Business performance evaluation methods and metrics

Performance of a Business

The overall performance of a firm must be measured against the firm's objectives. One objective is certain -- the firm exists to maximize shareholder wealth. The other objectives should be defined by management. These will vary depending on the firm. Metrics used can include market share, customer growth, or revenue growth. There can be non-financial measures as well, including those related to goals on ethics, corporate social responsibility and environmental stewardship.

As Milton Friedman (1970) famously wrote, the primary obligation of business is to maximize profit. The shareholders are the owners of the firm and management is the agent of the shareholders. Thus, measuring the success of management involves measuring the growth of the equity in the firm. If shareholder wealth is maximized, then management has been successful.

Kolstad (2007) argued, however, that maximizing shareholder wealth is not necessarily the ideal goal over a specific period of time. While it is true that business should maximize shareholder wealth over the long-run, the focus on wealth maximization over the short run can lead to a failure to maximize wealth in the long run. What this implies is that over any given period of time, there may be better and more firm-specific measures of success. These measures should relate to the long-run goal of wealth maximization. However, in the short run it may be more important to build market share, build revenues, improve corporate ethics or even demonstrate environmental leadership.

Thus, I would use net profit and equity gains as two financial measures, but would incorporate a variety of other measures that, when aggregated, will contribute in the long run but not necessarily in the short run to building equity growth and improving long-run profits.

Q2. The firm's financial statements can reveal a significant amount about the firm's operations. The quality of the firm's cash flows, earnings streams, balance sheet and other metrics can be measured against other firms in the same industry, and against the firm's past performance. This will yield sound information about the performance of the firm, simply from financial statement analysis.

There are three main ways to analyze financial statements. They are ratio analysis, common size analysis and trend analysis. These three forms of analysis allow the firm's financials be compared to industry norms, to the firm's past performance and on a raw basis. By using these techniques, the analyst can gain a sense of where the firm stands today, where the firm has been in the past, and what the current trends of the business are.

Ratio analysis covers a wide range of ground, including liquidity, profitability, solvency and managerial efficiency (Leka, 2007). These ratios outline the financial condition the firm is in, and attempt to derive some understanding of how the firm got into that position. Trend and common-size analysis allow for better year-over-year comparison, while ratio analysis can facilitate analysis across different firms in the same industry.