The ability to analyse financial statements using ratios and percentages to assess the performance of organisations is a skill that will be tested in many of ACCA’s exams. It will also be regularly used by successful candidates in their future careers. The FMA/MA syllabus introduces candidates to performance measurement and requires candidates to be able to 'Discuss and calculate measures of financial performance and non-financial measures'. This article will focus on measures of financial performance and will detail the skills and knowledge expected from candidates in the FMA/MA exam. FMA/MA candidates are expected to be able to calculate key accounting ratios, to know what they measure, and to explain what particular values mean. Ratios can be categorised into four headings: profitability, liquidity, activity (efficiency) and gearing. ProfitabilityProfitability ratios, as their name suggests, measure the organisation’s ability to deliver profits. Profit is necessary to give investors the return they require, and to provide funds for reinvestment in the business. Five ratios are commonly used. Return on capital employed (ROCE) = (Profit before interest and tax (PBIT) ÷ Capital employed) x 100% Return on equity (ROE) = (Profit after interest and tax ÷ total equity) x 100% Operating profit margin = (PBIT ÷ Revenue) x 100% Asset turnover = Revenue ÷ Capital employed Gross margin= (Gross profit ÷ Revenue) x100% Return on capital employed (ROCE)/Return on equity (ROE)
A return on capital is necessary to reward investors for the risks they are taking by investing in the company. Generally, the higher the ROCE or ROE figure, the better it is for investors. It should be compared with returns on offer to investors from alternative investments of a similar risk. Operating profit margin Asset turnover The ROCE and Operating profit margin ratios are often considered in conjunction with the asset turnover ratio. They are considered at the same time because:
This relationship can be useful in exam calculations. For example, if you are told that a business has an Operating profit margin of 5% and an asset turnover of 2, then its ROCE will be 10% (5% x 2). This is more than a mathematical trick. It means that any change in ROCE can be explained by either a change in Operating profit margin, or a change in asset turnover, or both. Gross margin LiquidityLiquidity measures the ability of the organisation to meet its short-term financial obligations. Two ratios are commonly used: Current ratio = current assets ÷ current liabilities Quick ratio (acid test) = (current assets – inventory) ÷ current liabilities Current ratio With the current ratio it is not the case of the higher the better, as a very high current ratio is not necessarily good. It could indicate that a company is too liquid. Cash is often described as an ’idle asset‘ because it earns no return and carrying too much cash is considered wasteful. A high ratio could also indicate that the company is not making sufficient use of cheap short-term finance. Quick ratio Activity (efficiency) ratiosThese ratios can be known as activity ratios, efficiency ratios, cash ratios or working capital ratios and can also be included under the liquidity heading. Receivables collection period = receivables ÷ credit sales × 365 days Inventory holding period = inventory ÷ cost of sales × 365 days Payables payment period = payables ÷ credit purchases (or cost of sales) × 365 days Activity ratios measure an organisation’s ability to convert statement of financial position items into cash or sales. They measure the efficiency of the business in managing its assets. Receivables collection period Inventory holding period Payables payment period GearingGearing relates to an organisation’s relative levels of debt and equity and can help to measure its ability to meet its long-term debts. These ratios are sometimes known as risk ratios, positioning ratios or solvency ratios. Three ratios are commonly used. Debt to equity ratio = non-current liabilities ÷ ordinary shareholders funds x 100% Debt to debt + equity ratio = non-current liabilities ÷ (ordinary shareholders funds + non-current liabilities) x 100% Interest cover = operating profit ÷ finance costs Capital gearing A large proportion of borrowed capital is risky as interest and capital repayments are legal obligations and must be met if the company is to avoid insolvency. The payment of an annual equity dividend on the other hand is not a legal obligation. Despite its risks, borrowed capital is attractive to companies as lenders accept a lower rate of return than equity investors due to their secured positions. Also interest payments, unlike equity dividends, are tax deductible. Levels of capital gearing vary enormously between industries. Companies requiring high investment in tangible assets are commonly highly geared. Consequently, it is difficult to generalise about when capital gearing is too high. However, most accountants would agree that gearing is too high when the proportion of debt exceeds the proportion of equity. Interest cover Written by a member of the Management Accounting examining team |