Performance Management and Control

Carolyn Foy Introduction

Part one of this report will investigate the role of financial control in organisations and evaluate the value of this system as a performance assessment approach. Financial controls are an important function of an organisation. Managers can evaluate expenditure, profitability and cash flow as well as forecast and manage resources. The aim is to plan, evaluate and coordinate financial activities to achieve the goals and objectives of the business. Part two of this report will evaluate the financial performance of Amazon.com using the 2020 Annual reports published in February 2021. The evaluation of this performance will be from an investor’s standpoint.

Part One

Financial Control

According to CIMA (2022), financial control is the policies and procedures used by the firm to ensure the validity and accuracy of its financial statements and information used by management. These controls can be used to plan and control costs to support management strategies by predicting costs and resources for a particular action over a specified period. Financial statements present the overall performance of the business and are used for internal analysis of the organisation’s performance and to detect any areas that may need to be improved (Kaplan, 2022). Financial statements are also used by external stakeholders for several purposes:

• Check creditworthiness

• Profitability

• Liquidity

• Work out tax obligations

• Determine the financial worth of the business

• Make equity evaluations

Ratio Analysis

Ratio analysis can be calculated using the financial statements and provide easily comparable data. These can be used to compare past and current performance or similar businesses depending on the user of the data. Ratio analysis can also be used by management to evaluate the financial stability and growth potential of the business and to make important investment decisions (Rashid, 2021). Ratio analysis consists of five categories: profitability, liquidity, efficiency, solvency and coverage.

Figure 1 opposite, shows some of the different ratios used by stakeholders for financial analysis. Depending on the stakeholder the group of metrics used may change. A manager may wish to access profitability, liquidity and turnover. However, shareholders may be more interested in return on net worth, earnings per share and profit to equity ratios (Thakur, 2020).

Value and Limitations

Ratio analysis is used extensively in practice by a variety of stakeholders such as managers, analysts, lenders, creditors and investors. The main strength is that it provides a systematic approach to analysing performance. However, ratio analysis also has limitations such as:

• Needing comparative information to make the data meaningful – examples include previous year’s figures to identify trends, industry averages or competitors’ performance.

• Using historical data and therefore may not account for seasonal trends or large capital expenditures that impact financial statements.

• Comparisons may be unreliable if different accounting policies are used by organisations (ACCA, 2022).

In an international context, ratio analysis can be flawed due to the use of different accounting principles, financial systems and tax systems. As well as mandatory and voluntary disclosure requirements depending on the country the business is operating in (Robinson, 2020). In recent years there has been a merger of the United States Generally Accepted Accounting Principles and the United Kingdom’s International Financial Reporting Standards however, it will still be several years before they are fully merged (Yusrina et al., 2017).

Part Two Amazon

Amazon provides an online shopping service to customers, selling consumer products and subscription services around the world. It was founded by Jeffrey Bezos in July 1994 and now has over 1.3 million employees worldwide (The Wall Street Journal, 2022). Amazon went public in May 1997 when its initial public offering was $18.00 (Amazon, 2022). Since then, Amazon shares have continued to increase in price and according to the London Stock market (2022), the stock price is $170. However, Amazon never has (and have stated they never will) paid dividends to their shareholders. Therefore, this report will analyse financial and non-financial data to see if Amazon is worth investing in.

Shareholder Information

Before deciding to purchase shares in an organisation a shareholder must ensure that they have the information needed to make investment, credit and other decisions. This information comes from the annual reports produced by the company each year. According to the Financial Accounting Standards Board (2020), the purpose of financial reporting is to provide useful financial information to existing and potential investors (as well as creditors and other lenders). The information gathered will help investors analyse the risk and returns associated with the investment. According to Harry Markowitz (1952), all investors are risk-averse and will only accept high-risk investments with higher levels of return. Investors can minimise this risk by diversifying their portfolios. Shareholders want to maximise their returns and will use the financial statements to calculate their share in the company, earnings per share, stock market value and cash flow status. Being able to determine the prospective cash flow against debt will help investors understand if the organisation will make a dividend pay-out in the future. Additionally, shareholders will want to know the organisation’s strategic objectives to decide if buying into the organisation is a good choice. Investors will look for dividends to:

• Reduce uncertainty as capital gains are unpredictable

• Measure financial strength - profits, liquidity and solvency

• Receive regular income (Livoreka et al., 2014).

