Financial ratios in managerial control and performance evaluation

Financial ratios as a control device

A financial ratio expresses the relationship between two figures taken from the financial statements, such as net profit to sales or current assets to current liabilities. Ratio analysis is one of the recognised techniques of managerial control: managers set target ratios as standards, compute the actual ratios from the accounts, compare them with the targets, with past periods and with competitors, and act on unfavourable differences. Because a ratio relates figures, it removes the effect of size and allows meaningful comparison across periods, divisions and firms.

Types of financial ratios used for control

1. Liquidity ratios: ability to meet short-term obligations.
   • Current ratio = current assets ÷ current liabilities.
   • Quick (acid-test) ratio = quick assets ÷ current liabilities.
2. Solvency (leverage) ratios: long-term financial soundness.
   • Debt-equity ratio = long-term debt ÷ shareholders' funds.
   • Interest coverage ratio = profit before interest and tax ÷ interest.
3. Activity (turnover) ratios: efficiency in using assets.
   • Inventory turnover = cost of goods sold ÷ average inventory.
   • Debtors (receivables) turnover = credit sales ÷ average debtors, and the related collection period.
   • Total assets turnover = sales ÷ total assets.
4. Profitability ratios: overall efficiency and return.
   • Gross and net profit margins = profit ÷ sales.
   • Return on investment (ROI) or return on capital employed = operating profit ÷ capital employed.
   • Return on equity and earnings per share for shareholders.

How ratios help in evaluating performance

1. Measuring efficiency. Turnover ratios show whether inventory, receivables and assets are being used well.
2. Judging profitability. Margins and ROI show how well the business converts sales and capital into profit; ROI can be broken into margin × asset turnover to find the cause of a change.
3. Assessing liquidity and solvency. These ratios warn early of cash shortages or excessive borrowing.
4. Comparisons over time (trend analysis). A falling margin or slowing debtor collection signals a problem before it becomes serious.
5. Inter-firm and inter-divisional comparison. Ratios allow divisions or competitors of different sizes to be compared, and help set targets.
6. Fixing responsibility. Ratios linked to particular departments (for example, debtor days to the credit department) make managers accountable.
7. Supporting decisions. Ratios guide decisions on pricing, credit policy, borrowing and investment.

Example. A distributor's net margin is steady, but its debtor collection period has risen from 40 to 65 days and its current ratio has fallen. The ratios show that profits are being tied up in customers' unpaid bills, so the manager tightens credit terms.

Limitations

Ratios are based on past accounting figures; they are affected by different accounting policies and by inflation; a single ratio means little without a standard for comparison; and they show symptoms rather than causes. They should be used together and with judgement.