Useful Financial Metrics and Ratios 2
Useful Financial Metrics and Ratios 2
Specific financial metrics are used to analyze productivity, determine return on investment, debt levels, inventory turnover, and more. Which metrics are useful depends at least in part of the nature of a business; for example, a small start-up is not concerned with determining the asset turnover ratio but may be very interested in knowing their return on investment.
Here are a few metrics that can be used to analyze operating and financial performance and make smart decisions:
Return on Investment (ROI)
Equation: ROI = (R – CI /) CI X 100
R = Return
CI = Cost of Investment
Return on Investment is a performance measurement used to determine the efficiency of a particular investment; the higher the ROI, the higher the investment return.
Example: You decide to run a new marketing campaign. The cost of the campaign is $3,000. As a result of the campaign you generate $16,600 in new sales.
16,600 – 3,000 = 13,600
13,600/3,000 = 4.53, or 453%. Your ROI was 453%.
ROI can be used to determine the specific results from any spending or investment. ROI is a simple tool, but it helps provide a quantifiable answer to a very basic management question: "Should we do this?"
Debt to Equity Ratio (DER)
Equation: DER= TL/TSE
TL = Total Liabilities
TSE = Total Stockholder Equity
Debt to Equity Ratio indicates the amount of money a company owes compared to what it owns; DER indicates the proportion of debt and equity a company uses to finance its assets and operations. A high debt to equity ratio could indicate the company has borrowed too heavily; a low debt to equity ratio typically indicates the company generates working capital through its operations rather than by borrowing. In general, a DER over 1.0 indicates assets are financed largely through debt, while a DER under 1.0 indicates shareholder equity is the main source of financing.
Example: ACME Stove, Inc. has total liabilities of $100,000. Shareholder equity totals $400,000.
100,000 / 400,000 = .25. The DER is .25.
A low ratio of .25 means ACME Stove uses, in large part, equity to finance operations. As a result the company has little exposure to rising interest rates or nervous bankers. On the other hand, investors may push for a greater return on their investment. ACME Stove could choose to take on more debt or buy back some of the outstanding shares; either approach would result in an increase in DER.
Let's look at the flip side. Say you calculate ACME Stove has a DER of 3; it's carrying a lot of debt relative to investor equity. Being highly leveraged could make the company nervous, so one way to reduce the DER would be to sell additional shares of stock and use the proceeds to pay down debt. The DER would decrease, but then again investors may not be happy because their ownership stake becomes more diluted every time additional shares of stock are issued.
The DER is closely monitored by both investors and lenders. Lenders are especially concerned, since a high DER can create liquidity problems which could lead to loan defaults (if a company doesn't have money to pay, and debt cripples its operations). Banks sometimes step in and require companies to use excess cash flow to pay down debt, restrict further investments, and/or even require investors to put more equity into the company so the DER is decreased.
Economic Value Added (EVA)
Equation: EVA = NOPAT – CC
NOPAT = Net Operating Profits After Taxes
CC = Capital Charges (capital invested X cost of capital)
Economic Value Added can be complicated to calculate. The goal of an EVA calculation is to determine the true economic profit of a company after taking into account the opportunity cost of capital invested.
Example: Operating profit, after taxes, is $10,000. A $20,000 capital investment was made in the company; the opportunity cost of that investment (which is what could have been earned if the money had been invested elsewhere) is 10%.
The capital charge is $20,000 X 10%, or $2,000.
$10,000 - $2,000 = $8,000. The EVA, or economic profit, is $8,000.
EVA is a somewhat esoteric financial measurement. The goal of EVA is to take into account the fact that there is a " cost" to any capital invested in the company. If $50,000 was invested in a company, it should generate a return, but not, possibly, right away. If the money was invested in a Certificate of Deposit yielding 5%, it could earn $2,500 per year in interest. So, in EVA terms, $2,500 is the cost of capital, and should be deducted from operating profits to show true profit.
Here's the bottom line: The goal of EVA calculations is to determine whether the company will generate a greater return on a capital investment than it could have received by investing the money elsewhere.
The goal of EVA is to answer this question: Does the investment truly add value to the company and generate profits that outweigh the risk?
Assets Turnover Ratio (ATR)
Equation: ATR= TR/TA
TR = Total Revenue, and
TA = Total Assets
The Asset Turnover Ratio calculates the amount of sales generated from each dollar of assets. Companies with low profit margins tend, on average, to have high asset turnover, while companies with high profit margins tend to have low asset turnover.
Example: ACME Stove, Inc. has total revenue of $250,000. Company assets total $200,000.
250,000 / 200,000 = 1.25. Assets "turned over" 1.25 times, or 125%. $1.25 in sales was generated from every $1 in assets.
The best way to use ATR is to compare one company to others in the same industry. Automotive and heavy manufacturing companies tend to have low ATRs; in many cases the ATR will be less than 1. A retailer may have an ATR of 10 or more since little equipment or capital expense is required and product moves at a relatively brisk pace. But keep in mind that if an ATR is higher than the industry average, it could be because the company has not invested in replacing or improving outdated equipment, buildings, etc. For now the company is doing well, but eventually it may need to make capital investments that will lower the ATR. For a few years, the ATR may be lower than industry average, but the investments made in equipment may then pay off in years to come.