Analysis of determinant factors of a companys performance

Author: Gabriela Loag

Abstract: The purpose of this paper is to present the concept of performance and to identify
the methods to measure the performance, in the attempt to answer to one question: which are the
factors that determine the performance of a company? More specifically, I have tried to
determine the extent to which accounting information contained in financial indicators has an
impact over the total shareholder return.

Chapter 1. Performance concept

There is no universally recognized definition of performance, the concept of performance has
many meanings, as it is perceived differently by each of us:
performance is success;
performance is the result of an action;
performance is a state of competitiveness of the company, achieved trough a level of
effectiveness and efficiency that ensures a sustainable market presence.
There are three main guidelines in the definition of performance:
definition of performance depending on the level of achievement of a company
strategic objectives;
definition of performance based on creation of added value;
definition of performance based on productivity and business effectiveness.
In my opinion, firm performance is achieved by balancing and merging the four forces:
the efficiency of production processes, satisfying shareholders, ensuring customer satisfaction
and company growth and development capacity, degree of innovation and use of opportunities.

Chapter 2. Approaches regarding the methods of determining firm performance

In this chapter, I have made a short review of the main theories on the company's
objectives and the major studies regarding the determinant factors of firm performance.

1) The industry theory originates from the works of E. S. Mason (1939) and J. S. Bain
(1951, 1956) - who believed that a firm is performant if it can achieve better market positioning
and can maintain at that level through various entry barriers (R. Caves, M. Porter (1997)). The
theory claims that certain industrial sectors tend to lead to an increase in the performance of all
companies, while others cause a decrease in performance.
2) The Chicago School - firm-specific effects (differences in efficiency) must be
considered the principal determinant of the performance of those firms, while their effects
industry should play a minor role.
3) The resource theory (B. Wernerfelt, 1984 J. Barney, 1991) considers that the market
of production factors (J. Barney, 1986), rather than the market of products (M. Porter, 1980)
defines corporate success. M. Porter (1991) criticizes this approach that seeks the separation of
managerial decisions from their company sectors of activity. Performing firms have the best
resources and the best skills that enable them to produce in an effective and / or efficient manner
offers that are valued by companys clients (S. Hunt, 2000, 1998).
4) Robert Kaplan and David Norton (1990) have proposed a system of performance
measurement, named Balanced Scorecard, to complement financial measures of past
performance with measures to ensure future performance. The objectives and measures of this
model are derived from the vision and strategy of the organization and its performance is
analyzed from four perspectives: financial results, customers, internal business processes, and
learning and growth.
5) Fama and Jensen (1985) studied the impact of the organization form over the
investment decision rules. According to Fama and Jensen's assumptions, we can say that the
listed companies, regardless of their form of management, must comply with the principle of
maximizing the companys value.
5.1) Maximizing the value of equity (or return on equity) - the most frequently
encountered in the financial theory and leads to performance appraisal from the shareholders
point of view. The indicators should be considered depending on the market value of capital. The
method for determining the performance must be adjusted to risk. The Jensen's theory (2001)
says that the company's manager must take the best decision to maximize firm value, is sustained
also by Marsh (1999), Arnold (1998) who agree that the primary objective of the companys
management is to increase the shareholders equity (the shareholders' theory).

5.2) Maximizing the total value of the firm (or economic return), differs in comparison to
the first approach from the following aspects:
- for the same value of the firm, the distribution may be made in favor of creditors, so at
the expense of shareholders, or vice versa (first goal) - Fama and Miller (1972) and Fama
(1978).
- Jensen and Meckling (1976), Galai and Masulis (1976) - shareholders may be interested
in the most risky investments, even if they conflict with the objective of maximizing the value
of firm.
The stakeholder theory argues that managers must make decisions taking into account the
interests of all stakeholders of the company. Because the proponents of this theory do not specify
how to reconcile potential conflicts of interest of stakeholders, managers are unable to make
decisions for a particular purpose and thus they can not be responsible and accountable for their
actions. If a manager is required to maximize profit, market share, increase future profits and any
other objective, then the manager will be in no position to make a decision. Therefore, the
manager will not have objectives.
Wallace says that if a company has obtained added value for its shareholders is unlikely to meet
other interest groups. Jensen (2001) and Rappaport (1998) also sustain this idea. Rappaport says
that maximizing the equity value must not conflict with stakeholder approach, if this process is
linked to socially responsible business conduct.

