Asset Turnover

Asset Turnover measures the relationship between Net Assets and Revenue. It is the number of times the Net Assets are turned over in the Time Period. Asset Turnover measures the Revenue generated for each dollar invested in Net Assets. Asset Turnover measures how efficiently the business utilises its assets.

Asset Turnover is one of the components of the Du Pont concept and is used extensively by management to track and improve performance.

Formula

Asset Turnover = Revenue/Net Assets

Worked Example

Revenue  = 10,000

Net Assets = 5,000

Asset Turnover = 2

For each $1 of Assets, the business generates $2 of Revenue.

The business is turning over its Net Assets 2 times per period.

Management Hint

A business should attempt to maximise it's Asset Turnover, to get the most Revenue from the lowest possible investment in Net Assets. Track the Asset Turnover and watch for adverse trends. A slowing down in the ratio will lead to a worsening of Cash Flow which may be undesirable.

Business Value

Business Value is a simple valuation of the business based on a multiple of the Net Income. The multiple of Net Income is the Price/Earnings Ratio. The Business Value should be compared to the Net Assets.

Formula

Business Value = (Price/Earnings Ratio) x Net Income

Worked Example:

Net Assets = 5,000

Price/Earnings Ratio = 8

Net Income = 1,000

Business Value = 8,000

The Business Value can be compared to the Net Assets (8,000 - 5,000 = 3,000), the difference being Goodwill.

Management Hint

The Business Value calculated should be compared to the Net Assets. If Business Value is greater than the Net Assets, this would imply that the management of the business has created Goodwill, above the Net Assets.

Business Value is important to owners or shareholders, who hope to derive not only Dividends, but also an improvement in their underlying investment in the business.

Business Value is important for Government or other organisations who are considering privatisation or fund raising, in order to help set a fair valuation to attract investment.

Business Value is a key driver for small business, where the owners have a reasonable expectation that a sale of the business may occur one day. The fruits of their hard work and investment will be realised, as an increase in the Business Value.

Banks and other lenders to business, consider the Business Value as a level of security against the borrowings ie. Could the business sell for the Business Value?

Cash Flow

Cash Flow is the Net Cash Flow for the Time Period. It is the difference between the Net Debt Opening and the Net Debt Closing. If Cash Flow is positive then the Net Debt will have reduced in the period. If Cash Flow is negative then Net Debt will increase as a direct result.

Formula

Cash Flow = Net Debt Closing - Net Debt Opening

Management Hint

There are three sources or uses of Cash Flow:

·   Retained Income

·   Changes in Net Assets

·   Equity or Other Funding

Management should monitor each element of the business that impacts on Cash Flow, as well as the relationship between the elements. For example increasing Profits, but allowing the Net Assets to grow too fast, could lead to the cash outflow from the increase in Net assets, outstripping the cash coming in from profits.

Management should particularly monitor and control the Working Capital at the detailed level ie Debtors days, Trade Creditors days, Raw Materials days, Work In Progress days and Finished Goods days as they usually have a direct and material impact on Cash Flow. Management should also control the expenditure on the Non Current Assets and Liabilities.

Contribution %

Contribution % measures the percentage of Revenue which remains as a Contribution after deducting the Variable COGS.

Formula

Contribution % = 100 - Variable COGS %

AND

Contribution % = (Revenue - Variable COGS)/Revenue x 100

Management Hint

The Contribution % is usually the prime driver of Profitability %; any adverse trends at this level should be investigated and corrected as soon as possible.

Cost of Goods and Services (COGS)

Cost of Goods and Services is the direct costs of producing and delivering the goods or providing services. It is made up of a combination of Variable COGS and the Fixed COGS.

Formula

Cost of Goods and Services = Variable COGS + Fixed COGS

Management Hint

The Cost of Goods and Services must be minimised, if a sufficient Gross Profit is to be achieved. Adverse movements must be corrected.

Current Assets

Current Assets represents the assets which will turnover within one year of operation ie. Would be turned into cash or sold and replaced within one year. Current Assets are made up of Debtors, Raw Materials, Work In Progress, Finished Goods and Sundry Current Assets.

Formula

Current Assets = Debtors + Raw Materials + Work In Progress + Finished Goods + Sundry Current Assets

Management Hint

Current Assets should be minimised within the constraints of the level of activity of the business. Reducing Current Assets reduces Working Capital and Funding requirements. Each element needs special attention, if all are to be controlled.

Current Liabilities

Current Liabilities represents the total of all liabilities due within one year. Current Liabilities is made up of Trade Creditors, Other Creditors and Sundry Current Liabilities. The current portion of debt should be included in Net Debt.

Formula

Current Liabilities = Trade Creditors + Other Creditors + Sundry Current Liabilities

Management Hint

The total of Current Liabilities represents amounts falling due within the next 12 months. Management must ensure that sufficient Cash Flow is generated to meet these Current Liabilities. Management should consider the relationship between Current Assets and Current Liabilities. It should be of concern to management if Current Liabilities was rising and Current Assets was falling at the same time.

Debt to Equity

Debt to Equity is the proportion of Net Debt Closing to Equity Closing. It is the key Funding measure as it is used by the business itself as well as the external providers of Funding and Credit.

