Using financial ratios for success

Richard Bull

What are financial ratios and how can they maximise value and success for your business? By author Richard Bull ACMA.

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.

Insight readers can order Richard Bull's book, 'Financial ratios: how to use financial ratios to maximise value and success for your business' with a 10% discount plus free P&P from CIMA Publishing.

Related Topic Gateways:
Performance measurement
Strategic analysis tools

December 2007

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