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 examinations.

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

The importance of each area depends on whose behalf that we are analysing the statements.

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

3 Worked example

Statements of Financial Position as at 31 December

	2007		2006
	$	$	$	$
ASSETS
Non-current assets
Tangible assets		1,341		826
Current assets
Inventory	1,006		871
Trade receivables	948		708
Cash	360		100
		2,314		1,679
TOTAL ASSETS		3,655		2,505

LIABILITIES AND CAPITAL
Capital and reserves
$1 ordinary shares	1,200		720
Retained profit	990		681
		2,190		1,401
Non-current liabilities
10% loan 2015		500		400
Current liabilities
Trade payables	653		516
Tax payable	228		140
Dividends payable	84		48
		965		704
TOTAL LIABILITIES AND CAPITAL		3,655		2,505

Statement of Profit or Loss 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
Dividends	169	95
Retained profit for the period	309	171

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

Answer to example 1

		2007	2006
Net profit margin	(790 / 7,180)	11%	8.5%

Gross profit margin	(1,795 / 7,180)	25%	22.5%

Return on capital	(790 / 2,690)	29.4%	25.7%

Asset turnover	(7,180 / 2,690)	2.67	3.02

Current ratio	(2,314 / 965)	2.4	2.4

Quick ratio (or acid test)	(1,308 / 965)	1.36	1.15

Inventory days	(1,006 / 5,385 × 365)	68.2 days	75.5 days

Receivables days	(948 / 7,180 × 365)	48.2 days	47.5 days

Payables days	(653 / 5,385 × 365)	44.3 days	44.7 days

Gearing ratio	(500 / 2,190)	22.8%	28.6%

Profitability

Net profit margin

Gross profit margin

Return on capital employed

(= capital + reserves + long-term liabilities)

Asset turnover

NB: ROCE = asset turnover × net profit margin

Liquidity

Current ratio

Quick ratio (or acid test)

Inventory days

Average collection period (receivables days)

Average payment period (payables days)

Gearing

Gearing

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.

Take the profit the ratio asks for: an operating margin and ROCE both use profit before interest and tax, so tax deducted in the statement has to be added back. Then use the comparatives the question gives — the prior year, the other division, the company average — and say which is performing better, and why.

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

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