Working capital management ratios – 4 in series of 6 on financial ratios
In this post, I’ll detail some ratios which can helps a business manage its working capital (working capital is current assets less current liabilities). A business can calculate a ratio for each of inventory, trade receivables, and trade payables which help interpret how well working capital is managed. In my previous post, I showed some ratios which help determine liquidity and solvency; with the ratios below, we have all elements of working capital covered (including cash) .
The first ratio is inventory turnover, which is calculated as follows:
Inventory turnover: Cost of sales
Average inventory
This ratio tells us how many times a year inventory is sold. You’ll notice the bottom line says “average inventory”, which might be a simple average of the inventory at the start of the year and the end of the year, or a rolling average. The reason for using an average is to try to remove seasonal variations.
The next ratio reflects how well trade receivables are managed:
Average period of credit given: Trade receivables x 365
Credit sales
This ratio tells how many days credit, on average, is given to customers. The top line is multiplied by 365 to give the answer in days. If you want it in months, multiply by 12 instead. If the period of credit given is getting longer, this could be problematic, as cash is not collected as fast by the business.
Now let’s see the average period of credit taken. This is very like the previous one, except it relates to suppliers. It is calculated as follows:
Average period of credit taken: Trade payables x 365
Credit purchases
One thing to note about this ratio is that it may not always be possible to obtain the credit purchases figure from published financial statements. The period of credit taken should not be too long either. If it is getting longer, it may be a sign of cash flow problems.
As in my previous posts, I’ll now calculate the above ratios using the figures from the 2010 annual report of Diageo plc.
The inventory turnover is: 4099 (3281+3078)/2 = (data from p.106/108) =1.2 times per annum. This means the company sells its inventory just over once per year. This probably seem really low if you think about how quickly beer and other alcohol sells in a retail sense. However, if we look at the detailed notes on inventory in the annual report, we can see that about 2/3 of the inventory is deemed “maturing” inventory.
The average period of credit given is: 1495 x365/9780 = 56 days (data from p.106/140). This seems a reasonable period of credit.
The average period of credit taken is: 843 X 365/4099 ) =75 days (data from p.106/148). Note that I am using the cost of sales figure as a substitute for the credit purchases figure – which is typically not available in published accounts. Again this figure seems reasonable and is longer than the period of credit given, which makes logical sense.
In summary from the figures above, the working capital of Diageo plc seems well managed.
Liquidity ratios – 3 in series of 6 on financial ratios
Your have probably heard the terms liquidity and solvency. Liquidity refers to the ability to convert assets to cash. For example, inventories may be more liquid (i.e. can be sold for cash quicker) than a non-current asset like a building. Solvency refers to the ability of a business to pay debts as they fall due. Liquidity and solvency are closely related concepts. If assets cannot be converted to cash, debts like loan repayments or payments to suppliers may not be met. To be unable to pay debts as they fall due means a business is insolvent, which can mean business failure. There are two useful ratios to help us assess the state of a businesses’ liquidity – the current ratio and the quick (or acid-test) ratio. The current ratio is:
Current ratio: Current assets
Current liabilities
The basic idea the current ratio is that for a company to be able to pay its debts as they fall due, current assets should cover current liabilities by a multiple. Generally a current ratio of at least 2:1 is good. This means that current assets are twice current liabilities. So, even if some stock could not be sold or some trade receivables not paid, current liabilities would still be covered for payment. However, the 2:1 figure is only a guideline. If we calculate the current ratio for Diageo plc for 2010 (from the statement of financial position on p. 108), we get:
6,952/3,944 = 1.76 : 1.
Although not 2:1, it should not be a major problem. Think about the type of business and the inventory it has – can you imagine Diageo having difficulty selling it’s stock of Guinness for example.
The Liquid ratio, and it is calculated as follows:
Liquid ratio: Current assets – inventory
Current liabilities
This ratio is also called the Quick ratio or the Acid Test ratio. It is very similar to the Current ratio, except that inventory is deducted from current assets. This is because inventory is typically regarded as being the least liquid current asset. Often the yardstick for the Liquidity ratio is 1:1, but this depends on the type of business. For example, large retailers may have relatively low stock and almost no receivables, which will skew the figure well below zero if we assume suppliers give credit.
