ACCA F5 Performance Management - 2010 - Study text - Emile Woolf Publishing
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Chapter 12: The scope of performance measurement
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2.3 FPIs for measuring profitability
Profitability depends on sales revenues and costs. Financial performance indicators
that may be relevant for assessing performance therefore include ratios for sales and
costs, as well as profit.
Profitability may also be assessed by relating profit to the amount of capital
employed by the business. Return on investment (ROI) and other similar financial
ratios are explained in the next chapter.
Percentage annual growth in sales
Business entities will monitor their annual growth (or decline) in sales, measured as
a percentage of sales in the previous year.
For example, if sales in the year just ended were $5,800,000 and sales in the previous
year were $5,500,000, the annual growth in sales has been ($300,000/$5,500,000) ×
100% = 5.45%.
Sales growth can be a very important measure of financial performance for a
number of reasons.
If a company wishes to increase its annual profits, it will probably want to
increase its annual sales revenue. Sales growth is usually necessary for achieving
a sustained growth in profits over time.
The rate of growth can be significant. For example, suppose that the annual rate
of growth in a particular market is 7%. If a company achieves sales growth in the
year of 15%, it will probably consider this to be a good performance. If sales
growth is 3%, this would probably be considered poor performance – although
sales have increased, they have not increased in line with growth in the market.
The period of time over which growth is achieved can also be important. For
example, if a company achieves growth in sales of 20% during one year, this
might be considered a good performance. However, performance would be even
better if the company achieves annual growth in sales of 20% over a five-year
period. Sustained growth would indicate that performance has been improving
over the long term, and might therefore be expected to continue in the future.
Sales growth (or a decline in sales) can usually be attributed to two causes:
sales prices and
sales volume.
Any growth in sales should be analysed to identify whether it has been caused by
changes in sales prices, changes in sales volume or a combination of both.
(Note: In some cases, a company may introduce new products, or cease producing
some of its products); in such cases, growth or decline in sales will also be
attributable to changes in the number of products sold.)
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Example
Laffco sells orange juice in standard-sized cartons. The market for orange juice is
very competitive and there are several larger competitors in the market. Sales data
for the previous three years are as follows.
Current year Year – 1 Year – 2
(just ended) (previous year)
Sales revenue $15 million $13.5 million $12 million
Cartons sold (millions) 6 million 5 million 4 million
Required: Analyse sales performance.
Answer
Sales growth in the current year was $(15 million – 13.5 million)/$13.5 million
= 11.1%.
Sales growth in the previous year was $(13.5 million – 12 million)/$12 million
= 12.5%.
The growth ratios are easy to calculate, but how should they be interpreted?
In a competitive market, achieving growth in revenue of 12.5% in one year
followed by 11.1% the next should probably be considered very good
performance.
The average sales price per carton was $3 two years ago, $2.70 one year ago and
$2.50 in the current year. This may suggest that sales growth has been achieved
by cutting the sales price: lower sales prices often result in a higher volume of
sales.
The volume of sales (cartons sold) rose by 25% two years ago and 20% in the
current year. This strong growth in sales may be due to excellent marketing
activity by the company, or to the reductions in the selling price.
On the basis of the limited information available, it seems possible that the company
has succeeded in increasing sales within a competitive market by reducing its
selling prices.
Profit margin
Profit margin is the profit as a percentage of sales revenue. It is therefore the ratio of
the profit that has been achieved for every $1 of sales.
Profit margin = Profit/sales × 100%
It is wrong to conclude, without further analysis, that a high profit margin means
‘good performance’ and a low profit margin means ‘bad performance’. To assess
performance by looking at profit margins, it is necessary to look at the
circumstances in which the profit margin has been achieved.
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Some companies operate in an industry or market where profit margins are
high, although sales volume may be low. Other companies may operate in a
market where profit margins are low but sales volumes are much higher. For
example, the profit margin earned on high-fashion clothes should be much
higher than the profit margin on low-priced clothing sold in large supermarkets
or stores.
Changes in the profit margin from one year to the next should be monitored
Improvements may be a sign of ‘good performance’ and falling profit margins
may be a cause for concern.
There are several ways of measuring profit margin. If you are required to measure
profit margin in your examination, the most suitable ratio is likely to be:
Gross profit margin (= gross profit/sales). Gross profit is sales revenue minus
the cost of sales.