Chapter 3. Measurement of firm performance

3.1 Financial indicators and non-financial indicators
In this chapter, I underline the fact that financial indicators are absolutely necessary, but
not sufficient in assessing a company's overall performance. Ittner, Larcker and Randall (2003)
say that there is no study showing whether the application of non-financial performance
indicators (eg Balanced Scorecard) has resulted in superior performance. However, Chenhall

(1997), which correlates the presence of non-financial indicators to the incentive system, notes a
significant increase in performance.
Behn and Riley (1999) found a direct link between customer satisfaction and future
performance of hotels and transport companies.
Najar and Rajan (2001) have examined the relationship between future sales and nonfinancial indicators of industry companies from Jordan, and concluded that the two types of
indicators are complementary in assessing the future volume of sales.
3.2 Measurement of financial performance based on accounting information
In this chapter, I have presented two of the most used indicators calculated ex-post ROE
and ROI, with emphasys on their advantages and disadvantages.
3.3 Performance measurement trough the rates method
The financial rate of return depends on the commercial rate of return (the commercial
policy), the economic rate of return (efficiency of capital employed), but also on the policy and
the financial structure of the company.
3.4 Performance measurement based on financial market criteria
The chapter presents the main modern financial ratios used in evaluating the financial
performance of companies: Q Tobin, Marris Rate, Total shareholder return, Sharpe Rate,
Treynor Rate, Jensen Rate, MVA and EVA. Here are also presented the main advantages and
disadvantages of each indicator. O`Byrne (1996) developed a theory in his attempt to test
whether EVA is systematically related to market value. He said that EVA should provide a better
prediction of market value than other measures of performance. Garvey and Milbourn (2000)
said that the degree of correlation between indicators that measure the value added and market
value of capital is a relevant factor in choosing benchmarks for granting bonuses and incentives.
D. Cormier, M. Magnan and D. Zeghal have made an empirical study on a sample of 300
companies from France, Switzerland and the USA; the conclusion - the most relevant financial
performance indicators are: net income, operating cash flow, operational result, the residual
result and the value added.

G.C. Biddle, Bowen R.M. and Wallace J.S. (2007) - study of a sample of 775 American
companies; findings: the indicator that best explains the variation of the excess return obtained
from holding company shares compared with average market return is the income tax, followed
by economic profit.
The theory of relevance of accounting information (Goodwin R, Ahmed M and N.
Sawyer, 2004). When information becomes public, it is an important signal for all investors.
Goodwin, Sawyer and Ahmed (2004) assume that the price formation process depends on the
emergence of information and how it is filtered in company accounts. Lev (2006) - the
relevance of accounting-financial indicators for shareholders is influenced by the quality of
accounting information.
Most studies (G. Feltham, Ohlson L. 2001, Biddle, Bowen and Wallace 2007, Moehrle F.
Reynolds and Wallace 2008) that have tested the relevance of financial accounting information
are based on assumptions that the company's shares are traded on an efficient market.
Researchers like R. Schmalensee (1975), B. Wernerfelt and C. Montgomery (1988), R. P.
Rumelt (1991) have concluded in their studies that the sector of activity explains around 1220% of the variation of companys performance, while the diversification does not have
significant effects, and the company's market share had a significant effect, but marginal.
On the contrary, other researchers like Hansen i Wernerfelt (1989), RJ. A. Roquebert
(1996), A. McGahan and M. Porter (1997), M. P. Michaels and A. J. Mauri (2003) have
concluded that specific differences between firms have explained most of the variation of their
performance.
Comparing the indicator Q Tobin for diversified firms with that of non-diversified firms,
Lang and Stulz (2000) showed that the financial market would value more the less diversified
firms.

