Showing posts with label measuring business performance. Show all posts
Showing posts with label measuring business performance. Show all posts

Sunday 18 April 2010

Evaluate a business using ratios

Ratio analysis is a useful tool that is widely used to measure business performance.  There are various groups of people who need information about the performance of a business.

Business success can be defined as "the achievement of business objectives".  Measuring success will therefore depend on a business's objectives.  For most businesses this is profit.

The financial performance ratios facilitate performance measurement between and within businesses.  Note that such ratios are meaningless in isolation and should be assessed in relation to a comparator or benchmark, which could include:

  • the previous year
  • the budget
  • an internal division or department 
  • a competitor.
Care should be taken to compare like with like.  There will be natural differences in ratios according to the nature of a business, its size, its age and the industry within which it operates.  Additionally, the period of comparison should be considered.  Ratios will usually fluctuate in the short term and therefore a medium- to long-term comparison should be used.



LIMITATIONS OF RATIOS

Ratios do not provide answers to every question and their interpretation can be subjective.  They are a useful guideline to business performance but only a starting point for a full analysis.  They are generally calculated on historic accounting information, which may itself include assumptions and estimates.



OTHER INDICATORS OF SUCCESS

A variety of information will present the best overall picture of a business, such as

  • other information included in a company's annual report (for public listed companies); 
  • the age and nature of a business; 
  • any recent changes in the business, such as new products or market; and 
  • any changes in the industry within which the business operates and the wider economy.



NON-FINANCIAL PERFORMANCE MEASURES (NFPM)

These include

  • market share, 
  • customer loyalty, 
  • productivity, 
  • quality, and 
  • investment in research and development.  
NFPMs should be used alongside financial performance measures to provide a balanced view of a business.


Know the uses and limitations of financial performance ratios.



Related posts:

Measuring Business Performance

Calculate investor ratios

Investor ratios are used by existing and potential investors of mostly publicly listed companies.  They can be obtained or calculated where necessary from publicly available information.


EARNINGS PER SHARE (EPS)

This is a popular profitability statistic used by financial analysts.  'Earnings available for distribution' is bottom-line net profit attributable to shareholders after all other costs have been deducted.  Many remuneration packages are linked to EPS growth.

EPS = Earnings available for distribution /  Number of shares in issue



PRICE/EARNINGS (P/E) RATIO

The P/E ratio applies to publicly listed companies and is a key measure of value for investors.  A P/E ratio of 10 means that investors are willing to pay 10 times previous year's earnings for each share.  Generally, the higher the P/E ratio, the higher the growth prospects perceived by investors.

P/E ratio =  Share price / EPS



DIVIDEND YIELD

This measures cash paid to shareholders as dividends.  This should be compared to capital growth, to measure the overall return to shareholders.

Dividend yield = Dividend per share / Price per share

Mature businesses tend to have higher dividend yields than young businesses, as the latter reinvest most of their earnings.  Investors looking for high-income investments choose high-dividend yield companies.



DIVIDEND COVER

This follows a similar principle to 'interest cover'.  It measures how many times a business can pay its dividends from its earnings.  It is used as a measure of dividend risk.

Dividend cover = EPS / Dividend per share

It also measure the proportion of profits retained in a business versus paid out as dividends.  For example, a dividend cover 3 times shows that a business has paid one third of its profits to shareholders and retained two-thirds.  Retained earnings are an important source of finance and therefore dividend cover is often high.

Use investor ratios to see if business goals are aligned with investor goals.


Related posts:

Measuring Business Performance

Measure long-term solvency and stability

Long-term solvency ratios measure the risk faced by a business from its debt burden.  Debt interest must be paid irrespective of cash generation or profits.  Consequently, the amount of profit that can be reinvested in the business or paid as dividends is diluted.  An excessive debt burden will restrict the ability of a business to raise further debt finance.


THE GEARING RATIO

Gearing (or leverage) is a measure of a business's long-term financing arrangements (or capital structure).  It is essentially the proportion of a business financed via debt compared to equity.

Gearing ratio = (Interest bearing debt - Cash) / [Equity + (Interest bearing debt - Cash)]

The ideal proportion is subject to the nature of a business and the current economic climate.  In practice many businesses have gearing levels less than 50%.  The higher the gearing, the greater the risks from dilution of earnings and sensitivity to changes in interest rates.


THE DEBT RATIO

This measures the ability of a business to meet its debts in the long term.  It is a measure of 'security' for financiers.  The ratio should certainly be less than 100% and many believe it should be less than 50%.

Debt ratio = Total debts (current and non-current liabilities) / Total assets (current and non-current assets)

The risk posed from high debt and gearing ratios can be mitigated by high interest cover.


INTEREST COVER

This measures how many times a business can pay its interest charges (or finance expenses) from its operating profit (or profit before interest and tax).  Ideally a business should be able to cover its interest at least 2 or more times.

Interest cover (times) = Operating profit (EBIT) / Finance expenses

The ability to service debt is a measure of risk to debt providers, shareholders and ultimately the business itself.