Formula

Debt to Equity = Net Debt Closing/Equity Closing

Management Hint

Management must establish the acceptable level of Debt to Equity for their business. The business should actively plan and manage Cash Flow and Net Debt to ensure that sufficient Funding will be available to carry on operating the business. This should ensure optimal access to credit from suppliers of goods and services.

External providers of debt or credit to the business are interested in the Debt to Equity being within acceptable levels. If the Debt to Equity is considered too high, providers of finance or credit will assess the business's credit risk to be too high.

As the Debt to Equity increases, the business will find it harder to get additional Net Debt. The cost of debt will increase, as the providers of finance attempt to cover their own increased risk by increasing the Interest % charged to the business.

Debtors

Debtors are the value of uncollected Revenue at the end of the Time Period.

Formula

Debtors = Debtors days x Revenue/Time Period in days.

Other Terms for Debtors:

Accounts Receivable

Trade Debtors

Trade Receivables

Management Hint

Management would usually attempt to collect Debtors as quickly as possible, to improve net Cash Flow and reduce Working Capital investment.

Debtors Days

Debtors days measures the average time taken to collect Debtors.

Formula

Debtors days = Debtors/Revenue x Time Period in days

Other Terms for Debtors days:

Accounts Receivable days

Trade Debtors days

Trade Receivables days

Debtors days Outstanding

Management Hint

Management would usually attempt to collect Debtors as quickly as possible, to improve net Cash Flow and reduce Working Capital investment.

Dividend per Share (Div/Share)

Dividend per Share measures the value of Dividends due or paid on each share.

Formula

Dividend per Share = Dividends/Number of Shares

Management Hint

Shareholders usually have expectations on the absolute level of Dividend per Share. These expectations should be reviewed in conjunction with the actual trend in the Dividend Per Share.

Dividends

Dividends are the amount due or paid to the shareholders from the Net Income.

Formula

Dividends = Number of Shares x Dividend per Share

Management Hint

Shareholders have expectations of the levels of Dividends they should receive. The business may attempt to meet these expectations and plan to meet the shareholder requirements. A Dividends policy is usually essential for consistent Dividends to be paid, which in turn will improve shareholder appreciation of the company's predictability. This will improve access to future Funding requirements.

Earnings Before Interest and Tax (EBIT)

Earnings Before Interest and Tax is the operational profit. The measure excludes Interest and Tax, as these are not considered to be operational issues. Earnings Before Interest and Tax is used in the calculations of Profitability % and Return On Capital Employed % - two of the three key Du Pont ratios..

Formula

Earnings Before Interest and Tax = Gross Profit - Expenses

Management Hint

Earnings Before Interest and Tax should be determined regularly and monitored. Management can have a direct influence on Earnings Before Interest and Tax, as its elements are operational.

Equity Closing

Equity Closing is the Equity at the end of the current Time Period. It is made up of all Funding items, which are of an Equity nature and ultimately represents the owner's interest in the business, and includes:

·   Share Capital

·   Retained Income or Retained Earnings

·   Reserves

·   Shareholders loans

·   Share premium

·   Trust units

·   Beneficiary loan accounts

·   Partners capital accounts

Formula

Equity Closing = Equity Opening + Equity Movement + Equity Adjustment

Equity Opening

Equity Opening is the Equity at the beginning of the Time Period. It is made up of all Funding items, which are of an Equity nature and ultimately represents the owner’s interest in the business, and includes:

·   Share capital

·   Retained Income or Retained Earnings

·   Reserves

·   Shareholders loans

·   Share premium

·   Trust units

·   Beneficiary loan accounts

·   Partners capital accounts

Expenses

Expenses are the administrative cost of operating a business. Expenses are the total of Fixed Expenses and Variable Expenses, less Sundry Income.

Formula

Expenses = Fixed Expenses + Variable Expenses - Sundry Income

Management Hint

If Expenses are large compared to Gross Profit, measures should be taken to reduce the Expenses, where appropriate.

Extraordinary Items (Extra Items)

Extraordinary Items is any abnormal income or deductions, which do not reasonably relate to the Net Profit After Tax. The amount is shown as a net amount. For example, a loss incurred in a major re-structuring of the business eg. closing down plant or outlets; the gain on sale of a subsidiary or part of the business; or a prior year accounting adjustment

Management Hint

If Extraordinary Items is material, investigate the nature of this item, as its occurrence may warrant management attention. If an item is recurring, then consider including it in Expenses, as a normal operating item.

Finished Goods (Fin Goods)

Finished Goods represents the cost of the finished product held in stock for sale. Finished Goods can either be produced from Raw Materials and enhanced in the Work In Progress stage, or bought already completed.

Formula

Finished Goods = Finished Goods days x Cost of Goods and Services/Time Period in days

Other terms for Finished Goods:

Stock

Inventory

Management Hint

Finished Goods can represent a significant component of Working Capital. Only sufficient Finished Goods should be held to ensure continuous supply to support sales. Surplus Finished Goods has an adverse impact on Cash Flow and Net Assets. The Finished Goods days should be monitored and minimised. Low levels of Finished Goods indicates efficient stock control, which has a favourable impact on Cash Flow.

