Financial performance measures - Profitability, liquidity, a...

Learning Outcomes

After completing this article, you will be able to define and compute ratios used to assess a business’s profitability, liquidity, and productivity. You will be able to interpret these ratios to analyse an organisation’s performance, identify trends, and comment on financial health. You will also understand the limitations of ratio analysis for performance measurement in the ACCA exam context.

ACCA Performance Management (PM) Syllabus

For ACCA Performance Management (PM), you are required to understand the calculation and interpretation of financial performance measures. This knowledge underpins effective evaluation of business results and forms the basis for making recommendations in the exam. Focus your revision on:

• The main financial performance ratio categories: profitability, liquidity, efficiency, and risk/gearing
• Calculation and interpretation of key ratios within these categories
• How ratio analysis assists in performance review and trend analysis
• Recognising limitations and possible manipulation of ratio analysis results

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 best measures how efficiently a company is generating profits from its assets?
   1. Inventory days
   2. Return on capital employed (ROCE)
   3. Current ratio
   4. Gearing ratio

2. True or false? A business with a high current ratio always has strong liquidity.

3. What does the asset turnover ratio indicate about a company’s operations?

4. Briefly explain the limitation of using year-end ratios in companies with strong seasonal trading patterns.

Introduction

Financial performance ratios are essential tools for analysing how well a business is achieving its objectives. For ACCA PM, you must be able to calculate, interpret, and comment on a range of ratios which focus on profitability, liquidity, and productivity (efficiency). Using these tools, you can make informed judgements about a business’s strengths, weaknesses, and risks.

Key Term: Ratio analysis
A technique that uses relationships between selected financial statement figures to evaluate organisational performance.

PROFITABILITY RATIOS

Profitability ratios show how well a business generates profit in relation to turnover, or relative to the resources invested. These are fundamental for assessing business success over time and compared with industry peers.

Key Term: Return on capital employed (ROCE)
Operating profit as a percentage of capital employed; measures how efficiently capital is used.

Main Profitability Ratios

• Gross profit margin: $\text{Gross profit margin} = \frac{\text{Gross profit}}{\text{Turnover}} \times 100$ Indicates the margin between sales and cost of goods sold.

• Operating profit margin: $\text{Operating profit margin} = \frac{\text{Operating profit}}{\text{Turnover}} \times 100$ Shows profit left after covering all operating costs.

• Return on capital employed (ROCE): $\text{ROCE} = \frac{\text{Operating profit}}{\text{Capital employed}} \times 100$ Capital employed is typically total assets minus current liabilities, or total equity plus long-term debt.

Worked Example 1.1

A business makes sales of $5,000,000, reports a gross profit of $1,800,000, and operating profit of $600,000. Capital employed at year-end is $4,000,000.

Required: Calculate the gross profit margin, operating profit margin, and ROCE.

Answer:

• Gross profit margin = $1,800,000 / $5,000,000 × 100 = 36%
• Operating profit margin = $600,000 / $5,000,000 × 100 = 12%
• ROCE = $600,000 / $4,000,000 × 100 = 15%

Profit margins have many drivers—review trends and compare with previous periods and competitors for exam analysis.

Exam Warning

Profit figures alone are insufficient. Always relate a ratio to turnover, assets, or capital for comparative analysis.

LIQUIDITY RATIOS

Liquidity ratios assess a business’s short-term ability to meet its liabilities. They are important for evaluating operational robustness and short-term risk.

Key Term: Current ratio
The ratio of current assets to current liabilities; measures short-term financial health.

Key Term: Quick ratio (acid test)
The ratio of liquid current assets (excluding inventory) to current liabilities; provides a stricter test of liquidity.

Main Liquidity Ratios

• Current ratio: $\text{Current ratio} = \frac{\text{Current assets}}{\text{Current liabilities}}$ A ratio above 1 is generally healthy, but high figures may reveal inefficiency.

