A business entity produces its financial statements at least once a year to satisfy relevant legal requirements. The income statement, the statement of financial position (otherwise known as the balance sheet), and the cash flow statement are prepared to provide a picture of a business's financial position and performance [1]. Apart from regulators, those statements are produced for different user groups, including current and potential investors, lenders, managers, competitors, tax and government authorities, or investment analysts… [2]. A seasoned financial analyst or investor would make sense out of a set of financial statements and be likely to determine and assess a company's performance along with some non-financial measures. Those may include the analysis of the quality and experience of management staff or the macroeconomic indicators (e.g., the prevalent rate of growth or unemployment, interest rates, or exchange rates), Those analysts would be likely to perform financial analysis, including some basic key performance indicators (KPIs), which we will cover in this article.
Key performance indicators can take different forms and have varying definitions. KPIs can be defined as a representation of a set of measures focusing on those aspects of organisational performance that are the most critical for the current and future success of the organisation [3]. Directors of all companies − except those businesses defined as 'small' by statute − are currently required by law to include a Business Review in their Directors' Report, which must include an analysis using financial key performance indicators. Section 414C (5) of The Companies Act 2006 (Strategic Report and Directors' Report) Regulations 2013 defines the key performance indicators as factors by reference to which the company's business's development, performance, or position can be measured effectively.
In this article, we discuss financial KPIs, which are, in fact, some basic financial ratios. They provide a quick and relatively simple means of assessing the financial health of a business [2]. Those ratios can be grouped into four categories: i) profitability; ii) efficiency; iii) liquidity; and iv) financial gearing.
Find the relevant ‘benchmark’
Financial ratios, i.e., key financial performance indicators, can indicate the degree of a firm’s success. However, it should never be analysed in isolation. Ratios should be compared with some ‘benchmark’ that the information can be interpreted and evaluated against. It may include a firm’s past performance or a comparative analysis of similar businesses for the same or past periods. A planned performance or budgeted performance can also be an essential factor in assessing a company’s financial performance. Most businesses will have specified their desirable gross profit and operating profit margins, or the amount of debt a company may be willing to take, which in turn can affect its gearing ratio or interest cover ratio. To illustrate the importance of a series of key performance indicators and comparing these, year-on-year, against a relevant ‘benchmark,’ please attempt to answer the question in Activity 1.
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Activity 1|
Can you tell which is the better business, i.e., the most successful (Firm A, Firm B, or Firm C) based on the figures in Table 1?
Table 1 . The income statement of Firm A, Firm B, and Firm C
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It is challenging to decide what is meant by better, only by looking at three unspecified businesses and their income statement for one fiscal year. From the figures in Table 1, we can assume that Firm A had the most significant sales revenue versus the two other companies. Nevertheless, its profit for the year was smaller compared with the Firm B whose revenue was, in fact, the smallest amongst all three companies. Each company might have different projections and expected profits. Each company might be in different industries. Each company might be at a different stage of development. Let us imagine that Firm B is a low-cost airline, while Firm C is a British restaurant operator. It would be fair to say that £136m of net profit may not be a bad outcome for a restaurant operator. However, we cannot say it for sure because we do not have information about the company's size, how many units/restaurants it owns, etc. On the other hand, a low-cost airline generating £150m of net profit may not be as impressive if we compare the figure with its competitors. For example, EasyJet plc recorded a net profit of £349m for the year-ended 30 September 2019.
We could go on with the list of potential factors that need to be considered when assessing a company's financial performance. In this article, we will use the past performance of the same company as the benchmark to interpret its overall financial performance. The company analysed in this article is a real company with actual figures reported for year-ended both in 2018 and 2019. We decided not to reveal its name to avoid any subjectivity and bias with assessing its financial performance.
| Company Profile|
Our company used for this analysis is a British non-fiction book publisher. It is an actual entity whose name has not been revealed to avoid subjectivity and bias when assessing its financial performance. Reported figures are for year-ended 31 December 2018 and 2019 (i.e., before the outbreak of the Covid-19 pandemic). For the purposes of this exercise, we shall name this firm Bookstar Ltd. Below in Table 2, Table 3, and Table 4 are the statement of financial position and the income statement needed for the analysis.