Chapter 4. Description of the database

This study aims to identify to what extent is explained the profitability of the market
shares of firms listed on U.S. stock market by the financial-accounting indicators. The sample
contains 34 companies with main activity in the IT sector, which are included in the major size
categories (from 8 to 10); there were selected only those companies with financial year ending in
December, thus leading to a relatively small number of firms to be analyzed. The financial

accounting indicators are calculated using information available in accounting reports of

companies for three consecutive years: 2008-2010.
The selected financial indicators are:
Total shareholder return - TSR (Rappaport, 1986) dependent variable;
Independent variables: Gross profit margin (MBE); Growth rate in sales (CCA); Net
current assets (ACRnete); Rate of tangible assets; Weight of intangible assets in
total assets; Financial Leverage; Earnings per share (EPS); Operating cash-flow
(CFE); Return on investment (ROI);Return on assets (ROA); Return o equity
(ROE); Working capital ratio; MB - Market to book ratio

Chapter 5. Research methodology

Testing the correlation between the size of the selected accounting indicators and the
TSR obtained by the shareholders of the analyzed companies was achieved through the
regression model represented by the equation:
Rt=0 + 1 * Xt-1 + 2 * (Xt- Xt-1)+ut
where:
Rt = TSR for financial year t;
Xt = financial indicator calculated for financial year t;
= regression coefficient;
ut = residual term for financial year t.

Chapter 6. Results
For year 2008 the regression equation is:

TSR = -0.7262889517 - 0.02963633924*ACRNETE_CA + 1.545506475*ANCORP_A 0.2344862897*CCA - 0.2052340175*CFE + 0.4701208492*EPS - 0.1708052205*LEVIERUL

+

0.07754474545*MB

0.3978238899*MBE

0.1337598788*RATA_AI

0.08597879574*RATA_FR - 0.191974397*ROA + 0.0106445072*ROE - 1.629173573*ROI

The conclusions resulted from testing the data for year 2008 are:
-

Indicators that have an impact on the level of TSR are: Financial leverage, Market to

Book ratio (MB) and weight of intangible assets in total assets. The information contained in
these financial indicators is relevant for investors in U.S. capital markets, the change in their
size having an impact on the size of TSR.
-

An increase of 1% recorded by the indicator Financial leverage causes a 0.17% decrease

in the TSR. Also to an increase of 1% recorded by the MB causes a 0.07% increase in the TSR,
and the increase by 1% recorded by the weight of intangible assets in total assets will generate a
1.54% increase of TSR.
-

The three indicators explain a proportion of 46.6% (R2-adjusted) the variance of TSR

variability at the level of the sample studied.

-

No other tested financial indicator is relevant (p-value is less than 5%), which means that

there is little correlation between the total shareholder return obtained by investors in the capital
market with the firm performance expected by them, taking as reference the evolution of the
accounting and financial indicators.
-

The result of Durbin-Watson test is 2.07, close to the value of 2, which indicates no

autocorrelation between the residual terms.

-

Also for the Q-statistic test, the results showed no autocorrelation between the residuals

because the p-value associated to estimated values (for different time lags of the residual) are
high.
-

The White test reveals a p-value greater than 0.05, hence the residual terms are

homoskedastics.
From the study of the correlation matrix, resulted that the strongest links are established
between ROI and ROA (0.97) between Gross operating margin and ROA (0.89), followed by
the link between Gross operating margin and ROI, the link between ROI and EPS (0.86) and

