Inherent limitations in using financial ratio analysis to assess small and medium

sized company performance

By
Jane Frecknall-Hughes, Mike Simpson# and Jo Padmore

Dr. Jane Frecknall-Hughes

Sheffield University Management School,
9, Mappin Street,
Sheffield.
S1 4DT
UK

Tel: (0114) 22 23491 (Direct line)

Fax: (0114) 22 23348
Email: j.frecknall-hughes@sheffield.ac.uk

# Author for Correspondence

Dr. Mike Simpson
Sheffield University Management School,
9, Mappin Street,
Sheffield.
S1 4DT
UK

Tel: (0114) 22 23450 (Direct line)

Fax: (0114) 22 23348
Email: M.Simpson@sheffield.ac.uk

Dr. Joanne Padmore

Sheffield University Management School,
9, Mappin Street,
Sheffield
S1 4DT
UK

Tel: (0114) 22 23373

Tel: (0114) 22 23439 (Direct line)
Fax: (0114) 22 23348
Email: J.Padmore@sheffield.ac.uk
Biographies

Dr Jane Frecknall-Hughes
Dr. Jane Frecknall-Hughes is a Senior Lecturer in Accounting and Taxation at
Sheffield University Management School, where she teaches financial and
management accounting, auditing and taxation. Her research interests focus mostly
on taxation.

Dr Mike Simpson
Dr Michael Simpson is a Senior Lecturer in Business Studies at Sheffield University
Management School and teaches Operations Management and Marketing.

Dr Joanne Padmore
Dr Joanne Padmore is a Lecturer in Business Studies at Sheffield University
Management School and teaches Quantitative Methods, Statistics, SPSS, Marketing
and Marketing Research.

2
Inherent limitations in using financial ratio analysis to assess small and medium
sized company performance

Structured Abstract

Purpose: This paper critically evaluates the limitations of using financial ratios to
assess the performance of small and medium sized enterprises (SMEs). The objective
of this paper is to inform the small business research community of the shortcomings
of such an approach to measuring the performance of SMEs.
Methodology/Approach: The approach taken was to discuss the problems inherent in
the use of financial ratios to assess company performance. A set of accounts from an
SME was also analysed to show how these ratios vary according to the definition
used.
Findings: Return on Capital Employed (ROCE) was found to be a particularly poor
indicator of performance in SMEs and may be defined in many different ways giving
rise to widely differing values of ROCE. In addition, the value of ROCE is open to
some manipulation by management and analysts. Some suggestions for dealing with
these problems are highlighted and discussed.
Implications: The paper calls into question the value of performance measurement
research based on financial ratios alone. The paper concludes that a mechanism is
required that takes account of other factors such as the context in which the company
operates to gain a clearer view of the performance of the company.
Originality/Value: The paper offers a unique insight into the issue of measuring the
performance of SMEs using financial ratios. The paper may be useful as a caution for
researchers and analysts interested in measuring the effects of particular management
practices in SMEs and larger firms.
Key Words: Performance measurement, financial ratios, small businesses, SMEs.
Classification: Technical Note.

3
Inherent limitations in using financial ratio analysis to assess small and medium
sized company performance

Introduction
A lot of research on the performance measurement of small and medium sized
enterprises (SMEs) and how various management practices might improve that
performance has been undertaken in the past (Rue and Ibrahim, 1998; Perry, 2001;
Gibson and Cassar, 2005; Kara et al., 2005). Much of this research has relied on the
use of financial ratios to determine if the performance of a firm has changed as a
result of various initiatives and practices. This paper aims to show that over-reliance
on such accounting/financial ratios is perhaps not the best way to measure the
performance of SMEs or larger companies given the inherent problems of ratio
analysis.

Problems with accounting/financial ratios

There are several problems inherent in attempting to use accounting/financial ratios to
assess company performance. Those springing immediately to mind are as follows.