Table 2. The income statement
Table 3. The statement of financial position
Table 4. The statement of financial position CONTINUED
Profitability ratios
The primary financial objective of any commercial entity is to increase the wealth of its shareholders. Therefore, in the long term, profitability is one of the keys to success for any business. As a result, profitability ratios indicate the company’s efficiency at generating profits from available resources.
Gross profit margin
Gross profit measures how profitable the sales have been after deducting the cost of sales. In this case, it is the cost of raw materials and consumables. Some companies would report and highlight their gross profit on the income statement. In this exercise, the gross profit can, however, be easily obtained by deducting the cost of raw materials from the revenue, i.e.:
For the year to 31 October 2019, the gross profit margin ratio for Bookstar Ltd is (all figures in £ millions):
The gross profit margin of 52.9% in 2018 was slightly higher than the one a company achieved in 2019. The slight decrease of 1.0% in 2019 relative to 2018 may result from lower prices of goods and services sold to customers. On the other hand, the cost of sales to make physical books may have been slightly higher relative to the revenue generated, resulting in a lower gross profit margin achieved when comparing year-on-year figures.
Return on capital employed (ROCE)
Return on capital employed (ROCE) measures the efficiency and profitability of capital investments undertaken by a corporation. According to Atrill and McLaney (2019), the ROCE is a fundamental measure of business performance [4]:
The ratio expresses the relationship between the operating profit generating during a period and the average long-term capital invested in the business.
Our formula used the term operating profit, which other sources may refer to as EBIT (earnings before interest and taxation). The sum of share capital, reserves, and non-current liabilities is often called the capital employed. Thus, the ROCE formula can be alternatively presented as EBIT divided by capital employed multiplied by 100.
Operating profit margin
Operating profit margin is a ratio that reflects the percentage of profit a company produces from its operations before tax and interest charges are incurred. It is commonly the most appropriate measure of operational performance when making comparisons because it is not influenced by how a business is financed [2].
For the year to 31 October 2019, the operating profit margin for Bookstar Ltd is (all figures in £ millions):
Liquidity ratios
In financial markets (e.g., securities trading), liquidity refers to the ease with which an asset can be bought or sold without unduly affecting its price [5]. The term liquidity is a widely used concept in finance, though its understanding varies significantly. Liquidity tends to be easily recognised but not so easily defined [6]. It is, however, a fundamental concept in financial planning in any organisation. For example, an illiquid bank can rapidly become insolvent, and an insolvent bank illiquid [7]. According to Atrill and McLaney, liquidity ratios are concerned with the ability of the business to meet its short-term financial obligations.
Current ratio
The current ratio, otherwise known as the working-capital ratio, compares the value of current assets (i.e., cash and those assets that will soon be turned into cash) with the current liabilities. As with other measures, the current ratio will vary across different industries. However, the current ratio of 2:1 or ‘two times’ will be treated as ‘ideal.’ This means that an abnormally high current ratio may indicate that a company has tied up a significant amount of cash or cash equivalents, and are not productively used as they might otherwise be. On the other hand, a low ratio may imply a company’s diminishing ability to meet short-term (less than a year) financial obligations.
Acid test ratio
The acid test ratio is a similar measure to the current ratio. However, it excludes the value of inventories. As a result, the acid test ratio may be more suitable to apply for companies whose inventories cannot be easily converted into cash. It is, therefore, a more rigorous test of liquidity.
For the year to 31 October 2019, the acid test ratio for Bookstar Ltd is (all figures in £ millions):
Cash generated from operations to maturing obligations ratio
Cash generated from operations to maturing obligations ratio is commonly known as the operating cash flow ratio. It indicates a company's ability to pay off its current liabilities with the cash flow generated from its core business operations. Thus, it usually provides a more reliable guide to a business's liquidity than current assets specified on the balance sheet [2]. The cash generated from the operations is taken from the statement of cash flows.
