounting. Retrieved fromhttp://www.slideshare.net/costmgmt/issues-in-global-management-accounting-transfer-pricing

Value-Based Management.net (n.d.) Economic Value Added (EVA). Retrieved fromhttp://www.valuebasedmanagement.net/methods_eva.html