Why we have to disclose ratios
To emphasize the importance of interpretation methods and skills, we could ask the question: 'Why do we have to disclose ratios?' The answers are clear:
- Interpretation is an essential support for tracking and planning strategies.
- The UK strategic report as discussed in Chapter 6 requires that KPIs are disclosed.
Extract from the UK strategic report
The analysis in the strategic report should include the financial and non-financial key performance indicators (KPIs) utilised by the directors to measure progress towards achieving a particular objective or strategy.
The KPIs used in the analysis should be those that the directors judge are most effective in assessing progress against objectives or strategies. Where possible, they should be accepted and widely used, either within the entity's industry sector or more generally.
The use of KPIs in relation to an entity's strategies will clearly show the progress an entity has made towards achieving its objectives or strategies.
Comparatives should be included for KPIs and the reasons for any significant changes from year to year explained.
The entity should provide information that enables shareholders to understand each KPI used in the strategic report. For example, the following information should be identified and explained where relevant:
(a) its definition and calculation method
(b) its purpose
(c) the source of underlying data
(d) any significant assumptions made
(e) any changes in the calculation method used compared to previous financial years, including significant changes in the underlying accounting policies adopted in the financial statements which might affect the KPI.
(Companies Act 2006)
The strategic report guidance does give an example of KPIs for what is often a touchy issue - executive incentive payments plans.
Highlighting those KPIs which form part of directors' incentive plans, along with links to principal risks, provides an overview of how the performance of the business is related to executive remuneration.
(Companies Act 2006)
It is hoped that this chapter helps you understand ratios and how they reveal what is going on. Do practise calculating the ratios; if you can find time, download copies of relevant accounts and re-create the spreadsheet calculations given in this chapter. Calculating the ratios, where the numerator and denominator come from, is a very good learning exercise.
- The ability to interpret financial statements is a must for executives.
- Your strategies will be revealed in the numbers and ratios.
- Competitors and other benchmark businesses' strategies will be revealed - can you learn from them?
Revision and learning pointers
- Replicate the spreadsheets in this chapter.
- Calculate ratios for your own company - do these tie in with your knowledge of the business?
- Look at customers', suppliers' or competitors' ratios.
- Look at the P/E ratio for your company (if listed).
A revealing exercise would be to carry out a five-year historic analysis of your own or a benchmark company's ratios. With your knowledge of objectives and strategies, has the company evolved strategically as planned?