Performance art
Philip Dunn outlines performance indicators and inter-firm comparison and how it relates to your studies
Trainee accountants preparing for assessment in Units 8 and 11 in the NVQ pathway, or Unit 33 in the Diploma pathway, must be able to calculate performance indicators in the form of ratios and their interpretation. Such measures include the elements of:
- profitability;
- liquidity;
- efficient use of resources (productivity); and
- financial position.
By applying ratio analysis, the users of financial statements often prepare comparisons that may include 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, or current performance against a standard benchmark. There have been times when in both the Unit 8 and Unit 11 examinations, such comparisons were required.
The CIFC has worked with a wide range of organisations in the UK and overseas for 50 years. It states that it ‘helps businesses of every kind to improve their profitability and productivity by providing expertise in benchmarking, performance measurement and financial control’.
Case study
The example that follows is an inter-firm comparison. However we simply don’t have the space here to illustrate the calculation of all the ratios, so only key measures have been selected.
You work as an accounting technician in the Business Advisory Unit of a firm of management consultants. One of your clients, Hawsker Quarries Ltd, belongs to a trade association that supplies its members with performance indicator benchmarks for the industry as a whole.
The latest information available is for the year 2007 and includes:
| Return on capital employed | 26% |
| Asset turnover | 1.63 |
| Net profit as a percentage of revenue | 16.00 |
| Current ratio | 1.6:1 |
| Liquidity ratio (or acid test) | 1.5:1 |
| Receivables collection period | 59 days |
| Payables payment method | 62 days |
| Finished goods inventory in days | 39 days |
| Labour costs as a percentage of revenue | 18.3% |
| Total operating costs as a percentage of revenue | 84% |
| Distribution costs as a percentage of revenue | 9.7% |
| Administration costs as a percentage of revenue | 4.8% |
| Value added per £1 of employee costs | 1.97 |
| Gearing | 30% |
An extract from Hawsker Quarries' accounts for 2007 showed:
Included in the above are distribution costs of £0.6m and administration costs of £0.26m.
For this analysis, we will focus on:
- return on capital employed;
- net profit before interest and tax as a percentage of revenue;
- current ratio;
- liquidity ratio (or acid test);
- gearing; and
- value added per £1 of employee costs.
These are measures of the company’s profitability, liquidity, financial position and use of resources.
Return on capital employed
This is considered to be the prime profitability ratio. Capital employed is defined here as:
Total assets less current liabilities
The return is expressed as:
It represents the percentage of profit being earned on the total investment. As capital invested in a corporate entity is only available at a cost in the form of interest on loans or dividends to shareholders, a business must plan to maximise profit per £1 of investment.
Net profit before interest and tax as a percentage of revenue
This is expressed as:
This is often referred to as the profit margin and indicates how much of the total revenue remains to provide for taxation and to reward the providers of capital in the form of interest and dividends. This return to revenue can be directly affected by the management’s ability to control costs and determine the most profitable sales mix.
Current ratio
This is a measure of liquidity and is expressed as:
If current assets exceed current liabilities, then the ratio will be greater than 1:1 and indicates that a business has sufficient current assets to cover demands from creditors. However, the speed at which inventories can be converted to cash flow is such that it is not prudent in many businesses to regard inventory as available to cover creditors. So, a second ratio that indicates liquidity has to be considered.
Liquidity ratio
Also known as the acid test, this is expressed as:
This indicates a sound level of liquidity.
Gearing or leverage
This is a measure of a company’s reliance on long-term borrowing. A ratio of 40–45 per cent or more would indicate a high level of gearing. It is expressed as:
The measure shows the relationship of fixed interest finance to total investment.
Value added per £1 of employee costs
This is a true measure of productivity and is perceived as a measure of the way in which the management has used the human capital resource. First, we need to determine the value added. This is expressed as:
Summary
Hawsker Quarries has achieved a return on capital significantly less than that for the sector as a whole. This profitability measure, together with the net profit as a percentage of revenue, indicates that the company is much less profitable than the average in the sector. There are a number of factors affecting this, and you will be able to identify these factors if you also calculate the other ratios in the trade association table not covered in this overview.
The company liquidity indicates a sound position as both the current ratio and acid test are greater than 1:1 and compare well to the published benchmarks. The company relies less on borrowed funds than the average for the sector and is a relatively low-geared business.
In terms of productivity, the value-added measure per £1 of employee costs shows that the company is less productive than its average competitor. This is a factor that influences the results shown in the profitability ratios. If you calculate, for good practice, the remaining ratios you can draw further conclusions about why profitability is lower.
Philip Dunn FMAAT is a lecturer and author
