Evaluating financial performance, position and strategies

A set of accounts is a pile of numbers. Ratios turn it into a story: is the company earning enough on what it uses, collecting cash fast enough, borrowing too much? One year’s ratio means little alone. Compared with last year, with competitors and with the industry, it shows direction.

And before the board backs a strategy, three questions decide whether it is sound: does it fit, will people accept it, can it be done?

This topic covers ratios for financial performance (return on capital employed, profit margins, asset turnover), working capital efficiency and the cash operating cycle, liquidity, gearing and interest cover, investor ratios, reading the cash flow statement, and the suitability, acceptability and feasibility test of a strategy. The previous topic covered forecast statements. The next covers corporate failure. Neither the May 2014 nor the November 2014 Pathfinder sets a stand-alone question on ratio analysis.

Key terms in plain English

Syllabus check

This topic is in syllabus area B (business analysis). It covers:

• calculating and interpreting ROCE, profitability, working capital, liquidity, debt and gearing ratios;
• analysing performance from information given;
• using the suitability, feasibility and acceptability framework.

CAMA 2020 and financial reporting

The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria.

Using ratios

Financial statements allow an evaluation of past performance (for example whether a company is a good takeover target), provide inputs to valuation and support forecasts. Revenue and cost information in the statement of profit or loss is often a proxy for cash flow, since profit and cash balance out over time.

Ratios compare: within the statements (revenue up 10%, so gross profit should rise similarly); over time (trends); with similar companies; and with projections. The five groups: financial performance, working capital, liquidity, debt and investor ratios.

Performance ratios

ROCE = profit before interest and tax ÷ (share capital and reserves + long-term debt + preference shares), using average capital employed where possible. ICAN’s Company X: profit before tax ₦210,000 plus interest ₦30,000 gives ₦240,000. Capital employed was ₦1,000,000 at the start and ₦1,400,000 at the end, so the average is ₦1,200,000. ROCE = 20%.

ROCE depends on profitability and asset utilisation: ROCE = profit ÷ sales × sales ÷ capital employed. With sales of ₦5,800,000, the margin is 240,000 ÷ 5,800,000 = 4.14% and asset turnover is 5,800,000 ÷ 1,200,000 = 4.83 times; 4.14% × 4.83 = 20%. Use the same definition of profit when comparing years. A high gross margin with a low net margin points to heavy overheads. Also watch each cost as a percentage of sales and the percentage growth in sales (5,800,000 against 5,500,000 is 5.45%).

Working capital efficiency

• Receivable days = receivables ÷ sales × 365. Long periods suggest weak collection.
• Inventory days = inventory ÷ cost of sales × 365.
• Payable days = payables ÷ purchases (or cost of sales) × 365.

Use averages in principle (year-end figures are common in exams). Too much working capital (a long, lengthening cycle) depresses ROCE; too little points to liquidity risk, with current assets financed by trade payables or an overdraft. ICAN’s Company Y: sales ₦3,000,000, cost of sales ₦1,800,000. Receivables averaged ₦435,000, so 52.9 days; inventory averaged ₦330,000, so 66.9 days; payables averaged ₦165,000, so 33.5 days.

The cash operating cycle = inventory days + receivable days − payable days. ICAN’s example: sales ₦1.2m, cost of sales ₦1.0m, inventory ₦250,000 (91 days), receivables ₦400,000 (122 days), payables ₦166,667 (61 days). Cycle = 91 + 122 − 61 = 152 days.

Liquidity, gearing and investor ratios

• Current ratio = current assets ÷ current liabilities. There is no ideal of 2:1; judge against trend, competitors and the industry.
• Quick ratio = (current assets − inventory) ÷ current liabilities. Better when inventory turns slowly.
• Gearing = long-term debt ÷ equity (debt to equity) or long-term debt ÷ (equity + debt). High gearing may make new borrowing difficult and raises the risk of failing to meet payments.
• Interest cover = PBIT ÷ interest. Under about 3 times is considered low. ICAN’s Company Z: debt ₦1,500k, equity ₦3,600k, PBIT ₦700k, interest ₦230k.
  Debt to equity = 41.7%
  interest cover = 3.04 times.
• EPS = profit attributable to ordinary shareholders ÷ weighted average shares.
• P/E = share price ÷ EPS. A high P/E signals confidence in growth; a low one suggests poor prospects.