If we calculate the current ratio for Diageo plc for 2010 (from the statement of financial position on p. 108), we get:
6,952-3,281/3,944 = 1.12 : 1
The Current and Liquid ratios serve as useful indicators of the liquidity/solvency or a business. However, as with other ratios, the trend over time is important. Any business may face short-term liquidity problems which could skew either of the above ratios. Short-term liquidity problems may arise if, for example, customers are slow to pay or inventories can’t be sold. Such problems are normally overcome through the management of inventory and receivables, which I’ll deal with in the next post.
(Image above from withfriendship.com)
Gross Profit Margin – 2 of 6 in series on financial ratios
Let’s now look at a second useful profitability ratio (see the previous post also). The Gross Profit Margin is a simple ratio which shows the percentage profit made on sales before deducting business expenses. It is calculated as follows:
Gross Profit x 100
Sales
The Gross Profit Margin will vary by business sector. For example, some businesses/sectors may make quite a large Gross Profit Margin on each, but have lots of overheads to pay e.g. the hospitality sector, like pubs and clubs. Other sectors may have a much lower figure. The Gross Profit Margin is usually closely watched by business owners in particular. If you remember that Gross Profit is Sales less Cost of Sales, and Cost of Sales in turn includes opening/closing inventories and purchases. With any abnormal changes in these figures the Gross Profit Margin will change.It might be something simple like an increased purchase price which has not yet been passed on to customers through a price increase, or it could be something more sinister like theft or stock or unrecorded sales.
As in the last post, let’s use the accounts of Diageo plc as an example. Based on their 2010 Income Statement (p.106 of the annual report), the Gross Profit Margin is;
5681 x 100 = 57.5%
9870
If you do the same figure for 2009 it’s 58.1%, which is in a similar range. Most business managers will know what their average Gross Profit Margin is. Although the Diageo figure seems high, there are lost of expenses to be paid out of the Gross Profit. You can also calculate a Net Profit Margin, which use the Net Profit before tax instead of Gross Profit in the above formula. This is not as useful as the business expenses tend to be more variable from year to year, although it is still widely used.
Return on capital employed – 1 of 6 in series on financial ratios
This is the first in a series of seven posts looking at some common ratios used to analyse financial statements.
The Return on Capital Employed (ROCE) ratio is defined as follows
Operating profit before interest x 100
Capital employed
Capital employed is the amount of money (capital) which is invested (employed) in a business. It can be calculated from the balance sheet (statement of financial position) as total equity plus non-current liabilities or total assets (current and non-current) less current liabilities.
There is a potential problem with the ROCE, which is what capital employed figure to use in the calculation. Normally, the year end figure is used, but might be higher than the capital employed at the beginning of the year. Some companies use a simple average figure, taking the average of the capital employed at the start and end of the year. Others use a rolling average, which might be best in a highly seasonal business. Whatever capital employed figure is used is a matter of judgement for the business. The important thing is to be consistent from one year to another with the calculations.
The ROCE tells us the return made on capital employed before any distributions of profits (e.g. taxation, dividends or interest). It can be compared to risk free returns like putting money on deposit. Normally anyone investing in a company would expect a reasonable return – approximately 15% – or more if the business is seen as risky.
As an example, you can get the 2010 annual report of Diageo ( owner of brand such as Guinness, Bailey’s and Bushmills) here. If I look at the income statement (p.106), I can see a profit before interest of £2,574m. Looking at the statement of financial position (balance sheet) (p.108), I can work out capital employed as total equity (£4,786m) plus borrowings from non-current liabilities (£8,177m) – I am keeping it simple and ignoring other non-current liabilities. This would give an ROCE as follows:
2,574 x 100
4,786+8,177
This equals 19.9%, which is quite a good return.
Using ratio analysis – an introduction
Over the coming weeks, I’ll be writing a number of posts on using ratios to analyse financial statements. First though, let me give an outline of what ratio analysis is about.
If you want to compare the financial statements on a business from one year to another, or, compare two businesses you cannot use direct comparisons of figures. Here’s a simple example:
Company A has a profit in 2010 of €1m according to its income statement. Company B has a profit of €5m. Which company is the most profitable?
You’re probably thinking Company B, as its profit is five times that of Company A. However, this comparison is mis-leading. Now let’s assume Company A has capital of €2m, but Company B has capital of €25m. Now we can do a quick calculation as follows::
Return on investment Company A €1m/€2m = 50%
Return in investment Company B €5m/€25m – 20%.
