Discuss the validity of the continuing emphasis by companies and analysts on traditional financial ratio analysis. Does this analysis have any part to play in the modern commercial world, or should companies and analysts focus solely on non-financial performance indicators?
Traditional financial ratio analysis is useful as it summarises quite complex accounting information into a relatively small number of key indicators, relating particular figures to one another, and covering profit, liquidity, growth and risk of a company. These financial analyses include:
Profitability ratios; these are concerned with the efficiency of the firm in generating profit and include ROCE, Return on equity ( return on shareholders' funds), Gross profit margin, and Net profit margin. Liquidity ratios; these ratios are used to measure how well the firm is managing its working capital, and include Current ratio, Quick ratio, and Working capital ratios. Activity ratios; these are used to try to weigh up the effectiveness of a firm in using its assets. These are Net asset turnover ratio, Stockholding period, Debtor collection period and Creditor payment period.
Unfortunately ratio analysis is not very accurate; the choice of the ratios which are calculated, the exact definition of these ratios and the conclusions drawn, are very much matters of judgement and assumption. When dealing with ratios, two main limitations arise; to begin with there is a predisposition for the profit and loss account to overstate profit, relative to a more true assessment of the amount of wealth created. Secondly, there is a propensity for balance sheet figures to devalue the amount of capital which is tied up in the firm. This is a particular problem when dealing with ratios which are calculated using one figure from the P&L a/c and one from the balance sheet. Financial indicators measure how successful a business has been, hence analysing the past of it, but they don't actually give a forecast for the future success of it. Due to these limitations, many businesses now days are adopting non-financial performance indicators (NFPI's), which are based on the critical success factors for a commerce. The main categories of NPFI's are:
-Quality of service and responsiveness to customer needs (e.g. customer returns, number of complaints, ability to deal with delivery requirements) -Resource utilisation (e.g. room occupancy, bed occupancy, time spent on non chargeable work) -Innovation (e.g. annual spend on new technology, proportion of sales on new products) -Competitiveness (e.g. market share, sales growth, conversion of enquiries into sales) NFPI's measure the performance of a business by predicting its future success through such applications, however, neglecting the numerical part. In fact the restraint of NPFI's is that it does not quantify production costs, making it impossible to have a complete vision of the company's expenses. It is vital for a business to be able to weigh out costs against profits in order to avoid failure. In conclusion, t is not possible to run a business by looking at one performance measure only.
To overcome these problems, many companies now days apply the balance scorecard (Kaplan and Norton), which focuses on four different business perspectives: Financial perspective: what is necessary for the business to achieve financial success? What would appeal and interest shareholders? E.g. cash flow, gearing, monthly sales growth, operating income. Customer perspective: how should the business appear to customers? What are their primary needs and wants? What should be supplied? E.g. market share, number of customer complaints, customer satisfaction, and lead time from receipt of order to delivery. Internal...