Net profit margin (= net profit/sales). Net profit = gross profit minus all other
costs, such as administration costs and selling and distribution costs.
Any change in profit margin from one year to the next will be caused by:
changes in selling prices, or
changes in costs as a percentage of sales, or
a combination of both.
Changes in costs as a percentage of sales may be caused by a growth or fall in sales
volumes, where there are fixed costs in the entity’s cost structure.
Example
Sobco makes and sells footwear. Its profits and sales revenue for the past three years
are as follows
Current year Year – 1 Year – 2
(just ended) (previous year)
Sales revenue $20 million $22 million $24 million
Items sold 1 million 1.1 million 1.2 million
Gross profit $5.8 million $6.6million $6.8 million
Net profit $0.4 million $1.2 million $1.4 million
Required: Analyse profitability and costs.
Answer
Profit margins are as follows:
Current year Year – 1 Year – 2
(just ended) (previous year)
Gross profit margin (%) 29.0% 30.0% 28.3%
Net profit margin (%) 2.0% 5.5% 5.8%
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The gross profit margin has fallen slightly in the current year, but is higher than the
gross profit margin two years ago. There is insufficient information to assess
performance, except to conclude that the gross profit margin has been fairly stable
over the three-year period.
(This means that the ratio of cost of sales as a percentage of sales has also been fairly
constant. The cost of sales/sales ratio is simply 100% minus the gross profit margin.)
The net profit margin has fallen from 5.8% two years ago to 2.0% in the current year.
The actual net profit has fallen from $1.4 million to $0.4 million. The reason for the
fall in net profit margin is attributable to either changes in selling prices or changes
in costs (as a percentage of sales).
The average selling price per unit has been $20 in each of the three years,
suggesting that the fall in net profit margin is not caused by changes in selling
prices.
The fall in net profit margin is therefore due to changes in costs. Although there
has been some variability in the ratio of cost of sales to sales revenue, the main
problem appears to be changes in ‘other costs’ as a percentage of sales.
Other costs = the difference between gross profit and net profit. Two years ago
these were $5.4 million (= $6.8 million - $1.4 million), one year ago they were
$5.4 million (= $6.6 million - $1.2 million) and in the current year they were also
$5.4 million (= $5.8 million - $0.4 million). This suggests that other costs are all
fixed costs.
Fixed costs have remained constant each year, but sales revenue has fallen due
to falling sales volume. The reduction in the net profit margin can therefore be
attributed mainly to the higher ratio of other fixed costs to sales revenue – in
other words, to falling sales.
Cost/sales ratios
Profitability may also be measured by cost/sales ratios, such as:
Ratio of cost of sales/sales
Ratio of administration costs/sales
Ratio of sales and distribution costs/sales
Ratio of total labour costs/sales.
Performance may be assessed by looking at changes in these ratios over time. A
large increase or reduction in any of these ratios would have a significant effect on
profit margin.
2.4 FPIs for measuring liquidity
Liquidity for a business entity means having enough cash, or having ready access to
additional cash, to meet liabilities when they fall due for payment. The most
important sources of liquidity for non-bank companies are:
operational cash flows (cash from sales)
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liquid investments, such as cash held on deposit or readily-marketable shares in
other companies
a bank overdraft arrangement or a similar readily-available borrowing facility
from a bank.
Cash may also come from other sources, such as the sale of a valuable non-current
asset (such as land and buildings), although obtaining cash from these sources may
need some time.
Liquidity is important for a business entity because without it, the entity may
become insolvent even though it is operating at a profit. If the entity is unable to
settle its liabilities when they fall due, there is a risk that a creditor will take legal
action and this action could lead on to insolvency proceedings.
In December 2008 a long-established retail company, Woolworths, became
insolvent. Although the company was operating at a loss, a major factor in the
collapse was lack of sufficient cash to pay for leases on premises that fell due for
payment in the month, and which the company did not have the cash to pay.
On the other hand a business entity may have too much liquidity, when it is holding
much more cash than it needs, so that the cash is ‘idle’, earning little or no interest.
Managing liquidity is often a matter of ensuring that there is sufficient liquidity, but
without having too much.
Changes in the cash balance or bank overdraft balance
A simple method of monitoring liquidity is to keep the cash balance at the bank
under continual review, and look for any deterioration (or improvement) in the cash
position. If the entity has a bank overdraft facility, the cash position should be
monitored to makes sure that the overdraft does not get too close to the limit.
