2.1 Evaluating Performance using Ratios
Financial ratios should not be evaluated in isolations. It must be compared with some benchmark (see Benchmarking) to reach some meaningful conclusion. Financial ratios can be compared against following benchmarks.
- Previous year (as above)
- Budget or standard
- Industry or sector average
- General standard (in the absence of above).
|Ratios||Industry or sector average|
|Gross profit margin||55%|
|Net profit margin||20%|
|Cost of sales %||45%|
|Operating cost %||25%|
|Sales growth or decline %||40%|
|Receivable turnover in days||30|
|Receivable turnover in times||9.8|
|Inventory turnover in days||100|
|Inventory turnover in times||3.67|
|Payable turnover in days||90|
|Payable turnover in times||4.7|
|Current asset ratio||2|
|Quick asset ratio||1|
|Debt to equity ratio||100%|
|Debt plus debt to equity ratio||50%|
|Contribution to PBIT ratio||0.4 or 40%|
|Interest cover in times||10 times|
|Earnings per share||$3 or 300 cents|
|Price earnings ratio||4|
|Earnings yield percentage||40%|
|Dividend yield percentage||43%|
|Dividend cover in times||1.2|
Use prescribed format in the requirement and address to recommended person, this will help you earn easy marks.
Calculate all the financial ratios at the end of report or memo in separately appendix and after doing this comment on these ratios by organizing them in logical order (profitability, liquidity, gearing etc).
Calculate ratios only to the extent that you can reasonably comment on each and every ratio within time limit. Calculation of ratios may not attract much mark at this level but it will disproportionate time, so you should be able to comment on ratios in reasonable depth.
Look for any Problem or underperforming areas of the organization. If organization is performing well then look for areas of strength. In most of the case, performance is deteriorating.
Compare ratios chosen as per problems or strength identified in the case in terms of percentages for each year and most importantly for first and the last year. You may skip middle years if marks do not justify such calculations.
Do not be confused if last year figures are the forecast of forthcoming year but make sure that your comments should reflect that you understand the situation.
Comment on any trend (increasing or decreasing) identified and suggest reason behind it. State any assumptions you have made to support your comments. Stating assumptions are useful to fill the information gap in the scenario.
Group all the ratios requiring the same interpretation, because you will not be rewarded for repeating the same reason twice.
Take care that the reason you suggest for financial ratios should be consistent (make sense) with the assessment of other financial ratios individually and to your overall assessment.
These ratios can be classified into following categories.