There are numerous reasons for business failures, most of which can be summed up as a shortage of cash. This may have been a problem from the start if the enterprise had insufficient capital, or it may have been a Financial ratios
subsequent development due to unprofitable trading, too-fast expan- sion, excessive borrowing, slow-paying customers, difficult trading conditions or just plain bad management. The final demise of a business is when a creditor sues or applies to put it into receivership or liquida- tion This may be a trade creditor who has waited much longer than the agreed credit period, but is just as likely to be the taxman or the bank manager.
It is claimed that up to one in every three new companies set up will not survive five years. These are by nature predominantly small busi- nesses. Other companies with a longer track record and a listing on the stock exchange have a much lower failure record. One reason may be their ability to raise new equity instead of having to rely on bank borrowing.
The financial ratios discussed in this chapter have been viewed with hindsight, based on information extracted from published financial statements. The trend of some key ratios may tell us a lot about the financial health of a company. Pointers to a poor financial state might include, in no particular order:
ᔢ increasing losses;
ᔢ falling profit margins;
ᔢ rising gearing ratio;
ᔢ increasing debtors days;
ᔢ increasing creditors days;
ᔢ falling stock turnover rate;
ᔢ reduced or passed dividend.
Z scores
The question might be posed as to which ratios could be used to predict a business failing in the future. A further question might be the relative importance to attach to each of the ratios identified as being useful in this context. A final question might ask if the above could all be wrapped up in a single score that could be used to predict failure or survival – a so called Z score.
A number of researchers in different countries have come up with their own models over the years, including Altman, Taffler and Robertson. Altman’s early model (1968) was based on 33 failed American manufacturing companies, each paired off against a similar
ongoing company. His final selection of the following five financial ratios was from an original 22 in number, and the calculation of his Z score comprised:
Z = 1.2X1+ 1.4X2+ 3.3X3+ 0.6X4+ 1.0X5
where Z is the combined total of the weighted ratios X1, X2....and X1 = Net current assets/ total assets.
X2 = Retained earnings/total assets.
X3 = Profit before interest and tax/total assets.
X4 = Market value of equity/book value of total debt.
X5 = Sales/total assets.
Both ongoing and failed companies are then ranked together by size of Z score and upper and lower limits identified. Above the upper limit no failed companies are misclassified as ongoing, whilst below the lower limit no on-going companies are misclassified as failed. Altman described a grey area between the upper and lower limits where compa- nies could be misclassified.
Z score models should be developed for specific industries and their use limited to such. This is because financial ratios have different values in different industries. Some industries are capital intensive (eg chemi- cals) and some are not (eg contractors). Some have large stocks and work-in-progress (manufacturing) and others have none (eg electricity distribution).
Information on Z scores can be obtained commercially and is likely to appeal to investment analysts and companies trying to check up on the durability of customers, suppliers and potential joint venture partners.
Information on creditworthiness can be obtained from credit agencies like Dun & Bradstreet with a comparison of the time taken to pay invoices against industry norms. Any consistent deterioration in this payment performance could also be an early warning of possible busi- ness failure.
Further reading
Reid, W and Myddleton, R (2005) The Meaning of Company Accounts, Gower Publishing, Aldershot.
Tiwari, AC (2002) Public Sector: Accounting and Auditing Standards, Excel Books, New Delhi.
Financial ratios
Walsh, C and ten Have, S (2004) Key Management Models: AND Key Management Ratios – Master the Management Metrics That Drive and Control Your Business, Longman, Harlow.
Self-check questions
1. What is an accounting ratio?
2. Complete the following equation:
Return on capital = profit margin × ...?
3. Is there an ideal value for each ratio? If not, how are ratios used?
4. Which ratio would you use to examine whether a company was short of cash if you knew it could not borrow any more money?
5. Which company is more vulnerable? Company A, which pays annual interest of £50,000 and makes a profit of £100,000, or Company B, which pays £150,000 interest and makes £500,000 profit?
6. What ratios are used to measure performance in public-sector services?
7. What is the purpose of a Z score?
Other
performance measures
INTRODUCTION
In the past, business performance has been interpreted as purely finan- cial performance with overmuch attention paid to the financial ratios derived from the two financial accounting statements of profit and loss account and balance sheet. Nowadays, it is recognized that perform- ance measurement should include non-financial indicators as well as financial indicators so that all business objectives can be monitored. The increasing use of non-financial indicators in business decision-making was evidenced in a study by Scapens et al(see Further reading).