Financial Performance Measurement

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1 Introduction

Financial statements are prepared to assist users in making decisions. They therefore need interpreting, and the calculation of various ratios makes it easier to compare the state of a company with previous years and with other companies.

In this chapter we will look at the various ratios that you should learn for the examination.

2 The main areas

When attempting to analyse the financial statements of a company, there are several main areas that should be looked at:

Profitability
Liquidity
Gearing

We will work through an example to illustrate the various ratios that you should learn under each heading.

3 Worked example

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Statements of Financial Position as at 31 December

	*2007*		*2006*
	$	$	$	$
ASSETS
Non-current assets		1,341		826

Current assets
Inventory	1,006		871
Receivables	948		708
Cash	360		100
		2,314		1,679
		3,655		2,505

EQUITY AND LIABILITIES
Share capital and reserves		2,190		1,401

Non-current liabilities		500		400

Current liabilities		965		704
		3,655		2,505

Income statement for the year ended 31 December

	*2007*	*2006*
	$	$
Revenue	7,180	5,435
Cost of sales	5,385	4,212
Gross profit	1,795	1,223
Distribution costs	335	254
Administrative expenses	670	507
Profit from operations	790	462
Finance costs	50	52
Profit before taxation	740	410
Company tax expense	262	144
Profit after taxation	478	266

You are required to calculate the profitability, liquidity and gearing ratios.

Profitability

Return on capital employed

(= capital + reserves + long-term liabilities)

Net profit margin

Asset turnover

NB: ROCE = asset turnover × net profit margin

Gross profit margin

Liquidity

Current ratio

Quick ratio (or acid test)

Inventory days

Average collection period (receivables days)

Average payment period (payables days)

Gearing

	2007	2006
Net profit margin	11%	8.5%

Gross profit margin	25%	22.5%

Return on capital	29.4%	25.7%

Asset turnover	2.67	3.02

Current ratio	2.4	2.4

Quick ratio (or acid test)	1.36	1.15

Inventory days	68.2 days	75.5 days

Receivables days	48.2 days	47.5 days

Payables days	65.4 days	61.0 days

Gearing ratio	22.8%	28.6%

4 Limitations of ratio analysis

You must learn the various ratios, however, it is important that you are able to discuss briefly the relevance of the various ratios, and also their limitations.

Very few of the ratios mean much on their own – most are only useful when compared with the ratios for previous years or for similar companies.

Many of the ratios use figures from the Statement of Financial Position. These only represent the position at one point in time, which could be misleading. For example, the level of receivables could be unusually high at the year end, simply because a lot of invoicing was done just before the year end. Perhaps more sensible in that sort of case would be to use the average for the year. Normally in the examination you will be expected simply to use Statement of Financial Position figures at the end of the year, but do be prepared to state the problem if relevant.

Answer the questions one at a time. Your progress is saved so you can leave and come back.

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