Evaluating
the performance of your firm
By Ravi Mahendra
Investors who are not financial professionals or don't have access
to financial advisors can still make a reasonable assessment of
the viability of their investments in listed firms by using a few
performance criteria.
A
challenge often faced by small investors is successfully evaluating
the performance of their companies based on information available
to them. The evaluation can be based on two criteria, which would
be the financial and non-financial. This article, which is the first
in a series, looks into the financial criteria whereas the next
article will look at the sources and types of non-financial information.
Financial
criteria
This is often Greek to many small investors who are not financial
professionals. Larger investors on the other hand are either very
experienced or tend to have an army of advisors. The tools which
can be used to evaluate companies financially would be:
1.
Ratios
2. Trends
Ratios
A ratio could be defined as one financial measure compared with
another. The common ratios which can be used for evaluation are:
1.
Profitability measures
2. Liquidity or short term solvency measures
3. Gearing or long term solvency measures
4. Management efficiency measures
5. Investor measures
Profitability
measures
These ratios look at the extent to which an organisation is profitable.
Commonly used measures are:
a) Profit Margin
b) Return on Capital Employed
Profit
Margin
Profit margin can be calculated as:
Profit for the period / sales for the period.
The profit can be compared with sales and a percentage can be calculated.
This percentage can be compared with the organisation's target margin
as well as the margins of other firms in the industry. For example,
an investor in United Motors should compare its Profit Margin with
that of AMW, which is a competitor.
Return
on Capital Employed
This measure compares the profit for the period with the capital
employed. It can be calculated as:
Profit for the Period /Capital Employed.
The capital employed should include both shareholders' funds as
well as loan providers' funds. This measure will simply show an
investor the return a firm is generating over the funds invested.
This can be compared over a period of time and also with that of
other similar firms.
Liquidity
or Short Term Solvency measures
Even when a business is profitable and it runs out of cash, it has
the risk of failing in the short run. Two performance measures can
be used in this regard, which would be:
a) Current Ratio
b) Acid Test Ratio
Current
Ratio
This is a measure of the extent to which a firm is strong in the
short run. The measure is calculated as:
Current Asset/ Current Liabilities.
Current
Assets are the short-term assets a firm has in its balance sheet
and would include those such as Stocks, Debtors, Cash etc. Current
Liabilities are the short-term dues in the balance sheet and it
would include those such as Creditors, Short term dues etc. The
idea with this measure is that firms should at least have enough
current assets to cover their current liabilities falling due in
the short run. Ideally this measure should be one that can vary
depending on industries.
Acid
Test Ratio
Of the current assets, Stock is regarded as the least liquid asset.
This measure attempts to test whether the firm has enough current
assets without stock to cover its current liabilities. It can be
calculated as:
Current
Assets- Stocks/Current Liabilities
There is no target number since Acid test ratios can vary across
industry.
My next article will consist of the remaining set of financial ratios,
the strengths and weaknesses of ratio analysis and what trend analysis
is all about. |
