Financial performance indicators
| by Philip Dunn 13 Nov 2002 Diploma in Financial Management Relevant to Both modules |
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‘The fundamental objective of corporate reports is to communicate economic measurements of, and information about, the resources and performance of the reporting entity useful to those having reasonable rights to such information’.
In more recent times the Accounting Standards Board published its Statement of Principles for Financial Reporting (December 1999). The concept of usefulness was a significant feature in this publication. The Statement of Principles seeks to identify why financial statements are produced and whether they are meeting their objective. The reasons stated are as follows: ‘to provide information about the financial position, performance and financial adaptability of an enterprise, that is useful to a wide range of users for assessing the stewardship of management and for making economic decisions’.
To meet their basic objective, financial statements must be useful and the information relevant and reliable. Information will have relevance if it influences the decisions of the users. Irrelevant information has no use. Relevance and reliability are primary characteristics relating to content – together with the threshold quality – materiality. The primary characteristics relating to presentation include comparability, clarity and understandability.
The Statement of Principles identifies the major user groups, as did the Corporate
Report in the 1970s. The main user groups include: investors / shareholders;
employees; lenders; suppliers; customers; government; and the public.
These user groups may apply a series of accounting ratios to interpret and appraise
financial performance. Such comparisons may include:
- The current year’s results with the previous year, to establish whether performance is more favourable or adverse than before.
- The current year’s results with those of comparable companies in the same line of business, to establish whether the company is performing better or worse than its competitors.
- Current performance against a standard or benchmark of performance.
- Comparisons of one segment or division of a business with others to establish which parts of the business are achieving their objectives.
Financial performance indicators in the form of ratios cover a number of concepts and are grouped as: profitability; liquidity; utilisation; financial structure; and investment – shareholder ratios.
The following case study covers the issues of profitability, liquidity and utilisation.
Case Study – Crescent Quarries Ltd
You work as an assistant advisor for a firm of accountants in their business
advisory and consultancy service. One of your clients, Crescent Quarries Ltd,
have experienced an increase in turnover but a downturn in their overall financial
performance in recent times. The company is owner-managed by Ray Staniland and
a small management team. They are members of the Quarrying Trade Association
and have recently received the following summary of performance for the sector
members for year X2.
Quarrying Trade Association
Performance indicators – financial ratios Year X2
| Return on capital employed | 24% |
| Asset turnover | 1.6 |
| Net profit before interest and tax as a % of turnover | 15.00% |
| Current ratio | 1.5 : 1 |
| Liquidity ratio (acid test) | 1.03 : 1 |
| Debtors collection period | 60 days |
| Creditor payment period | 70 days |
| Finished goods stock in days | 38 days |
| Labour costs as % of turnover | 18.1% |
| Operating costs as % of turnover | 85.00% |
| Distribution costs as % of turnover | 9.5% |
| Admin costs as % of turnover | 4.5% |
| Value added per ‘£’ of employee costs | 1.95 |
An extract from the company’s financial statements for years ended X1 and X2 showed:
Profit and loss account| Year X1 £m |
Year X2 £m |
|
| Turnover | 5.38 | 6.68 |
| * Operating costs | 4.43 | 5.82 |
| Operating profit before | ||
| interest and tax | 0.95 | 0.86 |
| Interest | 0.08 0.87 |
0.08 0.78 |
| Taxation | 0.30 | 0.27 |
| Profit after tax | 0.57 | 0.51 |
| Dividends | 0.16 | 0.16 |
| Retained profit | 0.41 | 0.35 |
| * Includes | £m | £m |
| Distribution | 0.49 | 0.61 |
| Administration | 0.22 | 0.27 |
| Operating costs comprise: Wages, salaries and other employee costs | 0.98 | 1.25 |
| Bought in materials and services | 3.21 | 4.32 |
| Depreciation | 0.24 4.43 |
0.25 5.82 |
| Balance sheet | ||
| Year X1 £m |
Year X2 £m |
|
| Fixed assets | 3.77 | 3.88 |
| Current assets | ||
| Stocks: raw materials | 0.12 | 0.15 |
| Finished goods | 0.43 | 0.45 |
| Debtors | 0.88 | 1.19 |
| Bank | 0.04 1.47 |
0.05 1.84 |
| Less current liabilities falling due within one year | ||
| Creditors | 0.66 | 0.82 |
| Taxation | 0.30 | 0.27 |
| Dividends | 0.16 1.12 |
0.16 1.25 |
| Net current assets | 0.35 | 0.59 |
| Total assets Less current liabilities |
4.12 | 4.47 |
| Less liabilities falling due after one year | ||
| Debentures | 1.00 3.12 |
1.00 3.47 |
| Finance by: | ||
| Capital and reserves | 3.12 | 3.47 |
Let us now prepare an analysis of Crescent Quarries Ltd, accounts for years X1 and X2 and compare their current performance with the inter-firm details provided by the Quarrying Trade Association, and summarise the findings.
