Analysing Financial Performance

Using Integrated Ratio Analysis

Nic La Rosa

• Publisher: Routledge
• Year: 2020
• ISBN:
  9781000319859
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Contabilidad financiera

Despite a plethora of techniques to analyse the financial performance of a business, there has been no single methodology that has been overwhelmingly preferred by users. This could be an indication that either the methods themselves are deficient or they are limited by other factors that are not easily overcome.

Unlike the current offerings in the field, which focus on issues relating to business performance management or non-financial aspects (such as market efficiency, satisfaction and workforce productivity), this book offers a solution to a major gap in the literature and understanding for those seeking to measure, analyse and benchmark the financial performance of any organisation (for-profit, not-for-profit and government agencies). It clearly identifies why current techniques fail; proposes and evidences a solution that overcomes these issues by including two algorithms that can be combined, to solve this problem; and demonstrates the practical application of the technique to the benefit of users in order to pinpoint real performance levels and insights. One of the largest issues this book will help to overcome is the inability to compare the accounts of businesses/organisations from different countries that report in different currencies. This technique eliminates the need for currency translations and the issues that arise with that process.

This book is an invaluable and practical guide to assist accounting and finance practitioners in measuring and comparing financial performance across firms with different business models, different accounting policies and different scales of operations.

1 Background and overview

Abstract

The aim of this chapter was to identify and explain the major reasons why currently utilised financial performance measurement systems fail to adequately fulfil their purpose. The four major problems that were identified were a lack of inherent context, the shortcomings of currency, perspective scale and temporal consistency. This chapter also explained how these issues negatively affected business financial performance measurement (BFPM) and analysis, and demonstrated that, because of these issues, current BFPM techniques are inadequate for their purpose.

Introduction

The practice of reporting, measuring and assessing the financial performance of organisations is a vital task for ensuring their financial well-being and longevity. Unfortunately, there are a number of issues that, to date, currently popular methods don’t address, which is why those techniques do not adequately fulfil this objective. Although it is commonly understood that current techniques are flawed and inadequate for their stated purpose, there has been a lack of clarity about what the causes of this failure are. Without an understanding of what a potential solution needs to overcome, it would be difficult to truly appreciate the benefits of the methodology espoused in this book. The aim of this chapter, therefore, is to provide a brief background to the problem; to clearly identify and explain the issues to be overcome; and to introduce the system that overcomes these issues and will enable the fulfilment of the task of financial performance measurement and assessment.

Overview

Organisations may operate with different currencies, accounting policies, time periods and scales of operation. The analysis of the financial performance of those organisations would require the use of instruments that will enable valid direct comparisons between every organisation (and also in relation to the same organisation) over time. Such an instrument would increase the level of confidence in any conclusions that are derived from the data generated. The integrated ratio analysis methodology (IRAM) was originally created to satisfy the requirement for a robust instrument to assist with the comparative financial analysis of organisations. The range of applications for which the system can be utilised has, subsequently, expanded such that it possesses an enhanced utility for internal financial performance assessment requirements.

The IRAM overcomes a number of specific issues of concern relating to previous efforts to enable the assessment of the financial performance of organisations. This includes the effects of the time period selected for assessment, perspective scale and, more importantly, the shortcomings of the currency unit of measurement itself. This chapter provides a general overview of the history, developments and limitations that relate to the field of business financial performance measurement (BFPM). It will clarify the arguments that underpin the creation and development of the IRAM and demonstrate how this system overcomes the deficiencies of predecessors. The liberal use of examples and case studies throughout this book should not only ensure a thorough understanding of why it works, but also how the methodology should be applied in practice.

Although some of the potential benefits that could be enjoyed by practitioners and academics will be identified, it is likely that many more applications and benefits will be discovered by adopters of the system as the use of the methodology becomes more widespread and accepted. One example of potential benefits is the possible use of the IRAM in establishing universal standards of materiality for auditors. Another benefit from this system includes the improvement of homogeneity of data between different (and within specific) organisations. This will ensure that practitioners will benefit from more meaningful, consistent and accurate insights into the financial performance of organisations as stand-alone enterprises or when benchmarked to other enterprises. The benefits of this system could revolutionise the financial reporting practices of organisations globally as the expected utilisation from analysts should exponentially increase with the growing awareness of the advantages of the system.