(i) Ratios give meaningless figures if the company has generated a loss;
(ii) There is no absolute definition as to what constitutes a “correct” ratio;
(iii) Given (ii), they may be calculated almost as one likes, which means
that they are capable of manipulation;
(iv) Compounding (ii) and (iii), ratios are often just presented as figures,
without any supporting calculations or definitions;
(v) Ratio analysis deals only with financial numbers and does not take
account of other factors which may affect company performance; and
(vi) If they are calculated over a period of years to provide longitudinal
data, then the value of currency in later years will not be the same as
that of earlier years, owing to the effect of inflation, etc.

These are discussed briefly below.

4
(i) Companies with losses
Although a loss may be a primary indicator that a company is not performing well, for
a small limited company it does not necessarily mean that that company is worthless.
Proprietors of small companies will often have a variety of reasons for running a
company (Jennings and Beaver, 1997; Jarvis et al., 2000; Greenbank, 2001), one of
which may be a “life style choice”, that is, it is their chosen “job”, and provided that
sufficient funds are generated to keep the company operational, and maintain their
particular life style, they will not see a need for long term growth to become a larger
company or develop into, say, a multinational enterprise.

In the long term all companies need to be profitable to enable them to continue in
existence (Reid and Smith, 2000), otherwise their capital structure will be eroded.
However, an occasional loss may be useful in that it can be utilised to reduce past
profits (and generate a refund of tax paid on those profits) or be carried forward to
reduce future profits and reduce future tax payable. However, for a public company
listed on a Stock Exchange, a loss may have adverse implications for its overall value,
as investors may perceive it as a bad sign. The wider implications of losses would not
be evident from financial ratio analysis, especially if trying to assess profitability, as a
loss would generate a negative figure.

(ii) Ratio definitions

Financial ratios may be calculated in different ways, using different figures (Gibson
and Cassar, 2005). In many ways, this is not surprising. If one tries to calculate how
profitable the business is, there are several profit figures disclosed in any income
statement which might be used – operating profit, net profit before interest and
taxation, net profit before taxation, net profit after taxation, net profit after taxation
and preference dividend – and all of these would give a different result. Students
calculating profitability ratios are therefore usually advised that the profit figure used
in ratio analysis should be justifiable, consistent and relevant to the relationship
measured.

A similar problem exists where the notion of “capital” is concerned, as there are
several figures which may be used, such as the figure at the “bottom of the balance
sheet” (equal to net assets), or shareholders’ equity (that is, share capital). There is a

5
question as to whether this should include preference shares, or any share premium,
and the extent to which reserves (retained profits or other types of reserves) should be
included.
For example, a common definition of Return on capital employed (ROCE) is:

Return on capital employed Profit before interest and tax (PBIT)

= × 100
(ROCE) Capital employed (SHF + LTL)

where SHF = shareholder’s funds and LTL = long-term loans

This ratio is intended to measure how profitably the business has used funds invested.

However, the following may also be used as definitions for ROCE:

Net profit before taxation

× 100 = X%
Average shareholders' funds

Net profit after taxation

× 100 = X%
Average shareholders' funds

Net profit after taxation and preference dividends

× 100 = X%
Average shareholders' funds less preference shares

Profit before taxation and interest

× 100 = X%
Average shareholders' funds plus long - term loans

It is important that the numerator and the denominator are compatible. If one is
looking at profit from the point of view of the entity as a whole, then net profit before
interest and tax should be related to the total amount of capital needed to generate it –
namely, shareholders’ funds plus long-term loans – the long-term loans being
included because profit before interest is used. The definition adopted should take
into consideration therefore the purpose for which the ratio is being calculated and the
perspective involved.

Also while many calculations for ROCE use year end totals for capital, strictly, as
profit builds up during the year, one really ought to take an average figure, that is,
½(opening capital + closing capital).

6
Regardless of whichever definition ones uses, there is a problem too as to what is
meant by the terms “shareholders’ funds” and “borrowings”. One has to decide.
Shareholders’ funds usually include:
Ordinary share capital
Preference shares
Share premium account
Capital reserves
Revenue reserves
Other reserves
Profit and loss account

Borrowings may (but will not necessarily) include the following:

Preference share capital
Debentures
Loans
Overdrafts
Provisions
Accruals
Current liabilities
Other amounts due for payment
It is usual, however, to include in borrowings only longer-term items – so one would
include preference share capital and long-term loans.

