Ratios of performance
|Ratios of performance
Discounting client paper
Acounting documents are used for comparison across
firms, and across time
Syntheses. Ratios of performance
There are four categories of ratios :
Accountants like to define sheaves of ratios. We will restrict ourselves to just a few. And you must keep in mind that they are rough measures. And to make life simple, many of them have different definitions, which don't yield the same figures.
The idea is to relate of measure of profit generated by the firm to a measure of means employed, or of size of the firm.
ROCE (Return on Capital employed)
The most important measure of "resources put to work":
the capital employed
The net worth
Net worth, and value of a firm
Definition of the capital employed
(When there is no ambiguity, this is written : CE = E + D)
A measure of profit generated by the use of the capital
The ratio of this profit divided by the CE is called the ROCE (return on capital employed).
ROCE = Profit before interest and taxes / Capital employed
The ROCE is the most important measure of profitability of the firm.
Variations on the formula
One more difficulty
The CE of the firm in our example, at the end of 2003, is : 520 K€ ; and, at
the end of 2002, it was 450.
So we get ROCE for 2003 = 70 / [ (450 + 520) / 2 ] = 14,4%
Some people don't bother to average the CE over the accounting period (and in fact there are several ways to proceed) and use simply the CE at the end of 2003, in which case they get 13,5%.
Be clear on which formula you've decided to use
For 2004, with the formula above, and averaging the CE in the denominator, we get ROCE for 2004 = 90 / [ (550 + 520)/2 ] = 16,8%.
So we can say that the firm's profitability improved.
ROE (Return on Equity)
A second profitability ratio is the ROE = net profit on equity. Now the idea is to look at the profit generation of the funds owned by the shareholders. So we must use as the numerator the net profit generation (the sales - all the costs of the year) :
ROE = Net profit / Equity
Here again, we have the problem that net profit related to a period, and equity relates to a date. So we shall use again an average equity over the accounting period.
Equity at the end of 2002 = 350
Equity at the and of 2003 = 370
So the average equity over 2003 is 360.
The net profit over 2003 is 47, so the ROE for 2003 = 13,1%
Once again, some analysts will not bother with the averaging, and obtain ROE2003 = 12,7%. Remember : ratios are quick and dirty measures.
For 2004, with our formula, we get ROE for 2004 = 60 / [ (400 + 370)/2 ] = 15,6%
Limit of the usefulness of the ROCE : if a firm has lost a lot of money over the past few years, its CE will be very small, and therefore its ROCE (a year when it makes an operating profit) can be extremely high. In this case, the ROCE is not representative of the real health of the firm.
Another ratio is very commonly used, even though it is quite debatable from a financial view point.
The idea is to relate the net profit to the simplest measure of the size of the firm, the sales.
Net Margin for 2003 = 47 / 800 = 5,9%
Net Margin for 2004 = 60 / 1000 = 6%
It is a debatable ratio because the Sales are not a good measure of the size of the firm. It is easy to inflate the sales artificially, by extra buying and selling at cost. A good measure of the size of the firm must account for the means employed : people, or CE, or value added.
In fact another way to try and measure the "size" of a firm is to use the Net Assets. The ratio of Net Profit / Net Assets is sometimes used by financial analysts.
A firm is a value creating machine. We use value measurements all over the place to record how the firm is doing. And we always make a distinction between value and cash. Stocks are value, but are not cash. Client receivables are value but are not cash, etc.
However, commerce is carried out with cash. When a firm has no more cash to pay a bill or a debt due, it goes bankrupt. That's the magic of cash : it has no intrinsic value (you will not take it with you on a desert island), yet it is the ultimate yardstick of value.
So a firm must always make sure it has enough cash, or it will get cash soon to meet its forthcoming obligations. These are the ideas behind the liquidity ratios.
The liquidity ratios are very simple.
Current assets ratio
It is the ratio of current assets divided by current liabilities.
