Financial ratios as a controlling tool

Financial ratios in controlling

A financial ratio is the relationship between two related figures in the financial statements, expressed as a proportion, percentage or number of times: for example, net profit as a percentage of sales. In controlling, ratios are used as standards and measures of performance: managers set target ratios, calculate actual ratios periodically, compare them with targets, past periods, other divisions and competitors, and act on unfavourable differences. Because ratios relate figures to one another, they allow fair comparison between units of different sizes and reveal trends and problems that absolute figures hide. Ratio analysis is one of the recognised techniques of managerial control.

Types of financial ratios managers can use

1. Liquidity ratios: ability to meet short-term obligations.
   • Current ratio = current assets ÷ current liabilities.
   • Quick (acid-test) ratio = (current assets − inventories − prepaid expenses) ÷ current liabilities.
   • Use in control: a falling ratio warns of cash difficulties.
2. Solvency (leverage) ratios: long-term financial stability and risk.
   • Debt–equity ratio = long-term debt ÷ shareholders' funds.
   • Interest coverage ratio = profit before interest and tax ÷ interest charges.
   • Use in control: keeps borrowing within safe limits.
3. Activity (turnover or efficiency) ratios: how well assets are used.
   • Inventory turnover = cost of goods sold ÷ average inventory.
   • Debtors (receivables) turnover = net credit sales ÷ average debtors; and the average collection period.
   • Creditors turnover and payment period.
   • Fixed-asset turnover and total-asset turnover = sales ÷ assets.
   • Use in control: slow-moving stock or slow collection signals inefficiency.
4. Profitability ratios: overall efficiency and returns.
   • Gross profit ratio and net profit ratio = profit ÷ sales × 100.
   • Operating ratio = (cost of goods sold + operating expenses) ÷ sales × 100.
   • Return on investment / capital employed = operating profit ÷ capital employed × 100.
   • Return on equity and earnings per share.
   • Use in control: show whether the business earns an adequate return on resources.
5. Market ratios (for listed companies): price–earnings ratio, dividend payout and dividend yield, which show investors' view of performance.

Using ratios for control

Ratios are most useful when compared: with targets (budgeted ratios), trends over several periods, other divisions and industry averages. Return on investment can be broken into profit margin × asset turnover, which shows whether a fall in return comes from lower margins or from under-used assets.

Example. A furniture retailer finds that its net profit ratio is steady but its inventory turnover has fallen from six to four times a year; the ratio directs management to slow-moving stock, which is cleared through a sale and better purchasing.

Limitations

Ratios use past accounting data; they are affected by accounting policies and inflation; a ratio means little without a standard of comparison; and ratios show symptoms, not causes. They must be interpreted with judgement and used with other controls.