Finished Goods days (Fin Goods days)

Finished Goods days measures the number of days of Finished Goods on hand, at the end of the Time Period. The Finished Goods days are related to Cost of Goods and Services.

Formula

Finished Goods days = Finished Goods/Cost of Goods and Services x Time Period in days

Other terms for Finished Goods days:

Stock days
Inventory days

Management Hint

If Finished Goods days rise, then more stock is on hand for a given level of operations. Reducing Finished Goods days will improve Cash Flow and reduce Working Capital requirements.

Fixed Assets

Fixed Assets is the Non-Current or Long term Assets used to produce EBIT. Fixed Assets by definition, are held for longer than a year and are usually not intended for resale. Examples of Fixed Assets are plant and machinery, land and buildings, computers and office furniture.

Management Hint

Fixed Assets is usually large in value and represents significant investment by the Business. Management should systematically review the Return On Capital Employed % of each major Fixed Asset, as follows:

At Purchase

Ensure that the projected Return On Capital Employed % will achieve a sufficient level to justify the purchase.

Ongoing Use

Review each major Fixed Asset to ensure that management take action to improve the Return On Capital Employed % for any under-performing Assets. Consider selling surplus Fixed Assets that are under-utilised, or those which will never produce sufficient Return On Capital Employed %.

In general Fixed Assets expenditure should be closely controlled, as Fixed Assets purchases will reduce Cash Flow and add to Net Assets.

Fixed COGS

Fixed COGS is costs that relate directly to producing Revenue, but do not vary with Revenue. An example is a repair to a machine used to produce goods for resale.

Management Hint

If the Fixed COGS is large compared to the Variable COGS, then it is critical that Revenue levels are maintained to produce sufficient Contribution % to cover these Fixed COGS. Large Fixed COGS can be a severe handicap if Revenue levels drop.

Fixed Expenses

Fixed Expenses is the fixed administrative Expenses incurred. Fixed Expenses by definition will not vary with Revenue. An example of Fixed Expenses is rent.

Management Hint

Management should challenge each major Fixed Expenses category and ensure that the need for the expense is still current. Fixed Expenses are only fixed in the short-term and can be changed over a longer period.

Gross Profit

Gross Profit is the difference between Revenue and Cost of Goods and Services

Formula

Gross Profit = Revenue - Cost of Goods and Services

Management Hint

Gross Profit is the operational profit available to cover the administration costs of running the business ie Expenses. Any adverse variation should be analysed into its components and corrected. Gross Profit should also be considered in relation to Expenses. Management should attempt to increase Gross Profit and decrease Expenses at the same time.

Gross Profit %

Gross Profit % measures the relationship between Revenue and Gross Profit, stated as a percentage. This measures the vital relationship between Revenue and Cost of Goods and Services.

Formula

Gross Profit % = Gross Profit/Revenue x 100

Management Hint

The Gross Profit % is usually the prime driver of Profitability %; any adverse trends at this level should be investigated and corrected as soon as possible.

Interest

Interest is the money paid on Average Net Debt ie amounts paid on borrowings, less any monies received for cash on deposit

Formula

Interest = Interest % x Average Net Debt

Management Hint

As the Interest rate is calculated on Average Net Debt, it is the effective Interest rate paid. The Interest % may be minimised, by effectively structuring debt and negotiating with banks. Average Net Debt should be kept within acceptable limits to reduce the Interest bill. The Debt to Equity must also be managed within the Bank's expectations, or higher Interest rates may be levied. The business may be seen to be more risky by Banks.

Interest %

Interest % measures the average Interest paid (or received) on Average Net Debt for the Time Period.

Formula

Interest % = Interest/Average Net Debt x 100

Management Hint

The level and trend of Interest % should be monitored and compared with the general level and movement in market Interest rates. Adverse movements should be corrected to reduce the cost of Interest, by re-negotiating with lenders.

Inventory days

Inventory days are a measure of the overall level of inventories.

Formula

Inventory days = Raw Materials days + Work In Progress days + Finished Goods days

Management Hint

Inventory days should be kept to a minimum as this will reduce Working Capital requirements, thereby improving Cash Flow and ROCE %.

Investments

Investments are Non Current Assets and Liabilities purchased with an aim to return income by way of Dividends or profits. Examples of Investments are shares or even parts of other businesses. Income from Investments will be shown in Sundry Income. Investments do not include any cash investments as these would usually be included in Net Debt.

Management Hint

Each individual Investment should be monitored and the income received determined to ensure sufficient returns are being made. Under-performing Investments should be sold.

Net Assets

Net Assets is the net operating assets of the business. Net Assets is the total of Working Capital and Non Current Assets and Liabilities. The Net Assets need to be funded and are therefore equal to Total Funding Closing.

If Net Assets have increased, more Funding would be required to fund the increases in Working Capital and/or Non Current Assets and Liabilities. Funding may be in the form of Net Debt, Equity or Other.

Net Assets should include all the operating assets and liabilities that generate EBIT.

Formula

Net Assets = Working Capital + Non-Current Assets and Liabilities

Management Hint

Management should attempt to minimise the Net Assets (and therefore, the Funding requirements). Management should consider selling any surplus assets. The relationship of Revenue to Net Assets is measured in the Asset Turnover.

