How to approach performance appraisal questions

Performance appraisal is an important topic in Financial Reporting (FR). This article is intended to give candidates some guidance as to what is expected from a good answer to performance appraisal questions and how to approach such questions. The scenario of a performance appraisal question can take many forms.

Vertical or trend analysis

A company’s performance may be compared to its previous period’s performance. Past results may be adjusted for the effects of price changes. This is referred to as trend or vertical analysis. A weakness of this type of comparison is that there are no independent benchmarks to determine whether the chosen company’s current year results are good or bad. Just because a company’s results are better than its results in the previous financial period, does not mean the results are good. It may be that its results in the prior year were particularly poor.

Horizontal analysis

To try to overcome the problem of vertical analysis, it is common to compare a company’s performance for a particular period with the performance of an equivalent company for the same period. This introduces an independent yardstick to the comparison. However, it is important to pick a similar sized company that operates in the same industry. Again, this type of analysis is not without criticism as it may be that the company selected as a comparator may have performed particularly well or particularly poorly.

Industry average comparison

This type of analysis compares a company’s results (ratios) to a compilation of the average of many other similar types of company. Such schemes are often operated on a subscription basis whereby subscribing companies calculate specified ratios and submit them to the scheme. In return they receive the average of the same ratios from all equivalent companies in the scheme. This has the advantage of anonymity and avoids the bias of selecting a single company.

The context of the analysis needs to be kept in mind. You may be asked to compare two companies as a basis for selecting one (presumably the better performing one) for an acquisition. Alternatively, a shareholder may be asking for advice on how their investment in a company has performed. A bank may be considering offering a loan to a company and requires advice. It may be that your chief executive asks for your opinion (as say the chief financial accountant) on your company’s results.

Question scenarios

Most questions on this topic will have information in the scenario that requires particular consideration. A common complaint from markers is that candidates often make no reference to such circumstances. In effect, the same answer would be given regardless of what the question said. It is worth noting that there are many ‘clues’ in the question – ignore them at your peril. Examples of such circumstance include:

Related party relationships and transactions: these have the potential to distort the results of a company (either favourably or unfavourably). Examples of related party transactions are:

• goods have been supplied to a company on favourable terms (in terms of price and credit arrangements)
• a subsidiary may enjoy the benefits of head office expertise (eg research knowledge) without any charge being made by the head office
• loans may be advanced at non-commercial interest rates.

A company may have entered into certain arrangements that mean its previous results are not directly comparable with its current results. Examples of this include:

• the sale and leaseback of a non-current asset. Such an arrangement would change the net operating assets and thus effect asset utilisation
• entering into debt factoring (the sale of receivables to a finance house). This would obviously reduce collection periods, but this would not be through improved credit control procedures
• a general revaluation of non-current assets would lead to higher capital employed (and thus a lower return on capital employed) without there being any real change in operating capacity or profitability
• a company may have implemented certain policy changes during the year (eg lowering profit margins in order to stimulate sales).

The possibilities of what might have happened are almost infinite, but what is important is that where the scenario describes events such as those described above, you must take them into consideration when preparing your answer.

Most performance appraisal is based on interpreting various comparative ratios. Some questions will leave it for you to decide which ratios to calculate, other questions may specify which ratios have to be calculated. However, some questions may give you ratios such that the majority of marks are for the analysis and interpretation of them.

Another common complaint of markers is that when candidates are left to decide which ratios to calculate, they calculate far too many, thus spending very little time on their interpretation. Even in questions where there are marks available for calculating ratios, the majority of marks will still be for their interpretation.

Lack of interpretation/analysis

By far the most common complaint by markers is that candidates’ comments explaining the movement or differences in reported ratios lack any depth or commercial understanding. A typical comment may be that receivables collection has improved from 60 days to 40 days. Such a comment does not constitute interpretation – it is a statement of fact. To say a ratio has gone up or down is not helpful or meaningful.

What is required from a good answer are the possible reasons as to why the ratio has changed. There may be many reasons why a ratio has changed and no-one can be certain as to exactly what has caused the change. All that is required are plausible explanations for the changes. Even if they are not the actual cause, marks will be awarded. There is no single correct answer to an interpretation question, and remember there may be clues in the scenario that would account for some of the changes in the ratios.

