Performance Measurement: An Empirical Study of Cash Flow Return on Investment and its Application on Smith & Nephew

Niclas Kristensen

Student thesis: Master thesis

Abstract

In this paper, we investigated the use of value-based metrics, which serves as an alternative to accounting ratios. Corporate operators have increasingly been under pressure to deliver shareholder value and as a tool to cope with this demand, - managers and executive’s turns to value based metrics such as CFROI and EVA to help them understand their firms underlying economics. Both measures provide their own advantages and disadvantages over traditional accounting metrics such as P/E and ROE. While accounting measures do provide some information on the current state of the firm, - it can be biased by accounting differences or by simple misclassification of reported expenses that explain little about true profitability. In particular, the handling of leases, and R&D can skew operating income while depreciation schemes can lower book value and increase returns. The main research question asked in this thesis were “How do CFROI compare to EVA as a financial management tool?” and consequently this thesis examined the pros and cons of both measures through a literature review and a case study. The thesis found EVA is superior as a corporate value based management tool. This is partly because it is easier to comprehend and calculate but also because EVA as an absolute measure provides managers with a clearer understanding of the magnitude of wealth that has been made. As a relative measure, CFROI on the other hand allows for benchmarking across firms as it is not distorted by differences in size. Another key advantage in the CFROI model is the fact that its inflation adjusted and not restricted to different accounting standards as it´s based on compressive accounting conversions – these attributes further enables benchmarking across time and national borders. Principle users of these metrics are corporate operators and investment managers, the latter will find CFROI more useful as it can work as a stock screening tool and provide an edge when looking for alpha. Firms however, will do well in understanding both metrics and serve the needs of both sides. The thesis provides the same recommendation to Smith and Nephew, which is to focus on EVA and ROIC for internal value based management and keep CFROI in the strategic department to assist executive management in their dialogue with investors and analysts who do look for CFROI when evaluating firms.

EducationsMSc in Applied Economics and Finance, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2016
Number of pages93