This chapter will identify and illustrate why current financial performance techniques fail to enable qualitative assessments of the financial performance of organisations. This will be followed by an analysis of how traditional approaches that were adopted to report and measure financial performance (such as ratios and percentages) have failed to overcome these deficiencies. Understanding the flaws of these techniques and approaches will allow a greater appreciation for the abilities of the solution offered in this book to better meet the needs of the users of financial information. This solution is the application of one algorithm in two different time settings that, when applied in tandem, become a very powerful system to generate insights into the actual financial performance of any organisation. Once this system has been explained and demonstrated, this book utilises case studies and examples to help you understand how to apply the system for your own needs.

One application of the algorithm (the anchored ratio [AR]) converts the currency value of any variable into ratio values that absolutely mirror the patterns of the currency values over time. The ratio values, however, are a normalised version of the currency values and, therefore, enable the ratios for any organisation to be directly comparable to any other organisation irrespective of perspective scale. The other application of the algorithm (the proportional asset ratio [PAR]) provides a true level of significance (or performance) of every variable for a single period of time. This is independent of any results from prior or later periods of time. The simultaneous combination (or integration) of the AR and PAR techniques defines integrated ratio analysis. By overlaying the results of the two applications, an analyst can obtain instant clarity as to whether changes in the growth of financial variables are holistic (real) or not. No matter the purpose for the system to be utilised, the knowledge that it overcomes the identified shortcomings of other measurement systems should provide the confidence to employ it for financial performance measurement and analysis purposes.

Background

Measuring the financial performance of an organisation should be a simple exercise. This task involves money, which is measured in numbers, and so it could be expected that the greater the amount of money that is generated, then the better the financial performance would seem to be. The issue with financial performance measurement is not, however, the ability to quantify the financial performance of a business. The major difficulty that has been plaguing analysts is the inability to adequately assess the quality of a performance. Behn (2003, p. 586) succinctly summarised this notion by postulating ‘Why measure performance? Because measuring performance is good. But how do we know it is good?’ There are simply no accepted norms for what would constitute a good financial performance and even less agreement as to how ‘good’ such a performance would be.

In 2008, a company called ABC Learning that was listed on the Australian Securities Exchange (ASX) collapsed. It appeared that nobody was able to foresee this occurrence. For at least the five years prior to failure, all of the traditional financial performance metrics had been indicating that the business was performing exceptionally well. Indeed, the 2007 Annual Report touted a 115 per cent increase in revenue to AU$ 1.7 billion and a 76 per cent increase in profit after tax to AU$ 143.1million (ABC Learning Annual Report 2007). The share price during this period had increased from around the AU$ 2 mark in 2001 to just over AU$ 8 in 2006 (Rush and Downie, 2006, p. 217).

It appears that, while the market had no problem with quantifying the financial performance of ABC Learning, it didn’t correctly appreciate the quality of that performance. Despite professional investors viewing ABC Learning as a very successful business, there was something fundamentally amiss about the actual performance that was not immediately apparent from the performance measurement systems available. If this was the case (and the evidence suggests that it was), then this was a failure that could have been prevented or, at the very least, the impact could have been minimised if the instruments used to measure the financial performance of the company were not fundamentally flawed. The pressure on managers and investors to make the correct resource allocation decisions is escalating as rapidly as technology and systems advancements are increasing. The need for methodologies that can reliably and accurately assist these decisions is, consequently, of paramount importance to such decision-makers.

This book will not only clearly explain and demonstrate what these flaws are, but also introduce a new measurement system that could have been used by the managers and investors of ABC Learning to avoid the failure altogether. The system in this book has been designed to provide a remedy for many of the deficiencies of current offerings in this field. It is believed that by eliminating many of the issues that reduce the reliability and comparability of traditional measures, this system will go a long way towards being able to answer the question of how ‘good’ a performance really was.

The need for business performance measurement

Much of the debate in this field has been centred upon the purpose of performance measurement. Behn (2003, p. 586) recognised this with the question, what ‘…is behind all of this measuring of performance? After all, neither the act of measuring performance nor the resulting data accomplishes anything itself…’ Pike and Roos (2007, p. 218) further expand on this notion with the statement that, ‘Performance measurement assumes that the results it provides and the benchmarking activities that accompany it are useful in themselves’. If the techniques and outcomes being performed and produced by the financial community are not the final objective, then it logically must follow that they are being employed to satisfy some other particular need or purpose. Indeed, Behn (2003) argues that performance measurement is being conducted in order to assist managers in achieving a number of specific managerial functions and purposes for which performance measures could prove to be useful. Behn (2003, p. 586) lists these purposes as ‘…to evaluate, control, budget, motivate, promote, celebrate, learn and improve’.

There is little need to e...