Issues with Balanced Scorecard: A Case Study

I. “I think Fitzharrys Ltd’s financial statements are incomplete.

a. They contain nothing about the company’s plans and budgets for the year to 31 December 2005, nor about performance since the year end. Its directors are failing in their duty to keep shareholders fully informed of the company’s current performance.”

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The most up to date records that are available are the records ending in 2004. Although they may not be entirely up to date for the complete benefit of the shareholders, they are the only records that we have to go on. However the results that we do have seem to paint a positive enough picture for us to be confident going forward. They show that Fitzharrys Ltd profit margin and other key indicators have risen inexorably over the past few years, giving Larkmead much to go on when looking at a potential purchase. The figures which we have so far are more than satisfactory, and therefore for us they do not pose a significant problem

b. “We know that the company has a great deal of goodwill represented by its established name, professional staff and loyal customers. Why does this asset not appear in the financial statements?”

There are many possible good reasons as to why the company’s goodwill does not appear in the financial statements. Goodwill is in itself an intangible asset. Whilst there are ways of measuring goodwill, it is not one of the key indicators that we are looking at. It is true that the goodwill of the company may add to what we have to pay for Fitzharrys Ltd, however goodwill is very much an important asset which we will see the many benefits of in any merger. A merger destroys the target’s ‘old’ goodwill and creates ‘new’ goodwill to appear in consolidated books. As such I am unconcerned about the fact that goodwill is not represented on these statements, and feel that it will provide a bonus for Larkmead after any takeover. The fact that it does not appear in the financial statements is more likely than not due to the fact that goodwill is difficult to define in purely monetary terms.

II. “I think its financial statements are wrong. The company increased its profit but its cash balance has declined in the year. How can this be correct?”

The fact that its profits are up can be seen to be the most important factor. There are also several other factors to be taken into consideration, and I do not believe that these figures are necessarily incorrect. When a profit is recorded other changes on the balance sheet depend on revenue transactions and expense transactions. Often a transaction does not significantly affect the balances in an account as many other factors come into play as a result. The figures which are available are satisfactory and are enough to suggest that Fitzharrys Ltd would be a good investment.

III. “The money Fitzharrys Ltd is owed by its customers has gone up by over 55% from 2003 to 2004, and this in a time of recession. Have they lost control over the situation? “

They may well be owed money; however they are a company who are paid in large by the public sector. Central and local government are not a high debt risk and we can be fairly confident that they will pay back the money which is owed to Fitzharrys Ltd. We will not need debt collection agencies to deal with any central government clients. The country was not in recession in 2003 and 2004, and therefore construction projects undertaken by the government or local councils were not unusual, and I am sure that Fitzharrys ltd had good reasons for accepting credit from these agencies. We can certainly be totally confident that the money will be paid back. Therefore in this case it is not fair to say that the management at Fitzharrys Ltd has lost control over the situation. On the contrary they have gained several good and reliable business contacts.

We can be confident to the reliability of Fitzharry Ltd’s clients that the situation is not as bad as if the debtors were individual customers of dubious credit history.

IV. “A similar thing has happened to its inventory – it has gone up by nearly 40% as well. Surely this must indicate a lack of management control?”

The fact that Fitzharrys Ltd’s inventory has gone up by nearly 40 per cent does not necessarily indicate that there has been any loss of management control by the company. An inventory is a list of goods and materials which is owned by the company – in this case it will be made up largely of construction related stock. In a growing construction company it is only natural that the inventory on that companies books will also grow. In the case of stock which is held by the company, the stock is all produce that can be sold on by the company and therefore adds to Fitzharrys Ltd’s overall value and desirability. Any businesses which stocks too little inventory will then be unable to take advantage of large orders from any customers. It can be seen as generally good overall practice for Fitzharrys Ltd to have this large an inventory as it represents stock that can be used for the benefit of potential clients or, alternatively, can be sold at a profit.

