by Steve Scott
01 May 2006
Performance appraisal is an important topic in Paper F7, Financial Reporting. This article is intended to give candidates some guidance as to what is expected from a good answer to performance appraisal questions and how to approach such questions. The scenario of a performance appraisal question can take many forms.
Vertical or trend analysis
A company's performance may be compared to its previous period's performance. Past results may be adjusted for the effects of price changes. This is referred to as trend or vertical analysis. A weakness of this type of comparison is that there are no independent benchmarks to determine whether the chosen company's current year results are good or bad. Just because a company's results are better than its results in the previous financial period - it does not mean the results are good. It may be that its results in the prior year were particularly poor.
To try to overcome the problem of vertical analysis, it is common to compare a company's performance for a particular period with the performance of an equivalent company for the same period. This introduces an independent yardstick to the comparison. However, it is important to pick a similar sized company that operates in the same industry. Again, this type of analysis is not without criticism - it may be that the company selected as a comparator may have performed particularly well or particularly poorly.
Industry average comparison
This type of analysis compares a company's results (ratios) to a compilation of the average of many other similar types of company. Such schemes are often operated on a subscription basis whereby subscribing companies calculate specified ratios and submit them to the scheme. In return they receive the average of the same ratios from all equivalent companies in the scheme. This has the advantage of anonymity and avoids the bias of selecting a single company.
The context of the analysis needs to be kept in mind. You may be asked to compare two companies as a basis for selecting one (presumably the better performing one) for an acquisition. Alternatively, a shareholder may be asking for advice on how their investment in a company has performed. A bank may be considering offering a loan to a company and requires advice. It may be that your chief executive asks for your opinion (as say the chief financial accountant) on your company's results.
Most questions on this topic will have information in the scenario that requires particular consideration. A common complaint from markers is that candidates often make no reference to such circumstances. In effect, the same answer would be given regardless of what the question said. It is worth noting that there are many 'clues' in the question - ignore them at your peril. Examples of such circumstance include:
Related party relationships and transactions: these have the potential to distort the results of a company (either favourably or unfavourably). Examples of related party transactions are:
- goods have been supplied to a company on favourable terms (in terms of price and credit arrangements)
- a subsidiary may enjoy the benefits of head office expertise (eg research knowledge) without any charge being made by the head office
- loans may be advanced at non-commercial interest rates.
A company may have entered into certain arrangements that mean its previous results are not directly comparable with its current results. Examples of this include:
- a sale and leaseback of property, plant or equipment. Such an arrangement would lower the operating assets and thus improve asset utilisation
- entering into debt factoring (the sale of receivablesto a finance house). This would obviously reduce collection periods, but this would not be through improved credit control procedures
- a general revaluation of non-current assets would lead to higher capital employed (and thus a lower return on capital employed) without there being any real change in operating capacity or profitability
- a company may have implemented certain policy changes during the year (eg lowering profit margins in order to stimulate sales).
The possibilities of what might have happened are almost infinite, but what is important is that where the scenario describes events such as those described above, you take them into consideration when preparing your answer.
Most performance appraisal is based on interpreting various comparative ratios. Some questions will leave it for you to decide which ratios to calculate, other questions may specify which ratios have to be calculated. However, some questions may give you ratios such that the majority of marks are for the analysis and interpretation of them.
Another common complaint of markers is that when candidates are left to decide which ratios to calculate, they calculate far too many, thus spending very little time on their interpretation. Even in questions where there are marks available for calculating ratios, the majority of marks will still be for their interpretation.
Lack of interpretation/analysis
By far the most common complaint by markers is that candidates' comments explaining the movement or differences in reported ratios lack any depth or commercial understanding. A typical comment may be that receivables collection has improved from 60 days to 40 days. Such a comment does not constitute interpretation - it is a statement of fact. To say a ratio has gone up or down is not helpful or meaningful.
What is required from a good answer are the possible reasons as to why the ratio has changed. There may be many reasons why a ratio has changed and no-one can be certain as to exactly what has caused the change. All that is required are plausible explanations for the changes. Even if they are not the actual cause, marks will be awarded. There is no single correct answer to an interpretation question, and remember there may be clues in the scenario that would account for some of the changes in the ratios.
