Using financial indicators to track performance

Using financial indicators to track performance

WHEN tracking the performance of an organisation using the balanced scorecard, managers review the performance of the business from four perspectives which are innovation and learning, internal processes, customer and financial. In this article we discuss the financial perspective. Most organisations use this perceptive in tracking the performance of the business but it has some drawbacks because it uses lagging indicators which only look at the past without giving a glimpse of how the company is likely to perform into the future.

The measures used to track performance are called key performance indicators (KPIs). A KPI reflect organisational success or progress in relation to a specified goal. The main purpose of KPIs is to monitor progress towards accomplishing the strategic objectives that are typically communicated in a strategy map and included in a reporting scorecard that enables top management, the board or other stakeholders to focus on the metrics deemed most critical to the success of an organisation.

When tracking the performance of profit seeking companies the main objective is to maximise shareholder wealth. The traditional argument being that shareholders are the legal owners of a company and so their interests should be addressed first.  However, this argument is now being challenged because of a number of stakeholders that have an interest in the performance of the company. Shareholders are generally concerned with current earnings, future earnings, dividend policy and the relative risk of their investment. They want to see that the business will continue to exist, is growing and being profitable.
The financial performance indicators are based on income statement or balance sheet items. They are broken down into profitability, liquidity, gearing and shareholders’ investment indicators. The critical element when developing KPIs is determining what is important or ‘key’ to the organisation.

This is why the process of developing KPIs should be part of an overall strategic management process that connects the overall mission, vision and strategy of an organisation, and its short- and long-term goals, to specific strategic business objectives and their supporting projects or initiatives.
Understanding the organisation’s value drivers and the core activities and competencies that underpin its value proposition is an important first step in this process.

As we discuss measures or KPIs to track performance towards achieving strategic goals it’s important to note that these measures are only meaningful when compared to other time periods, other companies, industry average or against the budget. The measures are meaningless on their own.

Profitability is measured by the return on capital employed (ROCE), gross profit margin and net profit margin among others. For a business to survive and grow it ought to be profitable. That means it should be making more revenue than expenses. The amount of profit can then be compared to last year’s performance to see if there is growth.
An important profitability ratio is the return on capital employed (ROCE), expressed as return on capital employed (ROCE) equals PBIT/Capital Employed. In computing this ratio profit is taken as profit on ordinary activities before interest and taxation (PBIT), and capital employed is shareholders’ capital plus long-term liabilities and debt capital.

This is the same as total assets less current liabilities. This ratio is one of the most important ratios to investors. It shows whether you are making enough profit to compensate for the risk of being in business. You need to compare this rate of return to less risky investments like treasury bonds. When evaluating the ROCE three comparisons can be made: the change in ROCE year-on-year, the ROCE being earned by other companies, the ROCE compared with current market borrowing rates. There are two factors that contribute towards a return on capital employed, namely gross profit and net profit.
The Gross Profit Margin is expressed as Gross profit/Turnover x %. A higher gross profit percentage is preferable because it means the business is covering its cost of sales. The gross profit margin therefore shows how much profit is earned on your products before considering indirect costs. One needs to establish if the gross profit margin is improving because small changes in gross margin can significantly affect profitability.

The last profitability indicator that we will discuss, although there are more, is the Net Profit Margin which is Net profit/Turnover x %. A higher Net Profit percentage is better. This ratio shows how much money you are making per every of sales. The ratio measures your ability to cover all operating costs including indirect costs.
The other category of financial indicators is the liquidity ratios.

Profitability is an important aspect of a company’s performance, however, a company can still get bankrupt due to lack of adequate liquidity. A company needs liquid assets so that it can meet its debts when they are due. Liquidity is the amount of cash a company can obtain quickly to settle its debts.
Liquid funds consist of cash, short-term investments, fixed term deposits, trade receivables and inventory.
The major measure of liquidity is the current ratio which is Current Assets/Current Liabilities. In practice, a current ratio of 2:1 is considered good but however a comfortable ratio varies between different types of businesses.

