Financial performance measures: operating leverage, ROI, and EVA

Transfer Pricing-SLP

The relevance of financial ratios cannot be overstated when it comes to the measurement of an entity's performance. It should, however, be noted that not all performance measures can be expressed as a ratio. This text concerns itself with various other performance measures: operating leverage, Return on Investment (ROI), EVA, and gross profit margin.

Transfer Pricing-SLP

Operating Leverage

According to Shim and Siegel (2008, p. 198) "operating leverage, a measure of operating risk, arises from the company's use of fixed operating costs." As the authors further point out, a simple indication of the said financial measure would be the "change in sales on earnings before interest and taxes" (Shim and Siegel, 2008, p. 198). It is important to note that a high degree of operating leverage is seen as an indicator that small changes in sales result in significant changes in not only EBIT, but also return on equity, return on assets and return on capital invested (Brigham and Ehrhardt, 2013). The degree of operating leverage could be computed by dividing the change in operating income/change in EBIT with the change in sales, in percentage terms (Shim and Siegel, 2008).

The relevance of operating leverage cannot be overstated. This is particularly the case given that investors can make use of this particular performance measure to evaluate an entity's risk profile. However, like is the case with most performance measures, operating leverage does not tell the whole story, i.e. with regard to how effectively the company's management is making use of the money at their disposal.

Economic Value Added

Shim and Siegel (2008, p. 105) define EVA as "a measure of economic profit, but not the accounting profit we are accustomed to seeing in the corporate profit and loss statement." Instead, as the authors further point out, this particular performance measure seeks to measure "an operation's true profitability." EVA, according to Brigham and Ehrhardt (2013), could be computed by subtracting after-tax dollar cost of capital used to support operations from the net operating profit after taxes (NOPAT). While economic value added could help a company keep track of its problem areas and thus institute corrective measures, it involves many assumptions (i.e. those made in the computation of WACC)

Gross Profit Margin

This performance measure seeks to present "the percentage of each dollar remaining once the company has paid for goods acquired" (Shim and Siegel, 2008, p. 54). According to the authors, it could be computed by dividing an entity's gross profit figure with the figure of net sales. Although it does not include all costs, gross profit margin could help in the estimation of how good an entity's pricing strategy is.

Computations

This section will present the computations of the measurements discussed above. The company that will be utilized in this endeavor is Sony.

Table 1

Ratio

Computation

Value

Operating Leverage

89.31% / 4.52% = 19.76

19.76

Return on Investment

Computation

Value

2014

2013

2014

2013

($1,246,000) / $148,893,000

$441,000 / $150,900,000

Negative 0.008

0.003

Economic Value Added

($1,318,000) -- (15% * $148,853,000)

$367,000 -- (15% * $150,869,000)

-$23,645,950

-$22,997,350

Gross Profit Margin

$17,586,000 / $75,421,000

$15,459,000 / $72,158, 000

0.23

0.21

Assumption with regard to EVA: weighted-average after-tax cost of capital is 15%.

Analysis

From the table above, the operating leverage of Sony is 19.76. This is particularly high as it means that, for instance, a 3% increase in sales would result in a 59.25% increase in operating income. Next, we have the return on investment which significantly fell in 2014, in comparison to 2013. What this means is that Sony was less efficient in the application of each dollar invested in the entity's assets to various investments in 2014. This may have, by extension, hurt the return on shareholder's equity. When it comes to EVA, it is clear that the company's economic profit is not that impressive. The top management of the company may, therefore, be required to take the relevant measures to further enhance Sony's performance (as based on its residual wealth). Lastly, we have the gross profit margin which increased marginally in 2014, in comparison to 2013. This is an indication that at the end of the most recent financial year, Sony had a higher proportion of money left over after C.O.G.S was taken into account.

Conclusion

Of all the performance measures computed above, return on investment remains my preferred measure. This is particularly the case given that it could come in handy as a measure of divisional performance as well as the overall performance of an entity.