Using financial ratios for success

What are financial ratios and how can they maximise value and success for your business?
Understanding financial ratios can give real insight into the best ways to maximise business value and
success. Management accountants use financial ratios to measure business performance.
Actual and potential investors take them from published accounts to track an investment’s underlying
performance. Managers also use them on a monthly basis to monitor business operating performance.
To get the most out of financial ratios, we need to understand exactly what they seek to measure and
how reliable they are as performance measures, in both the short and long terms.
Ratios are generally used to measure the relationship between two things. Financial ratios express the
relationship between an input to a process and the output from it. So what processes are these key
financial ratios measuring, and how do they relate to one another?

Dividend yield

The ratio which covers the widest range of a company’s operation is the dividend yield.
This measures the dividend income from the nominal value of a shareholder’s investment. It does not
measure capital value, but this is influenced as much by opinion of the future as the record of the past,
which means that it isn’t conducive to ratio analysis. By measuring how a company converts its original
source of funds into profit for distribution to its shareholders, the dividend yield encompasses all the
internal processes of a company.

Mapping these internal processes

The Enterprise Stewardship Model below shows a generic process of a business in six stages, or
subprocesses. The model below is shown as a building with foundations and five floors above ground.
Each stage reflects a component of the dividend yield. Just as ratios can be combined arithmetically to
ensure they are compatible, so the subprocesses work together to build a comprehensive picture of a
business.

The foundations
The foundations of any enterprise are built on an idea. The idea has to have value in the eyes of those it
is designed to benefit. Strategic management is the process of designing the ways that the idea and the
benefit will be realised. It is important to carry this out before the owner of the idea – the entrepreneur –
invests. Thinking it through is in itself an investment in time and energy.
If the idea’s owner is unable to raise all the funds required to realise the idea, she or he will have to
borrow. This process of funding management can be measured by the amount of borrowings that are
raised from equity investment (total liabilities/equity).
Funds are required firstly to build an infrastructure for the business. This may include purchasing
equipment, hiring people, or acquiring other assets. The asset turnover ratio (revenue/total assets)
measures the output from these assets based on the funds invested in them. It measures the process of
asset management.
At the heart of a business is the process of converting capacity into value for customers. In the diagram
this is represented by the stage of 'value added management' situated at the centre of the building. The
company takes its share of this added value in profit. This is measured in the profit margin ratio (net
before tax (NBT) profit/revenue).
The first call on a company’s profit is its liability for tax. You can measure how well a company manages
its tax management process by the ratio of profit left after tax compared to the amount before (NAT
profit/NBT profit).
Finally, the company can do two things with its disposable (NAT) profit. It can distribute it, or reinvest it.
The payout ratio (dividends/NAT profit) measures the proportion of dividends it distributes and measures
the company’s ability to raise funds for growth by determining the amount available for direct
reinvestment.

How can we be sure?

Now for the arithmetic!

In algebra, A/B multiplied by B/C = A/C. In the same way, each of the ratios used to build the Enterprise
Stewardship Model can be multiplied up the left of the picture to result in dividends (the summit of the
building)/ equity (at the bottom). This is a good way of testing that the fabric of the building is complete
and robust.
The picture also shows how ratios can be combined in sections to measure two or more floors of the
building at once.
The asset turnover ratio and profit margin combine to form the return on assets ratio (NBT profit/total
assets) and provide a shorthand measurement of the asset and value add management processes. If the
ratio of profit before and after tax and the ratio of total liabilities to equity are included as well, the result
is the return on equity ratio (NAT profit/equity) which measures the process from funding to tax
management.
Finally, if the dividend payout is added to the return on equity, we complete the ‘topping out’ of the
process and incorporate growth management to produce the dividend yield ratio.

What’s next?

Now that we have constructed and tested our model, we can examine some of the processes more
closely, compare them to our original strategy, and explore how they might be developed and improved.
We can also use the structure of financial ratios to compare our processes through benchmarking. By
matching financial ratios to the processes they are designed to measure, we can use both results -
benchmarking and process - together to find better ways of realising the original idea. This is how we
can help maximise value and success for our business.

Surviving the liquidity crisis - managing your cash

In the second in our series on coping with the credit squeeze, we look in more detail at tools
and processes used to aid cash management. By Audrey Besson, CIMA innovation and
development specialist.

When cash becomes a rare and expensive commodity, and banks seek to reduce their exposure to
market risk, cash management takes priority on the CFO’s agenda. Which tools and processes should be
used to facilitate cash management?
Visibility is crucial, and investors will expect CEOs and CFOs to know their cash position at any point in
time. Cash forecasting is no longer a ‘nice to have’ but rather a ‘must have’ along with profit and loss
projections.
The right methodology is essential to producing accurate cash forecasting. The direct method1 is best, as
it requires less reprocessing and reclassifying of data from both the income statement and balance
sheet.

