Finance with a review of accounting

Ratios of performance

Go to a newer more detailed version of lessons 1 to 4

Acounting documents are used for comparison across firms, and across time
Remember that to evaluate the state and the performance of a firm we must look at its accounts over several years. And we have to make sure the accounts have been kept using the same methods, as the consistency rule stipulates. Otherwise, the final documents figures would not be comparable. But, if they have been established using the same rule, we can see how the firm evolves.

Syntheses. Ratios of performance
The year end documents - the IS and the BS - are a synthesis of what happened in the firm during a year, and what is its situation at the end of the year. Yet, they are still very rich with information, and cannot be interpreted quickly at a glance. So, we introduce various quick and dirty measurements of performance, which we shall compute for several years, and which will give us an even more synthetic view of the firm. These are the ratios of performance.

There are four categories of ratios :

1. profitability ratios
2. liquidity ratios
3. efficiency ratios
4. investment 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.

Profitability ratios

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
Going back to the example constructed in the first half of the lecture, let's start with the year 2003. As I said, the most meaningful measure of the "importance" of the firm is the CE (capital employed). It it the sum of the accounts recording what belongs to the shareholders (capital account and cumulated retained earnings) and the accounts recording what the firm owes to external agents and pays for it (bonds and bank borrowings).

The net worth
The capital account + the cumulated retained earnings = The net worth. It is indeed the value, in the books, of all the assets minus all the liabilities to external agents. If you buy, from somebody called A, something worth 650, but with the purchase comes an obligation to pay 280 to a third party called B, we can say that what you buy has a net value to you of 370. And that is what you should be willing to pay to A, because you will receive 650, but will have to pay 280. That is the idea of the Net Worth. For a firm, it is also called "the shareholders equity" or simply "the equity".

Net worth, and value of a firm
Of course, we shall see that the "value" of a firm is rarely simply equal to its equity - cf. eBay and Skype, for instance. This is one of the central questions of finance: what is the value of a firm?  We shall see that it depends to whom. But for the time being let's remember the definition of the Net worth.

Borrowings
The borrowings that cost money (bonds and bank borrowings) are, more or less, the same as long term debt, so, in this lecture, I will assimilate the two concepts.

Definition of the capital employed
Then, capital employed = equity + L.T. debt

(When there is no ambiguity, this is written : CE = E + D)

A measure of profit generated by the use of the capital employed
Secondly, the measure of profit generation related to this CE is the profit before interest and taxes. It would not make sense to use the net profit, because the net profit depends upon the structure of the CE, between Equity and Debt. More Debt and Less Equity will not change the CE, but will change the net profit. So if we want to see how much profit the CE produce (disregarding how they are made up) we must look at a measure of profit generation before interest ; and we also consider the profit before taxes, assuming that taxes are an artificial deduction by the state (this point can be debated).

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.
Most financial analysts will look first at this ratio (and its evolution over time) when they look at a firm. It is the most significant as far as the capacity to make the financial resources produce value.

Variations on the formula
There are some variations on the definition, depending on tastes. Some analysts will add yearly depreciation on top. Some will subtract taxes.

One more difficulty
There is also one difficulty : the profit relates to a period, the CE relates to a date. Which CE to use ? The CE varies in the course of the period.

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.

Use the average CE between the beginning and the end of the year
One solution is to use an average value as the denominator of the ROCE.

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
Whenever you compute an ROCE, make sure you explain explicitely which formula you 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.

Net Margin

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.

Liquidity ratios

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.

Efficiency ratios

We shall study three ratios : one related to stocks, one related to clients, and one related to suppliers.

Stock turnover

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.)

Investment ratios

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.

Discounting client paper

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.

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