Financial Performance Measurement

1 Approach

Although you must be aware of several key measures of financial performance, it is important that you do not fall into the trap of simply calculating every ratio imaginable for every year available. What the examiner is after is much more of an over-view and being able to determine the key measures and to comment adequately.

The following points should be considered:

1.1 What is it that you are being asked to comment on?

^{For example, if you are looking at the information from the shareholders’ perspective, then growth} (or otherwise) in the share price will be of great interest.

However, if you are looking at how well the managers are performing, the growth (or otherwise) in the profit (to the extent to which they control it) is perhaps of more importance.

1.2 Growth:

Always make some comment as to the level of growth. The amount of detail required depends on the information available and the number of marks allocated, but growth in turnover, in profit, and in share price are all potentially relevant.

Look at the overall level of growth and look for any trends, do not waste time doing detailed year- by-year analysis.

1.3 Areas for analysis:

Subject again to exactly what you are being asked to comment on, the following areas are likely to be worthy of consideration:

Profitability   – how well a company performs, given its asset base

Liquidity   – the short term financial position of the company

Gearing   – the long-term financial position of the company

Investors’ ratios   – how well investors will appraise the company

1.4 Bases for comparison:

Most measures mean little on their own, and are only really useful when compared with something. Depending on the information given in the question, any comparison is likely to be with one of the following:

• Previous years for the same company

• Other similar companies

• Industry averages
  

2 Common ratios

The following is a list of the most common ratios that may be appropriate. However, do not simply calculate every ratio for every question – think about what you are trying to consider and choose the most appropriate ratios. If relevant by all means calculate additional ratios – there is no one set of ratios.

2.1 Total shareholder return

Total shareholder return (TSR) measures the overall return received by a shareholder from both the change in the share price and dividends.

TSR = (closing share price – opening share price + dividends per share) ÷ opening share price × 100%

2.2 Interpretation

TSR should normally be compared with prior periods, a suitable market or sector index, competitors and the return expected for the risk taken. A positive TSR does not necessarily mean that management has performed well if the relevant market produced a substantially higher return.

TSR links performance to shareholder experience and is less affected by differences in accounting policy than profit measures. However, the share price is influenced by market sentiment, interest rates, economic news and expectations outside management's control. It can also encourage short-term decisions if used alone. It should therefore be considered with measures of long-term value drivers, stakeholder outcomes and risk.

Exam focus: calculate TSR accurately, select an appropriate benchmark and explain the reasons for the result rather than merely describing the percentage movement.Introduction

It is very common in the examination to be given information about a company and to be asked to comment on the performance. It is clearly important in practice to have measures in order to determine whether or not the company is performing well.

It is important to measure both financial and non-financial performance, but in this chapter we will consider only financial performance. You will be given extracts from the company’s accounts for several years and be expected to analyse and interpret this information.

2.3 Profitability ratios

Note:   Capital employed = shareholders funds plus ‘creditors amounts falling due after more than one year’ plus long term provisions for liabilities and charges.

Net profit margin × asset turnover = ROCE

2.4 Liquidity ratios

2.5 Gearing ratios

2.6 Investor ratios

3 EBITDA

EBITDA is a financial performance measure that has appeared relatively recently. It stands for

‘earnings before interest, taxes, depreciation and amortisation’ and is particularly popular with high-tech startup businesses.
Consideration of earnings before interest and tax has long been common – before interest in order to measure the overall profitability before any distributions to providers and capital, and before tax on the basis that this is not under direct control of management.

The reason that EBITDA additionally considers the profit before depreciation and amortisation is in order to approximate to cash flow, on the basis that depreciation and amortisation are non-cash expenses.

A major criticism, however, of EBITDA is that it fails to consider the amounts required for fixed asset replacement.