298 CHAPTER 12 GETTING IT APPROVED
Indicators of profitability and operating efficiency
Indicator Comment
Profit margin
Trading profit
(before tax, interest, etc.)
divided by
Sales
This indicates the profit per unit of currency of
sales. A low figure is not necessarily bad – for
supermarkets it can fall to 1% – check against
inventory and receivables turnover, asset value,
gross profit margins, etc. and the industry average.
A figure below the industry average might indicate
low prices and/or high costs.
A high figure might attract competitors.
Return on total assets
(return on capital
employed)
Trading profit
(before interest and tax)
divided by
Total assets
OR
(Assets less current
liabilities)
This is clearly important as a measure of the
company’s operating efficiency. A low return on
assets or capital employed (very similar, given
the relationship between balance sheet entries)
suggests a candidate for disposal – or bankruptcy
in the next economic downturn. If the return is
below the cost of loans, additional borrowing will
reduce earnings per share. This measure provides a
good yardstick for assessing new ventures – if their
return is below it, it will be clawed down.
Turnover of (working)
capital
Sales
divided by
Capital employed
OR
Working capital (current
assets less current
liabilities)
This measures sales per unit of capital. It shows
how efficiently capital is being used to generate
sales. A low ratio (sales are low relative to capital)
tends to suggest that capital is not being used
profitably. At the other extreme, a very high ratio
of sales to working capital warns of overtrading
– inadequate working capital which could put
creditors at risk. Watch also that a growing ratio
might indicate that plant and machinery is not
being kept up to date (depreciation is reducing the
capital base and making the ratio look better).
Receivables turnover
(trade debtors to sales)
Accounts receivable
divided by
Sales
This shows credit allowed to customers. If payment
is collected by the end of the month following
delivery, receivables will run at about 12% of sales. A
high figure might indicate sloppy financial control.
A reduction might suggest better control – or reflect
a desperate need for cash. Factoring (selling) debts
also reduces the figure.
THOSE FINANCIALS AGAIN 299
Payables turnover
(trade creditors to sales)
Accounts payable
divided by
Sales
This indicates the amount of trade credit that a
company is
allowed by its suppliers. Watch trends
over time – an increase might indicate a rise in
trade credit necessitated by cash flow
problems. Other measures used include:
– Payables to inventory – which shows what
proportion of stocks is financed by suppliers
(exceeds 100% in food retailing).
– Debtors to receivables – where sudden big
changes can also give early warning of cash
flow pressures.
Inventory/stock
turnover
Cost of goods sold
divided by
Average inventory
(half opening plus
closing stock)
This shows how fast inventory is moving through
the business. A high turnover indicates healthy,
saleable and liquid inventory with lower demands
on cash flow (or maybe there are stock shortages!).
A low average turnover suggests overstocking
and dated merchandise (or stockpiling to meet
seasonal demand). Calculating the average from
only two days a period is highly dangerous if
those are not representative days. I am sure that
you would not manage your inventory levels to
influence this ratio.
Investment indicators
Indicator Comment
Return on equity
Profit (after tax)
divided by
Owners’ equity
Alternative measures of return (return on assets and
return on capital employed) are significant for the
business manager. But this one, return on equity, is
critical to shareholders. It is their bottom line. By the
way, contrast this with bankers – whose bottom line is
interest and security.
Earnings per share
(EPS) Profit
divided by
Number of ordinary
shares
The profit attributable to each ordinary share (i.e.
after tax, etc.) is one statistic that you cannot compare
between companies directly – it depends on the
number of shares issued. But the trend over time
is often regarded as critical – for many companies,
steady long-term growth in earnings per share is the
central objective.
300 CHAPTER 12 GETTING IT APPROVED
Price earning (ratio/
multiple) – PE/PER
Share price
divided by
Earnings per share
The price earnings ratio indicates the number of years’
earnings acquired when you buy one share. It reflects
the market’s expectation of future earnings growth –
and it is a crucial measure of the value of a company
(see Chapter 10). It is the carrot to dangle in front of
investors, because it indicates the way that they will
be able to leverage their share value on the way out.
Dividend cover
(payout ratio when
inverted)
Earnings per share
divided by
Net dividend per share
Dividend cover indicates how many times the
dividend is covered by profits. A high cover (low
payout ratio) suggests that profits are being
reinvested for future growth – and that there is
sufficient margin to ensure that dividends will remain
stable. The opposite suggests that dividends might
disappear in a downturn.
