Internal Audit: Performance Assessment

The Internal Audit

• Internal audit is used to evaluate and understand the internal condition of an organization.
• The purpose of an internal audit is to identify the competitively relevant strengths and weaknesses of the organization.
• The gathered information is used to leverage strengths, address weaknesses, and capitalize on opportunities.

Stage 1: Assessment of Performance

• The goal is to gauge how well the organization's strategies are working.
• The outcome is a list of potential strengths and weaknesses.
• Only competitively relevant factors are considered strengths or weaknesses.
• Common sources of information include financial reports, surveys, market analyses, staffing standards, and productivity reports.
• Common assessment tools include analysis of revenues, earnings, return on equity (DuPont formula), stock price, market share, employee turnover, and results from surveys.
• DuPont ROE formula: % ROE = net profit margin x asset turnover x equity multiplier, or Net Profits/Sales x Sales/Assets x Assets/Equity, factoring in efficiency, effectiveness, and leverage.

Stage 2: Analysis of Value Chain Activities and Linkages

• The value chain, by Michael Porter, identifies internal activities and their relationships for strategic planning.
• The value chain helps visualize and analyze value-creating activities.
• Competitive advantage is achieved when a firm creates more value for customers than its cost to create it.
• Primary activities directly relate to production, distribution, and sales (e.g., inbound logistics, operations, outbound logistics, marketing, sales).
• Support activities are required to perform primary activities (e.g., financing, HR, technology development, procurement).
• Value chain activities are interconnected via linkages, where one activity's performance affects others.
• Cross-functional linkages create trade-offs, emphasizing the need for holistic efficiency.
• The value chain recognizes interdependence among firms, with an individual company's value chain embedded in a larger value system.
• The value system includes a firm's suppliers (upstream) and distributors (downstream).
• The competitive advantage is not only a function of how well a firm integrates its own activities.
• Supply chain management is coordinating how well systems of firms integrate too.
• In a two-part value chain analysis, the firm focuses internally to determine the costs versus the value of each activity and how profit margins are realized.
• Understanding internal costs and cost drivers is crucial.
• Internal value chain analysis includes discrete activities, processes, and cross-functional linkages within the firm.
• Evaluation of supply chain management includes relationships among firms involved.

Stage 3: Understanding Core Competencies

• Core competencies differ from balance sheet assets or value chain activities, existing in people and processes.
• Core competencies are the collective skills and capabilities of the firm, particularly in coordinating skills and integrating technology.
• Companies exhibit different core competencies (expertise in product design, innovation, skills in developing).

Core Competence Requirements

• To be a core competence, a skill must pass three tests: customer value, competitor differentiation, and extendibility.
• Ignoring core competencies puts firms at risk of underinvestment, imprisoned resources, and bounded innovation.

Stage 4: Identifying Strengths and Weaknesses

• A weakness is competitively relevant if it creates disadvantage or undermines value creation.
• To be considered a strength or weakness, factors must be competitively relevant.
• To determine if a potential strength is real, managers ask questions about value, rareness, imitability, and organization.

Financial Ratio Analysis

• Financial ratio analysis involves measures of liquidity, leverage, activity, and profitability.
• Liquidity ratios show the ability to pay short-term obligations.
• Leverage ratios focus on capital structure and debt levels.
• Activity ratios indicate asset management effectiveness.
• Profitability ratios reflect the ability to turn sales into profits.
• Common ratios include:
  • Current Ratio (Current Assets/Current Liabilities): assesses the ability to meet short-term obligations.
  • Quick Ratio (Current Assets-Inventory/Current Liabilities): assesses the ability to meet short-term obligations without relying on inventory sales.
  • Debt-to-Equity Ratio (Total Debt/Total Stockholders' Equity): shows funds provided by creditors versus owners.
  • Times-Interest-Earned Ratio (Profits Before Interest and Taxes/Total Interest Charges): shows how much earnings can decline without affecting the ability to pay annual interest costs.
  • Inventory Turnover (Sales/Inventory of Finished Goods): measures how efficiently a firm manages its inventories.
  • Total Assets Turnover (Sales/Total Costs): measures sales volume generated from its asset base.
  • Accounts Receivable Turnover (Annual Credit Sales/Accounts Receivable): measures the average time to collect credit sales.
  • Gross Profit Margin (Sales-Cost of Goods): measures the available total margin.
• Efficiency: how well firm converted sales into profits.
• Effectiveness: how many sales were generated by each dollar of assets.
• Leverage: what proportion of assets were paid for by owners' equity.