Exam approach

In an exam there is a (time) limit to the amount of ratios that may be calculated. A structured approach is useful where the question does not specify which ratios to calculate:

• limit calculations to important areas and avoid duplication (eg inventory turnover and inventory holding periods)
• it is important to come to conclusions- as previously noted, candidates often get carried away with the ratio calculations and fail to comment on them
• often, there are some ‘obvious’ conclusions that must be made (eg liquidity has deteriorated dramatically, or a large amount of additional non-current assets have been purchased without a proportionate increase in sales).

Suggested structure to a typical answer 

Comment on company performance in the following areas:

• profitability and asset utilisation
• liquidity (look for overtrading)
• gearing and security of borrowings
• prepare a statement of cash flows  if specifically requested.

Profitability

The primary measure of profitability is normally considered to be the Return on Capital Employed (ROCE):

(Profit before interest and tax/shareholders funds plus long-term borrowings) x 100

This is a very important ratio, but it is open to manipulation. The secondary ratios that need to be explored to explain why the ROCE may have changed are:

1. Operating profit margin %: Operating Profit /sales x 100
2. Asset utilisation: sales/net assets

For example, an improvement in the ROCE is either because of improved margins and/or better use of assets. Increases may be due to increases in selling prices or reductions in manufacturing (or purchased) costs. They may also be caused by changes in sales mix or inventory counting errors. A change in the net profit margin is a measure of how well a company has controlled overheads. The asset utilisation ratio (sales/net assets) shows how efficiently the assets are being used.

Liquidity

Current ratio: current assets/current liabilities. Ideally it is thought that this should be significantly above 1 to 1, but it can vary depending upon the market sector (eg retailers have relatively few receivables so the current, and quick, ratios may be meaningless for such businesses).

Quick ratio (or acid test): current assets less inventory/current liabilities. This is expected to be at least 1 to 1. If the above liquidity ratios appear to be outside ‘normal ranges’ further investigation is required and inventory, receivables, and payables ratios should be looked at. These ratios can be calculated either as time periods (eg ‘days’) or as turnovers.

Receivables collection period (in days): (trade receivables/credit sales) x 365

Inventory turnover period: (average or closing) inventory/cost of sales x 365

Payables payment period (in days): (trade payables/purchases on credit*) x 365
*Note: you may have to use cost of sales if purchases figure is not available

Comments on the above ratios

Receivables collection period (expressed in a number of days)- when too high, it may be that some bad debts have not been provided for, or an indication of worsening credit control. It may also be deliberate, eg the company has decided to offer three-months’ credit in the current year, instead of two as in previous years. It may do this to try to stimulate higher sales. An indication of a change in policy would normally be identified in the question scenario.

Inventory turnover period (expressed in a number of days) – generally the lower this is, the better. If it is high, it may be an indication of obsolete stock or poor sales achievement. Sales may have fallen (perhaps due to an economic recession), but the company has been slow to cut back on production, resulting in a build up of inventory levels.

Payables payment period (expressed in a number of days) – if this is low, credit suppliers are being paid relatively early or there may be unrecorded payables. Although the credit period may represent a source of ‘free’ borrowing, if it is too high it may be an indication of poor liquidity (perhaps at the overdraft limit), and there may be a danger of further or renewed credit being refused by suppliers.

Liquidity problems may also be caused by ‘overtrading’. In some ways this is a symptom of the success of the business because it has expanded operations rapidly without the resources or finances to support the expansion which means the working capital and cash flows are overstretched. It is usually a lack of adequate financing and may be solved by an injection of capital.

Gearing

This is a far more important ratio than most candidates seem to be aware of. Company directors often spend a great deal of time and money to make this ratio appear in line with acceptable levels.

Its main importance is that as borrowings rise, risk increases (in many ways) and as such, further borrowing is difficult and expensive. Many companies have limits to the amount of borrowings they are permitted to have. These may be in the form of debt covenants imposed by lenders or they may be contained in a company’s Articles, such as a multiple of shareholders funds. Again this may be mentioned in the question scenario and, if so, it is something you should comment on in your answer.

Measures of gearing

Gearing is a comparison of debt to equity. Preference shares are usually treated as debt for this purpose. There are two alternatives: Debt/equity or Debt/debt + equity.

In any comparison of gearing it is important to use the same basis to calculate the gearing percentage in order for any interpretation to be meaningful. A question often asked by candidates is: ‘what level should a company’s gearing be?’ There is no easy answer to this – a lot will depend on the nature of the industry and composition of the company’s assets. For example, companies with large property portfolios often have high levels of gearing without it troubling investors. But companies that have large amounts of intangible assets are not considered to have a desirable type of security to support large borrowings. It is important that the effect of debt is understood.