Reading the cash flow statement

• Cash from operations against profit: much lower cash than profit, with big rises in inventory, receivables or payables, suggests rapid expansion absorbing cash or poor working capital control.
• Interest, tax and dividends: are they covered by operating cash? Interest and tax must be paid; the equity dividend need not be.
• Investing: large capital spending is usually a good sign, but not if funded by an overdraft.
• Financing: shares or borrowing? Can new interest be met, and when must debt be repaid?
• Change in cash: a fall is not necessarily bad; a huge cash balance is not necessarily good if it could earn more elsewhere. Consider tax, interest, dividends, expansion and debt due within a year.

Evaluating a strategy

Johnson and Scholes suggest judging a strategy by: suitability (does it address the strategic requirements, given the circumstances?), acceptability (is it acceptable to significant stakeholders?) and feasibility (is it practical?). The financial analysis sits within acceptability and feasibility.

Management will reject a strategy with low expected returns or high risk for the return; investors may reject one needing much new finance; employees and investors may reject one they see as unethical. Even a suitable strategy should not go ahead if the financial return is too low or it can only be done at a loss.

An example is to show the effect of raising ₦100,000 by shares or debt on ROCE, EPS and gearing, as in the topic on forecasts.

The rules in more depth

Why average capital employed

Profit is earned over the year, while capital may change during it. An average matches them better.

Why a ratio alone says little

It needs a benchmark: past results, competitors or the industry.

Why profit and cash differ

Timing: sales on credit, inventory build-up and payables all move cash and profit apart.

Why gearing matters

Debt has fixed claims. A fall in profit can threaten the ability to pay.

Effect on analysis

Compute, compare, explain the cause, say what it means and recommend.

Worked examples

1. Average capital employed = ₦900m
   ROCE = 180 ÷ 900 = 20%.
2. Margin = 180 ÷ 3,600 = 5%.
3. Asset turnover.
   3,600 ÷ 900 = 4.0 times (5% × 4.0 = 20%).

1. Current ratio.
   600 ÷ 400 = 1.5.
2. Quick ratio.
   (600 − 200) ÷ 400 = 1.0.
3. Compare with the industry before judging.

1. Interest cover.
   180 ÷ 45 = 4.0 times.
2. Debt to equity.
   500 ÷ 800 = 62.5%.
3. Gearing = 500 ÷ 1,300 = 38.5%.

1. P/E = 24 ÷ 2.00.
2. P/E = 12.
3. Investors pay 12 years of current earnings.

How to score full marks

• State each formula and the profit definition used.
• Compare with the previous year and a benchmark.
• Explain the cause of each movement.
• Link profitability, working capital and gearing.
• Use the three tests for strategies.
• Conclude with a recommendation.

Common mistakes in the exam

• Using profit after interest in ROCE.
• Mixing year-end and average figures.
• Using sales for inventory days.
• Describing without explaining.
• Stating an “ideal” ratio for every industry.
• Ignoring the cash flow statement.

Quick revision

• ROCE = PBIT ÷ capital employed = margin × turnover.
• Days: receivables on sales, inventory and payables on cost of sales; cycle = inventory + receivables − payables.
• Current ratio; quick ratio.
• Gearing; interest cover below about 3 is low.
• EPS and P/E.
• Strategy: suitability, acceptability, feasibility.
• CAMA 2020: ss. 305, 308, 377(1), 378, 385.

Practice questions

These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer. Full model answers follow the written questions.

Recall check: multiple choice

Recent ICAN papers are written, although older papers such as May 2014 included multiple-choice questions. These questions are for quick recall. The written questions that follow are closer to the exam.

Written questions

Model answers

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