Measures of performance
Relationships between the balance sheet and the profit and loss account
I often wonder what the vintners buy that is half so precious as the goods they sell.
RUBAIYAT OF OMER KHAYYAM (1859)
Relationships between the balance sheet and profit and loss account
When we wish to examine a company’s profitability performance, we look at its absolute profit in relation to the assets tied up in the business. But the question arises: which figure should we take from the profit/loss account, and which figure from the balance sheet?
Figure 5.1 shows the accounts for the Example Company plc with values extracted for:
| • Profit/Loss account | • Balance sheet |
| – EBIT | – TA |
| – EBT | – CE |
| – EAT | – NW |
Performance is measured by establishing relationships between these two sets of values.
However, we have a choice as to which value we use from each statement. Earnings before interest and tax could be measured against total assets or capital employed or net worth. We could do likewise, with earnings before tax and earnings after tax. This gives us nine possible measures of performance. In practice, we meet with all of these measures and even with some other variations.
Various names are given to these linkages or ratios between the balance sheet and the profit and loss account values. The names come and go, becoming popular for a while and then maybe disappearing according to fashion. A selection of these could be:
| • return on assets | – ROA |
| • return on net assets | – RONA |
| • return on capital employed | – ROCE |
| • return of invested capital | – ROIC |
This multiplicity of terms causes difficulty to the non-specialist, but the point to remember is that these are not different ratios. They all simply measure in one way or another the return on assets. The name used does not greatly matter. What is important, however, is that we know which profit and loss figure is being related to which balance sheet figure.
Figure 5.1 Important terms from the profit and loss account and balance sheet using data from the Example Co. plc
This book will initially use two measures only. They have been carefully selected and are illustrated in figure 5.2. We do not imply that these are the only correct ones or that all others are deficient in some way. However, they are two of the better measures. There is sound logic for choosing them in preference to others as we will see in due course.
The ratios ‘return on total assets’ and ‘return on equity’
The two ratios chosen here for the measurement of company performance are illustrated in figure 5.2. These are:
- return on total assets’ (ROTA) which gives a measure of the operating efficiency of the total business. The method of calculation is EBIT/TA expressed as a percentage. For the Example Company plc the answer arrived at is 14 per cent.
- return on equity’ (ROE) which assesses the return made to the equity shareholder. The method of calculation is EAT/OF as a percentage. In our example the answer is 16.66 per cent.
The significance of these numbers will be examined in chapter 6. In the opinion of the author these are the two fundamental performance ratios.
This said, there are many possible variations to them and some may well be more suitable for particular types of businesses. One that is widely used is ‘return on capital employed’ (ROCE). As we saw earlier in chapter 3, capital employed is the figure we get by deducting current liabilities from total assets. The corresponding profit and loss value used is EBIT with the deduction of interest on short-term loans. Because a smaller denominator is used in calculating return on capital employed, we would expect a higher answer than for return on total assets.
When new expressions for these ratios are encountered it is often not clear which profit and loss value is being measured against which balance sheet value. Then the question to ask is ‘How is it calculated?’ When you know what the calculation method is, it is as easy to work with one combination as another. However, there is a certain logic that should be followed in deciding on any particular ratio – if the value from the balance sheet includes loans, then the profit and loss value should include the corresponding interest charge and vice versa. This rule is not always adhered to and the resulting answers can be suspect.
Figure 5.2 The two measures of performance used in this book: return on total assets and return on equity applied to data from the Example Co. plc
Balance sheet layouts
A number of alternative forms of layout, particularly in the case of the balance sheet, are used in presenting accounts. While the layout itself does not affect any of the numbers, it can be difficult when faced with an unfamiliar format to find where items are located and what are values for ‘total assets’, ‘capital employed’, etc.
The first point to remember is that the items within each of the five boxes will always appear grouped together – they are never scattered around among other items. Sometimes, however, the total only of a subsection will appear in the balance sheet proper while the detail is to be found in the notes to accounts.
Vertical balance sheet – version 1
Given the five-box grouping, it follows that there is only a limited number of ways in which the boxes can be arranged. In figure 5.3, one such re-arrangement is shown. It is easy to see how the items in the two-column format have been re-ordered into a single vertical column. This type of layout has the advantage that corresponding values for successive years can be laid out side by side for ease of comparison. In this format, values for ‘total assets’ and ‘total funds’ are also emphasized.
Figure 5.3 Vertical sheet version 1 using data from the Example Co. plc
Vertical balance sheet – version 2
The second layout, as shown in figure 5.4, is a slightly more sophisticated version, but it is the one most often seen in published accounts. The difference here is that current liabilities have been moved out of the liabilities section and are instead shown as a negative value side by side with current assets. The totals of these two sections are netted off to give the figure for ‘working capital’.
Both sides of the balance sheet are, accordingly, reduced by the amount of the current liabilities – $240. The original totals amounted to $800, so the new balancing figure is $560. This figure, as seen earlier, is ‘capital employed’.
The advantage of this layout is that both working capital (current assets less current liabilities) and capital employed values are identified. The disadvantage is that the figure for total assets does not appear anywhere on the balance sheet.
It is largely a matter of personal preference as to which format is adopted. In the three types of layouts illustrated (the five-box format and vertical versions 1 and 2), practically all possible situations have been covered, so most balance sheets should now make sense. It is a good idea to take whatever form is used and transfer the figures into the familiar five-box format as the significant features will then quickly become evident.
Appendix 1 lists a number of items that we have deliberately omitted here because we can do most of our analysis without taking them into account. Two of these items are (1) preference shares and (2) minority interests. These will not be present at all in many accounts you encounter and where they exist they are likely to be insignificant.
Note: The headings ‘Creditors: amounts falling due within one year’ and ‘Creditors: amounts falling due after more than one year’ are widely used to refer to current liabilities and long-term loans respectively.
Figure 5.4 Vertical sheet version 2 using data from the Example Co. plc