1 Return on capital employed
This is also often referred to as return on investment (ROI). This is the main
measure of profitability and considered the primary ratio. Capital employed
is
defined as total assets less current liabilities or share capital and reserves
plus long term capital. The return is expressed as:
Profit on ordinary activities before
Interest and tax x 100/1
Capital employed
It represents the percentage of profit being earned on the total capital employed; and relates profit to capital invested in the business. Capital invested in a corporate entity is only available at a cost – corporate bonds or loan stock finance generate interest payments and finance from shareholders requires either immediate payment of dividends or the expectation of higher dividends in the future.
It is therefore good business strategy to maximise the profit per ‘£’ of investment. From Crescent Quarries Accounts we find:
| X1 0.95 x 100/1 4.12 = 23.06% |
X2 0.86 x 100/1 4.47 = 19.24% |
Percentage return on capital employed varies widely between business sectors. Research suggests that the ‘top 5’ supermarkets in the UK averaged around 19% over the past five years. Return may also be measured on equity and shareholders’ funds and this ratio will be considered in a later article on investment and shareholder ratios.
The primary ratio measuring overall return is analysed in more detail by using secondary ratios:
- Asset turnover.
- Profit margin – net profit before interest and tax as a percentage of sales.
These two separate factors, or a combination of both, influence the return achieved by the business entity. The asset turnover is a measure of utilisation and management efficiency. It indicates how well the assets of a business are being used to generate sales or how effectively management have utilised the total investment in generating income.
A former chairman of Tarmac plc was once quoted as: “We must make our assets sweat”. As many business overheads are fixed costs, high production and sales volumes need to be achieved to maximise overhead recovery, and ultimately, profit. It is expressed as:
Turnover
Capital employed
| Year X1 5.38 4.12 = 1.31 times |
Year X2 6.68 4.47 = 1.49 times |
The profit margin indicates how much of the total revenue remains to provide for taxation and to pay the providers of capital, both interest and dividends. This return to sales can be directly affected by the management’s ability to control costs and determine the most profitable sales mix. It is expressed as:
Net profit before interest and tax x 100/1
Sales
| Year X1 0.95 x 100/1 5.38 = 17.66% |
Year X2 0.86 x 100/1 6.68 = 12.87% |
It is interesting to note here that:
Return on capital employed = asset turnover x profit margin
For example, in year X2
19.24% = 1.49 x 12.87%
(the figures would reconcile if expressed to three decimal places)
Management’s objective is to increase return on capital. Therefore they
may focus on one or a combination of these two factors which influence and drive
performance. Measures of liquidity include:
Current ratio; Liquidity ratio (acid test)
The current ratio is expressed as:
Current assets : Current liabilities
If current assets exceed current liabilities then the ratio will be greater
than 1 and indicates that a business has sufficient current assets to cover
demands from creditors. However, the speed at which stock can be converted into
cash flow is such that it is not prudent to regard stock as available to cover
creditors. Thus a second ratio in terms of liquidity is considered – the
quick ratio or acid test. This is expressed as:
Current assets – Stocks: current liabilities
If this ratio is 1:1 or more, then clearly the company is unlikely to have liquidity
problems. If the ratio is less than 1:1 we would need to analyse the structure
of current liabilities, to those falling due immediately and those due at a
later date. The level of both the current ratio and acid test vary considerably
between business sectors.
