For many entrepreneurs, the most appropriate measure of performance is the personal financial benefits derived from owning a business.
These benefits include not only salary and direct fringe benefits, such as medical and life insurance and a retirement plan, but also indirect benefits, such as travel and entertainment, use of vehicles, a country club membership and other items of value the owner can extract from the business.These benefits, however, are not a measure of the viability of your business. The viability is determined with a broad spectrum of criteria, which in turn may be expressed by ratios. Ratios are useful in summarizing data in a form that can be more easily understood. Ratios can also provide a basis for monitoring and comparison.
Using a multitude of ratios can be confusing. When using ratios, there are two questions that must be answered. First, which ratios are meaningful for your business? Second, what should the ratios you calculate be measured against?
The identification of meaningful ratios begins with the appropriate analytical focus. Among the most frequently asked questions are: What are your sales? How profitable are you? What is your cash flow? What is your return on equity?
An analytical focus on sales ignores the cost of sales and the amount of assets needed to generate the sales. A focus on net income, once again, ignores the amount of assets needed to generate the income and can be greatly affected by non-cash charges such as depreciation and amortization. Cash flow theoretically measures the cash-generating capacity of the entity, but once again, ignores the amount of assets needed to generate revenue.
Return on investment measures the net results of operations in comparison with assets utilized. However, this focus does not differentiate between the fruits of equity and debt financing.
Return on equity, measuring the efficiency with which shareholder investment is utilized, is generally the best measure of performance. When using this measure, you should increase net income by the excess of your salary and benefits, net of income tax benefits, over what you would otherwise expect to be earning as an employee elsewhere.
This approach is appropriate because each investor has alternative investments. These alternatives range from relatively risk-free (government debt obligations) to comparatively risky (possibly the business itself). A business should earn, over time, a rate of return greater than what the owner could have earned by investing in relatively safe debt obligations. If not, the owner might have been better off by liquidating and simply buying a Treasury bill.
The advantage of using return on equity as a measure of performance is that it can be explained with mathematical precision.
The formula for return on equity is net income divided by stockholders' equity. The same result can be derived by using the following three formulas and multiplying the results: net income divided by revenue, revenue divided by assets, and assets divided by stockholders' equity. Stockholder's equity and asset figures should be the average for the period under consideration.
The three formulas measure profitability (net income divided by revenue), asset turnover (revenue divided by assets), and financial leverage assets divided by stockholders' equity).
Profitability is the amount of profits generated compared with sales for the period. Asset turnover measures how efficiently assets such as receivables, inventory and plant and equipment are being used in generating sales. Financial leverage measures the value of assets being financed by shareholders' money rather than by money provided by creditors.
Each of these three ratios might be thought of as secondary performance indicators, yet are keys in analyzing return on equity.
If you are in a situation where equity is relatively low and working capital is provided from a highly leveraged debt position, return on investment might be a substitute for return on equity.
The development and comparison of these ratios, for your business over a period of years, may prove helpful in making business decisions.
Should the results of the three secondary ratios deem that further analysis is required, this can be done. For example, asset turnover can be further broken down by reviewing receivables turnover, inventory turnover and fixed-asset turnover.
This approach creates an analytical framework through which you can understand the components or causes of change. Understanding the components of change then highlights areas for taking action to improve results.
Return on equity should be interpreted in conjunction with historical comparisons, budget versus actual operating results and projected returns for future years. Further interpretation can be achieved by comparing return on equity with the ratios generated by similar businesses and the yields on alternative investments.
Some cautions: Historical data may have some limitations. It may not be available, for whatever reason, or you may be involved in a start-up business that has none. Relying too much on historical data may lead to mediocre performance. Changes in accounting principles, new products, new territories or more debt financing can be troublesome.
If return on equity is compared to budget projections, the question should be, what is the quality of the budget? Is it a legitimate planning document or an extrapolation of past performance? If performance standards are objectively set in the budgeting process, comparison can be worthwhile.
Comparison to industry data is of value only if the data are accurate, timely and essentially comparable. Finding or developing data on companies of similar size and scope is difficult.
The real challenge is analyzing results to identify what determined performance and how to improve performance.