Ultimately, your financial structure is a policy decision, not an outcome. True, the numbers are an outcome—if total equity is $49,999,583.39, we have a precise outcome. But we might also say, “We want our equity to fund 50% of our assets, and we will make adjustments via dividends, stock issues, and stock repurchases to maintain this percentage.” That is a policy statement.
Performance measures are both policy decisions and outcomes. They shape and constrain the financial structure.
Equity
For example, return on equity (ROE) is defined as 
.
As equity approaches zero, ROE approaches infinity. Therefore, when a board of directors emphasizes ROE as a performance measure, managers respond by minimizing equity and maximizing profits. To minimize equity, they avoid issuing stock and they pay dividends to reduce retained earnings. They match all investments with new debt (increasing debt, or leverage) . They work the assets hard (asset turnover) .
Therefore, if the board says, “emphasize ROE,” you can predict that the company’s financial structure will be at least 50%/50% debt to equity. It might be as high as 75%/25% debt to equity.
Let’s look at how the performance measures affect financial structure by examining each measure as if they were the only one selected for the company. Examining the extremes can provide insight into the usefulness of each measure.
Performance Measures
The Capstone® Performance Measures (also called Success Measures) are:
- Cumulative Profits
- Market Share
- Return On Sales (ROS)
- Asset Turnover
- Return On Assets (ROA)
- Stock Price
- Return On Equity (ROE)
- Market Capitalization
- Cumulative Profits
Generically, profits are driven by the company’s asset base and by its efficiency working those assets. Given any two companies, if we hold efficiency constant, the company with more assets produces more profit. If we hold assets constant, the company with higher efficiency is more profitable. It follows that teams that choose cumulative profits will want a larger than average asset base, and that they will work their assets as hard as possible. A new product with an efficient plant meets those criteria. An older product with high plant utilization at high automation similarly meets the criteria. Both represent sizable investments in new assets.
In the end, an emphasis on cumulative profit drives management towards a large asset base. Managers are willing to increase debt to get there, but because interest payments consume profits, they will prefer funding with equity. Their funding priorities will retain earnings (no dividends) , then issue stock, and finally issue bonds.
Doubling Assets
For example, using the starting balance sheet, let’s double our starting assets and apply the constraints outlined. The company’s financial structure will look something like this:
| ASSETS | LIABILITIES & OWNER'S EQUITY | |||
| Cash | $8,000 | Accounts Payable | $14,000 | 7.0% |
| Accounts Receivable | $18,000 | Current Debt | $12,000 | 6.0% |
| Inventory | $22,000 | Long Term Debt | $80,000 | 40.0% |
| Total Current Assets | $48,000 | Total Liabilities | $106,000 | 53.0% |
| Plant and equipment | $201,000 | Common Stock | $50,000 | 25.0% |
| Accum. Depreciation | ($49,000) | Retained Earnings | $44,000 | 22.0% |
| Total Fixed Assets | $152,000 | Total Equity | $94,000 | 47.0% |
| Total Assets | $200,000 | Total Liab. & O. E. | $200,000 | 100.0% |
To grow its assets, the company has kept all of its profits and issued all the stock it could—$15 million profits plus $29 million stock for total new equity of $44 million. It leveraged the new equity with $43 million of new long term debt. Presumably the $87 million of plant improvements expanded the product line and/or improved the plant efficiencies.
In short, management’s top priority was to identify opportunities to accumulate efficient assets. When identified, managers raised the money first with equity (retained profits and stock issues) , and then with as much long term debt as needed (up to its credit limits) .
Note the trade-offs with other performance measures. We are increasing assets, equity and leverage. Dividends are zero. Stock is diluted.
The implications for other performance measures include:
- ROE: Likely falls in the short run, may climb in the long run
- ROA: Likely falls in the short run, may climb in the long run.
- Asset turnover: Likely stays neutral or falls slightly
- Stock price: Since dividends fall to zero as shares are diluted, likely falls.
- Market cap: Stays neutral. More shares, but at a lower price.
- ROS: Probably goes up.
- Market share: Goes up.
Of course, the team hopes that profit growth will outpace balance sheet growth, and if it does, all of these measures will swing positive in the long run.
If the board of directors imposes other performance measures, management will feel torn. That can be a good thing. While cumulative profits is, perhaps, the most important individual measure, it does not take into consideration all of the stakeholders interests, particularly stockholders.