Minimising the Net Assets will improve Return On Capital Employed % and improve Cash Flow. Management must closely monitor and control the absolute level of Net Assets, and the Asset Turnover.

Net Debt Closing

Net Debt Closing is the Net Debt at the end of the current Time Period; it is made up of all Interest bearing or receiving items. This would include both debt and deposits or cash balances, and includes:

·   Bank overdraft

·   Commercial bills

·   Other interest bearing debt

·   Amounts owing on Finance Leases

·   Hire purchase balances

·   Cash on deposit

·   Other interest receiving amounts

Net Debt Movement

Net Debt Movement is the difference between the Net Debt Opening and the Net Debt Closing and is equal to the Cash Flow for the period.

Net Debt Opening

Net Debt Opening is the Net Debt at the beginning of the current Time Period; it is made up of all Interest bearing or receiving items. This would include both debt and deposits or cash balances, and includes last years:

·   Bank overdraft

·   Commercial bills

·   Other interest bearing debt

·   Amounts owing on Finance Leases

·   Hire purchase balances

·   Cash on deposit

·   Other interest receiving amounts

Net Income

Net Income is the Net Profit After Tax plus or minus Extraordinary Items and is the actual profit from which Dividends are available to be distributed to the shareholders.

Formula

Net Income = Net Profit After Tax +/- Extraordinary Items

Management Hint

Net Income is the true bottom line result for shareholders. If Net Income drops, Dividends will be reduced. If Dividends are not maintained, shareholders will be reluctant to fund the business in the future. Meeting the Net Income requirements means the managing of Earnings before Interest and Tax, Tax, Interest, and Extraordinary Items.

Net Profit After Tax (NPAT)

Net Profit after Tax is the Profit after Interest and Tax. Net Profit After Tax is the normal profit attributable to the owners of the business, before Extraordinary Items.

Formula

Net Profit After Tax = Earnings Before Interest and Tax - Interest - Tax

Management Hint

Net Profit After Tax is the profit from which the shareholders expect to derive Dividends and add value to the business. Any fluctuation in Net Profit After Tax must be analysed from an operational view ie. Earnings Before Interest and Tax, Tax and Interest.

Non Current Assets and Liabilities (Net NC Assts)

Non Current Assets and Liabilities is the sum of Fixed Assets, Investments, Sundry Non Current Assets less Sundry Non Current Liabilities. This represents the Non Current Assets and Liabilities of the business or the enduring asset base upon which the company operates. Non Current Assets and Liabilities are usually not intended for resale.

Formula

Non Current Assets and Liabilities = Fixed Assets + Investments + Sundry Non Current Assets - Sundry Non Current Liabilities

Management Hint

Non Current Assets and Liabilities is usually a substantial component of Net Assets and should therefore be managed carefully. Movement in the Non Current Assets and Liabilities, which is often large in value, can have a dramatic effect on Cash Flow.

Number of Shares (No of Shares)

Number of Shares is the total number of ordinary shares issued to shareholders, at the end of the Time Period. This includes all share units which participate in Dividends

Management Hint

A Unit Trust has units instead of shares.

Other Creditors % (Other Crs %)

Other Creditors % measures the relationship between Fixed Expenses and Variable Expenses and Other Creditors, expressed as a percentage.

Formula

Other Creditors % = Other Creditors/(Fixed Expenses + Variable Expenses) x 100

Management Hint

If Other Creditors % is rising for a given level of Expenses, more credit is being given by the related suppliers. If Other Creditors % is increased, Working Capital will be reduced.

Other Funding Adjustment

Other Funding Adjustment is changes to the Other Funding during the Time Period..

Formula

Other Funding Adjustment = Other Funding Closing - Other Funding Opening)

Other Funding Closing

Other Funding Closing is the Other Funding at the end of the current Time Period and is made up of all Funding items, which are neither Equity Closing nor Net Debt Closing and includes:

·   Non operating provisions eg Tax and Dividend

·   Non interest bearing loan

·   Future income tax benefit

·   Deferred tax

Formula

Other Funding Closing = Other Funding Opening + Other Funding Adjustment

Other Funding Opening

Other Funding Opening is the Other Funding at the beginning of the Time Period and is made up of all Funding items, which are neither Equity Opening nor Net Debt Opening and includes:

·   Non operating provisions eg Tax and Dividends

·   Non interest bearing loan

·   Future income tax benefit

·   Deferred tax

Price/Earnings Ratio (P/E Ratio)

The Price/Earnings Ratio is the price of a business's shares expressed as a multiple of earnings. The Price/Earnings Ratio expresses the Price that buyers are willing to purchase the business for, as a multiple of Net Income. Price/Earnings Ratio is a simple method for calculating the Business Value.

For example, if buyers are willing to pay $100,000 for a business with earnings of $20,000, then the Price/Earnings Ratio is 100,000/20,000 or 5.

Where there is a ready market for a particular type of business, there will be an established range of Price/Earnings Ratios. For example, information on shares on listed stock markets usually includes the Price/Earnings Ratio.

Management Hint

Management usually try to maximise the Business Value. They may wish to use the Business Value as collateral to borrow/raise further Funding, or simply to improve the sale value of the business.