Bookstar Ltd reported £480 million of cash generated from operating activities with a net value of £369 million after interest charges and taxes were paid.
For the year to 31 October 2019, the operating cash flow ratio for Bookstar Ltd is (all figures in £ millions):
The ratio indicates that Bookstar Ltd would not be able to fully cover its current liabilities at the end of the year (that is, only ¼ or 25% of current liabilities would be covered) with the cash generated from operations. As with other liquidity ratios, the higher the operating cash flow ratio, the better the business's liquidity.
Efficiency ratios
Atrill and McLaney (2018) suggest that efficiency ratios are used to determine how successfully a business manages various resources [1]. In this section, we will look at:
average inventories turnover period;
average collection period;
average payables period; and
sales revenue per employee.
Average inventories turnover period
This ratio is used to measure the average period for which inventories are being held. For many businesses, in particular manufacturers and some retailers, inventories may account for a substantial amount of the total assets held [2]. An efficient and resourceful company will aim at the lowest ratio possible, indicating the inventory is not excessively held, e.g., in the warehouse. The average inventories held are calculated as an average of the opening and closing inventories levels for the year.
For the year to 31 October 2019, the average inventories turnover period for Bookstar Ltd is (all figures in £ millions):
Average collection period
Trade receivables refer to the amounts owing to a business from customers for invoiced amounts. Atrill and McLaney claim that almost every business sells their goods and services on credit, except for retailers, and that trade receivables are an inevitable evil. Consequently, a business will be naturally concerned with the amount of funds tied up in trade receivables. In addition, the average settlement period for trade receivables indicates how long (on average) it takes customers to pay a business the invoiced amounts.
For the year to 31 October 2019, the average receivables period for Bookstar Ltd is (all figures in £ millions):
Average payables period
Trade payables refer to the amounts owed by a business to suppliers (e.g., for raw materials). Average payables period ratio measures how long, on average, the business takes to pay its suppliers for goods and services received on credit. Because the amount of credit purchases may not be available for people outside of the organisation, we can use a surrogate figure for purchases. In this case, it would be the ‘cost of sales’ figure available on the income statement.
For the year to 31 October 2019, the average payables period for Bookstar Ltd is (all figures in £ millions):
Sales revenue per employee
We live in times where robots and machines replace humans. As a result, companies constantly strive to find new ways to make their operations more efficient. Sales revenue per employee ratio measures the productivity of a company’s workforce. For many companies, labour costs are the most significant financial liability, and that naturally encourages employers to deploy their staff efficiently. For instance, Pearson plc’s wage and salaries expense equaled 32.5% of its total sales revenue in 2019.
For the year to 31 October 2019, the sales revenue per employee for Bookstar Ltd is:
Financial gearing
Gearing simply means borrowing money to invest. A highly geared or leveraged company is one that took on a significant amount of debt to finance its commercial activities. Financial gearing is a fundamental concept in the private equity sector. For example, in leveraged buyout transactions (LBO), debt finance typically amounts for between 60-90% of capital structure [8] or 50-80%, according to Poniachek (2019), while in some cases may be as high as 95%. Regardless of the sector or industry, every business will have a varying degree of acquired debt.
In some cases, it would be a loan or an overdraft taken out from a bank. In other instances, a company may borrow money from investors by issuing corporate bonds. Atrill and McLaney describe the financial gearing with the following passage:
Financial gearing occurs when a business is financed, at least in part, by borrowing rather than by owners’ equity. The extent to which a business is geared (that is, financed from borrowing) is an important factor in assessing risk. Borrowing involves taking on a commitment to pay interest charges and to make capital repayments. Where the borrowing is heavy, this can be a significant financial burden…
There are two widely used ratios to assess gearing:
gearing ratio; and
interest cover ratio.
Gearing ratio
This ratio measures the contribution of long-term debt to the long-term capital structure of a business [1]. In other words, it is the ratio of long-term debt funding to equity funding. High gearing raises the risk to all funders since it raises the probability of financial distress [9].
