Variance analysis

This involves investigating the reasons for differences between actual results and budgeted figures, either in terms of money or in terms of volumes – for example, the number of labour hours, or amount of materials used in production.

Variance can be:

• Negative or adverse – if outturn sales are less than planned, or if outturn costs exceed budget.

• Positive or favourable – if outturn sales revenues are more than planned, or if outturn costs are below budget.

There are a number of important variances a firm will seek to monitor and analyse. The profit variance is usually the most important, showing the extent to which actual profit is greater or less than planned profit from the master budget.

Type of variance	Some reasons for variance
Sales variance Direct materials Direct labour Overheads	Unforeseen price changes Higher or lower sales volume than expected Higher or lower prices than usual Increased wastage or inefficiency Negotiated pay settlement Cut in labour force Change in labour productivity Equipment breakdown Paper wastage Power cut Rise in price of materials

Budgetary control, therefore, is the process of setting targets, preparing budget plans, monitoring those plans, and then analysing variances.

13.3. Ratio analysis

What is a financial ratio?

An accounting ratio or financial ratio is simply the comparison of two figures in company accounts produced by dividing one key figure by another, and usually taking a percentage.

Data on profit, sales, or capital employed in a firm alone tells us very little about how well a business is doing. Ratio analysis uses financial ratios to make meaningful comparisons of business performance over time and between different firms.

Even simple comparisons of financial data may reveal a great deal. For example, an investor has the choice of either placing money in a safe bank account and earning a guaranteed rate of interest, or risking money by buying shares which might provide a high rate of return – or none at all. Which is the best investment? A simple comparison of two figures could provide the answer. A bank account might pay 8% interest each year – that is, a return of 8 pence in every pound. If a firm received 100,000 pounds in shareholders’ funds and earned a profit of 5,000 pounds, this is only a return of 5%, which is significantly worse than the 8% which could be earned elsewhere. In this case, an investor would be better off placing savings in the bank. In making such a calculation, the investor is working out a financial ratio or comparing the return on savings to the return on investment in shares.

The key accounting ratios used by business organisations are:

• Liquidity ratios – to measure the ability of a firm to meet its debts

• Profitability ratios – to measure how well an organisation is doing

• Activity ratios – to measure how efficiently a firm is using its resources

Liquidity ratios

The liquidity of a firm is measured by comparing those assets which can turned into cash quickly, known as current assets, and those liabilities which have to be paid out in the short term, known as current liabilities.

If a firm has plenty of assets which can easily be converted to cash in order to meet liabilities which are due to be paid out soon, it is said to be liquid. If, however, it is illiquid, it may have to obtain an expensive bank loan or sell off important fixed assets, such as machinery, to raise cash in order to meet its business debts.

Liquidity ratios, also known as solvency ratios, are useful as they can give early warning of financial problems which might occur if there is a sudden demand for cash.

The ability of a firm to meet its short-term debts is measured by a liquidity ratio known as the current ratio, where:

Current Ratio = Current Assets / Current Liabilities

A generally accepted rule is that current assets should be about double current liabilities, to give a current ratio of 2:1. Any lower, and the firm could be in danger of running out of cash. A ratio any higher than 2:1 means that too much money is tied up in cash and not enough is being invested, either in interest-earning bank accounts or in capital equipment.

A ratio of less than 1:1 means that current liabilities exceed current assets, and the firm will not be able to pay its immediate debts and may have to sell some of its fixed assets.

An alternative ratio for measuring liquidity is known as the liquidity ratio or acid test ratio.

Acid Test Ratio = (Current Assets – Value of Stock) / Current Liabilities

The acid test ratio excludes stocks of finished products and materials from the calculation of current assets. That is, the ratio measures whether or not a business is able to meet its short-term debts without having to sell off stocks. This is because when a firm needs to raise cash quickly, it may be quite difficult to sell its stocks of finished goods.

