Department of Construction

CONS7820 Professional Business Management

Performance Measurement and Evaluation

Financial Analysis and Evaluation

Financial ratios
Activity ratios
Liquidity ratios
Gearing ratios

Comments on Financial Ratios

In class examples # 1 & # 2

Presented by:
Bill Oldfield
Lecturer in Accounting
Business Practice Pathway
Room: 115-3045. Ext. 8822
Email: woldfield@unitec.ac.nz

Performance Measurement and Evaluation

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Financial Analysis and Evaluation Introduction

A principal objective of accounting is to provide decision makers with useful financial

information. Decision makers include all users of financial information who will evaluate such
information in order to understand better an organisations situation, including its financial
performance, range of activities, liquidity, indebtedness, long-term commitments and other
investment criteria. Financial information includes both internally generated information that
is processed through an organisations accounting information systems and financial data
from external sources such as industry averages and other economic indicators.

Percentage analysis and ratio analysis are two commonly used techniques in financial
analysis and evaluation. The user can:
Identify important relationships between items in the same financial statements,
previous financial statements, planned performance, or related items of a similar
enterprise within the same industry,
Compare the relationships in terms of expectations and or trends,
Use the information to reveal those operational transactions which should be further
investigated and or which require managerial attention.

Financial Ratio Analysis

One of the most important means of providing an insight into financial reports and drawing
logical conclusions from financial statements is the use of Financial Ratios. These are simply
measures, often expressed as percentages or ratios or periods of time, that relate one
financial figure to another. Typically, the two financial figures come from the same set of
financial reports. The objective of calculating such ratios is to enable users to arrive at
meaningful comparisons so that insights into past performance and present conditions can
be gained. The following is a table identifying which ratios would interest which stakeholders.

STAKEHOLDER TYPES OF RATIOS REASONS

Owners & shareholders Profitability, Activity, Gearing, Shareholders are particularly
Investor interested in what profits have
been made and what prior
claims there may be on these
profits before shareholders can
participate. They are also
interested in how effectively
management has used the
resources at their command.
Government Profitability The government is interested in
the amount of tax to be
accurately calculated and
collected.
Management Profitability, Activity, Liquidity, Management needs to know the
Gearing overall financial position and
performance of the business so
that their attention tends to be
drawn to areas of improvement
and other related strategic
issues.
Customers Liquidity Customers are interested in the
ability of the business to survive
in the short term and to continue
to supply the goods and
services they need.

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 STAKEHOLDER TYPES OF RATIOS REASONS
Suppliers Liquidity Suppliers are also most
interested in the ability of the
business to survive in the short
term and meet its obligations.
Creditors Liquidity, Gearing Short-term lenders are
particularly concerned with the
ability of the business to meet its
financial obligations. Long term
lenders are interested in the
extent to which the business is
financed by long term lenders.
Employees Profitability, Activity, Liquidity Employees are suppliers of
labour and human resources.
Their close involvement with the
business tends to make them
interested in its performance.

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Financial Ratios

Profitability ratios

Return on total assets = Profit before tax X 100%

average Total assets

Return on equity = Profit after tax X 100%

Average ordinary equity

Gross profit ratio = Gross profit X 100%

Sales

Net profit ratio = Profit X 100%

Sales

Activity ratios

Net asset turnover = Sales

Net assets

Age of debtors = Accounts receivable X 365

(in days) Credit sales

Inventory turnover period = average Inventory held X 365

(in days) Cost of goods sold

Liquidity ratios

Working capital ratio = Current assets

(or current ratio) Current liabilities

Liquid ratio = Current assets less inventory

(or Quick asset ratio) Current liabilities

Gearing ratios

Debt to equity ratio = Debt capital X 100%

Total owners equity

Debt ratio = Total liabilities X 100%

Total assets

Equity ratio = Total shareholders equity X 100%

Total assets

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Comments on Financial Ratios

