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Specific financial metrics are used to determine return on investment, return on assets, profitability, and inventory turnover. Which metrics are useful depends at least in part on the nature of a business; for example, a small start-up may be not concerned with determining return on assets but may be very interested in knowing their return on equity.
Here are a few metrics that can be used to analyze operating and financial performance and make smart decisions:
Return on Assets (ROA)
Equation: ROA = NI/TA
NI = Net Income, and
TA = Total Assets
Return on Assets measures how much profit a company made for every dollar in assets. How hard is a company's money working? ROA gives a great indication.
Example: A company has net income of $100,000 this month. Its total assets equal $65,000.
$100,000 / $65,000 = $1.53. The company earned $1.53 for every dollar in assets.
Shareholders are especially interested in ROA because it measures the return on the money they have invested in the company. However, ROA can vary wildly based on the industry. Automobile manufacturers, for example, have a lot of money tied up in expensive equipment and large buildings, so their ROA will be relatively low as a result. In general terms, a capital-intensive business should have a relatively low ROA.
On the other hand, if the company is a small consulting business with no central office, the ROA should be very high because very few fixed assets are needed to maintain operations.
ROA can also be used to compare companies in similar industries. Say one company has net income of $100,000 and total assets of $200,000; the ROA is .50 per $1 in assets, or an ROA of 50%. Another company earns $100,000 but has assets of $125,000; the ROA is .80 per $1 in assets, or an ROA of 80%.
Which is doing a better job with its investment? Which company would you invest in? Which company would you consider purchasing? It's easy to tell.
Since ROA measures return based on all the resources at a company's disposal, it's a very easy way to determine how effectively the business is being run; a high ROA is very attractive to investors.
Return on Equity (ROE)
Equation: ROE = NI/ SE X 100
NI = Net Income, and
SE = Stockholder Equity
Equity is what is left on a balance sheet after all liabilities are taken care of. If, for example, you have invested in a company, that represents your money (even though you might have invested more than your equity is now worth), Return on Equity measures how well your money is being used, and what return you receive for your investment.
Example: Your neighbor is starting a business, and you lend him $100 in return for an ownership stake. He gives you 10% of the company because, including his own investment of $900, he now has $1,000 in capital to work with. In his first month of operation, he makes a profit of $500. Since you own 10% of the company, your share of the $500 is $50.
50 / 100 = .50, or 50%. You received a 50% ROE.
Return on Equity is similar to Return on Assets (ROA) because it also provides an indication of how well a company manages its assets. In simple terms, ROE shows how a company is doing with the money it currently has, while ROA can indicate how well a company would do if additional capital is invested (and all other business conditions remained stable.)
Keep in mind ROE may be meaningless in some circumstances. Let's say you own a company and are the sole employee. When you founded the company you invested $10,000 from your savings. You bring in revenue, pay expenses and liabilities (including a little of your original loan), and take the remaining funds as salary. Your "return on equity" comes in the form of salary – but since salaries count against company income, at the end of the year your company didn't "make money," even though you did.
The reason? Public companies generate an ROE; many small companies do not, at least under traditional financial calculations.
ROE is a key measurement used by many investors. Why? It's simple: If you plan to invest your money, you should expect a return on that investment – and the higher the return the better.
As a result, while lenders don't place a lot of emphasis on ROE, investors do.
Inventory Turnover Ratio (ITR)
Equation: ITR = CGS/I
CGS = Cost of Goods Sold, and
I = Inventory average value
The Inventory Turnover ratio reflects how many times a company's inventory is sold (and replaced) over a specific period of time. Inventory can include materials and supplies, finished products, work in process, or a combination of all types of inventory. The higher the ratio the more quickly inventory is turned over.
Example: Last year a company's average inventory value of finished goods (they took a physical inventory on the 1st of every month, and calculated the value of the inventory each time) was $10,000. The company sold $15,000 worth of finished goods during the year.
15,000 / 10,000 = 1.5. The ITR was 1.5; the company "turned" its inventory 1.5 times.
Turning over inventory as frequently as possible is critical; the less money invested in inventory, the more cash freed up for other purposes (that's why just-in-time purchasing and inventory systems are so popular). Say, for example, a company has $10,000 in inventory and sells $10,000 worth of goods. The ITR is 1. If the company could cut inventory value in half, to $5,000, and still sell $10,000 worth of goods, its ITR increases to 2 without losing any sales. The $5,000 can be used for other purposes: Paying off debt, expanding operations, increasing marketing efforts, whatever the owners decide.
Here's an example. Say you sell tennis balls and you like to keep a lot of stock on hand "just in case" a huge order comes in. You like to have three months worth of inventory on hand at any time.
The problem is those huge orders never come in, and your warehouse stays relatively full for months at a time. The tennis balls that fill up your warehouse represent dollars that are not working for you –they are just taking up space (and probably rent on the space they take up). If you find a supplier who can fill orders in a week or less, you could keep two to three weeks worth of inventory on hand (or less), and free up cash for other purposes.
Keep in mind that if a company sells a variety of products, some of its stock will turn more quickly, while less popular items will turn more slowly. That's okay – the company could simply increase inventory levels on popular items, and decrease inventory levels on slow-moving items. Reducing average inventory value increases ITR and ensures a company's money works harder.
Profitability Index (PI)
Equation: PI= PV / IV
PV = Present Value of future cash flow, and
IV = Initial Value of investment
The Profitability Index is a tool used to evaluate a project's potential return. Typically, PI is used to evaluate capital projects. The goal is to evaluate future cash flows against the cost of the initial investment.
Example: A company decides to purchase new servers to store customer data. The investment totals $20,000. The company estimates the present value of future cash flow to be $25,000.
25,000/20,000 = 1.25. The investment will yield a PI of 1.25.
Would you decide to invest in a project with a ratio below 1.0? Hopefully not; that means the return is less than the investment. As the PI goes up, the attractiveness of the project increases, too. In short: The higher the PI the better.
Let's compare two projects. Project A requires a cash investment of $15,000. You estimate the present value of future cash flows to be $16,000. Divide 16,000 by 15,000; the PI is 1.066.
Project B requires a cash investment of $9,000, and the present value of future cash flow is $9,900. Divide 9,900 by 9,000; the PI is 1.1.
PI measures the ratio between cash flow and investment. All other considerations being equal, Project B is the better project, at least in terms of return.