Current asset ratio = Current assets / Current liabilities
If it is less than one, the firm is in jeopardy of being short of cash to pay creditors when some bills are due. If it is more than one, the firm is healthy. If it is more than 3 or 4, the firm probably doesn't use enough its "free credit", or possibly it is mislead about the real value of its stocks or the quality of its client paper.
In our example we have :
Current asser ratio for 2002 = 330 / 80 = 4,1
Current asser ratio for 2003 = 3,5
Current asser ratio for 2004 = 2,7
We see that all these ratios are above 1, so there is no apparent problem. Secondly we note that they decline, from high value, which is also a good sign. But we must make sure that the liquid assets on top are good assets, and not accounting values unrelated to reality.
The first idea is to look at another ratio, which does not include the stocks on top.
Acid test ratio
Even though the stocks belong to the current assets (that is they move in and out of the firm relatively quickly), they are not as liquid as client paper or cash. So we look at a more stringent liquidity ratio :
Acid test ratio = ( Current assets - stocks ) / Current liabilities
For our firm we get :
Acid test 2002 = 230 / 80 = 2,9
Acid test 2003 = 2,5
Acid test 2004 = 2,5
So, again, no problem is noticeable.
We decided to look at liquid assets without stocks and we mentioned that we should also make sure our client paper is good. This leads us to the next category of ratios.
We shall study three ratios : one related to stocks, one related to clients, and one related to suppliers.
The stocks are an important tool to run a firm. They are here to serve the clients, and they are here to feed the manufacturing process. There are two contradictory principles concerning stocks : you want as much stocks as possible to always be able to satisfy client needs, or to have the raw materials you need ; but on the other hand stocks cost money (they must be financed), and often they actually hide problems. First of all, there may be items in the stocks that are never sold, and secondly large stocks may hide difficulties in the supply chain of materials to your plant.
In the old days of big manufacturing firms, in the first part of the XXth century (in the age of so called Taylorism, and Fordism), large plants use to have large stocks of raw material and parts. But the Japanese invented the Kanban system (also called Just In Time), where raw materials and parts are delivered almost exactly when they are needed. Two advantages : stocks, if any, are paid for by suppliers ; and secondly, if there is a problem in the delivery system, it shows immediately. One of the champions of these techniques (aside from most automotive plants) is Dell Computer. (They are also quite good at Client Relation Management.) If you order a Dell Computer via Internet, you can choose all the specifications of the machine you want ; you pay ; and the computer will be delivered to you within a week or two, depending where you live. When you order your machine, usually it is not yet manufactured. Dell does not keep it in stock. It may not even have the parts in stock. This, plus the system of direct sales, with no stores, has enable Dell to become the biggest manufacturer of PC in the world, and to be very profitable.
The questions of Supply Chain Management are quite interesting if you intend to go and work in a large manufacturing firm. For the time being let's look at one crude ratio to evaluate the stock management efficiency : the stock turnover.
Stocks feed to COGS (Cost of Goods Sold). The shorter the goods or parts stay in stocks before going into products sold, the better. So we look at
Stock turnover = COGS / Stocks
and again, as usual, we shall take, for the denominator, the average stocks over the accounting period.
Stock turnover for 2003 = 470 / [ (100 + 130)/2 ] = 4,1
This means that the COGS are 4,1 times the average stocks. So, on average, goods to be sold remain in the stocks for just a little less than 3 months. To understand the reasoning, think of a store where all the flows of goods are stable : goods enter the stocks, and, using the FIFO method, they leave as they are sold. If we find that the stock value of the goods sold over one year is four time the stocks at any time, the goods must be staying in the stocks for three months.
Three months of stocks is usually considered a high figure. Of course it depends upon the activity of the firm.
Stock turnover for 2004 = 6,4
This is much better. Now the goods remain less than two months in stock. The firm reduced its stoks from 2003 to 2004.
Of course, the purchaser and the stock manager will have to carry out much finer analyses to see whether they efficiently manage the stocks of the firm (stock turnover per category of products, what turns what does not turn ?, how to get rid of old stocks ?, cost of keeping rare items vs cost of loosing a rare sale, etc.)
