- Use of ratios in performance evaluation
Ratios provide an evaluation platform for companies. Through calculation of ratios, firms have two to three options for evaluation. The options involve a set of conditions that make the use of ratios possible. This is because ratios only play a comparison role and cannot be used in isolation. They have to be applied together with a set of other ratios to make comparison hence deduce information that enables performance evaluation.
The first option in using ratios involves the application of ratios together with industrial ratios of the firm’s industry. Often, the industry in which the firm operates in have industrial ratios. Their ratio is often an average of firms’ performance. The industrial ratios can be applied in connection with firm ratios. A quick comparison would tell whether the firm is dwindling or performing well. Ordinarily, firm ratios should be above industrial ratios. This is because as has been noted, industrial ratios give an average. Any firm whose ratios are below the industrial ratios are deemed to be performing below average. In that vein, ratios can be used to determine the going concern, profitability of a firm, and average industrial performance of firms. A firm would then make use of the information derived therefrom.
Another set of ratios applicable are previous firm’s ratios in previous years in comparison with current posted ratios. This often shows the trajectory assumed by the path over the years in terms of performance. Often, ratios are applied across the board, management and other consumers could analyse their performance across years. In this light, ratios do not merely tell the going concern or profitability of a firm, they also illustrate the tides a firm goes through over a period. Usually, management are privy to prevailing circumstances during the years of operation. They can hence relate a good or bad showing to the corresponding prevailing circumstances during that time. To this extent, ratios apply to inform consumers of the firm’s consistency or fluctuation in the annual performance. They also show the common trend, that is, whether the firm is on a declining, flat or descending nature if performance.
Finally, ratios of a firm can be read in connection with ratios of a competing firm. Usually, the industrial ratios only give the average ratios of the firm. However, the firm may want to get the exact ratios of its competitor and make a direct comparison. This would be used comparatively with the firm’s own ratios. It would inform the firm of its performance relative to its rival. This way, the firm can tell whether it stands better off or worse off as compared to its rivals in the industry. This method of ratios application is the most essential as it goes past mere show of a firm’s performance and indicates its competitive ability. Competitive ability of a firm is only judged by its performance relative to the rivals.
Limitation of the use of ratios
Ratios are basically a mathematical calculation that converts data into figures. This could be advantages in making raw comparisons. However, when the exact reasons behind the figures are needed, ratios do not give the answers. To this extent, it is argued that ratios are simplistic in nature. They fail to capture the exact causative of the conditions prevailing. In addition, ratios are susceptible to misinterpretation. This is essentially because while one may assume that the results are due to the commonly associated reasons, the exact cause of the result could be different from the assumptions made. The fact that the data fails to capture causes of results and merely relies on the final outcomes makes ratios too simplistic to rely on for the solution of complex business matters. Management and other consumers rely on more precise information and ratios play only a complimentary role.
- Ratios for years 2011 and 2012
- Commentary on the changes of ratios in years 2011 and 2012
Generally, the firm’s performance was better in 2012 as compared to the performance in 2011. The changes in the ratios illustrate this. This section briefly considers each ratio and the registered changes. The gross profit margin ratio essentially shows the level of profitability before any expenses are deducted. It shows how much the company made in operations only, that is, the turnover against the purchases. In 2012, it increases slightly from 8.00% to 8.15%. This indicates a slight increase in the level of profits made in that year before any expenses are deducted.
The Net profit margin shows the profits made after deduction of expenses. It shows how much profits the concern made after incurring all associated costs relative to that financial year. In 2012, it increased from previous 4.38% to 4.58%. This indicates that the firm performed better in that year as compared to the previous year and that it probably made more profits in that financial year.
Asset cover shows the level of use of the assets relative to the long term debts in the concern. It, therefore, reflects the utility level of assets relative to the debts and by extension how many times assets can cover the long term debts. A higher figure shows better performance as the business becomes more secure. In 2012 the asset cover reduced from the previous 2.28 times to 2.26 times. This indicates that the business increased the use of long term debts without increasing on the efficiency of the assets. This indicates a downfall in terms of performance.
The Return on capital indicates the return in terms of profitability relative to the capital committed to the concern. Return on capital measures the performance of the capital invested in the concern. The ROCE in 2012 improved from previous 9.06% to 9.29%. This shows that the firm utilized the capital employed better in terms of returns than it had done in the previous year.
Current Ratio denotes the liquidity position of the firm. This is dependent on the profitability of the firm. It shows how much the current assets can cover the current liabilities. A ratio of below one to one indicates likely insolvency as the current assets are not able to cover the current liabilities. This is the position of the firm in the two years. However, in 2012, the insolvency position slightly reduced from the previous 0.65: 1 to 0.68:1. This shows an improving liquidity position of the firm.
Gearing ratio shows the debt level of the firm. It exhibits the amount of debt the firm is using. To this extent, the firm’s debt level is on the increase. In 2012 it increased from the previous 43.90 times to 44.16 times. It shows that the firm is employing more debt in its financial structure.
The interest cover shows the extent to which the profit before taxation and interest can cover the interest charges. This shows the essence of incurring the debt. This is because debt serves the purpose of availing funds for transacting and profits arise out of the transactions. In 2012 the interest cover decreased from previous 8.32 times to 7.89%. This indicates an overall decline in profits relative to interest charges.
- Comparison of 2012 Tesco Ratios to Industrial average
Generally, a firm should exhibit better performance than industrial averages. However, it is necessary to note that the figures for the industrial average in this case were pulled from 10 peer companies. They, therefore, show the immediate rather than extreme performance within the industries. Tesco’s Gross Profit margin is higher than industrial at 8.15% against 7.85%. This shows better performance.
The net profit ratio is lower at 4.58% against industrial 5.21%. It shows that Tesco is incurring more expenses that what the peers incur. Tesco’s asset cover ratio is far below the industrial at 2.26 times against industrial at 5.42 times. This again shows the poor performance in terms of assets used relative to returns gained.
The Return on Capital Employed is also lower for Tesco at 9.29% compared against industrial at 21.31%. This shows poor performance in terms of returns on capital employed. The current ratio of Tesco is lower at 0.68:1 compared to industrial at 0.76: 1. This shows that Tesco stands at a lower liquidity position compared to its peers. The gearing ratio is lower than the industrial at 44.16% compared to 79.29%. This is advantages to Tesco as it shows use of lesser debt levels compared to peers. Finally, the interest cover is lower at 7.89% compared to industrial at 10.48%. This shows that the firm is making less out of its debt as compared to what the peers are making on average.
References
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