In an exam there is a (time) limit to the amount of ratios that may be calculated. A structured approach is useful where the question does not specify which ratios to calculate:
- limit calculations to important areas and avoid duplication (eg inventory turnover and inventory holding periods)
- it is important to come to conclusions, as previously noted, candidates often get carried away with the ratio calculations and fail to comment on them
- often there are some 'obvious' conclusions that must be made (eg liquidity has deteriorated dramatically, or a large amount of additional non-current assets have been purchased without a proportionate increase in sales).
Suggested structure to a typical answer
Comment on company performance in the following areas:
- profitability and asset utilisation
- liquidity (look for overtrading)
- gearing and security of borrowings
- prepare a cash flow statement - if specifically requested.
The primary measure of profitability is normally considered to be the Return on Capital Employed (ROCE):
(Profit before interest and tax/shareholders funds plus long-term borrowings) x 100
This is probably the most important single ratio, but it is open to manipulation. Secondary ratios indicate why the ROCE has changed:
- Gross and net profit margin %:
Profit (gross or net)/sales x 100
- Asset utilisation: sales/net assets
For example, an improvement in the ROCE is either because of improved margins or better use of assets. Increases may be due to increases in selling prices or reductions in manufacturing (or purchased) costs. They may also be caused by changes in sales mix or inventory counting errors. A change in the net profit margin is a measure of how well a company has controlled overheads. The asset utilisation ratio (sales/net assets) shows how efficiently the assets are being used.
Current ratio: current assets/current liabilities. Ideally it is thought that this should be between 1.5 and 2 to 1, but it can vary depending upon the market sector (eg retailers have relatively few receivables so the current, and quick, ratios may be meaningless for such businesses).
Quick ratio (or acid test): current assets less inventory/current liabilities. This is expected to be at parity, ie 1 to 1. If the above liquidity ratios appear to be outside 'normal ranges' further investigation is required and inventory, receivables, and payables ratios should be looked at. These ratios can be calculated either as time periods (eg 'days') or as turnovers.
Receivables collection period (in days): (trade receivables/credit sales) x 365
Inventory turnover: cost of sales/(average or closing) inventory
Payables payment period (in weeks): (trade payables/purchases on credit*) x 52
*Note: you may have to use cost of sales if purchases figure is not available.
Comments on the above ratios
Receivables collection period - when too high, it may be that some bad debts have not been provided for, or an indication of worsening credit control. It may also be deliberate, eg the company has decided to offer three-months' credit in the current year, instead of two as in previous years. It may do this to try to stimulate higher sales.
Inventory turnover - generally the higher this is, the better. If it is low, it may be an indication of obsolete stock or poor sales achievement. Sales may have fallen (perhaps due to an economic recession), but the company has been slow to cut back on production, resulting in a build up of inventory levels.
Payables payment period - if this is low, credit suppliers are being paid relatively early or there may be unrecorded payables. Although the credit period may represent a source of 'free' borrowing, if it is too high it may be an indication of poor liquidity (perhaps at the overdraft limit), and there may be a danger of further or renewed credit being refused by suppliers.
Liquidity problems may also be caused by 'overtrading'. In some ways this is a symptom of the success of the business. It is usually a lack of adequate financing and may be solved by an injection of capital.
This is a far more important ratio than most candidates seem to be aware of. Company directors often spend a great deal of time and money to make this ratio appear in line with acceptable levels.
Its main importance is that as borrowings rise, risk increases (in many ways) and as such, further borrowing is difficult and expensive. Many companies have limits to the amount of borrowings they are permitted to have. These may be in the form of debt covenants imposed by lenders or they may be contained in a company's Articles, such as a multiple of shareholders funds.
Measures of gearing
Gearing is basically a comparison of debt to equity. Preference shares are usually treated as debt for this purpose. There are two alternatives: Debt/equity or Debt/debt + equity.
In any comparison of gearing it is important to use the same basis to calculate the gearing percentage in order for any interpretation to be meaningful. A question often asked is what level should a company's gearing be? There is no easy answer to this - a lot will depend on the nature of the industry and composition of the balance sheet assets. For example, companies with large property portfolios often have high levels of gearing without it troubling investors. But companies that have large amounts of intangible assets are not considered to have a desirable type of security to support large borrowings. It is important that the effect of debt is understood.
Realm is financed by $5m 10% preference shares, and $5m equity.
Calculate the return to each provider of finance if Realm's profits are: