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How to measure financial performance of organisations. Ratio analysis is used in evaluating financial performance of organisations. The main documents used in analysing ratios are Profit and Loss account (Income Statment) and the Balance Sheet (Statement of Financial Position). For students who are not familair with a profit and loss account and a balance sheet may want to familiarse themselves by studying the next two pages before they proceed to the interpretation of financial performance.
INCOME STATEMENT (IAS)
Balance sheet IAS
Users of financial statements
There are many stakeholders who are interested in understanding statements of limited companies for different reasons. Financial statements communicate accounting information to users and therefore they should clearly communicate the following three aspects.
Financial position - This can be understood by looking at the Balance sheet
Financial performance - This can be understood by looking at the Income statement
Changes to financial positions - This is derived by looking at the cash flow statement.
Interpreting each ratio (How to write an effective answer)
Accounting can be considered as a language and you should be able to understand the language through the ratios. The skill of an investor is not the ability to calculate the ratios, but the ability to interpret what the ratio means. Therefore it is fundamental that you take few moments to revisit each clip on the underlying meaning of each ratio.
In the previous section we calculated different ratios for UT Nirmana Ltd furniture suppliers. Now we will interpret what each ratio indicates. What can we say about UT Nirmana Ltd?
Gross profit margin, at 25%, and Net profit margin, at 6.75%, seem to be acceptable for the type of business. However, this needs to be compared with the previous accounting period to measure whether this is an increase or decrease. It is also important to compare these figures with the industry average.
Distribution costs seem to be high. Again previous accounting period information should be available to understand whether this is an increase or decrease.
Return on capital employed seems low. You should also see that this is less than the 10% debenture interest. In other words the borrowing costs are higher than the return. An investor needs to compare with other similar companies in the same industry to evaluate whether this return is acceptable.
EPS indicates that the return is not highly profitable for ordinary shareholders.
In terms of the liquidity the current ratio is almost 2:1, which shows a healthy position for the creditors (suppliers). In other words, this gives assurance for the creditors on the company's ability to pay its current liabilities.
Acid test ratio also indicates a healthy position 1:1. However we should keep in mind that there are companies with a low acid test ratio and current ratio which operate successfully.
When we look at the efficiency ratios it shows a weak position in the company. Inventory turnover, at 61 days (approximately 6 times per year), is very low. This indicates that the business might not be selling enough of its inventory and a marketing strategy needs to be devised.
Debtor collection period is 32 days, which seems acceptable. When compared with the Creditor payment period of 61 days this shows that the company manages its cash flow effectively. In other words, they collect money quickly and delay payments to suppliers. This gives the business the opportunity to have cash, which can be invested in other profitable opportunities. However long payment periods could damage relationships with creditors.
Asset turnover is low which demonstrates the necessity to increase revenue or decrease net assets.
Interest cover is 10 times which clearly shows that the company does not have a problem in paying its borrowing cost (interests). The company gearing is 22.78% which is low and therefore the company can afford to borrow more money and invest in expansion plans. (Gearing -up to 50% is acceptable)
We could conclude that this is a profitable company which can be further improved massively using different techniques.
What is the Return on capital employed for the year ended December 2008?
8.85%, B) 12.3% C) 10.27% D) None of the above
What is the ROCE for the period ended December 2007?
7.9% B) 5.07% C) 10.34% D) 6.10%
Net Profit Margin
What is the Net profit margin for the year ended 31st December 2008?
10.10% B) 5.27% C) 12.12% D) 13.5%
Net profit margin
What is the Net profit margin for the year ended 31st December 2007?
8.3% B) 8.9% C) 4.57% D) 8.75%
What is the current ratio for the year 2008?
1.99:1 B) 2.08:1 C) 1.54:1 D) 1.67:1
What is the current ratio for the period ended 2007?
1.79:1 B) 1.01:1 C) 2.34:1 D) 1.67:1
Acid test ratio
What is the acid test ratio for the year 2008?
1.3:1 B) 1.21:1 C) 2:1 D) 2.34:1
What is the acid test ratio for the period ended 2007?
1.23:1 B) 2.14:1 C) 1.45:1 D) 1.09:1
What is the gearing ratio for the year ended 2008?
26.34% B) 35.93% C) 27.25% D) 20.12%
What is the gearing ratio for the year ended 2007?
A) 35.93% B) 26.78% C) 20.13% D) 13.45%
Activity five - comparing two businesses
Limitations of the ratio analysis
Ratio analysis is a useful management decision making tool which serves the needs of many different stakeholders such as investors, employees, shareholders etc. However we should bear in mind that ratio analysis is only the starting point of the analysis with its' limitations. Discuss the limitations of the ratio analysis when evaluating company performance. The audio clip above contains some of the limitations and you should research further and write a comprehensive answer.
1. Ratios are tools ofÂ quantitative analysis, which ignore qualitative points of view.
2. Ratios are generallyÂ distortedÂ by inflation.
3. Ratios give false result, if they are calculated from incorrect accounting data.
4. Ratios are calculated on the basis of past data. Therefore, they do not provide complete information for future forecasting.
5. Ratios may be misleading, if they are based on false or window-dressed accounting information.