EXAMPLE 1

Realm Co is financed by $5m 10% preference shares, and $5m equity.

Calculate the return to each provider of finance if Realm Co’s profits are:

i.   $1m

ii.   $1.3m

iii.  $700,000

Answer

Note that when profits increase by 30%, the increase in the return to equity shareholders is double this increase (a 16% return is 60% higher than a 10% return). However, the down side is that when profits fall by 30%, the reverse applies. The existence of debt increases the risks (favourable and unfavourable) to the equity shareholders. By contrast, the return to preference shareholders is 10% at all levels profit.

Investment ratios

Earnings per share

In isolation, this ratio is meaningless for inter-company comparisons. It is most useful as part of the P/E ratio and as a measure of profit trends.

Price/earnings ratio

This is calculated by dividing a company’s market price by its EPS. Say the price of a company’s shares is $2.40, and its last reported EPS was 20c. It would have a P/E ratio of 12. The mechanics of the movement of a company’s P/E ratio are complex, but if this company’s EPS improved to 24c in the following year, it would not mean that its P/E ratio would be calculated as 10 ($2.40/24c). It is more likely that its share price would increase such that it maintained or even improved its P/E ratio. If the share price increased to say $2.88, the P/E ratio would remain at 12 ($2.88/24c). This demonstrates the real importance of EPS in the way it has a major influence on a company’s share price.

Earning yield

The earnings yield is the reciprocal of the P/E ratio, however, many would argue that the P/E ratio is more meaningful. Earnings yield is the EPS/share price x 100. In the above example, a P/E ratio of 12 would be equivalent to an earnings yield of 8.3%.

Dividend yield

This is similar to the above except that the dividend per share is substituted for the EPS. It is a crude measure of the return to shareholders, but it does ignore capital growth which is often much higher than the return for dividends.

Dividend cover

This is the number of times the current year’s dividend could have paid out of the current year’s profit available to ordinary shareholders. It is a measure of security. A high figure indicates high levels of security. In other words, profits in future years could fall substantially and the company would still be able to pay the current level of dividends. An alternative view of a high dividend cover is that it indicates that the company operates a low dividend distribution policy.

EXAMPLE 2

Realm Co has 5 million ordinary shares of 25c each in issue. The market price of the shares just before its year end is $3.00 each. The dividend yield for companies in the same sector as Realm Co is 5%. Realm Co has paid an interim dividend of $200,000, and its profit for the year is $1,250,000.

Required, calculate:

i.   the final dividend (in cents per share) to be declared such that Realm Co’s dividend yield would equal its market sector 

ii.   Realm Co’s P/E ratio 

iii.   Realm Co’s dividend cover. 

Answer

i.   A dividend yield of 5% of a share price of $3.00 would be achieved if total dividends for the period were 15c ((15/300) x 100 = 5%). An interim dividend of $200,000 on 5 million shares would be 4c per share. Thus the final dividend would need to be 11c per share. 

ii.   Profits of $1,250,000 on 5 million shares gives an EPS of 25c ($1,250,000/5 million). The P/E ratio would be calculated as 12 (300c/25c) 

iii.   Dividends of 15c per share from earnings of 25c per share would give a dividend cover of 1.67 times (25c/15c).

In conclusion, candidates may be required to explain the weaknesses or limitations of ratio analysis. As a summary, it may be useful to read and work through a question (Example 3). The first section of the answer deals with the limitations of ratios.

EXAMPLE 3

Comparator Co assembles computer equipment from smaller components and distributes the equipment to various wholesalers and retailers. It has recently subscribed to receive sector average ratios from an inter-firm comparison service.

The specified sector average ratios and some of the equivalent ratios for Comparator Co are shown below.

Ratios of companies reporting a full year’s results for periods ended between 1 July 20X3 and 30 September 20X3 

Comparator Co’s financial statements for the year to 30 September 20X3 are set out below:

Statement of profit or loss

 

Statement of financial position

 

Current assets

 

Equity and liabilities

 

Current liabilities

 

Non-current liabilities

 

Total equity and liabilities

Notes

i. The details of the non-current assets are:

 

ii. The market price of Comparator Co’s shares throughout the year averaged $6.00 each.

iii. Dividends of $90,000 were paid during the year.