Looking at the figures this way, we can see that Company A actually manages to make 2.5 times the return of Company B. This simple shows one problem of compare raw numbers, that is scale. However if we use financial ratios, which express figures in relative terms, we are able to make more direct comparisons between businesses. Over the next few weeks, I ‘ll be writing a number of posts detailing some individual ratios, so keep an eye out. By the way, if you already know how to do ratios and/or want your accounts analysed, here’s a great website where you can plug in your data for a free analysis.
More responsive corporate reporting?
CIMA’s e-zine (June, 2011) suggests a more responsive corporate reporting system is need for organisations. The report by CIMA, PwC and a think-tank called Tomorrow’s Company suggests that an evolving reporting system is necessary to reduce risk within organisations and meet the changing needs to both organisations and society. From from brief reading of the report, a central argument seems to be that the traditional (and incumbent) corporate reporting system is still primarily aimed at the providers of capital. Other elements or reporting have been appended on to this system e.g. environmental reporting, rather than the full reporting system itself called into question. You may ask why change what is currently there. I’m not sure this is the definite answer, but changes in technology, the business environment and business risk (to mention but a few) have been arguably more drastic in the past 20 years than the previous 100 years.
The report argues that a new corporate reporting systems needs to have six characteristics, which I summarise below. It argues that if these are incorporated within internal reporting and management processes, the external reporting will likewise improve.
- Encourage innovation and change. This should allow a reporting system to respond effectively to shifts in the business environment.
- Balance judgement and compliance i.e. go beyond compliance reporting solely. What information is needed as a basis for good decisions.
- Focus more on long-term value, by more integrated management and external reporting.
- Make reporting accessible, timely and relevant.
- Give shareholder and investors more information in long term sustainability and value creating capabilities.
- Ensure some balances and checks are incorporated into the overall reporting system and make someone responsible for this.
Banning F1 – does it make sense (environmentally and on cost)?
I was in Germany a few months ago and seen a copy of Handelsblatt (a leading business newspaper) on July 20th last at a hotel bar. As you do, I scanned it while ordering a local beer (Moritz Fiege Pils). I noticed that the German Green Party wanted to ban F1 from the Nurburgring and Hockenheim. I read the article and it made me laugh to be honest. The reasoning was that the F1 circus is bad on CO2 emissions and all that stuff. Now a few facts first – I love motor sport, I am a management accountant, I like the old ways of doing things (now called environmentally friendly/recycling/grow-your-own) and I could not resist the picture of the F1 girls for this post.
But, being serious. Research and development expenditure is one of those things a management accountants might find hard to deal with. It’s normally a substantial cost, but the return is often uncertain. Now back to F1 and the German Greens. Motor manufacturers like Mercedes, Honda and Renault (among others) have over time spend $billions on F1. And what do they get out of it? Well, every car nowadays has an EMU (Engine Management Unit) or “brain” that controls and monitors every thing a car does – do you know most cars have no accelerator cables at all; it’s a sensor on the pedal which the EMU monitors and the pedal is tensioned to give the feeling of a traditional pedal. Where was this technology perfected? F1 of course. And nowadays, F1 cars are lighter, faster, more fuel-efficient and even capture energy under braking (the KERS system). Surely this will pass on eventually to normal road cars, which will mean lower fuel consumption and lower CO2 emissions and so on. So, to bring it all back to management accounting. If we were to do as the German Green Party suggests, there would be no F1 in Germany (home of Mercedes), which might mean less research and development expenditure in F1, which in turn might halt the development of more fuel and energy-efficient road cars for you and I. Okay, it might be hard to put a money value on the benefits of F1 research and development in the long run, but it seems daft to try to ban it. So far, the history of F1 has shown us what the cars of tomorrow will have on board. If that means efficient, energy harnessing cars for the future, we need to encourage it. The costs (monetary and environmentally) may be easier to ascertain and outweigh the benefits in the short-term. However, I can only see future benefits from F1 for car manufacturers who should be able to produce (in time), better, safer and more environmentally friendly cars for Joe Bloggs. Kind of goes against what I thought any Green Party stands for to go against such progress. But, hey I am no politician! But it seems a classic case (from the Green’s view) of not looking at all costs and benefits of an activity over the long term.
