Given the inherent shortfalls of benchmarking in the small firms sector, the standard and established alternative method of evaluating financial performance lies in the use of accounting ratios. These compare facts and figures gleaned from the annual accounts of businesses, and provide year-on-year data about performance in key areas for comparison. However, as stated above, these data are essentially concerned with internal performance, and do not make comparisons with the overall market environment, although they do facilitate year-on-year comparison. Accounting ratios are primarily tools that can be used to assess the performance of the business, particularly in terms of solvency and liquidity. There is a range of ratios that can be applied to test different aspects of business performance, but we will just concentrate on some of those that are of significance to the small business.
The Working Capital ratio (also called the Current ratio) tests the short-term liquidity of a business. It compares the current assets (cash, stock, debtors, work in progress) to the current liabilities (bills falling due for payment). Ideally, the current assets : current liability ratio should be 2:1. If the ratio is less, then stock levels or credit facilities given to customers may be too high.
The Liquidity ratio (also called the Acid test or Quick ratio) is a more precise measure of liquidity, as it compares the liquid assets of the business (current assets less slow-moving stock or bad debts) with the current liabilities. The liquid assets when compared to current liabilities should show a ratio of at least 1:1 to demonstrate that the business can meet its current obligations, i.e. it can pay its creditors on time.
The other way to check on solvency is to compare the average credit given with the average credit taken. In the first case we take the average outstanding debtors figure x 365, divided by the sales turnover. For example, an average outstanding debt of £20 000 compared with an annual turnover of £240 000 is one-twelfth of 365 days, which equals approximately 30 days. An average credit taken of £24 000 compared with the same turnover equals one-tenth of 365 days, i.e. 36.5 days. It is obviously more advantageous for the cash flow and working capital of the business to give 30 days’ credit to customers, and to take 36.5 days’ credit from suppliers.
The Gearing ratio is more concerned with solvency, as it compares the equity (or share capital) and reserves of the business with its long-term liabilities (loans, mortgages and preference shares), to ensure that loans etc. can be repaid if the business should cease trading. In simple terms, it compares the resources supplied by the owners with the resources borrowed from others, to ensure that the first exceeds the second. The preference shares are lumped in with the long-term liabilities simply because the dividends on these have to be paid before any ordinary share dividends can be considered. This ratio is regarded as a good measure of the borrowing capacity of the business, as the higher the ratio, the better the borrowing potential.
The Asset Cover ratio compares total assets with total debt to determine how many times the debts of the business are covered by its assets. This again reflects the borrowing capacity of the business, as the higher the ratio, the more it is likely to be able to borrow, because it is seen to have the surplus resources to cover further debt. The borrowing capacity is of interest not just to providers of long-term liability funds (bankers, debenture and mortgage lenders, etc.) but to the ‘current liabilities’, the ordinary suppliers and creditors who want to be assured that their credit is adequately covered by assets.
The Net Asset Value compares the ordinary shareholders’ funds (capital and reserves, etc.) with the number of shares issued. This measures the value of the assets of the business that are attributable to each share. So, a business with assets worth £4.00 for each £1.00 share issued would generally be regarded by a lender as being a better risk than one with assets worth just £1.50 per £1.00 share.
The Return on Capital Employed (ROCE) compares the profit received from ordinary trading activities before interest, with the sum of the capital employed in trading. It is expressed as a percentage. For example, if the company employs capital of £100 000 and produces a profit from ordinary trading of £30 000, it has made a Return on Capital Employed of 30 per cent. This ratio is of key interest to potential investors. It is also important to remember that if the ratio falls below the average level of interest paid on bank deposits or investments, then the business would be better off not trading, and just leaving its capital on deposit at the bank. In the case of owner-managers, this means that they would be better off shoving their money in the building society or some other form of investment, and getting a job working for someone else. The reduction in stress would probably also increase their life expectancy in the process! The point of this is that if you are working for yourself, you should expect a reasonable return on the time, money and energy you expend in running the business, and that the level of return should be demonstrably greater than that which could be achieved by leaving your money in the bank, and working for someone else (job satisfaction aside). The ROCE provides the means of comparing your results with the softer option.
The Earnings per share ratio compares the net profit after tax, less preference share dividends, with the number of ordinary shares issued. In very simple terms, the amount of tax paid profit that could possibly be distributed amongst shareholders, divided by the number of shares eligible to receive it.
Gross profit compared to turnover is another good indicator of profitability, especially on a year-on-year basis, as is also the operating profit to turnover ratio (gross profit less distribution and administration costs divided by sales turnover). However, these do not always necessarily correspond with each other year-on-year, if changes have occurred in distribution and administration costs during the year.
Another measure of profitability is the comparison between sales turnover and the number of employees in the organization, usually expressed in terms of thousands of pounds per head. Variants include comparisons of operating profit to turnover and net fixed assets to turnover. These ratios tend to be more popular in the USA than the UK, and can influence stock exchange values on the US stock markets. Whilst not particularly relevant to the small firms sector, these comparisons do actually influence the employment policies of large multinationals. Pfizer Pharmaceuticals, for example, employ large numbers of permanent contract staff in their UK locations for security and administrative duties, in order to maintain the ratio to their advantage in overseas stock markets. Those contract staff simply appear as an expense item on the profit and loss account. There is, of course, nothing illegal or improper about this practice, and it creates a lot of opportunities for the smaller local contract companies that supply the staff. However, employment policies such as these might create a false impression amongst individual US investors who had not taken the trouble to familiarize themselves with the details of the policies, or any relevant disclosures in the published accounts.
There are quite a few of these to choose from; for example, the working capital (current assets less current liabilities) to sales turnover ratio tests the number of times the working capital is being utilized each year. This is a measure of how well the business is using its resources, although obviously what is deemed as a satisfactory or good ratio will depend on the market in which the business operates. A wholesaler or retailer of foodstuffs will turn over its stock rapidly, so in turn the working capital will have been used on a regular basis, perhaps weekly. In contrast, a manufacturer of specialist engineering machinery, that could take six months to build, install and commission, may only turn over its working capital a few times each year. This is the contrast between a low-profit/ high-turnover business and a high-profit/low-turnover business.
The same comparison can be made using the whole capital employed by the business in relation to sales turnover to determine how frequently that is being utilized, but again, the outcomes must be reviewed in the context of what is satisfactory or good for the market in which the business operates.
By comparing the ratio of the average stock held against the total value of stock purchased in the course of the trading year, it is possible to determine how fast and how efficiently the stock is being turned over. For example, an average stock of £10 000 compared with a total annual purchase of £730 000 over 365 days would indicate that the stock is being turned over, i.e. sold, every five days. This figure in itself is not particularly helpful unless compared or benchmarked in some way with an industrial average. For example, a branch of Sainsbury or Tesco supermarkets might expect to turn their stock of baked beans over every couple of days, and their bread almost daily, but a furniture retailer, such as Courts, would no doubt be more than happy to turn all of their stock over once each month.
It is also possible to evaluate a whole range of specific costs as a percentage of sales turnover, for example sales costs, marketing costs, production costs, distribution costs, administration costs, etc., in the same way. In their own right, these are not necessarily immediately useful, but when compared year-on-year they can be a good indicator of changing patterns of performance within the business. For example, they may highlight how one cost area might be rising disproportionately in comparison with others, or perhaps to explain why the ratios of gross profit to turnover, and operating profit to turnover, may not be moving in the same direction or at the same rate, as mentioned earlier.