Financial Indicators That Can Be

¶ … financial indicators that can be used to help monitor a company's health and performance in the industry as well as the larger macroeconomic climate in which it competes. The first section provides a definition and description of various financial indicators that can be useful for managing a company on a day-to-day basis, including net turnover, return on equity, return on assets, equity-to-assets, earnings to operating costs, price to earnings and share price performance. The second section of this chapter provides an overview of specific financial indicators that are linked with corporate liquidity that represent some of the more important financial metrics that can help managers weather and ultimately survive financial crises including EBITDA, gross profit margin, operating cash flow as well as a discussion concerning the interrelationship between these financial indicators. A brief summary of the research concludes this chapter.

Section One: Useful Financial Indicators for Managing a Company

Net turnover

According to Shim and Siegal (1999), the term "turnover" refers to the number of times an asset such as inventory or accounts receivable is replaced during an account period which is usually one year. These authors add that, "Usually, turnover is the ratio of sales to a balance sheet item, such as sales to fixed assets. A high turnover rate is favorable because it indicates the efficient utilization of assets" (Shim & Siegal 1999, p. 476). The definition of net turnover provided by Webster's New World Finance and Investment Dictionary (2003) states that this is "a financial measurement that shows how well a company is utilizing its fixed assets. It is net sales divided by average net fixed assets. The resulting number must be compared to the net fixed asset turnover of other firms in the industry, as well as the company's historical data, in order to be relevant" (p. 439). The comparison of an individual company's net turnover ratio to the industry in which it competes can provide some useful indicators concerning market growth as well. For instance, in April 1995, the global foreign exchange market experienced a net turnover of 1.23 trillion dollars a day (after eliminating all double counting of transactions because there are two parties to every transaction) and the net daily exchange global market turnover in 1992 was $820 billion and the comparable figure in April 1989 was $590 billion representing an acceleration in the rate of growth in the market from 12% to 14% per year (Zaheer 1995, p. 699).

Return on equity

This is one of the more common financial indicators used to gauge the performance of a company. The rate of return on equity (ROE) is the ratio of net income to the average value of common equity (Harwood, Litan & Pomerleano, 1999). According to Chang and Zeides (2002), "Return on equity is earnings per share divided by equity per share, and earnings predictability is a Value Line index that calculates how well a company fulfills market analysis expectations" (p. 101). Likewise, Harwood and his associates note that, "The ROE tells common shareholders how effectively their money is being employed" (p. 99). Care must be taken in interpreting this ratio, though. As Penman (2003) cautions, "Standard formulas show that increased borrowing relative to equity typically creates higher return on equity and creates earnings growth. Yet, if borrowing is a zero net present value activity, then value is not created" (p. 77). It is also possible to present ROE figures that do not take into account important transactions that can present a false picture of corporate performance in ways that can deceive investors (White, Sondhi & Fried, 1998). In this regard Penman emphasizes that, "Add stock repurchases (at fair market value), financed by borrowing, and one levers up expected accounting returns and growth in earnings and earnings-per-share considerably" (p. 77).

Return on assets

Calculating return on assets (ROA) is a fairly straightforward matter. According to Kremer, Rizzuto and Case (2000), the ROA is calculated by taking net profit (from the income statement) and dividing this figure by average assets which are located on the balance sheet. These authors note that, "To find average assets for a given time period, you just add the assets at the beginning and the assets at the end, then divide by two" (Kremer et al., 2000 p. 57). As an example of this approach, Kremer and his associates indicate that if a firm has $1 million in assets at the beginning of a year and $1.2 million at the end, its average assets for the year are $1.1 million; in the event the company earned $100,000 in net profit during the year, the ROA for the firm would be calculated by taking this $100,000 figure and dividing it by $1,100,000, resulting in an approximate 9% ROA (Kremer et al., 2000). According to Spinard and Suter (1995), a high ROA can be partially attributable to excess capital, but Kremer and his colleagues emphasize that, "ROA is a terrific bottom line. It encompasses net profit, so it shows you whether you're doing a good job managing sales and expenses. It also shows you how effectively you're managing assets such as receivables, inventory, and fixed assets" (p. 59).

The return on assets indicator helps develop a useful picture of what is taking place in the real world rather than merely presented an abstraction of reality. In this regard, Kremer and his associates emphasize that, "ROA helps you evaluate what is really happening when your profit moves in one direction or the other. If your profit has risen but ROA has declined, for instance, it means your assets have grown faster than your profits. That's usually a sign that you're not managing your assets effectively" (2000, p. 59). Beyond these useful attributes, the ROA can also provide some valuable indications of how a company is measuring up compared to others competing in the same industry. For instance, Kremer et al. add that, "ROA has one other big advantage: it allows a company to compare itself to competitors in the same industry. Profit levels and cash flow can differ widely from one company to another. But ROA is a kind of universal solvent for companies in the same business: it shows how much profit a company is earning for a given level of total assets." (2000, p. 59).