Dividend Policy

There are several different viewpoints on dividend policies and their level of importance for the shareholder. The dividend irrelevance theory by Miller and Modigliani (1961) stated that the dividend policy is irrelevant to investors if the investors receive a higher return on their initial investment. The assumptions proposed by Miller and Modigliani are:

• Capital markets are profitable and provide income.

• Company information is available to everyone.

• Managers can make decisions that maximise the value of shares.

• The value of the company depends only on profits from investments, not dividend pay-outs.

However, in contrast to Miller and Modigliani’s theory, is that of Gordan and Lithner (1963). They proposed that shareholders prefer dividends to be paid now rather than wait for capital gains in the future due to uncertainty. They also believed that shareholders would rather have large dividends paid today from retained earnings rather than wait for increases in share price as this is deemed riskier (Smirnov, 2020).

The clientele effect explains a change in share price due to the corporate decisions caused by changes in tax, dividends pay-outs or other company policy changes. Different investors are attracted to different company policies so, when a company changes one of its policies this will cause a shift in demand. This will also impact the share price of that company (Pettit, 1977). Research on the clientele effect suggests that some investors may prefer regular earnings from dividends over capital gains. While others may prefer the company to reinvest their retained earnings towards growing the business and in turn see stock appreciation (Elton and Gruber, 1970; Kalay, 1982).

Since its initial public offering in 1997, Amazon has adopted a no-dividend policy and have never declared or paid a cash dividend on their common stock. Instead, the company believes that they need to focus on the future and reinvest any available capital to generate high growth through acquisitions and investing internally (Amazon. com, Inc.-FAQs, 2022). Amazon is still growing, developing and improving products and therefore feels that this is the best use of any cash surpluses. Similarly, Google has a no-dividend policy and funds expansion and Facebook have never paid dividends to shareholders stating that they do not expect to declare any future dividend pay-outs (Ghosh, 2022). Whilst dividend pay-outs would attract investors, these companies look at long term profitability and increases in stock price to attract investors instead. Amazon (2020) stated that they had, ‘created $1.6 trillion of wealth for shareowners’, this has been achieved by the increase in stock price since 1997. The clientele effect at Amazon has shown that investors are happy with their investments and are willing to wait for the stock price to increase and therefore their investment to grow. This suggests that any changes in company policies regarding dividend pay-outs may impact the share price and see investors sell their stock. Therefore, it may be beneficial for Amazon to continue with a no dividend policy for the foreseeable future and to attract investors who are willing to invest long-term and wait for capital gains rather than paying dividends. However, long-term investors would still need to analyse company performance to ensure that Amazon is a good investment and that stock prices will continue to grow, or they may lose money on their investment.

Financial Performance

Investors that are looking for long-term stock appreciation investments will want to see if the company is profitable, that they have retained earnings to reinvest, that they will remain solvent, the debt load is not high, price to earnings is good and return on equity acceptable. Using the financial statements of Amazon (Appendix 1), published on the 3rd February 2021 for the year ended December 2020, ratios will be calculated to analyse the performance of the company. These will then be compared with the industry averages to determine if Amazon is a good investment opportunity. Industry averages available on Investing.com stock exchange (2022).

Gross profit margin measures the percentage of revenue available to cover operating and other expenses. Amazon is just above industry averages showing it controls its cost of sales efficiently.

Net profit margin measures the actual profits after all expenses have been accounted for - this is lower than industry averages. This suggests, that compared to industry Amazon may use ineffective pricing strategies. This could be the result of no-delivery charges being made on Amazon’s own-brand goods bought or returned resulting in higher costs for the company. However, this policy encourages customers to use the company as there is no financial risk (Duvell, 2022).