The following comments can only be applied to the comparison of one year with the previous
years figures or the comparison of a businesss financial ratios with budget or the industry
norm.

a) The gross profit ratio

A falling Gross Profit ratio may be due to a decrease in the mark-up % but could also
arise because of theft or problems with inventory. The business may be carrying
inventory that is out of date causing management to hold cut-price sales or the business
has reduced prices at the end of the season.

b) The net profit ratio

A falling net profit ratio indicates that the proportion of the sales dollar spent on
expenses has risen. Individual expenses need to be studied to indicate which particular
expenses have caused the rise (advertising, marketing, rent?). Many expenses tend to
be fixed over a particular level of activity and therefore a small rise in sales should not
cause any increases in this area.

c) Return on Equity

This ratio should be measured against the current bank rate or other investment
alternatives available to the owner. If the ratio is too low, the owner may:
1) Wind down the business
2) Change the type of business
3) Expand the business

d) Working capital ratio ( Current ratio)

This ratio indicates whether a business is able to pay their current debts when they fall
due. A business that cannot pay their debts is unlikely to survive. However this ratio gives
only a limited indication of a businesss liquidity as they may have easy access to further
funds, particularly if they are a large company. Also, it is not good business practice to
have too much finance tied up in inventory or accounts receivable. An ideal Current ratio
is 2:1 for a small business but may be less for a large one

e) Liquid ratio (acid test or quick asset ratio)

This ratio indicates a businesss ability to pay their debts without disrupting normal trading.
(If a business must sell stock to pay their debts, they end up without a going concern as
they have nothing left to sell.) An ideal liquid ratio is 1:1 but again may be less for a large
firm. If this ratio is too low, the business will shortly cease trading and go into liquidation. A
general comment that may be made about a falling liquid ratio is that it may have been
caused by overtrading or expanding too quickly but this may not apply.

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f) Inventory turnover period

If this ratio is falling it may indicate that the business is carrying too little stock, too much
stock, out of date stock or that stock has been stolen.

g) Age of debtors

If the debtors are taking longer to pay their debts and particularly if the collection period is
more than 45 days or 1.5 months, it means that the business does not have good credit
control and must take immediate steps to collect debts more quickly. (Visit or telephone
the debtor, check the debtors ability to pay before allowing them credit and make sure all
credit sales are promptly recorded as well as sending them reminder letters as soon as
they become overdue).

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In class example # 1

Zeitman Consultants Limited is a company specialising in the management of projects in the

construction industry. You, as a Senior Project Management Consultant in the company, are
considering letting a significant contract. Frisby Construction Limited, a medium sized construction
company, is your preferred contractor. However, given the prevailing economic conditions and the
fact that your colleagues have heard some disturbing comments regarding the financial viability of
Frisby, you have decided to try and ascertain the viability of Frisby before awarding the contract.

Although Horatio Frisby, the principal shareholder of Frisby Construction, was at first reluctant, he
is keen to have the contract and has supplied you with the following financial information for his
financial year just completed - i.e. the year ended 30 September 200A. Given the reluctance to
supply this information, it is summarised but is sufficient to permit some analysis to determine the
financial viability of the company.

Frisby Construction Limited

Income Statement
for the year ended 30 September 200A

$000 $000

Gross Fees 5,300

Less Direct Costs

Salaries $ 2,750
Contract Labour 550
3,300
Gross Profit 2,000

Less Operating Costs

Accountancy and Audit fees 20
Depreciation 15
General administration 778
Interest on loans 140
Provision for bad debts 12
Travel 55
1,020

Profit before Taxation 980

Less Provision for Taxation 323

Profit after Taxation 657

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 Frisby Construction Limited
Balance Sheet
as at 30 September 200A

$000 $000
Assets

Current Assets

Cash 15
Debtors 1,240
Prepayments 255
Projects in Progress 940
2,450
Non-Current Assets

