The document discusses key performance indicators such as operating margin, return on capital employed, and gearing. It defines operating margin as operating profit divided by revenue. Return on capital employed is defined as operating profit divided by capital employed, where capital employed equals debt plus equity. Gearing is the amount of debt financing a company uses, and is measured as debt divided by debt plus equity. Higher gearing increases risk but lowers the cost of capital due to tax deductibility of interest payments. Free cash flow is defined as cash from operations minus interest, tax, depreciation, and represents cash available to reinvest in the business or return to shareholders.

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Key performance indicators
Aqhuman financial training & coaching

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Key performance indicators:
operating margin
Operating margin = operating profit %
revenue
Aqhuman financial training & coaching

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Key performance indicators:
operating margin
Operating margin = operating profit %
revenue
Aqhuman financial training & coaching
It is a measure of
“value added”: the
party that does
most should earn
most
Building up brand
strength often
enhances operating
margin (hence the
large ad. spend on
branded goods)

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Key performance indicators:
return on capital employed
To understand roce we first need to look at a 3rd version of
the balance sheet. First the asset=liability version:
Aqhuman financial training & coaching
Assets
Property, plant and
equipment
Cash at bank
Receivables (“debtors”)
Inventories (“stocks”)
Liabilities:
Trade payables (Creditors)
Short term debt
Long term debt
Shareholders’ Equity

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Key performance indicators:
return on capital employed
We keep the funding on one side and move the operational
stuff to the other:
Aqhuman financial training & coaching
Assets
Property, plant and
equipment
Cash at bank
Receivables (“debtors”)
Inventories (“stocks”)
Liabilities:
Trade payables (Creditors)
Short term debt
Long term debt
Shareholders’ Equity
-Trade payables
Capital employed
Capital employed

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Key performance indicators:
return on capital employed
We keep the funding on one side and move the operational
stuff to the other:
Aqhuman financial training & coaching
Assets
Property, plant and
equipment
Cash at bank
Receivables (“debtors”)
Inventories (“stocks”)
Liabilities:
Trade payables (Creditors)
Short term debt
Long term debt
Shareholders’ Equity
-Trade payables
Capital employed
Capital employed
Now the left hand
side is our
operational
assets (“above
the line”) and the
right just the
funding

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Key performance indicators:
return on capital employed
A tidied up version: The total of both sides is called the
capital employed
Aqhuman financial training & coaching
Property, plant and
equipment
Cash at bank
Receivables
Inventories
- Payables
Debt
Shareholders’ Equity
This side comes at a
cost; the weighted
average cost of capital
(“wacc”)

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Key performance indicators:
return on capital employed
A tidied up version: The total of both sides is called the
capital employed
Aqhuman financial training & coaching
Property, plant and
equipment
Cash at bank
Receivables
Inventories
- Payables
Debt
Shareholders’ Equity
Leaving this side to pay for that
wacc. So the yield of the
operating side has to cover the
wacc. “Above the line”
produces OPERATING PROFIT

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Key performance indicators:
return on capital employed
A tidied up version: The total of both sides is called the
capital employed
Aqhuman financial training & coaching
Property, plant and
equipment
Cash at bank
Receivables
Inventories
- Payables
Debt
Shareholders’ Equity
So the yield of the
operational side is
operating
profit/capital
employed

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Key performance indicators:
return on capital employed
Aqhuman financial training & coaching
Property, plant and
equipment
Cash at bank
Receivables
Inventories
- payables
Debt
Shareholders’ Equity
Every pound
taken into the
company as
funding; either as
debt or equity...
Costs
WACC
per £

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Key performance indicators:
return on capital employed
Aqhuman financial training & coaching
Property, plant and
equipment
Cash at bank
Receivables
Inventories
- payables
Debt
Shareholders’ Equity
Remember this is
a balance sheet
so...
Is represented
by a pound on
the
operational
side
Must yield
ROCE per £
Costs
WACC
per £