| Current Ratio: | |
|
Year X1 |
Year X2 1.84 : 1.25 = 1.47 : 1 |
| Acid Test | |
| 0.92 : 1.12 = 0.82 : 1 |
1.24 : 1.25 = 0.99 : 1 |
Measures of utilisation or those sometimes referred to as measures of efficiency
include:
- Debtors collection period
- Creditors payment period
- Stock turnover or stock days
Debtors Collection Period
This is a measure of management’s efficiency and is expressed as:
Debtors x 365 days
Sales
This is an indicator of the effectiveness of the company’s credit control systems and policy. Recent research suggests that UK businesses suffer more problems from slow payments than their European counterparts. On average, British companies take 70 days to pay compared with 48 days in Germany. The control of debtor days is an important element of working capital management. It will be interesting to assess the effect of the last phase of the introduction of the Late Payment of Commercial Debts (Interest) Act 1998, on the collection periods for various business sectors as from August this year.
| Year X1 0.88 x 365 days 5.38 = 60 days |
Year X2 1.19 x 365 days 6.68 = 65 days |
Creditor Payment Period
The balance between debtor and creditor days is influenced by the working capital
cycle. The creditor days is a measure of how much credit, on average, is taken
from suppliers. It is expressed as:
Creditors (trade)
Cost of sales
This ratio is an aid to assessing company liquidity, as an increase in creditor days is often a sign of inadequate working capital control. NB: The figures for Crescent Quarries Ltd show a breakdown of cost of sales and highlights bought in materials and services, and we will base this measure on that figure:
| Year X1 0.66 x 365 days 3.21 = 75 days |
Year X2 0.82 x 365 days 4.32 = 69 days |
Finished Goods Stock in Days
In published accounts we would usually focus on total stocks i.e. raw materials,
work in progress and finished goods. In this case the inter-firm comparison
figures highlight finished goods,and the accounts of Crescent Quarries Ltd clearly
shows the finished goods figure. It is expressed as:
Stocks x
365
Cost of Sales
This is a further measure of working capital management and relates to stock turnover. Controls need to be maintained so that liquidity is not sacrificed.
| Year X1 0.43 x 365 days 4.43 = 35 days |
Year X2 0.45 x 365 days 5.82 = 28 days |
NB: Based on total stocks we find:
| Year X1 0.55 x 365 days 4.43 = 45 days |
Year X2 0.60 x 365 days 5.82 = 38 days |
A further indication of company liquidity can be assessed by adding together stock and debtor days, which indicates how soon stock is converted into cash.
Other Measures of Efficiency
Labour costs, operating costs, distribution and administration costs all measured
individually as a percentage of sales are useful ways of comparing company performance
on an inter-firm basis. Significant differences provide a basis for considering
why company profitability may differ from that of competitors.
Labour costs as % of sales
| Year X1 0.55 x 365 days 5.38 = 18.22% |
Year X2 1.25 x 100/1 6.68 = 18.71% |
Operating costs as % of sales
| Year X1 4.43 x 100/1 5.38 = 82.34% |
Year X2 5.82 x 100/1 6.68 = 87.13% |
Distribution costs as a % of sales
| Year X1 0.49 x 100/1 5.38 = 9.11% |
Year X2 0.61 x 100/1 6.68 = 9.13% |
Admin costs as a % of sales
| Year X1 0.22 x 100/1 5.38 = 4.09% |
Year X2 0.27 x 100/1 6.68 = 4.04% |
Value Added – A Measure of Productivity
Value added per ‘£’ of employee costs is a true measure of employee
productivity. It can also be perceived as a measure of the way in which management
have utilised the human capital resource.
It considers the company’s ability to mobilise its human assets.
Value added is defined as: turnover less all bought in materials and services. It constitutes the ‘pool of wealth’ from which the company: pays employees; pays providers of capital; pays government taxation and maintains and expands assets.
Value added:
| Year X1 £m |
Year X2 £m |
|
| Turnover | 5.38 | 6.68 |
| Bought in materials and services | 3.21 | 4.32 |
| Value added | 2.17 | 2.36 |
| Value added per ‘£’ of employee costs: | ||
| Year X1 | Year X2 | |
| 2.17 | 2.36 | |
| 0.98 | 1.25 | |
| = 2.21 | = 1.89 | |
Refer to Table 1 below.
Table 1: Crescent Quarries Ltd – Inter-firm Comparison Summary
of Performance
Notes:
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Conclusion
The factors highlighted in Note (10) need full investigation so that remedial
action can be taken by management to control and hopefully reverse this downward
trend in overall performance experienced in Year X2. A complete review of business
strategy needs to be undertaken.
Philip Dunn, Esk Valley Business School