Many textbooks also suggest that there are “ideal” ratios. Commonly they suggest,
for example, that the current ratio should always have a value of 1 or above. Such
suggestions may be misleading and lead to dangerous simplifications. Many
companies (especially supermarkets) operate successfully with a current ratio of
much less than 1, largely because they have regular supplies of cash coming into the
business. One has to know what is usual and workable for the company.

To show the differences arising as a result of using different definitions, Table 1,

gives calculations for ROCE for Gripple Limited, a medium sized manufacturing
business with approximately 140 employees.

“Insert Table 1 about here.”

Given the variations produced by the use of different definitions and figures in Table
1, it is difficult to see which of the four years 1999-2002 inclusive would be judged to

7
be the “best” year. On the basis of figures calculated, different years vie for being
considered optimal, as follows:

Profit before interest and taxation/Capital employed = 2000 (30.5%)

Net profit before interest and taxation/Average shareholders’ funds = 2002 (37.9%)
Net profit after taxation/Average shareholders’ funds = 1999 (31.2%)
Profit before interest and taxation/Average shareholders’ funds + long-term loans =
2000 (33.8%)

One might conclude that 2000 is the “best” year, as it reveals the highest figures in
two of the four different calculations used, but this judgement would be determined
solely by frequency of occurrence. If, during a longitudinal series of calculations, the
person computing the ratios had switched from one definition to another, without
disclosing the change, the figures would not be comparable at all, which leads to the
problem of manipulation, as discussed below.

(iii) Manipulation
Given that there is no absolutely correct definition of a ratio, and because different
definitions are possible, as (ii) above and the calculations in Table 1 make clear, a
corollary (and third problem) is that ratios are capable of manipulation. It is open to
anyone calculating ratios to include or exclude particular elements to produce ratios
which “look better”, for example, by excluding borrowings, etc., from capital, to
smooth away distortions that inclusion might produce.

(iv) Lack of supporting calculations or definitions

Following on from (ii) and (iii) above, many databases offering company information
do not give easily traceable calculations or definitions for ratios that are computed or
included. This is true also of ratios given in sets of company annual reports and
accounts. To a large extent, this can undermine the value of the information they
provide, as the basis of calculation is not established – or provable.

The collection of data from primary sources can also be problematic. Data for small
businesses are often collected through self report mail surveys (Brush and
Vanderwerf, 1992; Chandler and Hanks, 1993; Murphy et al., 1996) and are open to

8
the interpretation of the respondent. Reported figures may not be consistent across
businesses, and hence, any ratios calculated from them may not be comparable
(Gibson and Cassar, 2005).

(v) Other factors not taken into account

A fifth and obvious shortcoming with financial ratio analysis is that it does not take
account of, say, the reputation of a company for products or supporting services,
changes in management, etc. All these things affect the value of any company
overall, but are not measurable in terms of ratios, though it is arguable that they would
affect profits by generating increased sales, and have an indirect effect.

(vi) Time value of money

It is common practice to calculate ratios for a company for a period of several years.
A potential problem here is that the value of £1 at a given date is not the same as the
value of £1 several years ago, as a result of price rises, inflation, etc. This gives no
cause for concern if all prices incurred by a company have been affected uniformly,
but often they have not. When inflation was high, especially in the 1980s, accounting
regulators developed methods of adjusting for this, by the use of current purchasing
power, current cost accounting, or other such adjustment mechanisms. However, it is
not very easy to compare a set of accounts expressed in historical cost accounting
with any calculated on a different basis, and while this is not usually required, the
underlying problems may produce inherent distortions in the base figures, which
mean that one year is not directly comparable with another. This problem is usually
ignored.