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Key performance indicators:
return on capital employed
Aqhuman financial training & coaching
Property, plant and
equipment
Cash at bank
Receivables
Inventories
- payables
Debt
Shareholders’ Equity
And that pound
needs to yield at
least the wacc
Must yield
ROCE per £
Costs
WACC
per £

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Return on capital employed
To summarise:
Return on capital = operating profit %
employed (roce) capital employed
Where capital employed = debt + equity
Aqhuman financial training & coaching

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Gearing
Gearing is a measure of how we finance our business.
There are two standard definitions:
Gearing = Debt % or Debt %
Equity Debt + equity
Aqhuman financial training & coaching

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Gearing
Which is more expensive, debt or equity?
For a given company it is equity. Why?
Aqhuman financial training & coaching
Return
RiskEquityDebt

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Gearing
Equity is more expensive because shareholders take more of a risk; they
are the last to get a share of the profits each year and they are the last
to get a pay out of assets in the event of a liquidation
Aqhuman financial training & coaching
Return
RiskEquityDebt

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Gearing
In other words because equity investors have taken more of a risk they
expect a higher return and so the company must find more profit to
accommodate that expectation
Aqhuman financial training & coaching
Return
RiskEquityDebt

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Gearing
So why do companies not have huge gearing ratios if debt is cheaper?
Because life is not that simple!
Aqhuman financial training & coaching
Return
RiskEquityDebt

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Gearing
As your gearing increases so does the risk profile of your company
increase; investors are getting nervous that their interest or dividends
are not going to be paid because of the extra loans that need to be
serviced
Aqhuman financial training & coaching
Return
RiskEquityDebt

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Gearing
Look what happens to the risk return graph when you increase gearing:
Aqhuman financial training & coaching
Return
RiskEquityDebt #1
before

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Gearing
Look what happens to the risk return graph when you increase gearing:
Aqhuman financial training & coaching
Return
RiskEquityDebt #1
One more loan
#2
Each loan is
more
expensive as
the chance of
getting paid is
lowered

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Gearing
Look what happens to the risk return graph when you increase gearing:
Aqhuman financial training & coaching
Return
RiskEquityDebt #1
One more loan
#2
Equity gets more
expensive as the
shareholders are now
at the back of a longer
queue

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Gearing
But despite the previous analysis, we find that by increasing the
gearing we do lower the cost of capital. Why?
Because the cost of debt, interest, is tax deductible. In other
words the payment is effectively subsidised
by the government.
This subsidy has the effect of lowering WACC
until gearing gets so high as to cancel the
“tax shield” effect.
Aqhuman financial training & coaching

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Free cash flow
Let us consider the key elements of the cash flow statement:
First...
Cash from operations
Aqhuman financial training & coaching
This is the “engine room” of the
business. Your customers need to be
paying you more in cash than you
are paying your suppliers – or else
where how is the deficit to be
funded?But we also need
to take account
of those items
that are non-
discretionary

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Free cash flow
Cash from operations
Less interest
Less tax
Less depreciation
= Free cash flow
Aqhuman financial training & coaching
But why
depreciation?

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Free cash flow
Cash from operations
Less interest
Less tax
Less depreciation
= Free cash flow
Aqhuman financial training & coaching
It gives us an estimate of how much we
need to spend each year just to replace
existing fixed assets (we take the
replacement of old assets as non-
discretionary otherwise our business
becomes non-productive)

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Aqhuman Financial Training
Aqhuman’s principal is Kevin Amor, FCA. Kevin qualified as a
chartered accountant with PWC. He spent 12 years working
in commerce at financial controller/director level.
Kevin now has more than 12 years experience in financial
training. He trains managers at all levels and gives 1 to 1
financial coaching to senior executives.
He also teaches corporate finance and
accounting for a number of business
schools’ MBA programmes.
Aqhuman financial training & coaching