Profitability %

Profitability % is the percentage of Earnings Before Interest and Tax (operational profit) produced from Revenue. Businesses are usually attempting to maximise their Profitability %. This measure informs management, how many cents of operational profit are made from each dollar of Revenue. Profitability % is calculated before Interest and Tax as these items are considered to be non-operating costs of doing business.

Profitability % is one of the components of the Du Pont concept, and is used extensively by management to track and improve performance

Formula

Profitability % = Earnings before Interest and Tax/Revenue x 100

Worked Example:

Revenue = 10,000

EBIT = 1,500

Profitability % = 15%

The business is making a 15c operating profit, from each $1 of Revenue

Management Hint

A business should attempt to maximise Profitability %, to get the most Revenue, with the maximum Gross Profit, from the minimum amount of Expenses. Management should monitor the trend of Profitability % and investigate, taking corrective action.

Raw Materials (Raw Matl)

Raw Materials inventory is the physical components, parts, or building blocks of a manufacturing or processing operation. Raw Materials are manufactured into Work In Progress and finally Finished Goods

Formula

Raw Materials = Raw Materials days x Variable COGS/Time Period in days

Management Hint

For a manufacturing company, Raw Materials may represent a significant investment. Raw Materials levels will therefore have a direct impact on both Cash Flow and Net Assets. Management should seek to maintain sufficient quantities of Raw Materials to enable smooth operations, but should not carry large surplus stocks. Management should set target stock levels and calculate economic re-order quantities.

Raw Materials days (Raw Matl days)

Raw Materials days measures the number of days of Raw Materials held at the end of the Time Period. The Raw Materials days are related to the Variable COGS.

Formula

Raw Materials days = Raw Materials/Variable COGS x Time Period in days

Management Hint

For a manufacturing company Raw Materials may represent a significant investment and a large part of Working Capital. Raw Materials levels will have a direct impact on both Cash Flow and Net Assets. Management should seek to maintain sufficient quantities of Raw Materials to enable smooth operations, but should not carry unnecessary large stocks of Raw Materials. Due to the large impact it may have on Cash Flow. Raw Materials days are a good indication of how well Raw Materials are controlled, compared to the overall activity level. Management should set target stock levels and calculate economic re-order quantities.

Reserve Transfers (Reserve Trfs)

Reserve Transfers are transfers of profits to reserves to cover future contingencies. The reserves therefore reduce the profits available for Dividends to the shareholders, but increase the strength of the business to meet future contingencies.

Management Hint

Use Reserve Transfers to provide for future known or unknown contingencies. This will tend to smooth Retained Income over a number of years. Review Reserve Transfers regularly and ensure that they are adequate. If Reserve Transfers are too high, consider releasing them slowly back to Retained Income.

Retained Income

Retained Income is the residual income left in the business to help fund its future growth. It is the amount left after all Expenses, Dividends, and other items are deducted. Retained Income should be regarded as a re-investment in the business by the shareholders. Retained Income has a direct impact on the Sustainable Growth %, and adds directly to the Cash Flow of the business.

Formula

Retained Income = Net Income - Dividends - Reserve Transfers

Management Hint

If Retained Income is low, the business will be unable to achieve a high Sustainable Growth %. Retained Income is directly impacted by the Dividends policy. If high Dividends are paid, then Retained Income will be lower. Since Retained Income affects the Sustained Growth %, then high Dividends will lead to a lower Sustainable Growth %.

Return On Capital Employed % (ROCE % )

Return on Capital Employed % is the primary measure of operating performance. ROCE % combines the Profit and Loss (Earnings before Interest and Tax) with the Balance Sheet (Net Assets) in a single measurement.

Return on Capital Employed % is the third of the three Du Pont measures. It is used extensively by management to track and improve performance..

Formula

Return On Capital Employed % = Earnings Before Interest and Tax/Net Assets * 100

Worked Example:

EBIT = 1,500

Net Assets = 5,000

ROCE % = 30%

Management Hint

Return On Capital Employed % is the operational return on the Net Assets. As such, it is a very good overall measure of performance and management should monitor this measure on a continuous basis. Return On Capital Employed % should be used in the decision making process, to compare the returns of alternative courses of action. The alternative yielding the higher returns should be favoured, if the advantage will continue into the future and the impact on Cash Flow has also been considered.

Return On Capital Employed % should be compared to the average Interest rate for the business. A business or project, must earn a return at least sufficient to cover the cost of borrowings.

Return On Capital Employed % can be split into its two key elements ie. Profitability % and Asset Turnover. These two measures are multiplied together to derive the Return On Capital Employed %; all three are the basis for Du Pont ratio analysis.

Management should have set Target levels of Return On Capital Employed %, for making decisions. For example, what returns should be derived from purchasing new assets; investing in products or services; setting bonus schemes for management or staff, or for a Target for part of the business.

Revenue

Revenue is the income from Sales and/or fees for selling goods and/or providing services.

Management Hint

Revenue is a key driver of the profit of a business and is a key area for decision making. Revenue levels influence the Balance Sheet requirements for Working Capital and Fixed Assets and the Funding required for the business. The relative mix of Revenue ie products and services, should be monitored as their Contribution % will differ.

