Financial Performance Measurement

1 Introduction

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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.

A ratio on its own does not tell us very much. A return of 29.4% is only good or bad when we compare it – with the same business last year, with a budget or target, or with similar businesses. If similar businesses earn 40%, 29.4% is poor; if they earn 10%, it is excellent.

2 The main areas

When attempting to analyse the financial statements of a company, the main area that we need to look at is that of profitability.

Looking at the profit figure alone can be misleading. If a business has doubled in size, we would expect it to make twice the profit just to be doing as well. So, rather than look at the absolute profit, we look at profit as a percentage of the money invested in the business and of the sales made.

Profitability is not the whole picture. A business must also be able to pay its debts as they fall due (liquidity), manage its inventory, receivables and payables well (working-capital efficiency) and not depend too heavily on borrowing (gearing). These ratios are covered in section 4.

3 The profitability ratios

We will work through an example to illustrate the various ratios that you should learn. First, the formulae:

Total long-term capital (capital employed) = share capital + reserves + long-term liabilities (non-current liabilities).

NB: ROCE = asset turnover × net profit margin.

Three points about the formulae:

• We use the profit before interest and tax (the profit from operations). Tax rates change from year to year and are outside the managers’ control, and the long-term capital includes loans as well as shareholders’ money, so we measure the profit that all of that capital generated before any of it is paid out as interest.

• In financial accounting “net profit” usually means the final profit after tax. In these ratios, net profit means the net operating profit – the profit before interest and tax.

• ROCE can be improved in two ways: by making more profit on each sale (a higher net profit margin – a higher selling price or lower costs), or by selling more for the size of the business (a higher asset turnover). That is why ROCE = asset turnover × net profit margin.

4 Liquidity, working-capital and gearing ratios

Calculating appropriate measures means choosing those that suit the business and the question being asked. The following ratios look at other aspects of financial performance.

Liquidity

Liquidity is the ability of the business to pay its short-term debts as they fall due. A profitable business can still fail if it runs out of cash.

A ratio that is too low suggests the business may struggle to pay its debts. A ratio that is very high may mean money is tied up in inventory, receivables or idle cash that could be used better. What is “normal” depends on the type of business: a supermarket, which sells for cash and holds fast-moving inventory, can operate safely with much lower ratios than a manufacturer.

Working-capital efficiency

If the question does not give credit sales or credit purchases, use revenue and cost of sales instead, and say so. Rising inventory days or receivables days tie up more cash; rising payables days keep cash in the business longer, but paying suppliers too slowly may damage the relationship with them.

Gearing

Gearing looks at how far the business is financed by borrowing rather than by its shareholders. Interest on loans must be paid whether profits are high or low, so a highly geared business carries more risk.

Equity is the share capital and reserves. The financial ratios apply to service businesses as well as to manufacturers – a hotel or a firm of accountants still has a ROCE, margins, receivables days and gearing – although a service business may hold little or no inventory, so inventory days and the quick ratio matter less.

5 Limitations of only looking at financial performance

Clearly any business wishes to improve its profitability, but there are dangers involved in only looking at the financial performance:

Short-termism

Performance measures are often used as targets for the managers and they are often rewarded as to how well they achieve or ‘beat’ the targets. As a result there is a danger that managers will be focussed on doing well in the short-term rather than making decisions that will benefit the business in the long-term.

For example, a manager could raise this year’s profit by cutting staff. Costs fall and the bonus is earned – but if quality then suffers, customers will be lost next year.

Manipulation of the profits

In order to meet their targets in the current period, managers may be tempted to make the results better by, for example, wrongly including revenue this year that should really be included next year, or treating some of this year’s expenses as next year’s.

Historic measures

Financial measures only measure the performance of the business in the previous period. For the business to grow in the future we need also to look at factors that will improve the business in the future, such as the quality of the goods or services that the business is providing. However well we perform financially this year, if the quality is suffering then we are likely to lose business and therefore be less profitable in the future.

For this reason it is important that we also consider non-financial performance measures.

6 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.