Even with a highly useful metric such as ROA, though, care must be taken to avoid an overreliance on this single indicator in isolation from its use with other relevant financial indicators. As Kremer and his colleagues point out, although the temptation may exist to just use ROA by itself, there are distinct limits to what this financial indicator can provide. Noting that the ROA is more complex than some other metrics thereby making it difficult to interpret by those without financial training, Kremer and his associates point out that ROA should not be used in isolation is that, "It too is an abstraction. The numerator (net profit) has drawbacks. The denominator (average assets) depends on how accountants value inventory, how they depreciate fixed assets, and so on. ROA is a good measure; it just isn't perfect -- and it still doesn't tell you how much cash you netted last month!" (Kremer et al., 2000, p. 59).

Equity-to-assets

According to Rosen (2003), "The equity-to-asset ratio is a measure of leverage, with higher values indicating lower risk" (p. 967). The asset/equity ratio shows the relationship of the total assets of the firm to the portion owned by shareholders, also known as owners equity. The asset/equity ratio indicates a company's leverage, the amount of debt used to finance the firm. A company's asset/equity ratio depends importantly on the industry in which it operates, its size, economic conditions, and other factors. There is no ideal asset/equity ratio. A relatively high asset/equity ratio may indicate the company has taken on substantial debt merely to remain in business. But a high asset/equity ratio can also point to a company that is wisely "trading on the equity." In other words, there is a high asset/equity ratio because the return on borrowed capital exceeds the cost of that capital. At some point, however, an asset/equity ratio can reach unsustainable levels, as the additional debt ratchets up interest costs and the deteriorating financial position puts the firm in jeopardy. By the same token, a low asset/equity ratio can indicate a strong firm that needs no debt, or an overly conservative company, foolishly foregoing business opportunities (Asset/equity ratio, 2009).

Earnings to operating costs

The earnings to operating costs ratio is calculated by taking net income from financial operations, adding income from equity investments, commission income, net income from securities transactions and foreign exchange dealings plus other operating income and dividing this amount by the commission expenses as well as administrative expenses and depreciation plus other operating expenses involved (Financial indicators and key ratios, 1998).

Price to earnings

The price-to-earnings ratio method relies on information reported on the income statement as well as on comparable industry information for adjustment purposes (Link & Boger 1999). According to these analysts, "The implicit assumption underlying the price-to-earnings method is that the fair market value of the closely held business can be approximated from the market value of comparable publicly traded businesses. To implement this method, the valuator must be able to identify a set of presumed-to-be comparable publicly traded companies and obtain sufficient information on each to verify the extent of comparability from an economic, management, and financial perspective. No publicly traded company will be precisely comparable to the closely held business being valued, so informed judgment must be exercised" (p. 81). As a general rule, the smaller in size and the more limited the scope of activities of the business being valued, the less likely there will be a set of publicly traded companies that are comparable, or even a single comparable publicly traded company. Publicly traded companies are for the most part large, measured in terms of revenues or assets, and they are diversified across product lines (Link & Boger 1999).

Share price performance

This is a fundamental financial metric that is used in virtually any analysis of how well a company is performing in terms of producing value for its stakeholders. Normally, share price performance is evaluated over the course of one- or three-year periods (Dobbs & Koller 2000). In this regard, Dobbs and Koller (1998) report that, "Any performance measure must incorporate a company's share price performance. If they do nothing else, investors will look at how well a stock has performed for them" (p. 32). These analysts, though, also emphasize that it is foolhardy to take a single metric such as share price performance in isolation from other financial indicators in measuring a company's overall performance in the market in which it competes (Dobbs & Koller 1998). According to Dobbs and Koller, "A performance measure must do more than simply record how much a stock goes up (or down). It must cut through the noise of the market and provide an accurate picture of exactly how and why managers are creating value" (1998 p. 33). Despite these constraints, share price performance represents a useful gauge of a company's ability to provide returns to its investors. In this regard, Cheffins (1997) points out that, "The pay-offs associated with good share price performance are more complex with institutional investors than they are for private investors, but higher prices are good news for all concerned" (p. 630).