The long-term debt is often found in the statement of financial position under the headline of ‘the non-current liabilities. So, for example, Bookstar Ltd had long-term financial liabilities from borrowings equal to £1,572,000,000 or simply £1.57bn.
For the year to 31 October 2019, the gearing ratio for Bookstar Ltd is (all figures in £ millions):
Interest cover ratio
The interest cover ratio aims to determine whether the operating profit is sufficient to cover the interest due to the company lenders. In the case of Bookstar Ltd, the interest is classified as the finance costs made up of (note 6 to the financial statements):
interest payable on financial liabilities;
interest on lease liabilities;
net foreign exchange losses;
finance costs associated with transactions;
derivatives not in a hedge relationship; and
derivatives in a hedge relationship.
For the year to 31 October 2019, the interest cover ratio for Bookstar Ltd is (all figures in £ millions):
In few words, Bookstar’s operating profit can cover over three times its interest payable.
Bookstar Ltd: year-on-year performance
As aforementioned, financial ratios, i.e., key financial performance indicators, can indicate the degree of a firm’s success. However, those ratios should be compared with some ‘benchmark’ that the information can be interpreted and evaluated against. For this exercise, we will use the previous year (2018) of Bookstar Ltd as the benchmark to assess its financial performance. The compared figures are presented in Table 5 below:
Table 5. Comparison of Bookstars Ltd financial performance based on year-on-year figures using key performance indicators.
It is sometimes difficult to gauge the financial performance of a company based on its year-on-year financial figures. This is because each year, a company may operate in a different macroeconomic landscape, with varying interest or exchange rates, unemployment, etc. In addition, a company may face external challenges, such as a new competitor with disruptive services or products. Therefore, it is pretty standard that it may take some time for such a company to become more resilient and find a solution to ‘fight off’ those competitors.
In the case of Bookstar Ltd, the profitability ratios indicate the company produced less profit in 2019 than in 2018. The operating profit took a massive hit from £553m in 2018 down to £275m in 2019. Liquidity ratios slightly improved as the current assets increased while current liabilities have reduced. From the financial statements, we calculated that in 2019 it took almost two days more, on average, to turn the inventories over, while the average collection period of trade receivables increased by over 16 days. Bookstar Ltd has more than doubled its long-term debt resulting in a 13.7% increase in the gearing ratio. All in all, Table 5 suggests unfavourable financial performance with respect to the Year 2018, with most of the indicators being in ‘red.’
Nonetheless, it is essential to remember that the financial statements are based on historic transactions, and thus some figures may be subjective. That is why any area of concern should be subject to further investigation, while key performance indicators are often deployed to provide a quick, reliable, and relatively simple means of assessing the financial health of a business.
References
[1] McLaney, E., Atrill, P. (2018). Accounting and Finance: An Introduction, 9th edition. [ebook]. Pearson. Available at: https://www.perlego.com/book/811392/
[2] Garvie, C. (2019). Financial Decision-Making: Supporting textbook [ebook]. Pearson. Available at https://read.kortext.com/reader/pdf/340888/28
[3] David, P. (2007) Key Performance Indicators: Developing, Implementing, and Using Winning KPIs. John Wiley & Sons Publications.
[4] Atrill, P., McLaney, E. (2019). Financial Accounting for Decision Makers. 9th ed. [ebook] Pearson. Available at: https://www.perlego.com/book/955158/
[5] Moles, P., Terry, N. (1997). The Handbook of International Financial Terms. Oxford University Press
[6] O’Hara, M. (1997). Market Microstructure Theory. Blackwell, Maiden, Oxford.
[7] Goodhart, C. (2008). Liquidity Risk Management. London School of Economics.
[8] Arnold, G. (2012). Modern Financial Markets & Institutions. [ebook] Pearson. Available at: https://www.perlego.com/book/812030/modern-financial-markets-institutions-pdf
[9] Oxford (2016). A Dictionary of Finance and Banking. 6th ed. Oxford University Press: New York