However I do share your concern about the level of inventory, at least to a certain extent as there are sometimes problems which an excessive amount of inventory can bring. For one thing there are many things which can be hidden by the account of inventory. Also, whilst it is an asset on the balance sheet, at the same time it is also money tied up which could be used for another purpose other than stock just sitting in a warehouse. Plus, it should be taken into account that a high inventory causes significant tax expenses, which is clearly not desirable. However looking at the overall picture I am unconcerned about this rise in inventory. It shows that the company is growing, can expect further business, and it does not in any way seem to indicate any loss of management control by Fitzharrys Ltd.

V. “I may have to sell some of my shares in Larkmead plc. My stockbroker tells me companies like ours have a price/earnings ratio of about 11 to 1. What does this mean, and what does it indicate about the price I should sell my shares for?”

Price/Earnings (P/E) Ratio is calculated as Market Value Per Share over the Earnings Per Share (EPS) of the company in question. A high P/E means that investors are expecting higher earnings growth in the future from that company. The lower the required rate of return then the greater the growth of earnings. The price earnings ratio tends to rise when the rate of return on surplus rises relative to the rate of growth of profitable investment opportunities. As bubbles inflate price-earnings ratios will rise above those predicted by fundamental analysis. Therefore in recent years many businesses may have experienced inflated Price Earnings ratios, and with the oncoming recession it could reasonably expected that the Price Earnings ratio will fall.

In your case 11/1 translates as 11. In the same way as 49/7 calculates as seven – this is how P/E is calculated. 11 is just below what you might expect to be the average for a P/E ratio, and therefore will fetch a fairly decent total on the stock market.

A balanced scorecard is a performance managing tool which is used for making sure that the various component parts of an organisation share one general overall shared goal. It is a highly effective way of assessing corporate performance. A balanced scorecard approach focuses not only on financial outcomes, but also on other key organisational factors, such as an organsiations’ employees and its customers. The balanced scorecard approach has been enormously successful and popular^[1] since its introduction. It is estimated that by 2005 the Balanced Scorecard approach had been adopted by 44 per cent of the UK’s top FTSE 100 companies^[2] meaning that it has almost eclipsed the traditional focus on reported profitability by organisations

The first individuals to put forward the balanced scorecard approach were Robert Kaplan and David Norton in the early nineties, although many of the practices that they set up had been in use for a while, with companies such as General Electric being pioneers in the 1950s. Kaplan and Norton were concerned with producing alignment in companies and suggested the use of the balanced scorecard approach, whilst they also suggested other methods such as Strategy Maps.^[3]

The strategic balanced scorecard is built up around central key perspectives – often four perspectives but occasionally up to five perspectives. These are the financial perspective, the customer perspective, the internal processes perspective, the perspective of innovation and improvement, and the employee perspective. The financial perspective was previously the only perspective which mattered in many organisational models, and the disproportionate focus on reported profitability was a problem. Hence the use of the word ‘balanced’ in the balanced scorecard, as the other perspectives provide a balance against the financial perspective, thus helping organisations to provide an effective overall strategy.

Many of the benefits of balanced scorecards come from the implementation methods. There are typically four processes in implementing balanced scorecards. Firstly translating the vision of the organisation into operational goals. Secondly communicating that vision and linking that vision to individual performances of members of staff operating within the organsiational framework. Thirdly business planning, and finally receiving feedback and adjusting the strategy in accordance with that feedback. The balanced scorecard relies on key performance indicators such as customer satisfaction and overall equipment effectiveness. The balanced scorecard defines the strategic linkages to integrate performance across organisations, and aligns strategic initiatives.

A balanced scorecard tends to have a set of goals which are linked to each of the four or five core perspectives. Once the goals linked to the perspectives have been decided upon then links are found between the goals across the various perspectives in order to join up the various component parts of the companies overall corporate strategy. These various links help to provide an effective overall joined-up corporate strategy. The role of the balanced scorecard is therefore to clarify strategy, to focus an organisation and to make the strategy easily operational. The balanced scorecard helps to promote an overall vision and it acts as an umbrella for a variety of often disconnected corporate programmes. Another advantage of the balanced scorecard is that it is not over-complicated, and it therefore does not result in confusion as to the meaning of the various perspectives and goals. In order to prevent any such confusion it is worth being cautious about setting an excessive number of objectives, as this can be a disadvantage^[4], introducing confusion to a relatively simple system.