The current ratio and quick ratio measure the solvency of the company and whether they have enough current assets to pay for its short-term obligations. Both of Amazon’s liquidity ratios are less than industry averages. Though, its quick ratio would suggest that Amazon may have difficulty paying for its short-term debts as they fall due. However, it has been reported that Amazon has a unique business strategy that focuses on its free cash flow. It uses this to pay down its debt and build cash reserves. Amazon also works on a negative working capital cycle meaning that it never pays for goods before sales are made finding itself in a state of permanent liquidity (Hake, 2021).

The debt-to-equity ratio is used to evaluate a company’s financial leverage. The higher the ratio the more the company relies on borrowed funds. Amazon has a lower debt-to-equity ratio than industry average and this shows that Amazon is less risky than its competitors. It also shows that stockholders have higher stakes in the business than creditors. However, a low debt-to-equity ratio may also indicate that the company is not taking advantage of financial leverage to grow the business.

Return on equity measures a company’s profitability against the profit it retains and outside investments. The higher the ratio the more profit the company is making. Compared to industry, Amazon’s ratio is higher. This is probably due to the low amount of debt the organisation has as shown in the debt-to-equity ratio.

Return on assets measures how efficient the company’s management is at generating earnings from the assets held in the company. Amazon’s return on assets is higher than industry averages indicating it is better at using its assets to make money. Investors use this ratio to find stock opportunities as it indicates how well the company is converting its investment into net income. A return on assets ratio that increases over time shows that the company is good at increasing profits and utilising its economic resources (CFI, 2022).

Revenue/share is the amount of revenue per share of the company’s stock. Revenue is the amount of money from the sale of goods. Companies with more consistent revenue and earnings growth are less risky as revenue is expected to be received at regular intervals. When comparing companies, revenue can be manipulated by changing how sales and payments are recorded in their financial data. This would then impact the comparability so should not be used as the only measure (Canina and Potter, 2018). Amazon’s revenue per share is higher than industry averages and would therefore indicate to investors this is a good investment.

Price to Earnings (P/E) ratio measures the company’s share price compared to the company’s earnings per share. The P/E ratio shows what investors are willing to pay for stock based on future earning potential. The lower the ratio the more valuable the company may be to investors as the stock may be undervalued. Amazon’s P/E is lower than industry showing that Amazon may be undervalued however, compared to S&P 500 as a whole, Amazon looks overvalued (Duggan, 2022). This may be because Amazon reinvests surplus cash to grow the business to boost its market share. From the financial ratios analysed, investors can be optimistic about Amazon’s future performance potential which could see the share price increase. However, investors should also look at non-financial indicators before considering investing.

Balanced Scorecard Approach

The balanced scorecard is a management tool developed by Norton and Kaplan in 1992. It is used to achieve the goals and objectives of the business by looking at both financial and non-financial data to measure performance as seen in figure 2 below.

This can also be used by investors by applying it to investments to help evaluate capital allocation decisions and allow performance to be effectively monitored. Financial performance has already been discussed previously; the other three perspectives will be evaluated next.

Customer Focus

Amazon stated in the 2020 annual report that its focus was on customers, invention, operational excellence and long-term thinking rather than competitors and profits. Amazon’s mission is to be Earth’s most customer-centric company believing that this can be achieved by looking at customer needs and working backwards (Amazon, 2020). This innovative strategy keeps customers at the centre of the decision-making process to create customer value and ensure that the products produced will be successful and profitable. This strategy seems to be working as sales have increased 39% since 2018 as shown in figure 3 below.

Figure 3: Net sales generated from internationally-focused online stores (in millions $) (Amazon, 2021).

However, this increase in sales may have been the result of the lockdown in 2020 as the majority of high-street retailers were forced to close due to the covid pandemic and consumers turned to online retailers, like Amazon, who were still allowed to operate.