Dealing with the problems

Ratio analysis is included as a performance measurement tool in nearly all accounting
textbooks (for example, Alexander and Britton, 1999; Glautier and Underdown, 2001;
Alexander et al., 2005; Elliott and Elliott, 2006). A development from that is their
long-established use as predictors of corporate failure (see, for example, Beaver,
1966; Altman, 1968; and Ohlson, 1980). However, very few up-to-date texts address
in any detail the inherent problems with ratio analysis as outlined above. Alexander
et al. (2005) is one of the few to cover this. There is only one in-depth attempt, as far
as we are aware, to address any of the problems, and that is by Moon and Bates in
their 1993 article entitled CORE Analysis in Strategic Performance Appraisal. CORE

9
is an acronym for: context, overview, ratio analysis and evaluation. The approach
recommended by Moon and Bates addresses many of the problems associated with
assessing company performance. Assessment may be done from a particular
standpoint, such as that of a prospective investor, lender or supplier.

Context has two aspects - external and internal. This part of the analysis “sets the
scene”. It has two aspects, namely external profile and internal profile. The external
profile refers to (1) the typical characteristics of the organisation being analysed; (2)
its industrial/business sector, when considered under steady state conditions; and (3)
changes in general market conditions during the period under review. The questions
one should be asking to determine the external profile of an entity as regards
categories (1) and (2) above are usually: what is it, what does it do, and what types of
assets and liabilities are typical of an organisation in this sector? Expectations differ
markedly for each different type of organisation and so one must interpret the
indicators contingent on the type of organisation under scrutiny (Murphy et al., 1996).

As regards the industry/business sector in which the company operates, then one
needs to know whether there are any particular factors which affect performance.
These are items peculiar to the industry, such as typical raw materials and whence
they are purchased or the type of customer base. They are distinct from the changes
in general market conditions referred to in (3) above. These latter are items outside an
organisation’s control which are imposed upon it and which it cannot influence. Such
changes may be induced by the economic, political or legislative environment.

Internal profile refers to: (1) developments in the organisation’s own strategic
positioning within its particular business sector; and (2) critical success factors
underlying its performance. Neither of these will be likely to be static and will
respond to changes in the market place, technology, relevant statutory and quasi-
statutory legislation. One needs to assess performance in the light of such changes. It
could be that the corporate profile changes or certain business segments are
discontinued. One must try to understand the scale of changes in circumstances like
these to assess meaningfully a company’s financial performance over a period of time
and the likely sustainability of any competitive advantage obtained as a result of these
changes - in other words, how critical success factors have developed over time.

10
To gain an overview of how the company has been performing, the accounts analyser
looks at the financial statements of the company, and reads the Chairman’s Report,
the Directors’ Report, etc., and any other publicly available information. He/she
looks at trends in sales, profits, asset and liability movements. No formal calculations
are done at this stage, as the purpose is to get a “feel” for how things are generally
outside of any financial calculations. One should also be alert for items which distort
figures, such as “one-off” events like mergers, acquisitions of other companies, share
issues, strikes, redundancies, major fires, or fraud. Differences in accounting policy
between one period and another are another cause of distortions. For example, if a
company suddenly decided to include brand names as an asset on its balance sheet,
then assets would increase and ratios involving returns on capital, for example, would
not be comparable with prior periods.

It is only after the context and overview have been established that Moon and Bates
recommend calculating ratios, as they will now have a foundation on which to rest.
The general advice is much as given above for ratios.

Evaluation is the final stage in the Moon and Bates assessment process. Having
gathered all this information, one must then interpret it. Here narrative explanations
have their part to play, and the use of ratios in combination, to see whether a coherent
picture is given - not only for the one year of one company but for all other periods
for which ratios have been calculated for that company, and for the competitors’
ratios for all periods as well. Comparative features need to be highlighted to
demonstrate how good or how bad the results are for any period in key strategic areas.
One should draw into this factors from the earlier parts of the analysis - context and
overview - as well, not just concentrate on the detailed explanation of ratios.

One should endeavour to come to some conclusion as to the organisation’s success in

terms of what is known about its corporate strategy, etc. It may be that one is
considering the financial results from a particular viewpoint, such as that of a
prospective shareholder or lender. If so, the analysis will have been given a specific
focus right from the start, and will need to be done from this point of view from the
beginning. This harks back to the starting point mentioned above.

