Financial performance indicators
| by Philip Dunn 30 Nov 2006 Diploma in Financial Management Relevant to Module A |
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Focus on the usefulness of published financial statements has been at the centre of public debate for over three decades. In 1975 the Corporate Report was published. This was the outcome from the Accounting Standards Steering Committee’s wide-ranging discussion paper and in part considered the usefulness of financial statements. The Report’s conclusion as to the fundamental objective of published accounts included the following statement:
‘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:
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The current year’s results with the previous year, to establish whether performance is more favourable or adverse than before.
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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.
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Current performance against a standard or benchmark of performance.
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Comparisons of one segment or division of a business with others to establish which parts of the business are achieving their objectives.
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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 Year X2
£m £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 0.08
0.87 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 0.25
4.43 5.82
Balance sheet
Year X1 Year X2
£m £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 0.05
1.47 1.84
Less current liabilities falling due within one year
Creditors 0.66 0.82
Taxation 0.30 0.27
Dividends 0.16 0.16
1.12 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 1.00
3.12 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 X2
0.95 x 100/1 0.86 x 100/1
4.12 4.47
= 23.06% = 19.24%
Percentage return on capital employed varies widely between business sectors. Research suggests that the ‘top 5’ supermarkets in the
The primary ratio measuring overall return is analysed in more detail by using secondary ratios:
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Asset turnover.
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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 Year X2
5.38 6.68
4.12 4.47
= 1.31 times = 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 Year X2
0.95 x 100/1 0.86 x 100/1
5.38 6.68
= 17.66% = 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
1.47 : 1.12 1.84 : 1.25
= 1.31 : 1 = 1.47 : 1
Acid Test
0.92 : 1.12 1.24 : 1.25
= 0.82 : 1 = 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.
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
Year X1 Year X2
0.88 x 365 days 1.19 x 365 days
5.38 6.68
= 60 days = 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 Year X2
0.66 x 365 days 0.82 x 365 days
3.21 4.32
= 75 days = 69 days
FINISHED GOODS STOCK IN DAYS
In published accounts we would usually focus on total stocks, ie 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 Year X2
0.43 x 365 days 0.45 x 365 days
4.43 5.82
= 35 days = 28 days
NB: Based on total stocks we find:
Year X1 Year X2
0.55 x 365 days 0.60 x 365 days
4.43 5.82
= 45 days = 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 Year X2
0.98 x 100/1 1.25 x 100/1
5.38 6.68
= 18.22% = 18.71%
Operating costs as % of sales
Year X1 Year X2
4.43 x 100/1 5.82 x 100/1
5.38 6.68
= 82.34% = 87.13%
Distribution costs as a % of sales
Year X1 Year X2
0.49 x 100/1 0.61 x 100/1
5.38 6.68
= 9.11% = 9.13%
Admin costs as a % of sales
Year X1 Year X2
0.22 x 100/1 0.27 x 100/1
5.38 6.68
= 4.09% = 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 Year X2
£m £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
Ratio Year X1 Year X2 Trade Association Benchmark
See Notes
1 Return on capital employed 23.06% 19.24% 24%
2 Asset turnover 1.31 1.49 1.60
3 Profit margin 17.66% 12.87% 15.00%
4 Current ratio 1.31 : 1 1.47 : 1 1.5 : 1
5 Acid test 0.82 : 1 0.99 : 1 1.03 : 1
6 Debtors collection period 60 days 65 days 60 days
7 Creditors payment period 75 days 69 days 70 days
8 Finished goods stock in days 35 days 28 days 38 days
9 Labour cost % of sales 18.22% 18.71% 18.1%
10 Operating cost % of sales 82.34% 87.13% 85.00%
11 Distribution costs % of sales 9.11% 9.13% 9.5%
12 Admin costs % of sales 4.09% 4.04% 4.5%
13 Value added per ‘£’ of employee costs
2.21 1.89 1.95
NOTES:
1 Return on capital employed
There has been a significant decline in profitability in Year X2 to a level well below that for the sector as a whole. The principal reasons for this reduction in performance will be highlighted in further comments below.
2 Asset turnover
The company has increased its volume and utilisation of net assets in Year X2, but is still not generating the volume of turnover in relation to total assets, achieved by its competitors.
3 Profit margin
The reduction in the primary ratio – the overall return is highlighted here. There has been a significant reduction in the profit margin and further relevant comment on this issue is shown in Note (10). Although a greater volume has been achieved, margins have fallen.
4 Current ratio
5 Acid test
Company liquidity is still relatively sound, with the acid test only marginally less than the desired level of 1:1 and also the sector average. Liquidity has strengthened in Year X2.
6 Debtors collection period
The debtor day period has increased, which indicates that tighter controls are required, as the period is now above the sector average. If this trend continued upward we would need to be assured that the company is not exposing itself to the possibility of bad debts. This measure is an important element in the assessment of the management’s control of its working capital.
7 Creditor payment period
This period is typical of the sector as a whole. There has been a reduction in creditor days as the company has used some of the excess cash generated from operating activities in reducing its reliance on creditors.
8 Finished goods stock in days
The company is not sacrificing liquidity by tying up excess working capital in the form of stocks. It is holding less than one month’s supply in Year X2 and its inventory management shows better control than that for the sector as a whole.
9 Labour costs % of sales
Labour cost to sales shows a marginal increase in Year X2 but is still at an acceptable level.
10 Operating costs % of sales
There has been a significant increase in the relationship of operating costs to sales, which suggest that operating overheads and some other direct costs need tighter control. It may be that the company has an ageing plant and maintenance charges are on an upward trend. If these assumptions are not the case, then there may have been a significant shift in product mix which can influence product profitability. An analysis of the above factors needs consideration to fully assess the change in this measure of efficiency.
11 and 12 Distribution and admin costs % of sales
These measures are well in line with the sector average and indicate good sound controls in these areas of cost.
13 Value added per ‘£’ of employee costs
The effectiveness and efficiency of the human asset resource has been offset by the adverse
factors highlighted in Note (10). The productivity of labour is some 3% less than the sector average.
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 is a freelance writer