Revenue (Price) Increase % (Price Inc %)

Revenue (Price) Increase % is a powerful function which allows instantaneous altering of Revenue by applying a price change. A price change is different from an increase in Revenue, which is a volume increase.

The effect of increasing price has the following impact: In the Profit and Loss:

·   Revenue increases

·   Cost of Goods and Services remains constant (it still costs the same to provide the goods or services per unit).

·   Gross Profit, Earnings before Interest and Tax, Net Income and Retained Income all increase.

In the Balance Sheet:

·   Debtors will rise; the dollar value of each sale has risen.

·   Trade Creditors and Inventories will remain constant as neither the Cost of Goods and Services nor the volume has changed.

Generally, the impact of a price rise will have a greater effect on Gross Profit than a volume increase. This is because the volume increase will increase the Cost of Goods and Services as each new unit sold will have a cost attached.

Management Hint

Management should carefully consider the different impact of changing prices compared to changing volume. The beneficial impact of increasing price is not just confined to the increase in profit but usually increases Cash Flow faster than selling a greater volume. This is because of the increase in margin with no increases in Inventory. The relationship between Price and Volume is very important for all businesses.

Revenue (Volume) Increase % (Volume Inc %)

Revenue (Volume) Increase % is a powerful function which allows instantaneous altering of Revenue by applying a change to the Volume of product or service sold.

The effect of increasing volume has the following impact:

In the Profit and Loss:

·   Revenue increases

·   Cost of Goods and Services increases as greater units of product or service have been sold

·   Gross Profit, Earnings before Interest and Tax, Net Income and Retained Income all increase.

In the Balance Sheet:

·   Debtors will rise; the dollar value of sales has risen.

·   Trade Creditors and Inventories will increase as the number of units sold has increased.

The impact of a Volume Increase will normally improve profits, but will raise the Working Capital requirements in the balance sheet, which may adversely affect Cash Flow.

Generally, the impact of a volume rise will have a lesser effect on Gross Profit than a price increase. This is because the volume increase will increase the Cost of Goods and Services as each new unit sold will have a cost attached.

Management Hint

Management should carefully consider the different impact of changing volumes compared to changing price. The beneficial impact of increasing price is not confined to the increase of profit but usually increases Cash Flow faster than selling a greater volume. This is because a price rise affects the margin with no increases in Inventory. The relationship between Price and Volume is very important for all business.

Sundry Current Assets (Sdry Curr Assets)

Sundry Current Assets represents any Current Assets that cannot be classified as Inventory or Debtors. Examples of Sundry Current Assets are Sundry Debtors and Prepayments.

Management Hint

Although Sundry Current Assets is usually not material compared to other Current Assets, it should be reviewed and any significant changes investigated and appropriate action taken. Minimising Sundry Current Assets will reduce Net Assets and assist Cash Flow.

Sundry Current Liabilities (Sdry Curr Liabs)

Sundry Current Liabilities is all other current Creditors or accruals or non debt Current Liabilities that are not Trade Creditors or Other Creditors.

Management Hint

Sundry Liabilities levels often do not vary significantly from one Time Period to another. Any material change should be investigated.

Sundry Income

Sundry Income is any sundry or non-operating Revenue. Sundry Income can include many miscellaneous sundry items, but does not include any Interest income. An example of Sundry Income is rent received

Management Hint

Sundry Income is usually not material in relation to Revenue. If Sundry Income is a significant number, it should be analysed separately, as it may in fact be concealing a separate business.

Sundry Non Current Assets (Sdry NC Assets)

Sundry Non Current Assets is all Non Current Assets which do not fit into the Fixed Assets or Investment categories. It may contain Non Current Debtors, Raw Materials, Work In Progress, Finished Goods, or Sundry Assets.

Management Hint

The nature of each major item of Sundry Non-Current Assets should be investigated and where appropriate these items should be reduced. This will reduce Net Assets and improve Cash Flow.

Sundry Non Current Liabilities (Sdry NC Liabs)

Sundry Non Current Liabilities are all liabilities not due within one year. It includes non current Trade Creditors, Other Creditors and Sundry Liabilities. Sundry Non Current Liabilities does not include any Funding items

Management Hint

Increasing the Sundry Non Current Liabilities reduces Net Assets and improves Cash Flow. Each item should be reviewed and extended if appropriate.

Sustainable Growth % ( Sust Growth % )

Sustainable Growth % is the maximum rate at which a business can increase its Revenue while maintaining the way it operates.

Increasing Revenue while maintaining the way the business operates means:

·   Margins remain constant

·   Expenses rise in line with Revenue

·   Dividends remain constant as a % of Profit

·   Working Capital remains constant to Revenue

·   Fixed Assets rise in line with Revenue

If this were to happen Profitability %, Asset Turnover, ROCE % and Debt to Equity would remain constant.

If Debt to Equity is 1.5, for each $1 of Equity the business currently borrows $1.5. Therefore if the impact of increasing Revenue produces Retained Income (Equity) of $10,000 the business will need to borrow $15,000 to maintain the same Debt to Equity. The $25,000 additional Funding would be used to purchase the new Fixed Assets and pay for the increase in Working Capital.

