Sample Masters Accounting and Decision Making Report
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A firm performance can be measured according to various factors: profitability, loss, employment rate, production value, etc. But the most important factors are the performance ratios.
Performance ratios determine the performance of a firm (Harrison and Wicks, 2013). How well it is running, the effects of one ratio on another, the relationship between factors, etc.
A firm’s performance can be measured by its performance ratios and non-financial indicators of the performance. A good degree of comparison is provided by the ratios that are measuring the performance, and the comparison is provided between the past and current performance of the firm.
Likewise, performance ratios can also provide a comparison between the performances of two different firms. The performance of the firm is affected by almost the same factors, despite what the firm is or what are the services provided by the firm.
The performance of the firm varies according to time and the situation of the economy (Zairi, 2012). The economy determines the rate of the products. The performance of the firm is often affected by the profits and losses suffered by the company.
The efficiency, liquidity, risk factors are important for a company to analyze its performance, or otherwise, the company will lose track of its performance.
After the time is gone, it will be hard to gather data and measure the overall performance (Borio and Zhu, 2012). So, a firm needs to measure its performance from time to time and keep track of its profitability and loss.
There are three areas in which a company has to measure: measuring risk, measuring profitability, and measuring liquidity. Risk can be measured by gearing ratio, interest cover ratio, and dividend cover ratio.
Gearing shows how much the firm is tied to its long-term liabilities whereas, interest cover shows the ability of the firm to pay the finance charge due on it.
On the other hand, Dividend cover depicts the firm ability to pay a dividend to its shareholders (Enekwe, Agu, and Eziedo, 2014). The higher these ratios, the better situation the firm is in. Profitability is measured through margin ratios, including gross profit margin and net profit margin.
Furthermore, there are ratios to compete in returns on capital employed and owner’s equity. The firm’s liquidity is measured through the computation of working capital and the computation of several ratios (Priya and Nimalathasan, 2013).
These ratios include the current ratio and acid test ratio. The acid test ratio is different from the current ratio, such that stock is removed from current assets in the numerator.
The stock is removed on the assumption that it is very illiquid and will not be useful when settling the current liabilities of the firm. Last but not least are efficiency ratios, which include the working capital cycle, which includes all the inventory holding period, creditors period, and debtors period (Zairi, 2012).
A business entity’s performance can be measured with the help of financial ratios and non-financial performance indicators. Financial ratios provide a good measure of comparison of current performance with past performance of the same business.
Similarly, the performance of the two companies can also be compared with the help of ratios. Businesses measure performance to track their profitability or measure its efficiency, risk, or liquidity.
For most organizations, profitability is the main reason to exist. Firms usually measure profitability to calculate how they perform compared to themselves or others in the same industry.
There are several profitability ratios such Gross Profit Margin, Net Profit Margin, Return on Capital Employed, Asset Turnover.
Net profit margin is calculated after deducting all expenses from sales revenue and dividing it by sales revenue. A high net profit ratio means the company is earning more profit per one pound of sales made by it (Al-Masum, 2015). This means the company is good at containing its expenses. The ratio is as follows:
Net profit margin = Net Profit / Turnover x 100
Return on Capital Employed shows how much the company is earning on the capital invested in the company. The ratio is as follows:
Roce = Net Profit / Capital Employed x 100
A business should be able to pay off its liabilities; the foremost include short-term liabilities. For the business to run in the foreseeable future, it must be able to meet its short-term cash requirements to settle its short-term debts.
The business should have sufficient working capital, i.e., current assets, to settle its current liabilities. A business in cash flow problems may not be able to continue, even if it’s highly profitable.
The reason for high profits may be excessive credit periods. The main measure of liquidity is working capital, followed by current ratio, acid-test ratio, inventory holding period, receivables collection period, and payables period.
Working capital is calculated by subtracting current liabilities from current assets, which shows how much surplus or deficit funds the business has to settle over its debt (Ding, 2013).
The current ratio shows for every pound of liability and how much worth of assets the company has.
Current Ratio = Current Assets / Current liabilities
For the business to be viable in the long run, it should minimize its risk. A highly geared company poses risks to the shareholders, as they rank after all the debts. Equity is paid off after the settlement of all the debts. Ratios about risk include gearing, interest cover, and dividend cover.
Gearing shows how much the company is tied up to its liabilities to run / function smoothly (Ahmadi, 2013). The ratio is calculated by dividing debt by equity.
Gearing = Dept / Equity x 100
A business can calculate many ratios as shown above, which may show the good or bad health of the company. These ratios are very important to control the business as a whole.
However, these ratios have their limitations; they depend on the very much economic factors of the business’s business and accounting policies. To overcome this problem, we have non-financial performance measures such as the balanced scorecard and building block model.
Ahmadi, M., Pouraghajan, A. and Salehnezhad, S., 2013. Performance measurement of receivable accounts’ risk management: A case study of Tehran Stock Exchange. Management Science Letters, 3(6), pp.1593-1598.
Al Masum, A., 2015. Performance Evaluation of Selected Ceramic Companies of Bangladesh. Asian Business Review, 1(1), pp.37-48.
Borio, C. and Zhu, H., 2012. Capital regulation, risk-taking, and monetary policy: a missing link in the transmission mechanism?. Journal of Financial Stability, 8(4), pp.236-251.
Ding, S., Guariglia, A. and Knight, J., 2013. Investment and financing constraints in China: does working capital management make a difference?. Journal of Banking & Finance, 37(5), pp.1490-1507.
Enekwe, C.I., Agu, C.I. and Eziedo, K.N., 2014. The effect of financial leverage on financial performance: evidence of quoted pharmaceutical companies in Nigeria. IOSR Journal of Economics and Finance (IOSR-JEF), 5(3), pp.17-25.
Harrison, J.S. and Wicks, A.C., 2013. Stakeholder theory, value, and firm performance. Business ethics quarterly, 23(1), pp.97-124.
Priya, K. and Nimalathasan, B., 2013. Dividend policy ratios and firm performance: a case study of Selected Hotels & Restaurants in Sri Lanka. Global Journal of Commerce and Management Perspectives, 2(6), pp.16-22.
Zairi, M., 2012. Measuring performance for business results. Springer Science & Business Media.
The general formula to measure risk is typically calculated as the standard deviation of returns/expected return, yielding a risk-to-reward ratio.