Learning and Growth

Amazon’s growth strategy is focused on entry and growth in new markets as well as developing new products. This has contributed to Amazon’s success globally trading in over 100 countries worldwide. Amazon now has multiple capabilities from online shopping, streaming services, cloud computing, and teamed with Morrisons in the UK for delivery of groceries the same day. Amazon also has specialist brand devices such as tablets and smart speakers that are continually updated to offer new features and have sold over 150 million devices worldwide (Amazon, 2020). By continually being innovative Amazon has seen its business grow to a trillion-dollar corporation. However, this has meant reinvesting surplus cash and forfeiting dividends to shareholders as they continually aim to grow the organisation.

Business Processes

In 2019 Amazon made headlines when it stated it would spend $700 million on staff training to build a highlyskilled workforce to improve employee retention. A similar strategy to that of Google and Walmart who are also offering employee training programmes (Scott, 2019). However, it has been reported that employees are still unhappy due to long hours and working conditions. Employees frequently complain about the huge warehouses and amount of walking done on a shift and this escalated during the covid pandemic when the volume of work increased exponentially (BBC News, 2021). Listening to the grievances of employees, Amazon has developed warehouse robots that will reduce physical work for employees. Amazon has used robots since 2012 to streamline processes, improve safety and increase efficiencies while creating 200,000 extra jobs so employees should feel secure in their employment rather than feel they are being replaced (Amazon, 2021).

Amazon also highlights competitive factors such as selection, price, convenience and fast reliable fulfilment of orders as part of its business strategy. Using these factors to encourage customers to shop from Amazon. Additionally,

Amazon ensures product variety and availability along with low prices and next day delivery creating loyalty with customers that allows them a competitive edge over competitors.

Other Considerations

Milton Friedman developed shareholder theory in 1970 by stating that an organisations responsibility is to maximise its revenues, increase returns for shareholders and responsibilities to society are disregarded (Friedman Doctrine, 2022). In Contrast to Freidman’s view is that of Edward Freeman who proposed Stakeholder theory. This theory involves directors balancing the interest of all stakeholders, customers, suppliers, creditors, shareholders and the wider community. This is done by identifying available options and determining the effect they may have on the stakeholders (Freeman, 2009). As stakeholders, investors believe that the company will be successful in the future and will receive capital gains and/or dividend payments. Historically, this was the only concern of the shareholder however, research conducted by Ernest and Young’s (2019) found that investors have increased their interest on environmental and social topics. While, research by Schroders Global Investors found that investors were willing to divest and move to an entirely sustainable portfolio by placing more importance on sustainability and corporate social responsibility (Needham, 2021).

Corporate Social Responsibility

Amazon has stated in their Sustainability Report 2020 that:

• they use 65% renewable energy across the organisation

• use electric vehicles

• pay above minimum wage

• set new diversity, equality and inclusion goals

• invested $2 billion in the research and development of carbon-reducing technology (Amazon, 2020).

Amazon invests heavily in CSR and shares this knowledge with shareholders. This encourages investors to remain loyal to the company rather than selling their stock as shareholders can see the value of the social impact of the investments being made. However, shareholders should be aware that Amazon may only share highlights of good practice that benefits Amazon’s Image to retain this loyalty.

Investment Opportunity Recommendation

Overall, Amazon continues to generate high profits by utilising its assets well and managing its cash flow to ensure it remains solvent. The company has kept its debts low although it could take advantage of leverage to fund growth. However, it does use retained earnings for this purpose meaning dividends are not paid. The company has proved that it is innovative and will continue to develop and grow by offering new products and improving the others. This should mean that shares prices will appreciate in the future. However, due to continued reinvestment

Amazon are unlikely to pay dividends anytime in the new future. The biggest risks of investing in Amazon are increasing competition, uncertainty around profits and share price volatility. Amazon has delivered high revenue growth since 1997 when it first went public which could be a good indicator of future performance. However, due to the unpredictability in share price, for a short-term investment, this would not be a good investment as shareholders may lose money. Yet for long-term investors who are happy to watch Amazon grow and continue to develop this is a good choice as the investors will see their investment appreciate in the future.

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Appendices

Appendix 1

Amazon.com financial statements taken from the annual reports