Liquidity issues – Apple has more cash than the United States
I read a new report on the BBC iPhone app this morning and just had to write about it. Over the coming months I will be writing a series of posts on analysing businesses. One area I’ll cover is liquidity and solvency. Liquidity is the ability to turn assets into cash, while solvency is the ability to pay debts as they fall due. Now, we have been hearing quite a lot about some European countries and the US having debt problems. Things really come to a head when those debts cannot be repaid, and to repay them, you need cash. According to the report by the BBC, Apple Inc had $76 billion in liquid resources (cash and other assets easily converted to cash) according to its most recent accounts. The report puts the liquid resources of the US $73 billion. When I read this I started to understand why it is so important for the US to raise more cash – hence the need to raise it’s borrowing limit. If the US were a small business, there’s a good chance it would be gone by now, as it would have little cash and no way to raise more. Watch out for more posts on business analysis soon. In these posts I’ll write about some common ways to evaluate and analyse how a business is doing.
Just in case or just-in-time?
Just-in-time is a management concept originating from Japan. The basic idea is that everything happens “just-in-time”; materials and supplies arrive just in time for production to start, and production finishes just in time for the customer to take it. With not much room of error, if a supplier fails to deliver goods on time production is disrupted and may even cease. Normally companies that use the just-in-time philosophy have close supplier relationships and tend not to run into supply problems. The savings from reduced inventory levels are obvious. Recent events in Japan however have raised issues about how tight things can get with just-in-time. A disastrous earthquake/tsunami in March this year left parts of Japan’s east cost in ruins. Factories were destroyed and power supplies disrupted for months. An article in The Economist (March 31, 2011) mentions how global firms are re-thinking how the manage production following events in Japan. According to the article, one company that controls 90% of the market for a resin is in smartphones had ceased production. Another company which supplies 70% of the global supply of a polymer used in iPod batteries is also out of action. And, car manufacturers in Japan and America have had to cut back on production as parts are in short supply. The events in Japan have prompted some commentators to say a “just-in-case” systems is also needed, according to the Economist.
Key metrics for your small business
In management accounting, we often talk about Key Performance Indicators (or KPI). These are measures of business performance which catch the essence of how a business is doing. Choosing the right KPI is not an easy task, even for a business with accountants on the payroll. This leaves it tough on smaller businesses, who probably have little expertise in this area. Having said that, there are a number of key things you might focus on as a small business.
The first is cash, without it you are snookered. Accountants often refer to liquidity issues, meaning a business cannot generate enough cash. Liquidity issues lead to solvency problems, meaning you can’t pay debts as they fall due. Traditionally, accountants will tell you need the ratio of cash and receivables to payables to be about 1:1. To make this sort of metric even easier, why not think about it like this:
Cash in the bank/Monthly cash requirements = number of months until cash runs out.
You could easily work this measure out at any time and try to collect debts from customers before you run out of cash. If you have a bank overdraft which is within its limit, you could quickly alter the above to figure out how long until you hit the overdraft limit.
A second key metric is your cost structure. You could regularly compare you costs as a portion of sales revenue. Keeping a tab on this might help prevent cost overruns over a period of time. So if you see sales drop off, are costs remaining the same?
Finally, think beyond the traditional financial measures. Try to think of what it is that keeps your business ticking over. The key metric(s) here will vary by business but you should consider things like:
- number of new sales enquiries
- number of customer complaints
- how efficient is your production and/or purchasing
- what’s your market share.
- sales revenue by customer/product or segment
Brand valuation standard sets challenge to finance
CIMA’s Insight e-zine from November 2010 (here) reports on a recent ISO standard which give guidelines on attributing a monetary value to brands. Under international accounting standards (IFRS3 in particular) brands are normally only valued when acquired as part of a new business (i.e. only when bought). According the CIMA piece, the new ISO standard suggests three well-known methods for valuing brands:
- Income approach: the objective of the income approach is to calculate the after-tax, present value of future cash flows attributable to the brand. These cash flows are the difference between the cash flows generated by the business with and without the brand. The standard outlines six key ways of doing this: the price premium, volume premium, income split, multi period excess earnings, incremental cash flow and royalty relief methods.
- Market approach: this methodology compares the brand with comparable transactions, looking at acquisition ratios that can be adjusted to consider the similarity of brand strength, goods and services or economic and legal situation.
