Financial and non-financial measures - Profitability, liquid...

Learning Outcomes

By studying this article, you will be able to explain and calculate key financial performance ratios including profitability, liquidity, efficiency, and gearing ratios. You will understand the purpose of each, interpret their values, and identify how non-financial measures complement financial analysis. You will also be able to assess business performance from multiple viewpoints and prepare for related questions in the ACCA exam.

ACCA Management Accounting (MA) Syllabus

For ACCA Management Accounting (MA), you are required to understand how to measure and interpret financial and non-financial organisational performance. This article will help you revise the following syllabus areas:

• Discuss and calculate measures of financial performance (profitability, liquidity, efficiency and gearing ratios) and non-financial measures
• Explain the purpose of profitability, liquidity, efficiency and risk (gearing) ratios
• Interpret the results of key ratios and explain their significance to management and stakeholders
• Discuss the limitations of relying solely on financial indicators and the role of non-financial measures in performance assessment
• Describe performance indicators for service and manufacturing businesses, as well as public sector and non-profit organisations

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which ratio measures the ability of an entity to meet its short-term obligations?
   1. Gross profit margin
   2. Acid test ratio
   3. Receivables turnover
   4. Capital gearing
2. A company’s return on capital employed has increased, but its sales revenue has remained static. Which factor could explain the improvement?
   1. Decreased efficiency in inventory management
   2. Increase in non-current liabilities
   3. Decrease in operating costs
   4. Extended payables period

3. Define the term "gearing" and give one reason why high gearing might concern potential investors.

4. True or False? The receivables collection period is a measure of profitability.

5. Name two non-financial indicators that could be used to assess the performance of a service business.

Introduction

Assessing an organisation’s performance requires more than simply reviewing revenue and profit figures. To provide meaningful analysis, businesses use a range of financial ratios—including profitability, liquidity, efficiency, and gearing ratios—as well as non-financial performance measures.

Together, these indicators help management and stakeholders understand not only how profitable an organisation is, but also its cash position, operational effectiveness, risk profile, and general sustainability. This article sets out the purpose, calculation and interpretation of key financial and non-financial measures and explains their value and limitations in performance evaluation.

Key Term: Ratio Analysis
The process of calculating, interpreting and comparing financial ratios to evaluate aspects of a business’s performance or financial health.

FINANCIAL PERFORMANCE RATIOS

Financial ratios are critical for comparing and understanding performance from different viewpoints. They commonly fall into four main categories: profitability, liquidity, efficiency, and gearing (risk).

Profitability Ratios

Profitability ratios indicate how well a business turns revenue into profit. They are important to shareholders, management, and potential investors as they show the return achieved for the resources used.

Key Term: Profitability Ratio
Any ratio that measures the ability of a business to generate profit from its resources and operations.

Common Profitability Ratios

• Gross Profit Margin = (Gross Profit / Revenue) × 100
  Shows gross profit as a proportion of sales.

• Operating Profit Margin = (Operating Profit / Revenue) × 100
  Indicates operating profit (before interest and tax) as a percentage of revenue.

• Return on Capital Employed (ROCE) = (Operating Profit / Capital Employed) × 100
  Measures efficiency in using company capital to generate profit.

• Return on Sales (Operating Margin) = (Operating Profit / Revenue) × 100
  Shows profit level per dollar of sales made.

Key Term: Capital Employed
Total equity plus non-current liabilities or, equivalently, total assets less current liabilities.

Interpretation

A higher margin means a greater proportion of sales is retained as profit. Declining profitability is a warning sign, often caused by rising costs, static or falling sales prices, or both.

Worked Example 1.1

Company X has the following for the year: Revenue $800,000, Gross Profit $200,000, Operating Profit $80,000, Capital Employed $900,000. Calculate the Gross Profit Margin and ROCE.

Answer:
Gross Profit Margin = ($200,000 / $800,000) × 100 = 25%
ROCE = ($80,000 / $900,000) × 100 = 8.89%

Liquidity Ratios

Liquidity ratios measure the business’s ability to pay its short-term debts as they fall due. They indicate whether the company has enough resources to meet immediate obligations.

Key Term: Liquidity Ratio
Any ratio that assesses a business’s ability to settle short-term liabilities from its current assets.

Current Ratio

Current Ratio = Current Assets / Current Liabilities
Values above 1 indicate likely ability to pay debts. A very high figure may suggest excess cash or asset holdings.

Quick Ratio (Acid Test)

Quick Ratio = (Current Assets – Inventory) / Current Liabilities
By excluding inventory, this ratio assesses the most liquid assets. Often, a value above 1 is regarded as prudent.

Key Term: Acid Test Ratio
The ratio of a business’s most liquid current assets (excluding inventory) to its current liabilities.

Worked Example 1.2

A company has Current Assets of $120,000, Inventory of $30,000, Current Liabilities of $80,000. Calculate the Current and Quick Ratios.

