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There are a number of stakeholders who have an interest in the health of an organization and its performance, such as: its directors (who run the company); its shareholders (who have invested in the business); its suppliers of goods and services; institutions who have provided loans to the company; its customers; and its employees. This article outlines the various methods of analyzing financial performance.
Analyzing Financial Performance
Examining a company’s balance sheet and profit and loss account will give you an indication of the company’s financial situation in monetary terms. However, knowing the amount of profit or the value of assets does not always provide a full picture of how well the company is performing. Stakeholders of a company will want to analyze key relationships between sets of financial information, such as:
- How much of the company is financed by long-term debt?
- How can I determine what the rate of return is on the capital I have invested?
- Is the company making sufficient profits in relation to its competitors?
Ratio Analysis
Ratio analysis provides a method of analyzing a company’s financial performance.
- Ratio: a method of measuring the relationship between two sets of quantitative data.
There are four main areas in which stakeholders will wish to analyze the company’s performance:
- liquidity
- gearing
- profitability
- investor returns
1. Liquidity
Short-term Analysis: Liquidity Ratios
Liquidity ratios measure the amount of cash a company has available to meet its short-term liabilities, i.e. debts and requests for payment from creditors. The company should also ensure it has enough cash available to meet unforeseen circumstances which might occur.
A company that does not have enough cash to meet its short-term liabilities could become insolvent or forced into liquidation by one or more of its creditors.
Institutions that have loaned money to the business, suppliers of goods and services and also existing and prospective investors will be interested in the liquidity position of the company.
The value of the company’s current assets and current liabilities is used to work out the company’s liquidity position.
- Current assets = stock debtors cash in bank cash in hand.
- Current liabilities = payments to creditors falling due within one year.
Current Ratio
This ratio is sometimes called the ‘working capital ratio’. It indicates how much short-term capital the company has at its disposal from payments, debts owed to the company and cash in its bank account to meet its liabilities. By short-term, we mean a period of up to one year.
Current Ratio Formula
Current assets
Current liabilities
£725,000
£440,000
= 1.65:1
Typically, financial analysts suggest that a ratio of 2:1 is the ideal ratio – but this will depend on the company's business sector. For example, a company in the construction industry, which has to spend a lot of money on materials to complete a job before receiving payment from the customer, may require a higher safety margin than a company in the services sector.
Quick Ratio
This is sometimes called the ‘acid test’ ratio as it removes stock from the calculation of current assets. This is because stock is not a very liquid asset, as it may be difficult for a company to sell its stock in the short term and hence, realize cash.
Quick Ratio Formula
Current assets (minus stock)
Current liabilities
£725,000 minus £400,000
£440,000
= 0.74:1
Business analysts suggest a ratio of 1:1 as being ideal, but this will depend on the industry sector in which the company is operating. Therefore, a lower than average quick ratio for a company when compared to competitors in its sector will be a cause for concern to the creditors of the company.
2. Gearing
Gearing is a method of comparing how much of the long-term capital of a business is provided by ‘equity’ (ordinary shares and reserves), and how much is provided by those who are entitled to interest (from providing long-term loans to the company), or who are entitled to dividends from holding preference shares). Collectively, these sources of capital are known as ‘prior charge capital’. That is, payments to lenders and preference shareholders have to be paid before ordinary shareholders receive their dividend.
Gearing Ratio Formula
Prior change capital (loans preference shares)
Equity (ordinary shares reserves)
£275,000
£835,000
= 0.33:1
The Problem of High Gearing
If a company decides it needs to raise extra capital, for example, to expand its business, it may find it difficult to raise a loan because prospective lenders may consider that the company already has too much ‘prior charge capital’ commitment in relation to its equity..
3. Profitability
The amount of profit a company makes is stated as a defined amount of money. We can compare two companies in the same market sector in terms of the amount of profit each makes. For example, ‘Our company made ?50,000 profit this year, while yours only made ?20,000.’
However, stakeholders may also want to know how much of the company’s capital was used to generate profits in a particular accounting period.
Return on Capital Invested (ROCE) Ratio Formula
Profit before interest and tax
Capital employed
x 100
£140,000
£835,000
x 100
= 16.8%
It is sometimes called the ‘primary ratio’ in financial analysis, as many stakeholders will be interested in a company’s profitability, such as existing and prospective investors, lenders and creditors.
It also provides the company with a comparable profitability figure when measuring its performance against competitors.
4. Investor Returns
Investors who hold ordinary shares in a company will want to find out what kind of return they are getting on their investment. The return on each ordinary share is expressed in terms of the ‘earnings per share’.
- Earnings: the profits after tax and preference share dividends have been paid.
In investment analysis, earnings per share are used as the basis to work out the price earnings ratio (P/E ratio), which is the method of comparing the market value of a share in relation to the earnings per share.
Investors use the P/E ratio to analyze how well their investment is performing. P/E ratios for each of the stock market listed companies are published in the financial press.
Price Earnings Ratio Formula
Share price
Earnings per share
x 100
£0.94
£4.3
x 100
= ?21.9 (P/E ratio)
The P/E ratio is useful for two main reasons:
- It provides a historical comparison for investors, i.e. in comparing returns in the current period with anther period.
- It is a useful way of comparing how well your investment is performing in relation to same sector competitors.
Summary: Purposes of Ratio Analysis
- Ratio analysis shows trends in a company’s financial performance over time.
- Ratios can be compared against a standard (for example, 1:1 being the standard for the quick ratio).
- Ratio analysis is good for inter firm comparison, i.e. ‘How are we doing in relation to our competitors?’
Financial Key Performance Indicators (KPIs)
These financial measures provide an indication of how much monetary value is being generated by an organization. Managers tend to use these as an indication of overall organizational performance since all an organization’s activities have an impact on the bottom line.
Name of measure
How is it calculated
How is it presented
Useful Notes
gross profit
Calculated as sales - costs directly related to those sales.
Expressed as an amount of currency.
The higher the value the better the performance.
net profit
Calculated as total revenue - total expenses (including tax).
Expressed as an amount of currency.
The higher the value the better the performance.
profitability
Calculated as (net profit divided by net sales) x 100%.
Expressed as a percentage.
This metric can be applied to particular business units, products and product lines as well as the whole organization.
net profit growth
(Net profit this period, net profit last period) x 100%.
Expressed as a percentage.
This metric can be applied to business units, products and product lines as well as the whole organization.
return on investment (ROI)
(Financial benefit, amount invested) x 100%.
Expressed as a percentage.
Also referred to as return on capital (ROC). This metric can be used for a wide range of situations such as projects, products, marketing activity, training, etc.