Open and clear communication

All cash outflows and inflows need to be listed, and sources of information identified. The operating
rhythm of review and update should be defined in advance and key stakeholders brought into the
process. Open and clear communication between all departments will make a huge difference in the
success of the process.
A rolling forecast should be used, prompting you to regularly review your cash outlook and update when
required, ensuring accuracy and transparency. Monitoring tools, such as a daily cash reporting and
variance analysis, enable you to monitor forecast against actual results and make adjustments to inputs
and forecast processes as required. Sensitivity analyses are also suggested to help you understand the
implications of downside scenarios and allow the business time to prepare appropriate actions where
possible.
Spreadsheets are the usual tool of choice for small and medium sized enterprises as they are easily set
up and have great flexibility. They are definitely the right place to begin for companies who are just
starting the process. A more complex business will probably require a more integrated solution that will
link operating systems to a forecasting system.

Cash forecasting

Cash forecasting can be facilitated if some of the peripheral cash related processes are automated.
Receivable and payable systems can usually project, day-by-day, a schedule of payments that can be
downloaded into your spreadsheet.
While big companies are using more and more integrated systems and implementing solutions like e-
invoicing and supply chain financing, simple tools such as online bank statements can also help forecast
cash. Management accounting techniques such as Activity Based Costing (ABC) can also be helpful to a
cash forecasting model.
Implementing rolling cash forecasts is an evolving process. Getting the forecast right on the first attempt
is less important than initiating a baseline and continuing to apply improvements in both accuracy and
user effectiveness.

Optimising the working capital cycle

Cash management is not just about having the right tools and methodologies to forecast cash. It also
requires the underlying processes such as receivables, payables and inventory to be in place to optimise
a company’s working capital.
Customers are key enablers of your cash flow cycle. From the moment a product or service is ordered to
the time it is paid, there are many milestones a company can influence to improve its working capital
cycle.
A well defined credit policy is the starting point. It needs to be written and signed off by the board,
understood by the sales force, and include information from your credit criteria and standard payment
terms, to reporting requirements.
Invoicing customers efficiently is also a critical step. Invoices need to be accurate and timely and
payment standards stated clearly. Discounts for prompt payment can be offered to accelerate cash
inflows. Friendly payment facilities such as electronic payments are highly recommended to increase
chances of getting paid on time.

Collection

An efficient collection process is a next step. A company has control over the time allowed to collect
money and can tighten it when needed. To control process efficiency, it is important to have the right
routines and controls in place. The sooner a default payment is identified, the more likely it can be
mitigated.
Days Sales Outstanding (DSO) is a critical metric to have in place and should not be overlooked.
Receivables reports will help keep track of ageing accounts and ideally would be reviewed on a daily
basis. It is possible to try to get ahead of delinquent accounts by identifying behaviour that leads to late
payments and by making reminder calls the week before a payment is due.
Companies can also use staff incentives to improve the effectiveness of collection processes.
Understanding that nothing is sold until it is paid for is important and the best way to do so is to link
compensation to the appropriate collection metrics. Finally - if the company policy includes penalty
interest on late payments, now is the time to enforce it.

Cash outflows

Improving cash inflows is only one part of the cash management equation. Controlling cash outflows is
equally important. This is where supplier and inventory management come into play.
Now is the right time to strengthen purchasing policies. Consolidating suppliers will allow a company to
place larger orders and increase negotiation power around price and payment terms. Approval process
for expenditures should be in place and followed strictly and the threshold for CFO sign off might need to
be lowered given the current environment. A ‘No purchase order, no pay’ policy is easy to implement and
will ensure that purchase orders are raised and approved before an order is placed.
Supplier payments should be made on the last day they are due, except if it makes sense to take
advantage of early payment discounts. In the same way DSO is used to monitor receivables, Days
Purchases Outstanding should be applied to the efficiency of the payables process. If in doubt about
what the metrics say, comparing them to industry benchmarks should help define where there is
opportunity for improvement.
Inventory management also comes into play when looking at reducing a company’s working capital
requirement. Transparency in inventory is crucial to understanding the cash position of a company. Just
in time inventory can be a preferred option in a situation where one cannot afford to have cash tied up
for an extended period of time. And there again metrics like inventory turnover, inventory levels or stock
to sale ratios will help make the right decisions.

Cross border cash pooling

For large companies, it might be worth evaluating the advantages of centralised shared services and
outsourcing. Cash pooling is also a powerful tool when it comes to cash management and allows
businesses to strengthen controls, maximise cash return, decrease borrowing needs and get easier
access to funds. At a time where European initiatives like the Single European Payments Area (SEPA) are
taking place, cross border cash pooling appears to be an obvious solution.
Cash management is vital in an environment where access to liquidity is problematic. It asks companies
to have the right tools available, ensure the basics are in place and think outside of the box when it
comes to alternative sources of funding.
Overcoming the challenges of the current economic situation, although difficult, is possible and managing
cash efficiently will be an important determinant of a company’s success.
Footnotes
1
The direct method statement reports cash flow directly from the different operating activities, such as
collection from customers, payments to suppliers or payroll. The indirect method calculates cash flow
based on variance between financial statements from one period to another and requires reclassification
to take out all non cash items such as depreciation or accruals.