11
Surprisingly, the Moon and Bates approach has not been formally incorporated into
any accounting textbook that we can find, though the latter do all address similar
issues. Their approach does address many of the problems innate to company
performance assessment, but cannot eliminate the problems inherent in ratio
calculation itself. All ratio analysis is predicated on accounting figures, and given the
underlying facility for manipulation and smoothing away distortions, no approach
could eradicate this entirely.

Conclusion
To accountants, and accounting students, the problems with ratio analysis are clear
because they are inherent as part of the calculations, but they are not clear to other
disciplines, such as marketing or operations management, which may use ratios as
performance measurement tools without full awareness of their innate flaws. Because
there is no real way to address the issues of a “correct” ratio or manipulations, where
full calculations and definitions are not given, or the time value of money, what is
really required is a mechanism, which takes account of all aspects of a company’s
performance, both financial and non-financial, and examines whether a year’s
performance has added to or detracted from what has gone before.

Despite the widespread recognition of its problematic nature (Venkatraman and

Ramanujam, 1986; Murphy et al., 1996; March and Sutton, 1997; Meyer, 2005),
studies in which organisational performance is measured and treated as a dependent
variable continue to proliferate. In the context of small business research there is a lot
of interest in showing that a particular initiative when undertaken, or critical success
factor when present, improves the performance of a firm as often measured by
ROCE/ROI, profitability and other ratios and measures. This paper clearly
demonstrates that much of that research may be flawed or at least suspect when
accounting ratios are involved. Some researchers (Simpson et al., 2006) have looked
into this area in the hope that it might be possible to “prove” that SMEs undertaking
marketing activities performed better than companies that did not engage in marketing
activities. Other research has used marketing orientation (Narver and Slater, 1990;
Denison and McDonald 1995; Rafiq and Pallett, 1996; Henderson, 1998; and Pelham,
2000), the presence of marketing plans or business plans (Perry, 2001; Gibson and

12
Cassar, 2005; Rue and Ibrahim, 1998) and has used ROCE/ROI or other “objective”
measures of performance based on financial ratios and accounting information to try
and show that firms performed better than those firms without such an orientation or
plans. Some researchers have also tried to verify SME managers’ opinions about their
company’s performance by referring to “objective” measures such as sales, profit,
ROCE and so on (Siu, 2000). Such work should be viewed with considerable caution
when looking for real relationships between management practices, critical success
factors and company performance.

13
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15
 Table 1: Gripple Limited – Return on Capital Employed (ROCE) for years ended 31 December:

Definition 2002 2001 2000 1999

£ £ £ £

1,524,039 820,292 943,678 714,390

PBIT
× 100 = 29.1% = 23.7% = 30.5% = 26.1%
CE 4,400,859 + 832,810 3,049,784 + 410,865 2,577,143 + 519,573 1,968,420 + 768,003

1,410,945 842,598 642,414

NPBT
× 100 = 37.9% 730,321
= 26.0% = 37.1% = 36.4%
Av. SHF (3,049,784 + 4,400,859) 2 (2,577,143 + 3,049,784) 2 (1,968,420 + 2,577,143) 2 (1,560,883 + 1,968,420) 2

1,114,718 590,321 692,616 550,914

NPAT
× 100 = 29.9% = 21.0% = 30.5% = 31.2%
Av. SHF (3,049,784 + 4,400,859) 2 (2,577,143 + 3,049,784) 2 (1,968,420 + 2,577,143) 2 (1,560,883 + 1,968,420) 2

PBIT 1,524,039 820,292 943,678 714,390

× 100 (3,049,784 + 4,400,859) 2 + 832,810 (2,577,143 + 3,049,784) 2 + 410,865 (1,968,420 + 2,577,143) 2 + 519,573 (1,560,883 + 1,968,420) 2 + 768,003
Av. SHF + LTL

= 33.4% = 25.4% = 33.8% = 28.2%

Abbreviations:
Av. = Average
CE = Capital employed (SHF + LTL)
LTL = Long term loans
NPAT = Net profit after taxation
NPBT = Net profit before taxation (but after interest)
PBIT = Profit before interest and taxation
SHF = Shareholders’ funds (share capital and all reserves)