Vehicles and Equipment 1,740

Furniture, Fixtures and Fittings 90
1,830
$4,280

Less Liabilities

Current Liabilities

Bank Overdraft 740

Trade Creditors and Accruals 370
1,110
$3,170

Non-Current Liabilities

Bank Loans (secured) 220

Subcontract Retentions 1,280
1,500

Net Assets $1,670

Represented by

Shareholders Funds

Share Capital 200

Retained Earnings 1,470
Total Shareholders Funds $1,670

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The most recent average ratio analysis statistics for similar sized firms operating in the
construction industry are as follows:

Gross Profit Ratio 33% (Gross Profit Gross Fees)

Net Profit Ratio 20% (Net Profit Gross Fees)
Expenses to Fees Ratio 80% (Total Expenses Gross Fees)
Return on Assets 28% (Profit before tax Total Assets)
Return on Equity 18% (Profit after tax Total Shareholders Funds)
Gearing Ratio 2:1 (Debt Funding Equity Funding)
Interest Cover 6 Times (Profit before interest and tax Interest Expense)
Current Ratio 1.1 : 1 (Current Assets Current Liabilities)
Age of Debtors 63 Days ([Debtors Gross Fees] X365)

REQUIRED:

(a) Calculate the above ratios for Frisby Construction Limited for the year ended 30
September 200A

(b) Using your calculations done for (a) and referring to the industry averages given
above, comment on the operating performance, profitability, liquidity and cash
management of Frisby Construction and suggest courses of action you would take
to correct any problems that you have found.

(c) As a consequence of your analysis, state with reasons whether you would place the
contract with Frisby Construction Limited.

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In Class Example # 2

Study the following accounts of two companies and prepare a suitable table of ratios and
percentages. Both companies are shops selling similar goods.

Income Statements
R Ltd T Ltd
$ $ $ $
Sales 250,000 160,000
less Cost of sales
Opening inventory 90,000 30,000
add purchases 210,000 120,000
300,000 150,000
less closing inventory 110,000 190,000 50,000 100,000
Gross profit 60,000 60,000
less Expenses
Wages and salaries 14,000 10,000
Directors remuneration 10,000 10,000
Other expenses 11,000 35,000 8,000 28,000
Net profit 25,000 32,000
add Retained earnings 13,000 6,000
48,000 38,000
less dividends 25,000 20,000
Retained earnings balance $13,000 $18,000

Balance Sheets
Share Capital and Reserves
Issued ordinary shares at $ 1 each 100,000 50,000
Asset revaluation reserve 7,000 12,000
Retained earnings 13,000 18,000
$120,000 $80,000

Current assets
Inventory 110,000 50,000
Accounts receivable 62,500 20,000
Bank 7,500 10,000
180,000 80,000
less Current liabilities
Accounts payable 90,000 16,000
Working Capital 90,000 64,000

Non-current assets
Equipment (cost) 20,000 5,000
less accumulated depreciation 8,000 12,000 2,000 3,000

Vehicles (cost) 30,000 20,000

less accumulated depreciation 12,000 18,000 7,000 13,000

Net Assets $120,000 $80,000

Additional information:
Current market price per share: R Ltd. = $2.50 T Ltd. = $2
Performance Measurement and Evaluation
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Profitability ratios:

Gross profit ratio = Gross profit x 100%

Sales
Net profit ratio = Profit x 100%
Sales
Return on shareholders equity
= Profit after tax x100%
Shareholders funds

Measures of liquidity:

Working capital = Current assets

or Current ratio Current liabilities

Liquid ratio = Current assets - inventory

Current liabilities - overdraft

Measures of activity:

Inventory turnover = Cost of sales

average inventories

Debt collection period = Accounts receivable x 365

credit sales

Investors ratios: do not calculate these

Dividend per share = Dividends

Number of ordinary shares

Dividend rate = Dividends x 100

Ordinary share capital

Dividend yield = Dividend per share x 100

Market price per share

Earnings per share = Profit after tax

Number of ordinary shares

Price /earning ratio = Market price per share

Earnings per share

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Small changes in profits can have big effects on your business

Gearing - ratio of debt to equity (funding) . It is a measure of risk. The higher the gearing,
the higher the proportion of profit that must be paid out to creditors. Interest must be paid.
shareholder dividends need not be paid.