- Cost approach: the cost approach calculates the amount invested in creating the brand and the cost of recreating it.
Reading an income statement
This is the first of three posts which give you a quick guide to reading the three key financial statements – the income statement, balance sheet and statement of cash flows. This post deals with the income statement, with the other two coming over the next few weeks.
The Income Statement
An income statement presents the results of a company’s operations for a given period—usually a year. The income statement presents a summary of the revenues, expenses, profit or loss of an entity for the period. This statement is similar to a moving picture of the entity’s operations during the time period specified. Along with the balance sheet and the statement of cash flows, the income statement is one of the primary means of reporting financial performance. The key item listed on the income statement is the profit or loss.
Within the income statement there’s a good bit of information. If you’re knowledgeable about reading financial statements, in a company’s income statement you’ll find information about return on investment, risk, financial flexibility, and operating capabilities.
The current view of the income statement (in line with International Financial Reporting Standards (IFRS)) is that income should reflect all items of profit and loss recognised during the accounting period. The following summary income statement illustrates the format under IAS 1 – Presentation of Financial Statements (image from http://www.accaglobal.com):
This example above is fairly typical of the income statement of a large public company. I’ll explain some items below.
Some terms on the income statement explained
Revenue
According to the IASB’s IAS 18, revenue is defined as “the gross inflow of economic benefits (cash, receivables, other assets) arising from the ordinary operating activities of an entity (such as sales of goods, sales of services, interest, royalties, and dividends)”. This means that revenue is typically the figure for sales of goods or provision of services for the period of the income statement.
Cost of sales.
The cost of sales figure includes all expenses incurred in buying to making the product or service which generates revenue.
Other Income
This is income from sources like interest or investment income.
Expenses
Expenses are classified as either distribution cost, administrative expenses, other expenses or finance costs. No further detail is needed.
Share of profit of associates
This figure is the share of the profits made in an associate company – one where 20-49% is owned by the company (or group of companies) the income statement is prepared for.
The final item in the example above represents a loss made in a section of a business which is discontinued. This separate disclosure is required by accounting standards. Additionally, IAS1 also requires a short statement of comprehensive income, which shows unrealised gains (like unrealised asset revaluations, or currency gains/loses on translation). I don’t include it here, but it is usually no more than a few lines.
Determining the value of your business: recasting the income statement
Valuing your business is something you’ll need to do if you’re about to sell it off. There are several ways to value a business, but the most reliable methods are based on cash-flows rather than profits. Here’s a piece from the You’re the Boss blog in the NY Times which gives a good example of one cash flow based method. The method uses the income statement/profit & loss account as a starting point to work out what’s often termed the owners’ cash flow. This is turn is`often combined with a multiplier (e.g. a number of years) to derive a value for a business.
How do you measure your business performance? Ideas for small businesses
Measuring performance of any kind means a target, plan or standard must be in place to measure against. Any business, large or small needs some kind of a plan. In the accounting world plans equals budgets – yes those annoying things! A budget is plan expressed in money terms. Usually budgets for incomes and expenditures are set for a year and each month the business performance is measured against the budget. This is common practice in many businesses but how useful the comparison of results versus budget is depends on how good the budget was in the first place. Should a business complement measuring against budgets with other types of performance indicators? Yes is the answer. Larger businesses use many indicators of performance other than comparing to budgets or profits. For example, a key performance indicator for an airline is”bums on seats”. This is something that can be measured by flight, day etc and related to the costs of running the airline. Could a small business do something similar? Sure it can. Here’s an example for a business I know, Priority Engineering (www.priorityengineering.ie), who automate entrances gates for residential and business customers. This business both offers both installation and maintenance services. As a small business, the owner does not have time to do detailed plans and compare these to actual performance. But, he does know the costs of running the business. So he equates these costs to a number or service calls or installations needed per week. This is much easier to track and relates the work done to performance in terms of covering costs. So what performance indicator would you use for your business?
How to track the “Critical Numbers” in your business
I read an article recently from Inc Magazine -“How to Track Your Company’s Critical Numbers” – which a useful piece on how to watch the key numbers in your business. The article emphasises the need to achieve a balance between having a good accountant, and not being too reliant on them at the same time. You don’t need to be an accountant yourself to keep a track on key figures and ratios in your business.
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