When there is a big change in the cash position, it is important to investigate its
cause and judge whether liquidity has become a matter for concern. If you are
familiar with statements of cash flows, you should be aware of the various sources
of cash and reasons for payments of cash. A large fall in cash (or a big increase in the
bank overdraft) may be caused by:
Operating losses
Increases in working capital (inventory plus receivables, minus trade payables)
Expenditures on investments, such as purchases of new non-current assets
Repayments of debt capital (bank loans) or payments of dividends.
A reduction in cash caused by operating losses would be the most serious reason for
a loss of liquidity, but when a business entity is short of liquidity anything that uses
up cash may be significant.
Liquidity ratios
Liquidity may also be monitored by looking at changes in a liquidity ratio over
time. There are two ratios for measuring liquidity that could be used:
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current ratio
quick ratio, also called the acid test ratio.
The more suitable ratio for use depends on whether inventory is considered a liquid
asset that will soon be used or sold, and converted into cash from sales.
The current ratio is the ratio of current assets to current liabilities.
Current ratio =
Current assets
Current liabilities
It is sometimes suggested that there is an ‘ideal’ current ratio of 2.0 times (2:1).
However, this is not necessarily true and in some industries, much lower current
ratios are normal. It is important to assess a current ratio by considering:
changes in the ratio over time
the liquidity ratios of other companies in the same industry.
The
quick ratio or acid test ratio is the ratio of ‘current assets excluding inventory’
to current liabilities. Inventory is excluded from current assets on the assumption
that it is not a very liquid item.
Quick ratio =
Current assets excluding inventor
y
Current liabilities
This ratio is a better measurement of liquidity than the current ratio when inventory
turnover times are very slow, and inventory is not a liquid asset.
It is sometimes suggested that there is an ‘ideal’ quick ratio of 1.0 times (1:1).
However, this is not necessarily true and in some industries, much lower quick
ratios are normal. As indicated earlier, it is important to assess liquidity by looking
at changes in the ratio over time, and comparisons with other companies and the
industry norm.
When there is a significant change in liquidity, the reason should be investigated.
Liquidity ratios will deteriorate (i.e. get smaller) when:
there is an increase in current liabilities without an increase in current assets
there is a reduction in current assets without a reduction in current liabilities (for
example, writing off inventory or bad debts).
Examples of reasons for a reduction in liquidity are:
operating losses
using cash to purchase new non-current assets.
2.5 FPIs for measuring financial risk
Financial risk is the risk to a business entity that arises for reasons related to its
financial structure or financial arrangements. There are several major sources of
financial risk, such as credit risk (= the risk of bad debts because customers who are
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given credit will fail to pay what they owe) and foreign exchange for companies that
import or export goods or services (= the risk of an adverse movement in an
important currency exchange rate).
For the purpose of the F5 examination, however, the most significant financial risk
is the risk that could arise through borrowing. If an entity borrows money, it will
have to pay the money back at some time, and will also have to pay interest. The
risk is that if an entity borrows very large amounts of money, it might fail to
generate enough cash from its business operations to pay the interest or repay the
debt principal.
Example
Zapco is an advertising agency. Next year it expects to make a profit before interest
of $300,000. The company has a bank loan of $3 million, which is repayable in one
year’s time and on which the rate of interest is 8%.
What are the financial risks for Zapco?
Answer
The annual cost of interest on the bank loan is $240,000 (= 8%
× $3,000,000). The
profit is enough to cover the interest, but with only $60,000 to spare.
A financial risk for Zapco is that if profit next year is more than $60,000 below
expectation, it will make a loss after interest.
Another risk is that it may be unable to meet the interest payments on the loan,
unless it has spare cash that it can use or other sources of liquidity such as extra
bank borrowing.
A third risk is that when the bank loan has to be repaid in one year’s time, Zapco
may need to borrow more money in order to repay the loan. This is often
referred to as ‘renewing’ a loan. However the bank might refuse to re-lend the
money and might insist on repayment in full and on time. If Zapco can’t do this,
it will be faced with the risk of insolvency.
