Financial Storytelling and Data Storytelling with Profitability Ratios

Following on from my earlier blog post, discussing Accounting Ratios, let’s take a look at a specific set: Profitability Ratios.Profitability Ratios can be defined as understanding the effectiveness of the company in generating profit. In this blog post, we will concentrate on profitability ratios, working our way around the flow chart presented here:

Screenshot (1)

The formula are presented below, in terms of their meaning:

  • Return on Net Assets (RONA) (Return on Capital employed) – return on the fixed and current assets less current liability. It is also known as the primary ratio.
  • Return on Equity (Return on Shareholders’ Funds) – This also looks at return on the fixed and current assets less current liability, but it looks at it from the Shareholder’s perspective.
  • Gross Profit Margin – percentage of sales revenue remaining after the expense of making the product / solution / delivering the service is taken into account.
  • Net Profit Margin – This is the percentage of sales revenue that’s left, after all of the expenses of running the firm have been fully met.

Let’s have a look at how they are calculated, and what they mean.
money-2696229_1920

Calculating the Profitability Ratios

1.Return on Net Assets (RONA) (Return on Capital employed)

Net Profit before long-term interest and tax /

Total Assets less creditors falling due within one year

This figure is expressed as a percentage, so it is multiplied by 100%. That said, at root, it is fundamentally calculated as follows, expressed as a percentage:

Profit /

Capital

Profit can include one of the following metrics:

  • Operating Profit
  • Net Profit before Interest and Taxation
  • Net profit after taxation
  • Net Profit after taxation
  • Net Profit after taxation and preference dividend

Capital can be measured by one of the following options:

  • Total Assets
  • Total Assets less intangible assets
  • Total Assets less current liabilities
  • Shareholders Funds
  • Shareholders’ Funds less preference shares
  • Shareholders’ Funds plus long-term loans
  • Shareholders’ funds plus total liabilities

What combination do you choose? Basically, the MVP answer holds here: it depends. The definitions depend on what business question you are trying to answer. The RONA definition was chosen here in order to illustrate how it differs from Return on Equity, which is explained below.

2. Return on Equity (Return on Shareholders’ Funds)

Net Profit before long-term interest and tax /

Share Capital and Reserves

This figure is expressed as a percentage, so it is multiplied by 100%.

3. Gross Profit Margin

Gross Profit /

Sales

This figure is expressed as a percentage, so it is multiplied by 100%.

4. Net Profit Margin

Net Profit before long-term interest and tax /

Sales

This figure is expressed as a percentage, so it is multiplied by 100%.

It’s possible to see that these ratios are made of five different things. I’m a visual person so I’m marking these in colour since I will need to remember them for my exam!

  • Gross Profit
  • Net Profit before long-term interest and tax 
  • Sales
  • Share Capital and Reserves
  • Total Assets less creditors falling due within one year

Interpreting the Profitability Ratios

With the Return on Net Assets figure, we are looking at the effectiveness of the assets that are financed by long-term creditors as well as the shareholders, and we are looking at the profit generated as a result of these combined assets. Higher RONA can mean that the company using its assets efficiently. Also an increasing RONA may indicate an emphasis on executing efficiently, as evidenced in improved profitability and overall performance.

The Return on Equity ratio looks at the same issue, but from the perspective of the shareholder only. The long-term creditors are partialled out. Understandably, shareholders want to see a high return on equity ratio, since this would show that the organisation is being effective in its deployment of investors’ funds. Shareholders can also track progress by calculating the return on equity at the beginning of a period and then check it again at the end of a period to see if there is a change in return.

Net Profit Margin shows the sales revenue after all of the expenses have been removed. It should be as large as it can possibly be, as long as it is sustainable. However, this should not be taking place at the expense of another aspect of the business. Be wary of short-term attitude to profit. This is sometimes evidenced in the net profit margin.

Limitations on the Productivity Financial Ratios

Accounting Ratios give us useful insights in the management of a company, but it is not the whole story. The business context, and the company itself, should also be considered. RONA does not calculate a company’s future ability to create value. Additionally, the values on the balance sheet might not represent the replacement cost, therefore masking the reality of asset utilisation.

In the next post, we will look at Activity Ratios and how they are calculated, along with some advantages and limitations. We are leading up towards visualizing these ratios in Power BI, and it’s important to understand the ‘why’ as well as the ‘how’ of visualizing these ratios.

Financial Storytelling and Data Storytelling in #PowerBI

money-1604921_1920

As a consultant, I think it’s important to understand the numbers that make up a business. It means I can provide better advice to my customers since I can read their balance sheets, understand their financial statements, and translate these numbers into effective data visualization in tools such as Tableau and Power BI.