Section Two: Specific Financial Indicators Connected with Corporate Liquidity that are the Most Important Indicators for Surviving Financial Crises

Earnings before interest, taxes, depreciation, and amortization (EBITDA)

The usefulness of the EBITDA in gauging a company's performance and fiscal health depends on a number of factors, including who is conducting the analysis and for what purpose (Fields, 2002). The guidance provided by Fields (2002) indicates that, "The board of directors of the company, as well as security analysts and credit analysts, are concerned with the performance of the company as a whole. Therefore, the measure they use to evaluate company-wide performance will probably be net income. Increasingly, however, security analysts, who are concerned with the company's performance within the context of the stock market, are using EBITDA" (p. 94).

The reasons cited by many authorities for this increased emphasis on EBITDA relates to its ability to be combined with other financial indicators to produce insights that might not be otherwise possible (Hardwood et al. 1999). Indeed, according to Penman (2003), the EBITDA is "the premiere pro forma number" but it carries a number of inherent flaws that require care in its interpretation. For instance, Penman notes that, "EBITDA ignores depreciation in addition. Investment bankers like this number for their comparable analysis in IPOs, for they like to create IPO bubbles. EBITDA ignores a real cost. Factories rust and become obsolescent. Overcapacity in telecom networks is a cost" (p. 78). Moreover, there are some other constraints to the use of the EBITDA that must be taken into account. For example, Penwood emphasizes that the EBITDA was used by WorldCom with some infamous results:

EBITDA promotes substitution of capital for labor, creating excess capacity. EBITDA also provides incentives to capitalize expenses. WorldCom, while promoting EBITDA as the 'gauge of vigorous growth,' capitalized operating expenses in a $3.8 billion fraud exposed in 2002. By shifting the expenses to depreciation, these operating costs never affected the EBITDA on which we were asked to focus. Combine EBITDA with revenues recognized from (excess) capacity swaps and one has a telecom bubble going. But the bubble bursts" (p. 78).

Generally speaking, though, when used with care, there are some valuable applications for the EBITDA. For instance, according to Harwood et al. (1999), "Low ratios of EBITDA to interest payments indicate firms with high financial risk" (p. 104).

Gross profit margin (GPM)

A company's profit is expressed in terms of either the gross profit margin or the gross profit markup. According to McCalley (1992), "The gross profit margin (GPM) is derived by dividing the dollars ($) of gross profit (GP) per unit of sale by the unit of selling price (SP). GPM = GP $/unit + SP" (p. 40). In addition, the GPM for most products tend to vary over time such as from year to year or even from sale to sale (McCalley, 1992). The significance of the GPM will also be different for different types of products, but these differences are relative; for instance, a company may realize high profit on products such as heavy equipment while other companies such as pharmaceuticals will realize smaller profits on individual sales with the volume of sales therefore representing a key element in this analysis (McCalley, 1992).

Operating cash flow (also termed cash flow from operating activities)

Cash-flow statements differ from company to company, but most follow some standard practices that can be used to identify how much money is coming in and going out. According to Kremer and his associates (2000), not all of the cash inflows are traditionally located at the top of a cash-flow statement, but the statement is rather separated into three categories, each with its related inflows and outflows. As to operating cash flow, Kremer et al. report, "The first several lines on the statement reflect cash related to a business's operations. Collections is the top line and in ordinary circumstances represents a company's biggest inflow of cash. It is all the cash a business collects from outstanding receivables or from cash sales" (p. 43). These authors also note that, "Although the cash-flow statement has three categories, it really has only one bottom line, operating cash flow. Cash flow from operating activities, or operating cash flow, shows how much cash the company generated from operations" (Kremer et al. 2000, p. 44).

The importance and relevance of the operating cash flow will differ for creditors, potential investors and existing stakeholders, though. In this regard, Allen and Cote (2005) report that, "Investors' and creditors' differing goals offer initial clues to differences in their decision-making behavior. Investors are the residual owners and their returns are limited only by the opportunity set and managerial motivations. Thus, they place primary emphasis on profitability to signal whether their return expectations will be met. Operating cash flow and solvency are secondary concerns to investors" (p. 198). In addition, investors will look to the operating cash flow for corroboration with earnings predictions by companies they may be interested in as a potential investment. According to Quirin, O'Bryan and Wilcox (1999), "As discretionary accruals can be used to manipulate earnings information, investor reaction to the earnings signal may be dependent on the operating cash flow signal" (p. 3). By contrast, creditors analyze a company's operating cash flow to determine the company's ability to consistently generate cash flow from their ongoing business activities (Allen & Cote 2005). In this regard, these authors add that, "Creditors have a specific interest in operating cash flows because of the need to determine a firm's ability to repay loans. Given the risks they assume and the nature of their relationship with the firm, creditors are expected to incorporate cash flow information into their assessments of a borrower's creditworthiness" (Allen & Cote 2005, p. 199). In sum, the financial indicator represented by operating cash flow is a measure that can be used to analyze the consequences of a company's performance volatility (Sorensen 2002).