ACCA PM Syllabus E. Performance Measurement And Control - Financial Performance Indicators - Notes ^{1 / 7}

Ratio Analysis

A key aspect of performance measurement is ratio analysis. Ratios are of little use in isolation. Firms can use ratio analysis to compare

• budgets, for control purposes

• last year’s figures to identify trends

• competitors’ results and/or industry averages to assess performance

Measuring Profitability

1. Sales Growth

   Sales in current year - Sales in previous year
   -------------------------------------------------
   Sales in previous year

   In looking at sales growth, we usually consider other factors such as inflation. Hence, we analyse sales also in real terms.

2. Return on Capital Employed

   Net Profit before interest and tax x 100
   -------------------------------------
   Capital Employed

   The main ratio to measure profitability in an organization is return on capital employed (ROCE).

   Capital employed is defined as total assets less current liabilities or share capital and reserves plus long term capital. 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.

   The primary ratio measuring overall return is analysed in more detail by using secondary ratios:

   • Asset turnover
   • Net 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.

3. Asset Turnover

   Turnover                   
   ----------------
   Capital Employed

   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.

4. Net Profit Margin

   Net Profit  x 100
   -------------
   Turnover

   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.

5. Gross Profit Margin

   Gross Profit x 100
   ---------------
   Turnover

Measuring Liquidity

Liquidity is the ability of an organization to pay its debts when they fall due. There are two main measures of liquidity: -

1. the current ratio
2. the quick (or acid test) ratio

1. Current Ratio

   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.

2. Quick (Acid Test) Ratio

   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. 

   Measures of utilisation (measures of efficiency) include:

   • Debtors collection period

   • Creditors payment period

   • Stock turnover or stock days

3. Debtors (receivables) 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. The control of debtor days is an important element of working capital management.

4. Creditors (payables) 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)   x 365 days
   --------------------
   Purchases

   This ratio is an aid to assessing company liquidity, as an increase in creditor days is often a sign of inadequate working capital control.

5. Inventory holding period

   This is expressed as: 

   Inventory      x 365 days
   ---------------
   Cost of sales

   The holding period may increase because of: -

   • Build-up of inventory levels as a result of increased capacity following expansion of non-current assets.

   • Increasing inventory levels in response to increased demand for product.

6. Work-in-progress period

   This is expressed as: 

   Value of WIP       x 365 days
   ------------------   
   Cost of Sales

7. Finished goods period

   It is expressed as:

   Value of Finished Goods    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.

Measuring Risk

Measurement of risk considers the financial risk incurred by borrowing.

1. Financial Gearing

   Financial gearing can be calculated as: -

   Debt    x 100%
   --------
   Equity

   OR

   Debt            x 100%
   ---------------
   Debt +  Equity

   If the firm has excessive debt, then the need to pay interest before dividends will increase the risks faced by shareholders if profits fall.

2. Interest Cover

   Interest cover is expressed as:

   Profit before interest and tax = Number of times
   ---------------------------------------                                  
   Interest paid

   This ratio represents the number of times that interest could be paid out of profit before interest and tax.

3. Dividend Cover

   This is determined by dividing profit available to equity holders by the dividend for the year.
   It is expressed as:

   Earnings after tax and preference dividends = Number of times
   ----------------------------------------------------
   Ordinary dividend

   This is an indication of dividend policy – whether profits tend to be distributed or reinvested.

4. Operating Gearing

   Operating gearing refers to the proportion of a company’s operating costs that are fixed as opposed to variable. 

   Fixed Costs
   --------------
   Total Costs

   The higher the proportion of fixed costs, the higher the operating gearing. Companies with high operating gearing tend to have volatile operating profits. This is because fixed costs remain the same, no matter the volume of sales. 

   Thus, if sales increase, operating profit increases by a larger percentage. But if sales volume falls, operating profit falls by a larger percentage. 

   Generally, it is a high-risk policy to combine high financial gearing with high operating gearing. High operating gearing is common in many service industries where many operating costs are fixed.