As a general rule, an acid test ratio of 1:1, where current assets minus stocks equals current liabilities, is considered reasonably safe for a business, because it can meet all its short-term debts without having to sell off its stocks. If the ratio falls below 1:1, then the firm could face problems if all its creditors demanded to be paid at the same time. In this case, it would need to sell stocks to meet these debts and, should this not be possible, either borrow the money or sell fixed assets.

Profitability ratios

Profitability ratios used to measure how well a business is doing deal with such financial indicators as gross profit margin, net profit margin, and return on capital employed (ROCE).

The gross profit margin is a measure of how much total profit is made as a percentage of sales. The ratio is a measure of trading efficiency. The higher the percentage, the better the business trading performance.

Gross Profit Margin (%) = Gross Profit x 100 / Turnover

Net profit is arrived at after overhead expenses, such as electricity, telephone, and gas, have been paid out from gross profit. The difference between gross and net profit therefore gives an indication of a firm’s ability to control its costs. The higher the net profit margin, the smaller the difference between costs and revenues.

Net profit Margin (%) = Net Profit x 100 / Turnover

The net and gross profit margins provide a useful means of judging business performance when comparing business performance across two or more years. If gross margins stay constant but net margins decrease, this means that overheads must have increased during the year. With this information, management may wish to investigate cost control and budgeting for overhead costs.

For example, sales staff may spend increasing amounts on entertaining clients with expensive lunches in order to generate sales and earn more commission. Whilst gross profits will stay high due to extra sales, net profits may begin to fall, because of the increased expense involved in earning these extra sales. In this case, the self-interest of sales staff in earning high commission works against the good of the firm, because it leads to lower net profits. By monitoring changes in net profit margins over time, business managers can identify any potential future problems and take corrective measures.

Return On Capital Employed (ROCE) expresses the net profit of a business as a percentage of the total value of its capital invested in fixed and current assets.

Return On Capital Employed = Net Profit x 100 / Total Assets

The return on capital should ideally be higher than the rate of interest a business could earn by placing money in a bank account. If not, then the business might just as well convert its assets to cash and put the money into an interest-earning account.

In limited companies, the business owners are its shareholders and they expect to be paid a dividend from company profit. They will clearly be interested in earning more from their money invested in shares than they would get from an interest-earning account, or from investing their money in another business venture. The ROCE ratio allows them to compare these alternatives.

The higher the ROCE, the better it is for business owners. Profits are high, and therefore the dividends on their shares will be healthy.

Return on net assets is very similar to ROCE, but measures the ratio on long-term capital only. Short-term sources of capital, such as creditors, are excluded. Deducting current liabilities from total assets in the balance sheet gives a figure for net capital employed or net assets.

Return on Net Assets (%) = Net Profit x 100 / Net Assets

This ratio should be higher than ROCE, because net assets will be less than total capital employed.

Activity (or performance) ratios

There are a number of ratios which examine whether or not a business is using its resources efficiently. These include: administration to sales, asset turnover, stock turnover, and debt collection period.

Administration expenses to sales. Another way in which a business can monitor how well it is controlling its costs is by calculating the ratio of administration or overhead expenses to sales revenue or turnover. The larger the percentage of sales revenues used to pay for administration expenses, the worse the cost control performance of the firm.

Admin to Sales (%) = Admin Expenses x 100 / Sales Revenue

Asset turnover. Since the net assets of a business represent the value of the capital invested in it, it is useful to see how many times a business can generate sales in a year equal to the value of its capital or net assets. Asset turnover is a measure of the number of times that net assets are ‘turned over’ in sales in a year. This is another means of measuring the productivity of a business.

Asset Turnover = Turnover / Value of Net Assets

The stock turnover ratio measures the number of times in a year that a business sells the value of its stocks. It is a measure of business activity. The faster the rate of sales, the more times stocks will need to be replaced. If sales are poor, stocks will build up, indicated by low and falling ratio, and production will have to be cut.

Stock Turnover = Turnover / Value of Stocks

Generally, the higher the rate of stock turnover, the better the sales performance of the firm. What is an acceptable level of stock turnover will vary with the type of business. For example, a high-quality jeweller may only replace his or her stock of expensive rings and necklaces once each year, whilst a bakery would expect to replace its stock of fresh bread every day, giving a ratio of 365, and ratios of around 6 – 7 are probably acceptable for a car dealer.