NET DEBT TO EBITDA

Although not a traditional measure of long-term solvency, the 'net debt to EBITDA' ratio has become increasingly popular with banks as a measure of gearing.  (EBITDA stands for 'earnings before interest, taxes, depreciation and amortization'.)

Net debt to EBITDA (times) =  (Interest bearing debt - Cash) / EBITDA

Banks will typically lend a business up to 5 times its earnings.  Cash generated from operations can be substituted for EBITDA.


Use gearing and debt ratios to calculate long-term risk levels.


Related posts:

Measuring Business Performance

Measure short-term solvency and liquidity

Short-term solvency is the ability to meet short term debts from liquid assets.  Liquid assets include money on short-term deposit and trade receivables, but not inventories, which cannot be quickly turned into cash.


LIQUIDITY versus PROFITABILITY

In the short term liquidity is more essential to financial stability than profitability.  Cash generated from operating activities is a major source of liquid funds, as measured by the statement of cash flows.  There may be other priorities for funds from operating activities, therefore it is important to have sufficient liquid assets to meet short-term debts.



CASH FLOW

The cash operating cycle is the length of time between paying out cash for inputs and receiving cash from sales.  It is a useful measure of the time taken to generate cash.  Cash flow forecasts enable businesses to predict and deal with liquidity problems before they arise.  It is one of the most important measures of future solvency.


THE CURRENT RATIO

Current ratio =  Current assets / Current liabilities

This is a standard test of short-term solvency and simply measure if a business can meet its current liabilities from its current assets.  Depending upon the nature of the business, the current ratio should usually be greater than 1, depending upon the speed of inventory turnover.



THE QUICK RATIO (or ACID TEST RATIO)

Quick ratio = (Current assets less inventory) / Current liabilities

This is a more reliable short-term solvency measure because inventory is not easily convertible into cash for many businesses.  This ratio should be close to 1, depending upon the business.


INTERPRETING LOW AND HIGH RATIOS

Don't interpret current and quick ratios too literally.  Different businesses operate in different ways.  Low ratios are not always indicative of insolvency risk and high ratios are not always healthy.

LOW RATIOS.


For example, a high volume retailer, such as a supermarket could have healthy liquidity but very low current and quick ratios.  Supermarkets have relatively low inventories as their goods are mainly perishable and turnover quickly.  They have minimal receivables as customers pay in cash.  In addition, their purchasing power results in long trade payable payment periods.  Therefore overall - relatively low current assets and relatively high current liabilities.

HIGH RATIOS.


A poorly managed business with slow-selling inventories and many outstanding receivables may have high current and quick ratios.

Short-term solvency is the ability to pay short-term debts from liquid assets.


Related posts:

Measuring Business Performance

Measure Profitability

Measure Profitability

The business with the largest profit is not necessarily the best performer.  Profit should be measured in relation to the size of the investment required to achieve that level of profit.  Therefore, the best measure of profitability is 'return on investment'.



MEASURING 'RETURN'

Gross profit margin % =  Gross Profit / Revenue

This measures the margin made on top of direct costs.  A relatively high sales margin demonstrates the ability of a business either to charge a premium price or to control input costs.  It is useful when benchmarking against similar businesses in the same industry.

Net profit margin % = Operating profit / Revenue

This is similar to gross margin but takes account of operating expenses.  Net profit margin measures the ability to control costs.  Operating profit is preferred to other profit totals, as it exclude finance and taxation costs, which can vary between businesses and years.


MEASURING 'INVESTMENT'

The most common definition of 'investment' is capital employed, which is equity plus non-current liabilities (alternatively, total assets less current liabilities).  Capital employed is effectively the amount invested in a business by both shareholders and debt holders.

Asset turnover (times)  = Annual revenue / Capital employed

This shows how well the finance invested in a business, subsequently invested in assets, has been utilised to generate sales.  It measures the amount of revenue earned from each $1 invested.  Asset turnover demonstrates the number of times assets generate their value in terms of revenue each year.  It is sometimes referred to as a measure of activity.  A relatively high asset turnover could indicate efficient use of assets, although the measure is sensitive to the valuation of assets.


MEASURING RETURN ON INVESTMENT/CAPITAL EMPLOYED

'Return on Investment' (ROI) has many permutations, the most common of which are

  • return on capital employed (ROCE); 
  • return on net assets (RONA); 
  • return on total asset (ROTA); 
  • return on equity (ROE); and 
  • accounting rate of return (ARR).  
They are all essentially measuring the same thing - profit as a percentage of the investment required to achieve that profit.  ROI is also used in internal investment appraisal.

ROCE = Net profit margin x Asset turnover

ROCE = Operating profit / Revenue) x (Revenue / Capital employed)

Analysing the net profit margin or asset turnover will help to explain a high or low ROCE.

Measuring Business Performance

Business success can be measured using ratios.  Financial performance ratios can facilitate performance measurement.  Let us look at the following:

Profitability
Short-term solvency and liquidity
Long-term solvency and stability
Investor ratios


Related posts:

Measuring Business Performance