Financial risk depends to a large extent on conditions in the financial markets. There
have been times when ‘credit’ has been easy to obtain, and a company wishing to
borrow more money could do so quite easily. However, a ‘credit bubble’ can turn
into a ‘credit squeeze’, when banks cut their lending and are reluctant to renew
loans. A global credit squeeze began in 2007, and for many companies with large
amounts of borrowing, the risks of insolvency became much greater.
Debt ratios
Debt ratios can be used to assess whether the total debts of the entity are within
control and are not excessive.
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Gearing ratio (leverage)
Gearing, also called leverage, measures the total long-term debt of a company as a
percentage of either:
the equity capital in the company, or
the total capital of the company.
Gearing =
Long - term debt
Share capital and reserves
×
100%
Alternatively:
Gearing =
Long - term debt
Share capital and reserves + Long - term debt
× 100%
When there are preference shares, it is usual to include the preference shares within
long-term debt, not share capital.
A company is said to be
high-geared or highly-leveraged when its debt capital
exceeds its share capital and reserves. This means that a company is high-geared
when the gearing ratio is above either 50% or 100%, depending on which method is
used to calculate the ratio.
A company is said to be
low-geared when the amount of its debt capital is less than
its share capital and reserves. This means that a company is low-geared when the
gearing ratio is less than either 50% or 100%, depending on which method is used to
calculate the ratio.
The gearing ratio can be used to monitor changes in the amount of debt of a
company over time. It can also be used to make comparisons with the gearing levels
of other, similar companies, to judge whether the company has too much debt, or
perhaps too little, in its capital structure.
Interest cover ratio
Interest cover measures the ability of the company to meet its obligations to pay
interest.
Interest cover =
Profit before interest and tax
Interest charges in the year
An interest cover ratio of less than 3.0 times is considered very low, suggesting that
the company could be at risk from too much debt in relation to the amount of profits
it is earning.
The risk is that a significant fall in profitability could mean that profits are
insufficient to cover interest charges, and the entity will therefore be at risk from
any legal action or other action that lenders might take.
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2.6 The limitations of financial ratios
There are several limitations or weaknesses in the use of financial ratios for
analysing the performance of companies.
Financial statements are published infrequently. If ratios are used to study
trends and developments over time, they are only useful for trends or changes
over one year or longer, and not changes in the short-term.
Ratios can only indicate possible strengths or weaknesses in financial position
and financial performance. They might raise questions about performance, but
do not provide answers. They are not easy to interpret, and changes in financial
ratios over time might not be easy to explain.
Using financial ratios to measure performance can lead managers to focus on the
short-term rather than the long-term success of the business.
There is some risk that managers may decide to ‘manipulate’ financial
performance, for example by delaying a large item of expenditure or bringing
forward the date of a major business transaction, in order to increase or reduce
profitability in one period (and so reduce or increase the profit for the next
financial period). The risk of manipulating financial results is particularly
significant when managers are paid annual bonuses on the basis of financial
performance.
Non-financial aspects of performance should also be assessed, because:
as suggested earlier, non-financial aspects of performance determine the size of
profits that a company will make in the longer-term
therefore targets should be established for non-financial aspects of performance,
and performance should be measured against those targets.
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Non-financial performance indicators (NFPIs)
Difficulties of target setting for non-financial aspects of performance
Analysing non-financial performance
NFPIs in service industries
3 Non-financial performance indicators (NFPIs)
3.1 Difficulties of target setting for non-financial aspects of performance
There are several difficulties with measuring and assessing performance using
NFPIs.
Selecting the key performance indicators
Non-financial performance refers to every aspect of operations within a business
except the financial aspect, and performance targets can be set for every department
throughout the entity.
Here are just several non-financial performance indicators that might be used in a
reporting system:
Product quality or quality of service
Speed of order processing or speed of any other processing cycle
Customer satisfaction
Brand awareness amongst target customers
Labour turnover rate
Number of man-days of training provided for employees
Amount of down-time with IT systems
Number of suppliers identified for key raw material supplies
Length of delays on completion of projects
Capacity utilised (as a percentage of 100% capacity).
For the purpose of assessing the performance of the entity as a whole, however, it is
necessary to identify which aspects of non-financial performance are the most
important. The problem is to decide which aspects of performance are critically
important. A number of frameworks or models for selecting key non-financial
performance indicators have been suggested. These include:
the balanced scorecard
the performance pyramid
the building block model of Fitzgerald and Moon.
These models are described later.