There are a number of accounting ratios which can be used to help determine the success – or otherwise – of a business. There is no ‘magic silver bullet’ that can help to determine definitively, but it is possible to put the ratios together to make a story that will help us to understand the business better. We can tell the story better through data visualization. So we move from data storytelling to finance storytelling.

Once we have the ‘story’ behind the accounting ratios, we can start to use these as a basis for storytelling in Power BI. In this blog series, we will start to look at the accounting ratios and how they are calculated. Then, we will look at how we can visualize this information in Power BI.

Accounting Ratios

Click here to see a bigger version.

Since we are looking at accounting ratios and how we can visualize them, let’s use this flow chart as a starting point. In the next topics, we will look at what these accounting ratios mean in more detail. We will also look at some of the McKinsey modelling, such as ROIC and the calculation of value.

Motivating Teams and Individuals: Reward Systems

What is motivation? Willingness to exert high levels of effort toward organizational goals, conditioned by the effort’s ability to satisfy some individual need or desire (Robbins, p.168). Motivation is studied in terms of how it refers to other things, such as needs, drives, goals, incentives of disincentives. (McKenna, E., 1996).

Work motivation can be described as a willingness to apply one’s efforts towards the achievement of the organisation’s goals, while concurrently an individual need is satisfied.​

What is the main interest of managers in motivation?​ Managers and Leaders need to work on motivation in order to achieve objectives for the organisation and the team​. The  aim should be to change employees’ motivations from what they are, to what the manager wants them to be (Purcell et al, 2003)​

Therefore, it is related to performance. Performance is behaviour​ because you are doing something. Concepts of performance involve ‘levels’ of performance and ‘quality’ of performance​, which means that performance is linked to measurement​. Therefore, motivation is key to achieving good performance.

The key theories of motivation involve

  • content theories – the ‘what’ of motivation – This is based on Outcome and Reward
  • process or Cognitive theories – the ‘how’ of motivation – cognitive processes used to connect effort with outcome or reward)

The ‘internal forces that impel action and the external forces that can act as inducements to action’ ​ (Locke and Latham, 1979)​.  There are three main aspects of action:​

  • direction of choice
  • levels of effort or intensity
  • duration or persistence

​Latham and Locke (1979), cited in McKenna (2000), distinguish between extrinsic and intrinsic motivation. Extrinsic motivation is derived from expectation of receiving extrinsic or tangible reward (e.g. promotion or pension).​ Intrinsic motivation is derived from expectation of receiving intrinsic or ‘psychological’ reward (e.g. recognition, respect or an Award).

Content Theories

Content theories can be listed below:

  • Maslow’s hierarchy of needs​
  • Alderfer’s ERG hierarchy – ERG (existence-relatedness-growth)​
  • Herzberg’s two factor theory​
  • McClelland’s achievement motivation theory​
  • Hackman and Oldman’s job characteristics model.​

These theories mostly adopt a universal approach, and they assume all people possess a common set of needs. They assume that people have a bucket of motivations that await gratification, and this is used to explain why people choose to act in one way and not another.

Content Theories are described next:

Maslow’s Hierarchy of needs is probably the most well-known, and the theory probably stops there for a lot of people. However, it was later refined by other content authors, and then the emphasis turned to more cognitive theories.

heirarchyofneeds

Credit: Penn State Leadership https://sites.psu.edu/leadership/2014/11/29/prepare-for-success-path-goal-theory-and-maslows-needs-hierarchy/ 

 Alderfer’s ERG theory summarizes these needs into three related needs:​

  • existence needs​
  • relatedness needs​
  • growth needs.​

More than one need can be activated at any one time, and we can regress back to a lower need if a higher need is not met. This is known as the ‘frustration regression’ process.

McClelland’s Achievement Needs Theory (1961) perceives motivation as being influenced by three trait-like needs: achievement, power, affiliation and belonging. Traits are based on experience and can be developed and honed, for example, through training or positive reinforcement through hierarchical positioning.

2318744_635513412058845000-1

Herzberg (1996) is consistent with the earlier theories of Maslow, and, at its simplest, states that people are motivated towards things that make them feel good, and away from things that make them feel bad. There is plenty of empirical evidence to support this idea; if you consider going to the gym at 6am as an example, how does that make you feel? Most people will stay in bed because it makes them feel good. Herzberg applies this idea to the workplace.

two-factor-theory-herzberg-toolshero

Credit: https://www.toolshero.com/psychology/theories-of-motivation/two-factor-theory-herzberg/ 

Cognitive Theories

Cognitive Theories, or Process theories, view humans as actors who want to produce an impact and an effect on their environment, and that humans are fundamentally life-long learners who want to learn skills and new things. We have a need for new information, data and wisdom. Certainly, in my experience, no customer ever has ever said ‘We have enough reports and data now’. We always want to pitch forward with our data.