Net asset value
(Ordinary) shareholders’
equity
divided by
Net dividend per share
Net asset value indicates the proportion of the share
price that is represented by assets (albeit at book
value) – the other portion of the price therefore
reflecting expectations about profits. The alternative
is market capitalisation to book value (how much it
would cost you to buy all the
Market to book
(see comments)
Company’s shares – and how much you would get back
if you sold all the assets and settled all liabilities). These
indicators reveal exactly what the market thinks about
the value of the company’s future income stream.
Economic value added (Note: EVA is based on the work of Professors Franco
Modigliani and Merton H. Miller, extended and trade marked by Stern, Stewart & Company; EVA
momentum is a further development by Stewart.)
Indicator Comment
Economic value added
Net operating profit less
taxes less cost of capital.
A measure of value and performance. When
profits exceed the cost of doing business and
the cost of capital, the firm creates wealth for the
shareholders. Here, capital includes cash, inventory
and receivables (working capital), plus equipment,
computers and real estate. The cost of capital is
the rate of return required by the shareholders and
lenders to finance the operations of the business.
EVA momentum
This year’s EVA minus last
year’s EVA all divided by last
year’s sales revenue
A measure of the EVA growth rate, scaled to the
sales size of the business, and therefore directly
comparable across businesses of differing sizes and
in differing industries.
THOSE FINANCIALS AGAIN 301
IT DEPENDS WHAT YOU MEAN BY RETURN?
Everyone wants to know what return on investment (ROI) they will earn – how much will
they get back in return for their outlays?
For lenders, the ROI is the interest that you pay them on the money loaned.
Equity investors’ ROI is measured by return on equity (ROE) – since, of course, their
investment is your equity capital.
For you, as the business manager, the ROI that you are interested in is return on
capital employed (ROCE) or return on assets (ROA).
This is straightforward. If someone enquires about ROI, just ask who wants to know? ROE is
important to equity investors, so we should look at how they will extract its likely outturn
from your financials.
‘Who the hell wants to hear actors talk?’
H. M. WARNER, WARNER BROTHERS, 1927 ON THE
INTRODUCTION OF SOUND IN MOVING PICTURES
KEY INFLUENCES ON RETURN ON EQUITY
The way that the objectives of company management and of investors hang together is
illustrated in Figure 12.2. The connection between the two sides of the diagram is self-
evident. Vary one number in the profit and loss account or balance sheet, and this must
result in a change in the return on equity. It does not take a genius to see this. However,
if you follow the logic through the centre – and remember that assets = liabilities (debt)
plus equity – you can see how the following classic relationship holds true:
Profit Sales Assets Profit
divided by × divided by × divided by = divided by
Sales Assets Equity Equity
Or, essentially:
Profit margin × Asset turnover × Leverage = ROE
Thus, increase any one of the terms on the left (profit margin, asset turnover or leverage)
and you increase return on equity. Some companies actually manage these indicators
specifically. You can see why equity investors enjoy them.
‘Airplanes are interesting toys but of no military value.’
MARSHALL FERDINAND FOCH, PROFESSOR OF STRATEGY, ECOLE SUPERIEURE DE GUERRE
302 CHAPTER 12 GETTING IT APPROVED
Profit and loss
account
Balance sheet
Return on
equity (ROE)
Profit after tax
divided by
Net worth
(owners'
equity)
Change one of these ... and you change this
T
T
Debt
divided by
Equity
Leverage or
gearing
Debt
Equity
Assets
Costs
Sales
Profit before
interest/tax
divided by
Total sales
Profit margin
Sales
divided by
Total assets
Asset
turnover
Profit before
interest and
tax
divided by
Total assets
Return on
total assets
(ROTA)
Figure 12.2 How it all fits together
Health warning: watch all the gauges
The nice people with money are going to be very interested in the potential return
on their investment. But beware of the perils of monitoring the health of your
business using too few indicators.
Here’s why. In 2008 Lehman Brothers collapsed. Overnight it went from being
the fourth largest US investment bank, to the world’s largest bankruptcy case –
with US$619 billion (yes, billion) in debt. Why? Executive pay was linked to return
on equity (ROE). Borrow more, ROE increases; get paid more; never mind the firm’s
burgeoning debt.
Measuring performance using one indicator is similar to driving a car using only
the speedometer. All well and good but if you don’t notice the engine temperature
rising, oil pressure falling, or revs going off the scale, the engine will seize and you
won’t be going anywhere anymore.
Post-Lehman, commentators are showing interest in a comparatively new indicator
called EVA momentum (see page 300) that takes a broader view of corporate
performance. EVA momentum rankings for top US companies are now being published
in journals such as Fortune and Forbes. See this book’s website for more information.
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