REQUIRED:

a) Explain the problems that are inherent when ratios are used to assess a company’s financial performance. Your answer should consider any additional problems that may be encountered when using inter-firm comparison services such as that used by Comparator Co   (4 marks)

b) Calculate the missing ratios for Comparator Co equivalent to those provided by the inter-firm comparison service   (5 marks)

c)    Write a report analysing the financial performance of Comparator Co based on a comparison with the sector averages   (11 marks)

Total 20 marks

ANSWER (produced in the CBE word processing workspace)

Note: As the majority of marks in this question are for a narrative requirement (ie explain and write) AND because you need to refer to the ratio calculations when writing your report, you will be provided with one wordprocessing answer space to answer all parts of the question.

(a) Ratios are used to assess the financial performance of a company by comparing the calculated figures to various other sources. This may be to previous years’ ratios of the same company, it may be to the ratios of a similar competitor company, to accepted norms (say of liquidity ratios) or, as in this example, to industry averages. The problems inherent in these processes are several. Probably the most important aspect of using ratios is to realise that they do not give the answers to the assessment of how well a company has performed, they merely raise the questions and direct the analyst into trying to determine what has caused favourable or unfavourable indicators.

In many ways it can be said that ratios are only as useful as the skills of the person using them. It is also true that any assessment should also consider other information that may be available including non-financial information. More specific problem areas are:

• Accounting policies: if two companies have different accounting policies, it can invalidate any comparison between their ratios. For example, return on capital employed is materially affected by revaluations of non-current assets. Comparing this ratio for two companies where one has revalued its non-current assets and the other carries non-current assets at depreciated historic cost would not be very meaningful. Similar examples may involve depreciation methods, inventory valuation policies etc.
• Accounting practices: this is similar to differing accounting policies in its effects. An example of this would be the use of debt factoring. If one company collects its receivables in the normal way, then the calculation of receivable days would be a reasonable indication of the efficiency of its credit control department. However if a company chose to factor its debts (ie ‘sell’ them to a finance company) then the calculation of its receivable days would be meaningless. A more controversial example would be the engineering of a lease such that it fell to be treated as a-short term lease rather than a right-of-use lease.
• Financial position averages: many ratios are based on comparing statement of profit or loss items with statement of financial position items. The above ratio of receivable days would be a good example. For such ratios to be meaningful, it is necessary to assume that the year-end figures are representative of annual norms. Seasonal trading and other factors may invalidate this assumption. For example, the level of receivables and inventory of a toy manufacturer could vary largely due to the nature of its seasonal trading.
• Inflation can distort comparisons over time.
• The definition of an accounting ratio. If a ratio is calculated by two companies using different definitions, then there is an obvious problem. Common examples of this are gearing ratios (some use debt/equity, others may use debt/debt + equity). Also, where a ratio is partly based on a profit figure, there can be differences as to what is included and what is excluded from the profit figure. Problems of this type include the treatment of finance costs.
• The use of norms can be misleading. A desirable range for the current ratio may be between 1.5 and 1:1, but all businesses are different. This would be a very high ratio for a supermarket (with few receivables), but a low figure for a construction company (with high levels of work in progress).
• Looking at a single ratio in isolation is rarely useful. It is necessary to form a view when considering ratios in combination with other ratios.

A more controversial aspect of using ratio analysis is that management have sometimes indulged in creative accounting techniques in order that the ratios calculated from published financial statements will show a more favourable picture than the true underlying position.

Examples of this are sale and repurchase agreements, which manipulate liquidity figures. Debt that has been kept off the statement of financial position will also distort return on capital employed and flatters gearing.

Inter-firm comparisons

Of particular concern with this method of using ratios is:

• They are themselves averages and may incorporate large variations in their composition. Some inter-firm comparison agencies produce the ratios analysed into quartiles to attempt to overcome this.
• It may be that the sector in which a company is included may not be sufficiently similar to the exact type of trade of the specific company. The type of products or markets may be different.
• Companies of different sizes operate under different economies of scale, this may not be reflected in the industry average figures.
• The year-end accounting dates of the companies included in the averages are not going to be all the same. This highlights issues of statement of financial position averages and seasonal trading referred to above. Some companies try to minimise this by grouping companies with approximately similar year-ends together as in the example of this question, but this is not a complete solution.

NOTE: this is a very full answer and it is unlikely that a candidate would provide such an answer under exam conditions. However, all of the points made above are valid and so have been included here. As this part of the question is for 4 marks, candidates would be expected to make at least four valid points in attempting their answer. 

