Operating and performance ratios

The key to remedying many financial ills is to improve operations.  All creditors and investors are interested in the results of operations, and it is not surprising that a number of operating and performance ratios are used.  The most widely used ratio is earnings per share, and is a integral part of the basic financial statements for public companies.  Several additional ratios offer excellent insight into operations.

The first of these is the 'efficiency ratio'.  This shows the relative volume of business generated from the company's operating asset base.  In other words, it shows whether sufficient revenue use are being generated to justify the assets employed.  When the efficiency ratio is low, there is an indication that additional volume should be sought before more assets are obligated.  When the ratio is high, it may be an indication that assets are reaching the end of their useful lives and an investment in additional assets will soon be necessary.

The second ratio is the profit margin ratio.  This shows the portion of sales which exceeds costs (both variable and fixed).  Where there is a weakness in this ratio, it is generally an indication that either, 1) gross margins (revenues in excess of variable costs) are too low, or 2) volume is too low with respect to fixed costs.  Two ratios which indicate the adequacy of earnings relative to the asset base are the profitability ratio and the return on total assets ratio.  In effect, these ratios show the information of the efficiency and profit margin ratio combined.

An important perspective on the earnings of a company is what kind of return is provided to the owners.  This is reflected in the return before taxes on common equity.  If this ratio is below prevailing long-term interest rates or returns on alternative investments, owners will perceive that they should convert the company's assets to some other use, or perhaps liquidate, unless return can be improved.

An interesting supplemental analysis is provided through leverage analysis.  Here, the proportionate share of assets for each source of capital is multiplied times the company's return on total assets (RTA).  This determines the return on each source of capital.  This is compared to the cost of capital (e.g., interest expense), and a net contribution by capital source is determined.  If the amount is positive for a capital source, it may be an indication that additional capital should be sought.  If the leverage is negative from a capital source, recapitalization alternatives and/or earnings improvements should be investigated.  It is helpful to use this leverage analysis when considering the debt to equity ratio.

The 'book value per common share' shows the combined effect of equity transactions over time.  'Return on Investment' (ROI) is an overall financial operating indicator that bring together operations with net assets.  The ROI is basically 'operating results' divided by 'invested capital'.  Invested capital in this case is considered to be 'net assets' (assets minus liabilities) which in effect equals balance sheet equity.  Click here for further info on ROI.

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