• Quick ratio (acid test): $\text{Quick ratio} = \frac{\text{Current assets} - \text{Inventory}}{\text{Current liabilities}}$ Excludes inventory; valuable when stock liquidity is questionable.

• Receivables collection period: $\text{Receivables days} = \frac{\text{Receivables}}{\text{Credit sales}} \times 365$

• Inventory holding period: $\text{Inventory days} = \frac{\text{Inventory}}{\text{Cost of sales}} \times 365$

• Payables payment period: $\text{Payables days} = \frac{\text{Payables}}{\text{Purchases or Cost of sales}} \times 365$

Worked Example 1.2

A company reports:

• Current assets: $480,000 (including $130,000 inventory)
• Current liabilities: $320,000
• Receivables: $170,000; annual credit sales: $1,000,000
• Inventory: $130,000; cost of sales: $780,000

Required: Calculate current ratio, quick ratio, receivables days, and inventory days.

Answer:

• Current ratio = $480,000 / $320,000 = 1.5
• Quick ratio = ($480,000 − $130,000) / $320,000 = 1.09
• Receivables days = $170,000 / $1,000,000 × 365 = 62 days
• Inventory days = $130,000 / $780,000 × 365 = 61 days

Interpretation: Current and quick ratios suggest reasonable liquidity, but the trading cycle is slow.

Revision Tip

In the exam, support every liquidity conclusion by comparing against industry averages or previous years.

PRODUCTIVITY AND EFFICIENCY RATIOS

Efficiency (or productivity) ratios show how well a business utilises assets and manages working capital to generate sales and profit.

Key Term: Asset turnover
The ratio of sales revenue to capital employed; measures efficiency in using assets to generate revenue.

Main Productivity Ratios

• Asset turnover: $\text{Asset turnover} = \frac{\text{Turnover}}{\text{Capital employed}}$ A higher figure indicates better utilisation of assets.

• Inventory turnover:
  $\text{Inventory turnover} = \frac{\text{Cost of sales}}{\text{Inventory}}$

• Receivables turnover:
  $\text{Receivables turnover} = \frac{\text{Credit sales}}{\text{Receivables}}$

• Payables turnover:
  $\text{Payables turnover} = \frac{\text{Purchases or Cost of sales}}{\text{Payables}}$

Worked Example 1.3

Company Z:

• Turnover: $6,000,000
• Capital employed: $2,000,000
• Inventory: $200,000; cost of sales: $4,000,000

Required: Calculate asset turnover and inventory turnover.

Answer:

• Asset turnover = $6,000,000 / $2,000,000 = 3.0
• Inventory turnover = $4,000,000 / $200,000 = 20 times

Conclusion: Company Z turns over its assets three times and sells inventory twenty times per year. Investigate if high asset turnover is efficient or due to underinvestment.

LIMITATIONS AND INTERPRETATION OF RATIOS

While ratios are powerful, they are not perfect. Consider the context for better analysis.

Limitations:

• Year-end figures may be distorted by seasonality or one-off items
• Definitions and accounting policies may differ between companies, affecting comparability
• Ratios do not, on their own, explain causes—investigation is always needed
• Results are open to manipulation (window dressing) at period-end
• Industry norms and economic conditions must always be considered

Exam Warning (Interpretation)

Never interpret one ratio in isolation. Always look for supporting trends or peer comparisons.

Summary

Financial performance ratios help you break down a company’s results and compare them with budgets, competitors, and past performance. Use profitability ratios to assess returns, liquidity ratios to gauge short-term health, and productivity ratios to evaluate operational efficiency. Always interpret your results in context and be alert to the limitations of ratio analysis.

Key Point Checklist

This article has covered the following key knowledge points:

• Define and calculate profitability, liquidity, and productivity ratios
• Understand the main types and formulas in each category
• Interpret ratios for assessment of business performance and trends
• Recognise key limitations and the need for context when using ratios

Key Terms and Concepts

• Ratio analysis
• Return on capital employed (ROCE)
• Current ratio
• Quick ratio (acid test)
• Asset turnover