Answer:
Current Ratio = $120,000 ÷ $80,000 = 1.5
Quick Ratio = ($120,000 – $30,000) ÷ $80,000 = $90,000 ÷ $80,000 = 1.125

Efficiency Ratios

Efficiency ratios show how well the organisation manages its assets and working capital. They focus on inventory, receivables, and payables.

Key Term: Efficiency Ratio
A measure of how effectively a business utilises its assets and resources.

Key Efficiency Ratios

• Inventory Days (Holding Period) = (Inventory / Cost of Sales) × 365
  Measures the average days inventory is held before being sold.

• Receivables Days (Collection Period) = (Receivables / Credit Sales) × 365
  Indicates how quickly customers pay.

• Payables Days (Payment Period) = (Payables / Credit Purchases or Cost of Sales) × 365
  Shows how long on average the business takes to pay suppliers.

Lower inventory or receivable days may reflect good management, but numbers far below industry norms may affect relationships or signal aggressive practices.

Worked Example 1.3

If a business has $50,000 inventory, $15,000 trade receivables, $12,000 trade payables, annual cost of sales $200,000, credit sales $180,000, and credit purchases $160,000, what are inventory, receivables, and payables days?

Answer:
Inventory Days = ($50,000 / $200,000) × 365 = 91.25 days
Receivables Days = ($15,000 / $180,000) × 365 = 30.4 days
Payables Days = ($12,000 / $160,000) × 365 = 27.4 days

Gearing Ratios

Gearing (also called debt gearing) measures the degree to which a business is financed by debt rather than equity. It is important for assessing long-term financial stability and risk.

Key Term: Gearing
The proportion of a company’s capital that comes from debt rather than shareholders’ equity.

Common Gearing Ratios

• Capital Gearing Ratio = (Non-current Liabilities) / (Equity + Non-current Liabilities) × 100
  Higher values suggest greater financial risk.

• Interest Cover = (Operating Profit / Finance Costs)
  Shows how many times profits can cover interest payments. Low interest cover represents greater risk.

Worked Example 1.4

Company Y has $300,000 in non-current liabilities, $700,000 equity, and $40,000 operating profit with $8,000 finance costs. Calculate capital gearing and interest cover.

Answer:
Capital Gearing = ($300,000 / $1,000,000) × 100 = 30%
Interest Cover = $40,000 ÷ $8,000 = 5 times

Exam Warning

Remember, a high gearing ratio means greater financial risk, particularly if profits fall or interest rates rise.

NON-FINANCIAL PERFORMANCE MEASURES

Financial ratios are important but not sufficient for a complete view of performance. Non-financial measures capture other factors affecting long-term value, efficiency, and customer satisfaction.

Examples of Non-financial Measures

• Customer complaints, repeat business, and satisfaction scores
• Product and service quality metrics (e.g., defects, delivery times)
• Employee turnover, morale, and training levels
• Environmental impact measures
• Innovation, such as new product launches

Key Term: Non-financial Performance Indicator
Any quantitative or qualitative measure that evaluates performance aspects not directly reflected in financial statements.

Non-financial measures are particularly useful where financial data is insufficient—for example, in service industries or for public sector and non-profit organisations. They also help balance short-term and long-term decision making.

Revision Tip

In the exam, demonstrate an understanding that good performance management requires both financial and non-financial measures, as each provides different but supportive information.

USING RATIOS: STRENGTHS AND LIMITATIONS

Interpretation and Use

Ratios enable:

• Year-on-year business comparisons
• Benchmarking against similar companies
• Assessing strengths and weaknesses in profitability, liquidity, efficiency, and risk

However, ratios alone can be misleading. Always consider:

• Industry norms and trends over time
• The root causes for changes
• Seasonal effects and one-off events
• Consistency of accounting policies

Limitations of Solely Relying on Ratios

• Ratios do not explain why a trend has occurred
• Accounting figure manipulation or different methods (e.g., inventory valuation) impact ratios
• Non-financial factors, such as customer satisfaction, are not reflected
• Ratios can be affected by inflation or external market conditions

Key Term: Ratio Analysis
The calculation and critical review of ratios to facilitate business performance evaluation.

Summary Table: Key Ratio Types and Their Purpose

Key Point Checklist

This article has covered the following key knowledge points:

• Explain the function of ratio analysis in measuring performance
• Calculate and interpret profitability, liquidity, efficiency, and gearing ratios
• Identify common non-financial performance indicators and their relevance
• Recognise how to use ratios for business assessment and their limitations
• Understand the need for both financial and non-financial measures in decision making

Key Terms and Concepts

• Ratio Analysis
• Profitability Ratio
• Capital Employed
• Liquidity Ratio
• Acid Test Ratio
• Efficiency Ratio
• Gearing
• Non-financial Performance Indicator