(b) Calculation of specified ratios

The workings are in $000 (unless otherwise stated)

Note: Because you have been provided with a wordprocessing answer space, you will not be able to use a spreadsheet to produce the ratio calculations. This means that you will need to provide the marker with full workings for each ratio calculation (as shown above) so that the marker can apply the “own-figure rule”. An incorrect ratio calculation that has no workings will get no marks. An incorrect ratio calculation that has full workings is likely to get some marks because at least some of the working is likely to be correct.  

(c) Operating performance

The return on capital employed of Comparator Co is impressive being more than 100% higher than the sector average. The components of the return on capital employed are the asset turnover and profit margins. In these areas, Comparator Co’s asset turnover is much higher (nearly double) than the average, but the operating profit margin is below the sector average.

This short analysis seems to imply that Comparator Co’s superior return on capital employed is due entirely to an efficient asset turnover (ie Comparator Co is making its assets work twice as efficiently as its competitors). A closer inspection of the underlying figures may explain why its asset turnover is so high. It can be seen from the note to the statement of financial position that Comparator Co’s non-current assets appear quite old. Their carrying amount is only 15% of their original cost. This has at least two implications: (i) they will need to be replaced in the near future – worrying as the company is already struggling for funding; and, (ii) their low carrying amount gives a high figure for asset turnover. Unless Comparator Co has underestimated the life of its assets in its depreciation calculations, its non-current assets will need replacing in the near future. When this occurs its asset turnover and return on capital employed figures will be much lower. This aspect of ratio analysis often causes problems and, to counter this anomaly, some companies calculate the asset turnover using the cost of non-current assets rather than their carrying amount as this gives a more reliable trend. It is also possible that Comparator Co is using assets that are not on its statement of financial position. For example, it may be taking advantage of the exemptions in IFRS 16 Leases and so some assets may not have been recognised on the statement of financial position.

As Comparator Co’s operating margin is also lower than the sector, it would appear that Comparator Co has less good control over its operating costs.

Liquidity

Here Comparator Co shows real cause for concern. Its current and quick ratios are much worse than the sector average, and indeed far below expected norms. Current liquidity problems appear to be due to high levels of trade payables and a high bank overdraft. The high levels of inventory are also noteworthy and they may be indicative of further obsolete inventory.. The receivables collection figure is reasonable, but at 74 days, Comparator Co takes longer to pay its payables than do its competitors. While this is a source of ‘free’ finance, it can damage relations with suppliers and may lead to a curtailment of further credit.

Gearing

As referred to above, gearing (as measured by debt/equity) is more than twice the level of the sector average. While this may be an uncomfortable level, it is currently beneficial for shareholders. The company is making an overall return of 53.5%, but only paying 8% interest on its loan notes. The level of gearing may become a serious issue if Comparator Co becomes unable to maintain the payment of its finance costs. The company already has an overdraft and the ability to make further interest payments could be in doubt.

Tutorial note: you will notice that the question does not tell you whether or not you should include the overdraft as part of your gearing calculations. Its inclusion (or otherwise) depends on the information in the scenario. For example, if there is evidence that the overdraft is a long–term source of finance then it should be included as part of gearing. If the scenario shows it to be a short-term provision of finance, then it should not be included. To be clear, you should ALWAYS show your workings and state your assumptions.

Investment ratios

Despite reasonable profitability figures, Comparator Co’s dividend yield is poor compared to the sector average. It can be seen that total dividends are $90,000 out of available profit for the year of only $96,000 (hence the very low dividend cover). It is surprising the company’s share price is holding up so well.

Summary

The company compares favourably with the sector average figures for profitability although there is concern over the continued impact of high finance costs.. Additionally, Comparator Co’s liquidity and gearing position is quite poor and gives cause for concern. If it is to replace its old non-current assets in the near future, it will need to raise further finance. With already high levels of borrowing and poor dividend yields, this may become a serious problem for Comparator Co.

Yours faithfully

A N Allison

 

Candidates should note how this answer does more than merely comment that specific ratios have increased or decreased – it offers potential reasons as to why these ratios have changed and highlights the potential advantages and disadvantages of some of these changes. Overall, it provides a well-rounded and measured assessment of the company’s performance and financial position. Finally, it concludes and summarises the most interesting points made during its analysis. This is a professional piece of writing that any accountant would be proud to submit to an employer. It is these professional skills that Financial Reporting encourages and which should prepare you well for your Strategic Business Reporting exam.