If the bank is not prepared to advance additional Debt, the business will have to fund Growth by other means:

This could be done by the owners putting in additional Equity -

·   By reducing Dividends paid out

Or by operating more efficiently -

·   Increasing Profitability %

·   Increasing Asset Turnover

If no additional Funding can be obtained, nor can the business operate more efficiently, the business will not be able to grow.

Formula

Sustainable Growth % = Retained Income/Equity Opening x 100

Management Hint

Sustainable Growth % is a powerful overview measure. Management should have a view of the future growth targets they wish to achieve. They should also know the limitations of the business to sustain future growth in financial terms ie the Sustainable Growth %.

If Revenue grows faster than the Sustainable Growth %, the business will need to fund that growth. There is a danger that Debt to Equity will need to increase substantially, as more Debt will be needed to achieve the growth. Alternatively, the owners would need to contribute more Equity to fund this growth.

Sustainable Growth % is fundamental in planning for the future of the business. For example, if growth in the industry is 10% per annum and management wish to match this in Revenue growth. There are two possibilities:

The Industry Growth is less than the Sustainable Growth %. The business must ensure that no fundamental changes in operations occur that may lower the Sustainable Growth %. For example the bank requires a reduction in Net Debt levels, or the Dividends policy changes.

The Industry Growth is more than the Sustainable Growth %. The business will either have to lose market share or fund the growth by borrowings, equity or by operating more efficiently.

Management should realise that they can improve the Sustainable Growth % by improving the Retained Income. Retained Income can be improved by changing its components. The most immediate impact is to look at the levels of Dividends which the business pays out. If the Dividends payout is very high then it will be difficult to achieve a high Sustainable Growth %.

All improvements to the Earnings Before Interest and Tax, Interest, Tax and any reduction in Dividends will contribute to the increase in Retained Income, and therefore to the lifting in Sustainable Growth %. Note that Interest is a function of Cash Flow, so good management of the balance sheet will improve Cash Flow which reduces Interest and improves the Sustainable Growth %.

Tax

Tax is the net Tax expense for the business.

Formula

Tax = (Earnings Before Interest and Tax - Interest) x Tax %

Management Hint

The value of good Tax planning cannot be overestimated. The trend of Tax % should be studied carefully over a number of periods and compared to overall prevailing Tax rates to ensure that the Tax incurred is within acceptable limits. Good Tax advice should be sought if the Tax % is too high.

Tax %

Tax % measures the effective Tax rate paid on the profit earned.

Formula

Tax % = Tax/(Earnings Before Interest and Tax - Interest) x 100

Management Hint

The Tax % should be compared to the general Tax levels, to ensure that it is reasonable. Sudden changes in the Tax % should be investigated for underlying causes.

Total Funding Adjustment

Total Funding Adjustment is the sum of the Equity Adjustment plus the Other Funding Adjustment.

Formula

Total Funding Adjustment = Equity Adjustment + Other Funding Adjustment

Total Funding Closing

Total Funding Closing is the sum of the Net Debt Closing plus Equity Closing plus the Other Funding Closing. Total Funding Closing is always equal to the Net Assets.

Formula

Total Funding Closing = Net Debt Closing + Equity Closing + Other Funding Closing

Total Funding Movement

Total Funding Movement is the sum of the Net Debt Movement plus Equity Movement.

Formula

Total Funding Movement = Net Debt Movement + Equity Movement

Total Funding Opening

Total Funding Opening is the sum of the Net Debt Opening plus Equity Opening plus the Other Funding Opening.

Formula

Total Funding Opening = Net Debt Opening + Equity Opening + Other Funding Opening

Trade Creditors (Trade Crs)

Trade Creditors is the amount owing to suppliers of goods or services. Trade Creditors relates to the Cost of Goods and Services. Trade Creditors rise and fall with the activity level of the business, and with the length of trade credit extended by the suppliers, measured as Trade Creditor days.

Formula

Trade Creditors = Trade Creditors days x Cost of Goods and Services/Time Period in days

Other terms for Trade Creditors:

Accounts Payable

Management Hint

Establishing good working relationships with your suppliers and negotiating good credit terms (and taking them!) will increase the amount in Trade Creditors, which will reduce the Working Capital requirements of the business and assist Cash Flow. Simply put, the more the Trade Creditors extend credit, the longer the period available to sell Inventory and collect Debtors, before payment is due to the Trade Creditors. This will reduce the external Funding requirements for Working Capital, reduce Net Assets and improve Cash Flow. Management should review the relative credit terms they receive from suppliers and look for opportunities to increase the number of Trade Creditors days. The impact of discounts given for early settlement should be assessed in relation to the impact on Cash Flow and Return On Capital Employed %.

Trade Creditors days (Trade Crs days)

Trade Creditors days measures the average time taken to pay Trade Creditors. The calculation is based on Trade Creditors at the end of the Time Period and Cost of Goods and Services for the Time Period.

Formula

Trade Creditors days = Trade Creditors/Cost of Goods and Services x Time Period in days

Other terms for Trade Creditors days:

Accounts Payable days

Management Hint

If Trade Creditors days are rising, then more credit is being given on purchases by suppliers. This could be a good sign, as Trade Creditors are reducing the Working Capital. Management should consider how far Trade Creditors days can be extended, without endangering the relationship with suppliers. Extension of Trade Creditors days may be a sign of a business experiencing Cash Flow problems.