Interest Cover - ratio of operating profits to interest costs. The higher the ratio (10:1), the
less the degree of risk. The lower the ratio (1: 1.5) the higher the degree of risk.

Acid Test - compares interest charges to the assets that the business can liquidate at short
notice (its liquid assets - cash, debtors, inventory??, marketable securities). A ratio of 1:1 is
fairly safe, whereas anything less is risky.

Discussion Question

How far would your profits have to fall below target before you failed to cover your interest
charges ?

6. Hedging can help make profits more predictable

Hedging - a form of insurance (to reduce/eliminate risk) which a business can take out
against variations in factors that affect profits but which management cannot influence. This
should ensure that profits actually reflect the quality of the business rather than simply good
or bad luck with matters outside managements control.

Discussion Question

Determine the main factors affecting your profits (performance) that are outside your businesss
control.

Key Points

Measure profits by quality not just quantity

Discover the difference between trading profits and one-off gains

Compare returns against real asset values

Acknowledge risk

Single suppliers or customers

Debt / Equity ratio

Interest cover and availability of cash

Factors outside control of management

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THE BALANCED SCORECARD Managing Future Performance

Introduction

The balanced scorecard is a management approach that leads a company or business unit
to focus both on achieving current financial results and on creating future value through
strategic activities. Kaplan and Norton argue that senior managers need this balanced
approach because managements traditional emphasis on financial measures alone cannot
motivate, predict or create future performance. With the scorecard, an organisation
measures performance from four different perspectives financial, customer, internal
operations and innovation and improvements activities. The balanced scorecard examines
some new thinking about how businesses measure and manage performance.

The video first examines why managing indicators that focus on financial measures alone
cannot ensure that a business is building future value. Kaplan and Norton then present the
balanced scorecard technique which tracks performance from the four perspectives of
equal importance:

Financial How we look to our shareholders?

Customer How do we become our customers most valued supplier?
Internal Processes What processes both long and short term must we excel at to
achieve our financial and customer objectives?
Innovation and Improvement How can we continue to improve and create value,
particularly in regard to employee capabilities and motivation and the
rate of improvement of existing processes?

Several benefits of using the balanced scorecard:

It makes strategy operational by translating strategy into performance measures and targets
It helps focus the entire organisation on what must be done to create breakthrough
performance
It can act as an integrating device, an umbrella, for a variety of diverse often disconnected
corporate programs such as quality, reengineering, process redesign, and customer service
Corporate level measures can be broken down to lower levels in the organisation so that local
managers, operators, and employees can see what they must do well in order to improve
organisational effectiveness.
It improves a comprehensive view that overturns the traditional idea of the organisation as a
collection of isolated, independent functions and departments.

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The Key Questions:

Do the problems and issues of relying solely on financial performance indicators apply to us?
If so, should we consider adopting the balanced scorecard in our organisation?

1. At the highest level in the business, do we assess overall performance by using primarily
financial results?
2. Do we tend to focus on one or two numbers that we think tell the story about the business
performance?
3. If we do, are we entirely comfortable with that focus?
4. Do we systematically convert our strategies into measures that are tracked regularly
throughout the year?
5. Do we systematically track our performance in non-financial dimensions, critical to our future
success?
6. Are we certain that we are actually managing to build future value? Can we identify exactly
how we are building future value?
7. Is the company, or each business unit within the company, clearly focused on carrying out its
specific strategies for building competitive strength and future value?
8. Does each employee understand his or her role in helping the business achieve its strategic
objectives? (Have we been able to translate our mission and strategies into meaningful
objectives for employees?).

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