Debtor collection period
Client paper is also an important tool to run a firm. We extend credit to (good) clients, in order to have large sales. But we want to make sure our clients pay us. We don't want to carry in our accounts client paper which in fact will never be transformed into cash. (That is why, sometimes, we make provisions for bad clients, or even write-offs.)
A crude measure of the client account is to compare it with the sales. The reasoning is exactly the same as for the stocks. How long our sales remain as client paper, before they actually become cash in our till ?
So we shall compare the client account to the sales.
Debtor collection period = Clients / Sales
Here the sales relate to a period, and clients relates to a date. So, as usual, we shall average the Clients figure.
Debtor collection period for 2003 = [ ( 160 + 200 ) / 2 ] / 800 = 0,225. The unit of this figure is "years". The client paper represent 0,225 of a year, on average. If we want it expressed in days, we multiply be 365. And we obtain 82 days.
To understand well this figure of 82 days, think of a store where all the flows are steady, and all the sales are on credit. If the client account is 0,225 of the sales, then this means that the sales become IOU's for 22,5% of a year (82 days) before they are actually paid in cash by the clients.
For 2004, the Debtor collection period is 86 days : a slight deterioration over 2003. It is a signal that we should comb our client account and see whether we don't have bad clients hidden in it.
Creditor payment period
Just like we can analyse how well our clients pay us, we can analyse how well we pay our suppliers of goods to be sold.
Creditor payment period = Trade Creditors / Purchases
Trade Creditors is another term for Suppliers of goods to be sold. We don't want to include other creditors, like the state, or some accruals in our ratio.
Creditor payment period for 2003 = [ (80+50)/2 ] / 500 = 0,13 years = 47 days
Creditor payment period for 2004 = 0,18 years = 66 days
We see that we pay our trade creditors much better than our clients pay us. However, we increased our ratio from 2003 to 2004, which means that we are using better our "free credit".
(All these ratios are very crude. This one makes the assumption that the figures in the "Suppliers" line, in the liabilities, refer only to suppliers of goods to be resold, and that the investments into new assets are either paid cash or on a credit recorded elsewhere.)
These ratios are of interest to people in the stock market. They look at the performance of shares bought by people in the stock market. Remember that shares, once issued by the firm, are traded in the stock market, in the so called secondary market. They have a price which is not the issuing price. In our example, the issuing price of the shares was 300 €, some years before 2002. The market price of these shares is not necessarily (and usually is not) the issuing price. It may be, for instance, somewhere around 400 €.
It is too early, in this course, to study the investments ratios. But you may note that one of them, the Price Earning Ratio, is the market price of one share divided by the earning per share. In 2003, PER = 400 / 47 = 8,5.
PER are studied at great length by stock market analysts. More on this later.
In France, one customary way to get cash when we are short of cash and must make some payments, is to "discount" some good client paper. Here is what is meant by that : you go to your bank and ask it to give you money in exchange for some good client paper ; in the most favorable case, the bank will give you the face value of the client paper minus a discount which is equivalent to a financial charge. (In French : escompte d'effets de commerce.)
But it must be noted that this operation is nothing more than borrowing from the bank, providing as a guarantee (a collateral) some assets of the firm. It must also be noted that if the client, in the end, does not pay, the bank will ask the borrower to pay back the loan.
There are situations where the firm can sell its client paper to some external financial institution. (In French it is called "factoring".) Usually the discount on the face value is much bigger than in the case of a simple discount with a bank.
Finally, there was a law in France that enabled firms to borrow money from a bank, offering as a collateral only future invoices, for work already done but not yet billed, or not yet paid for, even without an IOU. This procedure was called in French "Dailly". Dailly lead to all sorts of accounting manipulations, and was mostly used by firms entangled in hopeless difficulties. And it did not eliminate the need for trust between the banker and the firm, which is really what we want to study in this course.