Chapter 13: Performance measurement and control Flashcards
General considerations for all ratio analysis
1) figures used from a particular point in time - not necessarily representative throughout a period
2) ratios little use in isolation - compare YoY to find trends or competitors results
3) can be manipulated by management- window dressing
4) indicate areas of further investigation rather than a definitive answer
What is gross profit margin
Gross profit as a % of turnover
Gross profit/ turnover *100
aim: high GPM- either sales price are high or production costs are under control
What is operating profit margin
Operating profit (turnover- expenses) as a % of turnover
Operating profit/ turnover * 100
aim: High OPM- sales prices are high or production costs are under control
What is return of capital employed (ROCE)
measures profitability
operating profit as a % of capital employed
shows op profit generated from each $1 of assets employed
Good for investors- under/over performance
operating profit/ capital employed * 100
capital employed= total assets- current liabilities or total equity+ LT debt
If OP not given (profit before finance charges & tax) use net profit instead
Aim: high ROCE- increased OP (sales price of cost control) or reduced capital employed (repaying LT debt)
ROCE= operating profit margin x asset turnover
What is asset turnover
measure of efficiency
shows turnover generated from each $1 assets employed
turnover/ capital employed
aim: high- increased turnover (launch new products/ successful ad campaign) or reduced capital employed (repaying LT debt)
What is an inventory holding period
measues efficiency
Inventory/ cost of sales * 100
shows average no of days inventory items are held for
increase: problems selling stock, increased obsolete inventory, want to increase turnover e.g remove slow moving stock/ unpopular items
Decrease: desirable- improved ability to turnover inventory, no cash tied up in inventory, could show difficulties managing liquidity and not have the ash to hold optimum inventory level
What is the receivables (debtor) collection period
measure of efficiency
receivables/ credit sales * 365
shows average period taken for debtors to pay what they owe.
increase- company struggling to manage its debts- credit checks on customers to ensure they’ll pay on time, improved credit control i.e invoice on time, chase up bad debts
decrease- improved management of receivables but if it’s well below industry average could show them to be uncompetitive and impact profit
What is the payables (creditor) payment period
measure of efficiency
payables/ credit purchases * 365
shows average period for a company to pay its purchases. If credit purchases not available use purchases or cost of sales
increase- company struggling to pay debts when due or taking advantage of better credit period offered
decrease- improved payments but don’t pay too early ( credit is a useful source of finance)
What is the current ratio
Measure of liquidity
current assets/ current liabilities
shows the company’s ability to meet ST liabilities as they’re due
aim- ratio >1 - but depends on the type of industry
decrease YoY- shows they they’re below industry average (liquidity problems). Company should try and improve liquidity e.g pay debtors when due or better manage receivables to reduce bad debts
What is the quick ratio (acid test)
measure of liquidity
current assets don’t include inventory (poor ST liquidity)
(current assets- liquidity)/ current liabilities
shows the company’s ability to meet ST liabilities as they’re due
aim- ratio >1 - but depends on the type of industry
decrease YoY- shows they they’re below industry average (liquidity problems). Company should try and improve liquidity e.g pay debtors when due or better manage receivables to reduce bad debts
What is operating gearing
measures gearing/ risk
shows extent to which a firm’s operating costs are fixed rather than variable- affects level of business risk in firm
1) fixed costs/ variable costs
2) fixed costs/ total costs
3) % change in EBIT/ % change in revenue
4) contribution/ EBIT
firms with a high proportion of FC known as having a high operating gearing
What is financial gearing
LT debt as a % of equity
debt/ equity * 100
or
debt / (debt+equity) * 100
debt includes LT debt, bank overdraft (net of cash balances) and preference shares
Equity includes issued ordinary share capital, share premium and reserves of the company (e.g retained earnings)
high gearing - relies heavily on debt to finance its LT needs. increases risk since interest & capital repayments must be made on debt, no obligation on equity
improve ratoi via reducing LT debt and raising LT finance using equity
What is interest cover
measure of gearing/ risk
operating profit (before finance charges & tax) / finance cost
decrease- company is facing increased risk of not being able to meet its finance payments as they’re due
improved via increasing operating profit e.g better cost management, reduced finance via reduced debt
What is dividend cover
measure of gearing/ risk
net profit (available to ord shareholders (profit after tax and preference divs)/ dividend
decrease- indicates company is facing increased risk of not being able to pay its div payments to shareholders
Issues of financia performance indicators to monitor performance
1) short-termism - linkig managers and rewards- focus may not be LT e.g cut investment or purchase cheaper/ poorer quality materials
2) manipulating results - accelerate revenue = from 1 year could be included in prev year to improve that performance
delaying costs= could record in next year to improve performance and meet target for this year
understating provision / accrual= would improve performance to achieve targets
manipulation of accounting policies = closing inventory values overstated so increased profits for year
3) not conveying the full picture- doesn’t include factors driving LT profitability e.g customer satisfaction/ quality