Debtor collection period. It is possible to measure how well a firm is controlling the giving of credit to its customers by calculating the average amount of time taken by debtors to pay their invoices. Most firms give credit to their trade customers. The credit period will vary by the type of the firm. Typically, firms will give trade customers up to 60 days to pay invoices for goods or services delivered. If debtors are taking longer than this to pay, it indicates that the firm may have given credit unwisely and could be left with bad debts. However, some large firms may give credit for 90 days, while some small firms may struggle if their debts are not repaid within 30 days.

Because it is assumed that debtors will pay their invoices in the near future, sales on credit are treated as a current asset in the balance sheet. However, the larger the proportion of sales accounted for by credit sales, the more serious the consequences for the business if some of the debtors fail to pay.

Businesses can calculate the average number of days it takes for debtors to settle their debts. To do this, it is first necessary to work out the figure for an average day’s sales, by dividing total sales revenue by 365 days in a year. The next step is to calculate how many average days’ sales is represented by the debtors figure:

Debt Collection Period (Days) = Debtors / Average Daily Sales

= Debtors / Turnover / 365

For example, a firm may have average daily sales of 300 pounds and total credit sales during a year of 6,000 pounds. This means that the debtors figure represents on average 20 days of sales revenues (i.e. 6,000/300). That is, debtors take on average 20 days to settle invoices. Or, to look at it another way, it would take 20 days of sales to cover the credit sales to debtors if they should all fail to pay up within an agreed period.

Long delays in receiving payments from debtors can create cashflow problems for a business. Businesses will, therefore, normally operate a system of credit control, using an aged debtors list. This lists the names and the ‘ages’ of the debts of all the firm’s debtors. The business can then concentrate on collecting the oldest, or longest- outstanding, debts. Those debts that cannot be recovered after written warnings and even legal action are written off as bad debts.

Other performance indicators

To complete the picture of past performance, there are a host of other indicators an organisation might use. For example:

• Advertising costs per unit of sales

• Output per employee

• Average time taken to produce a unit of output

• Staff absenteeism

• Man days lost due to illness, machine breakdowns, disputes, etc.

• Number of faulty or sub-standard goods

• Number of customer complaints

• Average response time to customer orders

The limitations of financial ratios

Although financial ratios are very helpful in analysing accounts, they have some important limitations.

Accounting information cannot alone tell us everything about company performance. For example, accounts give no indication of changes in economic conditions, changes in the activities of a business – for example, the release of a new product – or about the quality of a firm’s workforce, all of which can affect business performance.

The balance sheet is simply a snapshot of performance at a particular moment. If the business is a seasonal one, like a seaside hotel, the balance sheet might look particularly healthy during the summer months, but this will not give a true picture of the business throughout the year.

Different firms may compile their accounts in different ways – for example, in the way they value stocks, or account for the impact of price inflation on the value of assets such as land and buildings. This makes inter-firm comparisons difficult. Additionally, firms may have financial years which end on different dates, which also makes comparison difficult, especially where seasonal factors affect the business.

Past performance may be a poor guide to future performance. Any analysis of past accounting information to inform future decision-making and business planning must be treated with caution.

Non-financial business objectives

Many firms have non-financial objectives which represent important targets that cannot be measured simply by looking at the financial performance of the company. Increasingly, firms are becoming aware of environmental issues and are setting targets relating to cleaning up their production processes, reducing waste, and repairing environmental damage caused by their past activities. Customer care is also important in an increasingly competitive business environment.

Objectives like these are usually outlined in the annual company report and accounts, together with a review of how well the company has progressed towards achieving them, for example, through buying wood from renewable sources and not from tropical rainforests, abolishing tests of cosmetics on animals, etc. with an increasing number of green consumers, firms are unlikely to be able to continue to make profits without taking an increasingly public environmental stance.