Variable COGS (Var COGS)

Variable COGS is the direct variable cost of producing the Revenue.

Formula

Variable COGS = Revenue x Variable COGS %

AND

Variable COGS = Revenue x (100 - Contribution %)

Management Hint

The Variable COGS is usually a large proportion of Revenue and, as such, any changes will have a significant impact on Profitability %, Cash Flow, and ROCE %. Management should exercise constant control over these costs.

Variable COGS % (Var COGS %)

Variable COGS % measures the relationship between the Variable COGS and Revenue.

Formula

Variable COGS % = Variable COGS/Revenue x 100

AND

Variable COGS % = 100 - Contribution %

Management Hint

The Variable COGS % is a critical performance factor, as such, any changes will have a significant impact on Profitability %, Cash Flow and ROCE %. Management should exercise constant control over these costs.

Variable Expenses (Var Expenses)

Variable Expenses are overheads that vary directly with Revenue. An example is commissions paid.

Formula

Variable Expenses = Variable Expenses % x Revenue

Management Hint

The relationship between Fixed Expenses and Variable Expenses should always be considered. If for example the business operates with high Fixed Expenses and low Variable Expenses, then as Revenue decreases, profit will decrease. If Revenue increases, the low Variable Expenses will allow a significantly greater profit. The Variable Expenses % should be minimised by constant review of its component parts.

Variable Expenses % (Var Expenses %)

Variable Expenses % measures the relationship between Variable Expenses and Revenue, expressed as a percentage. The Variable Expenses are overheads that relate directly to Revenue. For example, commissions.

Formula

Variable Expenses % = Variable Expenses/Revenue x 100

Management Hint

The Variable Expenses % should be managed within acceptable limits. Any adverse trends should be investigated and corrected as soon as possible.

Work In Progress (WIP)

Work In Progress may be applicable to both manufacturing and service industries.

Manufacturing - Work In Progress is the value of Inventory under manufacture at the end of the Time Period. It is the Raw Materials cost plus any value adding costs, such as direct labour. On completion, Work In Progress becomes Finished Goods.

Service - Work In Progress is work completed, but not yet billed. It should include the labour cost of doing the work, plus any additional indirect costs which are incurred. Once billed Work In Progress is effectively transferred to Debtors.

Formula

Work In Progress = Work In Progress days x Cost of Goods and Services/Time Period in days

Other terms for Work in Progress:

Work in Process

Management Hint

Work In Progress can be a material amount. Most costs during this stage of the process are directly variable. Management must exercise continuous control over these costs. If not, the cost of the Finished Goods/Services will escalate, causing the business to become less competitive and less profitable. The absolute value of Work In Progress also represents significant investment in Working Capital, which has a direct impact on Cash Flow and Net Assets. Management should reduce the Work In Progress days where possible, as a reduction will shorten the processing time ie. efficient processing and reduction of Working Capital requirements.

Work In Progress days (WIP days)

Work In Progress days measures the number of days of Work In Progress held at the end of the Time Period. This is related to Cost of Goods and Services.

Formula

Work In Progress days = Work In Progress/Cost of Goods and Services x Time Period in days

Other terms for Work In Progress days:

Work in Process days

Management Hint

If Work In Progress days rise, then more Work In Progress is on hand for a given level of operations. Reducing Work In Progress days will improve Cash Flow and reduce Working Capital requirements.

Working Capital

Working Capital is the net of Current Assets and Current Liabilities. Working Capital is the current portion of the Net Assets that is used to generate the Revenue.

Formula

Working Capital = Current Assets - Current Liabilities

Management Hint

Management must minimise the level of Working Capital without jeopardising the smooth running of the business. Each element of Current Assets and Current Liabilities must be monitored with particular regard to:

Minimising -

·   Debtors

·   Raw Materials

·   Work In Progress

·   Finished Goods

Maximising -

·   Trade Creditors

·   Other Creditors

Improvements to the above will improve the relative size of Working Capital with regard to Revenue. Good Working Capital management will improve Cash Flow and reduce the need for external Funding.

Working Capital to Revenue Ratio (WrkCap/Rev)

Working Capital to Revenue Ratio shows, how much Working Capital is required to generate a dollar of Revenue. The ratio is a forward looking measure; it indicates how much of each dollar of Revenue is being invested in Working Capital, to generate the next dollar of Revenue.

Formula

Working Capital to Revenue Ratio = Working Capital/Revenue.

Worked Example:

Revenue = 10,000

Working Capital = 2,500

Working Capital to Revenue Ratio = 0.25

For every $1 of Revenue, 25c is invested in Working

Capital.

Management Hint

Management should monitor the Working Capital to Revenue Ratio, looking for variations, as well as analysing why changes occur. It is extremely important for management to know the relationship between the components of this measure. If the business is to increase Revenue, management should be aware of the required investment in Working Capital.

A variation in this measure may be as a result of changes in the management of Working Capital, or Revenue may have changed due to price changes.

The Working Capital to Revenue Ratio should be compared to the Contribution %. The Contribution % must be greater than the Working Capital to Revenue Ratio. If it is not, the business operations are not producing Cash Flow to pay for Expenses, Dividends, Tax etc.