In this view, humans are essentially purposeful and individua. We understand our risks, and we make plans and set a course. These cognitive or process theories acknowledge choice, and discuss how behaviour is initiated, directed and re-directed, and terminated altogether.

The key theories include:

  • expectancy theory​
  • goal-setting theory​
  • equity theory.​

Vroom’s Expectancy Theory  postulates that individuals will behave or act in a certain way because they are motivated to select a specific behaviour over other behaviours. The choice depends on their expectations on what they perceived the outcome of the behaviour to produce.

f0070_01

Vroom’s Expectancy Theory

F (Motivation) = V x I x E

V = Valence or value an individual places on  the reward. ​

I = Instrumentality or the extent to which the individual believes carrying out an action will lead to positive reward/outcome. ​

E = Expectancy or the perception that a behaviour/effort will lead to desired level of performance.

Locke’s Goal Setting Theory (1968) may be something that you use a lot. Have you seen SMART objectives? They arise from Locke’s theory. Goals must be:​

  • specific and challenging​
  • capable of objective measurement​
  • attainable and time bound​
  • owned and accepted by employees.​
  • Prompt, precise feedback required so people know how they are doing​

Equity Theory (Adams, 1965) postulates that employees consider the inputs they bring to the work in relation to the outputs. It is a balance between inputs and perceived rewards they gain as a result of their inputs.  ​It is particularly important for performance appraisal and reward, since a perception of unfair or unjust treatment will be demotivating.

Does money motivate?

It is implied as a motivator in content theories e.g. Taylorism, Maslow, Locke  etc and therefore is implied as a motivator.​ Barber and Bretz (2000) suggest that money is among the most important factors for people when deciding on a job.​ Anecdotal evidence from exit interviews shows that money is the key reason why demotivated employees leave the job or they leave to earn more elsewhere.

Some theorists argue against the idea that it is a main motivator, such as eming, Herzberg, Kohn, Deci and Ryan, Pfeffer​. The theme here is that a job gives people meaning, purpose, commitment and engagement. Job satisfaction is also considered to be a primary motivator.

Some research shows that money can reduce the effectiveness of intrinsic engagement. For example, Deci et al (2001) found that “rewards as a motivational strategy is a risky proposition”.

A reasonable conclusion is that money is a motivator for some and most will not work without pay, but it depends on individual circumstances and other factors.​ “The question of whether money is a motivator that can lead to improved performance is a very complex one and the answer is by no means clear” (Latham 2007).

Here, we can combine expectancy and equity, by perceiving it as a vicious cycle for some individuals. The individual might be motivated to increase inputs, in the hope of getting increased rewards or outputs. People who are underpaid can see their role in terms of cost rather than value, thereby decreasing overall performance of the team because the competition within the team has been increased. If the value of the role is perceived as equitable to the cost, or amount of pay or reward, then the perception of fairness and balance is met.

Position and reward distribution need to be met fairly, or one team may not feel valued. If the reward distribution is perceived as being concentrated at C level at the expense of others, this can result in a perception of unfairness. There have been plenty of stories recently about overpaid C-suite members!

The reward mix is also important. The gender pay gap is well documented, and the finding is replicated across the world (Costa Dias, Joyce, and Parodi, F., 2018).

Conclusion

The reality is that motivation is a difficult and complex topic and there is the element of choice. That said, understanding people’s motivations can impact performance so there is a real need to understand this complex topic, in order to demystify people’s choices and make possible predictions and outcomes on their behaviour.

References

Adams, J. Stacy. “Inequity in social exchange.” In Advances in experimental social psychology, vol. 2, pp. 267-299. Academic Press, 1965.

Alderfer, C.P., 1969. An empirical test of a new theory of human needs. Organizational behavior and human performance4(2), pp.142-175.

Barber, A.E. and Bretz, R.D., 2000. Compensation, attraction, and retention. Compensation in organizations, pp.32-60.

Costa Dias, M., Joyce, R. and Parodi, F., 2018. The gender pay gap in the UK: children and experience in work. Institute for Fiscal Studies. https://www. ifs. org. uk/publications/10356.

Latham, G.P. 2007. Work motivation: History, theory, research, and practice ISBN 0 7619 2017 X; 337 pages. Thousand Oaks, CA: Sage

Locke, E.A., 1968. Toward a theory of task motivation and incentives. Organizational behavior and human performance3(2), pp.157-189.

Maslow, A.H., 1943. A theory of human motivation. Psychological review50(4), p.370.

McKenna, E.F., 2000. Business psychology and organisational behaviour: a student’s handbook. Psychology Press.

Vroom, V.H. and Yetton, P.W., 1973. Leadership and decision-making (Vol. 110). University of Pittsburgh Pre.