The second liquidity ratio is the quick ratio, or acid test ratio which is Current assets less inventory/Current Liabilities. This ratio should ideally be at least 1:1 for companies with a slow inventory turnover. For companies with a fast inventory turnover, a quick ratio can be less than 1 without suggesting that the company is in cash flow difficulties. An excessively high current or quick ratio may indicate a company that is over-investing in working capital, suggesting poor management of receivables or inventories by the company.

The third category of financial indicators is the gearing ratios. These ratios are concerned with how much the company owes in relation to its size and whether it is getting into heavier debt or improving its situation. The main ratio in this category is the Gearing ratio which looks at Long Term Debt/Long Term Debt plus shareholder capital.
Capital gearing is concerned with the amount of debt in a company’s long-term capital structure. Gearing ratios provide a long-term measure of liquidity. When a company is heavily in debt, and seems to be getting even more heavily into debt, banks and other would-be lenders are likely to refuse further borrowing and the company might well find itself in trouble.

The other measure of gearing is the interest cover ratio expressed as PBIT/interest. It shows whether a company is earning enough profits before interest and tax to pay its interest costs comfortably, or whether its interest costs are high in relation to the size of its profits, so that a fall in profit before interest and tax (PBIT) would then have a significant effect on profits available for ordinary shareholders. When a company is earning only a modest profit before interest and tax, and has a heavy debt burden, there will be very little profit left over for shareholders after the interest charges have been paid.

The fourth category of financial indicators is the shareholders’ investment ratios or stock market ratios. These are very important for shareholders. The first of these ratios is the earnings per share (EPS). Earnings per share is Profit after tax, extraordinary items and preference dividends divided by the number of ordinary shares that are ranking for dividends. EPS is widely used as a measure of a company’s performance and is of particular importance in comparing results over a period of several years. A company must be able to sustain its earnings in order to pay dividends and re-invest in the business so as to achieve future growth. Investors also look for growth in the EPS from one year to the next.

The other ratio is the P/E ratio or Price/earnings ratio. The P/E ratio is, simply, a measure of the relationship between the market value of a company’s shares and the earnings from those shares. The value of the P/E ratio reflects the market’s appraisal of the shares’ future prospects. In other words, if one company has a higher P/E ratio than another it is because investors either expect its earnings to increase faster than the other’s or consider that it is a less risky company or is in a more ‘secure’ industry
There are limitations to the use of financial ratios. There could be challenges in the availability of comparable information. When making comparisons with other companies in the industry, averages may hide wide variations in figures.

Figures used for comparisons are mostly historical. Comparisons with the previous history of a business may be of limited use, if the business has recently undergone, or is about to undergo, substantial changes. In addition, ratios based on published accounts suffer from the disadvantage that these accounts are filed some months after the end of the accounting period. Comparisons over time may also be distorted by inflation.

Ratios are not definitive in determining the state of a business. ‘Ideal levels’ of indicators vary industry by industry, and even they are not definitive. Companies may be able to exist without any difficulty with ratios that are rather worse than the industry average.  There is need for careful interpretation of the ratios. For example, if comparing two businesses’ liquidity ratios, one business may have higher levels. This might appear to be ‘good’, but further investigation might reveal that the higher ratios are a result of higher inventory and receivable levels which are a result of poor working capital management by the business with the ‘better’ ratios.

Ratios are also subject to manipulation. Any ratio including profit may be distorted by choice of accounting policies. For smaller companies, working capital ratios may be distorted depending on whether a big customer pays, or a large supplier is paid, before or after the year-end.

l Jakarasi is a business and financial strategist and a lecturer in business strategy, advanced performance management and entrepreneurship. He is the Managing Consultant of Shekina Consulting (Pty) Ltd. For assistance in implementing some of the concepts discussed in these articles please contact him on the following contacts: sjakarasi@gmail.com, call on +266 58881062 or WhatsApp +266 62110062.

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