ROA (0.85) and the link between ROA and EPS. By eliminating the three factors ROI, EPS and
Gross operating margin, it results the regression with Adjusted R2 of 0.42 and only two relevant
factors: MB and Weight of intangible assets in total assets.
The study of the correlation matrix for year 2009 shows that the strongest links are
established between ROI and ROE (0.77), between ROE and MB (0.70), followed by those
between ROI and ROA (0.68) and Gross operating margin (0.63). Of all indicators, TSR is best
correlated with MB (0.34). Eliminating the two financial indicators ROI and ROE, results the
following regression equation for 2009:
TSR = 2.836019664 - 1.877807179*ACRNETE_CA - 4.405163706*ANCORP_A +
0.6500545066*CCA + 1.41891425*CFE + 2.58930961*EPS - 0.7850613372*LEVIERUL +
0.3310741716*MB + 2.23883*MBE - 1.76688641*RATA_AI - 0.8501881919*RATA_FR 0.5395321151*ROA
The conclusions resulted from testing the data for year 2009 are:
-

Indicators that have an impact on the level of TSR are: Market to Book ratio (MB) and
working capital ratio. The information contained in these financial indicators is relevant
for investors in U.S. capital markets, a change in their size having an impact on the size
of TSR.

Thus, an increase of 1% recorded by the indicator working capital causes a decrease by

0.85% of the TSR. Also to an increase of 1% recorded by the MB causes a 0.33%
increase of TSR.

The two indicators explained a much smaller proportion (adjusted-R2 is only 0.20) the
variability of TSR in the studied sample, compared with 2008.

No other tested financial indicator is relevant (p-value is less than 5%), which means that
there is little correlation between the total shareholder return obtained by investors in the
capital market with the firm performance expected by them, taking as reference the
evolution of the accounting and financial indicators.

The result of Durbin-Watson test is 2.15, close to the value of 2, which indicates no
autocorrelation between the residual terms

The study of the correlation matrix for year 2010 shows that the strongest links are established
between ROI and ROE (0.79), between ROI and MBE (0.78). Of all indicators, TSR is best
correlated with MB (0.68). By eliminating the financial indicator ROI, it results the following
regression equation for 2010:
TSR = -0.3959455692 + 0.3410490022*ACRNETE_CA + 0.05440378508*ANCORP_A +
0.6335195586*CCA + 0.7429497381*CFE + 0.990277243*EPS - 0.03683893219*LEVIERUL
+ 0.06854815508*MB - 0.9002978082*MBE + 0.4836387424*RATA_AI 0.0311977168*RATA_FR + 0.4146884284*ROA - 0.1338780805*ROE
According to test performed on the 34 companies in the sample, the explanatory power of
MB increases more - adjusted R2 is 0.57, and an increase of 1% recorded by the MB causes a
0.06% increase in the TSR. No other financial indicator has turned out to be relevant. DurbinWatson test result is 2.17, close to the value 2, which indicates no autocorrelation between the
residuals. Jarque-Bera test shows a p-value associated with the estimated value of the test of
0.43, higher than 0.05, so we do not reject the null hypothesis of normal distribution of residual
terms resulting from the regression equation.

Chapter 7. Conclusions and recommendations

After these tests were realized, very few selected key financial indicators have resulted as
being relevant in terms of the information contained, concerning the future performance of
analyzed companies. In addition, they were not maintained from one period to another, except
the financial indicator MB, but its explanatory power varies significantly from one year to
another. Therefore, we can not consider this as an useful reference for the management of these
firms in managing their business and maximizing the value of equity.
There are various studies according to which capital market investors do not consider as
relevant the information contained in the accounting performance indicators. Therefore, they do
not base their investment decision by considering the available information in financial reports.
Inconclusive results of tests performed may be the effect of selection for the analysis of a set of
financial indicators which are not in fact considered when investors are making investment
decisions.

This inconvenience can be overcome by resorting to a more extensive database of

financial indicators, respectively non-financial indicators, measuring this way a wider range of
information available to investors on the capital market. Given the complex nature of the
causality relations between financial indicators, it is difficult to separate the direct influence that
each of them have on the level of TSR (as tested with the regression equation). The period for
which the data were available could be considered a special one, given the international financial
crisis that began in late 2008, with considerable negative impact on the activity of companies in
the following year and a sensible comeback in year 2010.
In conclusion, it is impossible to use a single measure of financial performance, given the
complex and diverse nature of economic processes of the companies and of the economy as a
whole.

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