A balanced scorecard is a highly desirable tool as it helps to provide an overall organisational performance, which is very much important in business. An example of an organistaion which naturally has an obvious overall strategy is a football club. Whereas at a football club everyone knows that your aim is to score goals and move up the league table, such clear aims do not necessarily exist in an organisation, particularly for individual employees working in that organisation who often only see there existence as within their little team. The aim of the balanced scorecard was to move away from this narrow perspective, and to create a broader vision where what the company is trying to achieve becomes more obvious for employees. A sporting analogy can often be successful in an organsiation

As with football clubs, in business a simple goal is always most desirable. Progress needs to be communicated to individuals in a business, in a similar way to how they would in a football club. A balanced scorecard provides a methodology that turns the eyes of all employees in a single direction, and helps those at the top of the organisation keep in contact with those in the rest of the organsiation. The role of feedback in the balanced scorecard method is vital.

The balanced scorecard is however not entirely without its critics. One criticism of balanced scorecards is that they are not based on any proven financial or economic theory, and that the relative youth of the theory means that few holes have yet to be picked in the scorecard. There is also a belief that positive feedback from balanced scorecards could be in part due to a sort of placebo effect from companies who are in thrall to the supposed wonder of balanced scorecards, and are incapable of looking at balanced scorecards with a critical eye. These criticisms will still take several years to be borne out, however it does seem at this time that those companies – both public sector and private sector – are very happy with the advances that the balanced scorecard has brought. As a result of this criticisms of the balanced scorecard approach are still very much few and far between.

In conclusion a balanced scorecard is very useful in providing an overall organisational vision and organisational strategy. Through a balanced scorecard the often undervalued employees are included as part of an overall vision in an organsiation, and are helped to understand their overall role and their responsibilities. In this way corporate performance is assessed and feedback can in turn go back to the top of the organsiation so that improvements can be successfully implemented. The traditional focus on reported profitability lacks the subtlety of the balanced scorecard approach, which is perhaps why top organsiations in both the public and the private sector are increasingly using the balanced scorecard approach to the assessment of corporate performance. It certainly seems to be a highly successful mode of assessment, and any criticisms are yet to be fully fleshed out. By providing a framework of assessment which works this effectively, overall organisational goals can be more easily set out any implemented.

Bibliography

Kaplan, R.S. & Norton, D.P. 1996, The Balanced Scorecard: Translating Strategy into Action, Harvard Business School Press, Harvard.

Kpcke, Richard W., “Profits and Stock Prices: The Importance of Being Earnest”, New England Economic Review, 1992, p 26+

Maclean, Rob, “Alignment: Using the Balanced Scorecard to Create Corporate Synergies”, Australian Journal of Management, Volume: 31. Issue: 2, 2006, p 367+

Stancil, John L., “Balanced Scorecard Diagnostics-Maintaining Maximum Performance”, Issues in Accounting Education, Volume: 21. Issue: 2, 2006, p 158+

“Kaplan Brings Balanced Scorecard to Brum”, The Birmingham Post, March 11 2005

Footnotes

^[1] Maclean, Rob, “Alignment: Using the Balanced Scorecard to Create Corporate Synergies”, Australian Journal of Management, Volume: 31. Issue: 2, 2006, p 367+

^[2] “Kaplan Brings Balanced Scorecard to Brum”, The Birmingham Post, March 11 2005

^[3] Maclean, Rob, “Alignment: Using the Balanced Scorecard to Create Corporate Synergies”, Australian Journal of Management, Volume: 31. Issue: 2, 2006, p 367+

^[4] Stancil, John L., “Balanced Scorecard Diagnostics-Maintaining Maximum Performance”, Issues in Accounting Education, Volume: 21. Issue: 2, 2006, p 158+