Assessing Performance (interpreting Ratios)

One of the most important measures of a company's success is its profitability. However, individual figures shown in the income statement/profit and loss account for gross profit and net profit mean very little by themselves. When these profit figures are expressed as a percentage of sales, they can be compared with other ratios and can be useful. Changes in the gross profit percentage ratio can be caused by a number of factors. For example, a decrease may indicate greater competition in the market and therefore lower selling prices and a lower gross profit or, alternatively, an increase in the cost of purchases. An increase in the gross profit percentage may indicate that the company is in a position to exploit the market and charge higher prices for its products or that it is able to source its purchases at a lower cost.The relationship between the gross and the net profit percentage gives an indication of how well a company is managing its business expenses. If the net profit percentage has decreased over time while the gross profit percentage has remained the same, this might indicate a lack of internal control over expenses.

The return on capital employed (ROCE) ratio is another important profitability ratio. It measures how efficiently and effectively management has deployed the resources available to it, irrespective of how those resources have been financed. Various formulae can be found in textbooks for calculating ROCE. The most common uses operating profit and the closing values for capital employed (although using averages for the year is more accurate). This ratio is useful when comparing the performance of two or more companies, or when reviewing a company's performance over a number of years.

LIQUIDITY RATIOS

Liquidity refers to the amount of cash a company can generate quickly to settle its debts. A reasonable level of liquidity is essential to the survival of a company, as poor cash control is one of the main reasons for business failure. The current ratio compares a company's liquid assets (ie cash and those assets held which will soon be turned into cash) with short-term liabilities (payables/creditors due within one year). The higher the ratio the more liquid the company. As liquidity is vital, a higher current ratio is normally preferred to a lower one. However, a very high ratio may suggest that funds are being tied up in cash or other liquid assets, and may not be earning the highest returns possible. A stricter test of liquidity is the acid test ratio (also known as the quick ratio) which excludes inventory/stock as a current asset. This approach can be justified because for many companies inventory/stock cannot be readily converted into cash. In a period of severe cash shortage, a company may be forced to sell its inventory/stock at a discount to ensure sales. Caution should always be exercised when trying to draw definite conclusions on the liquidity of a company, as both the current ratio and the acid test ratio use figures from the balance sheet. The balance sheet is only a 'snapshot' of the financial position at the end of a specific period. It is possible that the balance sheet figures are not representative of the liquidity position during the year. This may be due to exceptional factors, or simply because the business is seasonal in nature and the balance sheet figures represent the cash position at just one particular point in the cycle.

EFFICIENCY RATIOS

Most companies offer their customers credit in order to increase their sales. However, giving credit to customers incurs an opportunity cost as the cash is tied up in financing receivables/debtors, and there is also the risk of the debts not being paid. Therefore, companies will normally seek to collect their debts as soon as possible. The receivables/debtors collection period (in days or months) provides an indication of how successful (or efficient) the debt collection process has been. How efficient the firm is in controlling expenditure will also be assessed with these ratios.

Stock turnover (stockturn) Debtor collection period (debtor days) Creditor collection period (creditor days) Turnover in relation to fixed assets Turnover in relation to net current assets Overheads in relation to turnover