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by Ronnie Patton 02 Mar 2004 Diploma in Financial Management Relevant to Module A

Assessing a company’s performance in the correct context is an important issue in both Subject Area 1, Interpretation of Financial Statements and Subject Area 2, Performance Management.

The importance of ensuring that an assessment of a company’s performance is considered in context is clearly signalled by the Study Guides for both subject areas of Module A.

For example, the Study Guide for Interpretation of Financial Statements Session 28 includes the outcome ‘Present an appraisal of the results of the financial statement analysis in a given context’, and Session 1 of the Study Guide for Performance Management states ‘Discuss the importance of relating performance measurement and Performance Management to the overall mission, strategy and objectives of the organisation.’

In addition, based on the two projects submitted for the sittings in June and December 2003, it is clear that many candidates could increase the number of marks they obtain if they simply paid more attention to placing their analysis in context.

This article considers the issue of ‘context’ in both Subject Area 1, Interpretation of Financial Statements and Subject Area 2, Performance Management. For this reason, the term ‘ratios and other measures’ is used.

Be selective
A ratio is simply a statement of the relationship between two figures. Unless there is an underlying relationship between the two figures, and we are using the ratio to discover something about how the figures have influenced performance, the ratio will be of no relevance. This is why the context is so important. It might be helpful to think of the plethora of ratios and measures which are considered in the study text as a ‘menu’. From this menu you should select only the ratios and measures which serve your purpose.

To take this point a little further, a ratio which may be extremely relevant in one company may be of little relevance in another. For example, the stock turnover ratio will be very important in a retail company, but will tend to have less relevance if assessing the performance of a service company.

All of this means that an assessment of performance will only be meaningful if the context is taken into account. An analysis which simply calculates a series of standard ratios without reference to the context will lack depth - and perhaps more importantly - marks.

Similarly, Performance Management and performance measurement will lack depth - and marks - if the analysis does not move beyond standard financial measures to incorporate composite and non-financial measures.

Context
It follows from this that the starting point for an assessment of performance is the context. This can be considered by looking at information provided by the company regarding its assessment of the environment in which it operates, and the resulting strategic objectives. But how can these be incorporated into the kind of answers which are expected from Diploma candidates?

First, the environment. Clearly it is not reasonable to expect candidates to have a detailed knowledge of the external environment, as each project is based on a specific company. To obtain a detailed knowledge of that company’s environment would require candidates to undertake extensive and time-consuming research. (Equally it should be noted that if a candidate has personal experience of the specific business, this will not give them an advantage over other candidates.)

However, it is reasonable to expect candidates to demonstrate an awareness of the importance of the external environment and general trends. In essence, this might be described as ‘business awareness’. Very often, the reports of the chairman and the chief executive, as well as the Operating and Financial Review will make some reference to how the company is affected by external trends and pressures. These will have been taken into account by the company in developing its strategy.

By demonstrating an awareness of the ‘fit’ between the environment and the company’s strategy, candidates will have begun to put their analysis in context. It should be noted that this should be relatively brief.

An example of the importance of this awareness can be seen in the project for December 2003. Candidates were required to assess the performance of easyJet. Quite rightly many candidates referred to the fact that most airlines had been affected by the attacks on the World Trade Centre in New York in September 2001. However few candidates noted that, in the medium-term, it was mainly trans-Atlantic carriers which were affected. The impact on easyJet, which operates within Europe, was less significant.

Strategy
As is indicated by the Study Guides, the company’s strategy is of considerable significance in carrying out an assessment of performance. Put simply, the most significant benchmark against which performance can be assessed is the strategy that the directors were seeking to achieve.

For example, if a company is seeking to achieve growth, the decisions which the directors take, and the results, will be different to a company which is seeking to improve profitability. A company seeking growth will usually reduce margins to encourage sales, while a company seeking to improve profitability will often focus on higher margin products. Therefore the expected outcome as measured by gross profit/sales % and the net profit/sales % will be quite different.

This can be seen in the comparison in Figure 1.The reason for the question marks for ROCE (Return on capital employed) is that we cannot be definitive about the effect of the strategies. The overall effect will depend on the interaction of the changes in net profit/sales % and asset utilisation. The key point to note is that by considering the strategy, we can have some idea of how key ratios may be affected.

Maximising marks
From the discussion above, it should be apparent that marks will not be maximised by calculating all the ratios listed in the study text. Rather, every ratio selected should be justified by clearly showing how it will help to assess the company’s strategy.

When commenting on the ratios, there is little value in stating the change which has occurred in numerical terms. For example, if sales have increased by 4.87% a simple statement that this represents a real growth in sales because it is greater than the rate of inflation will not gain marks. However, a consideration of whether the increase of 4.87% is in line with the strategy will obtain marks, as will comments which consider why the change has occurred.
A further point to note is that ‘linking’ ratios to develop the analysis will increase the marks awarded. For example, if a company is seeking growth, we might expect to see a relationship between sales (which should increase) and gross profit margin (which is likely to fall). In addition it would be useful to check if the growth is being controlled by considering whether there has been a significant change in the debtors collection period. In short, maximise your marks by considering the strategy, selecting relevant ratios, commenting on why the ratios have changed from one year to the next (based on the strategy), and using other ratios to confirm the reason for the change. For Performance Management, include composite and non-financial measures, which should once again be justified - and remember to state clearly how performance should actually be measured.

How to maximise your marks

• Always justify the ratio or performance measures you are using. Don’t expect the examiner to decide for you.
• If you aren’t absolutely clear how a ratio or measure will develop your analysis, there will be little value in including it.
• Select ratios and other measures which allow the performance to be assessed in the context of the stated strategy.
• Don’t simply calculate all the standard ratios. Be selective. Fewer ratios, with a justification for using each one will gain more marks.
• When considering performance measures, provide a clear statement of how performance will actually be measured (e.g. customer satisfaction could be measured on the basis of the trend in customer complaints).
• Don’t simply say whether a ratio has improved or worsened - consider why the change has happened.
• When considering why the change has happened, link your comments back to the stated strategy.
• Check the result of one ratio by looking at others which may be expected to have changed.
• Include measures of performance which go beyond the standard financial ratios (i.e. include composite and non-financial indicators).
• Consider the overall picture, not just the individual ratios.

When justifying your ratios and measures, don’t let the fact that you think it is obvious why a ratio or measure should be used to stop you from providing a justification. Marks can only be awarded for material that is included in your answer. If something isn’t there - you won’t get any marks.

Ronnie Patton is examiner for Module A of the Diploma in Financial Management

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