Measuring Corporate Performance
It must be integrated with the overall strategy of the business: Balance Score Card
The value-based management (VBM): EVA, CFROI…
Accounting Rates of Return: Acid test, Quick ratio, Leverage …
Even though more sophisticated valuation techniques like IRR, CFROI, and
DCF modeling have come along, ROE has proven enduring.
Accounting Rates of Return: Using the case of Sainsbury
When accountants draw up an income statement, they start with revenues and
then deduct operating and other costs. But one important cost is not included: the
cost of the capital the firm employs. Therefore, to see whether the firm has truly
created value, we need to measure whether it has earned a profit after deducting
all costs, including the cost of its capital.
The profit after deducting all costs, including the cost of capital, is called the
company’s economic value added or EVA.
EVA, or residual income, is a better measure of a company’s performance
than is accounting income. Accounting income is calculated after deducting
all costs except the cost of capital. By contrast, EVA recognizes that companies
need to cover their opportunity costs before they add value.
EVA makes the cost of capital visible to operating managers. There is a clear target:
Earn at least the cost of capital on assets employed. A plant or divisional manager
can improve EVA by reducing assets. Evaluating performance by EVA pushes
managers to flush out and dispose of underutilized assets. Therefore, a growing
number of firms now calculate EVA and tie managers’ compensation to it.
Return on equity = (return on assets) *(Assets/equity)
Assets/equity is the ratio for measuring the long term solvency of any firm. This ratio is
actually useful for measuring the financial leverage. Through this ratio the use of debt
and equity in financing for a firm is measured. Debt and equity have different cost and
risk; cost of equity and cost of debt is different for any company is more specific to
illustrate here. This use of debt and equity in total asset can denote the capital
structure of the company. This ratio is useful to get the idea on above fact for any firm
and varies accordingly with different industry and company. High value of the ratio may
be the reason of the better return from borrowing than the cost of capital but this
higher value can raise the interest amount and risk excessively.
Return on assets indicates that how much dollar of sales the firm generated
from one dollar asset. This ratio is not fixed rather changes with the pattern of
industry. Return on assets of car industry or of retail industry is different as the
requirement of assets for the operation is different and purposeful. Asset
includes fixed asset and current asset. Under current assets it is usual to
include parts working capital like cash, marketable securities, account payable,
account receivables, inventory etc. And under fixed asset, machines, land,
buildings and other capital equipment are inclusive. Return on assets can be
calculated as either through (net profit margin* asset turn over) or through
(net income % assets for the period). If any industry has lower return on assets
then that industry can be told as high asset intensive industry and same way
when return on assets has higher value then industry can be told as low asset
intensive industry. Any manufacturing industry is asset heavy industry and any
software industry is asset light industry.
Return on assets (ROA)= After-tax operating income as a percentage of total assets.
This return of assets can decomposed further as below:
ROA=Net profit /assets= (Net profit/sales)*(Sales/Assets) = Net profit margin*
Hence change in the ROA can be further explained through the profit margin and
asset turnover. Lower return on assets can explained thorough lower margin or
lower asset turnover. Lower Asset turnover can be the reason of lower sales in
comparison to other companies in the same industry or in comparison to the
previous year. May be the lower variation of change can lead to higher change in
return of assets. This situation can be explained through the cost structure of the
company. Cost of company is the sum of variable and fixed cost and those are
like cost of goods sold(COGS), administrative expenses, overhead expenses,
interest due to debt ( this is dependent to the leverage of the firm and
asset/equity part of this Du Pont analysis) and taxes. If the firm has higher cost
structure then net income can be reduced after considerable good amount of
sales. Because the net income is sales minus total cost. Cost structure of the firm
is dependent to the capital structure, economy of scale etc.
Net profit margin
In order to understand revenue generation capacity of a company against utilization of
assets, sales volume, and equity of that business, profitability ratios are applied.
The volume of investment made to a business and other factors are measured against the
revenue, cash flow, and profits by these ratios. The optimization of business profitability is
also measured by profitability ratio such as, return on equity or ROE, return on sales, gross
profit margin, net profit margin and return on capital employed.
Gross profit margin represents the proportion of gross profit to sales revenue. Here, gross
profit is calculated by deducting cost of sales from gross sales. This ratio implies at what
percentage gross profit is higher than production and expressed as, Gross profit/revenue=
Gross profit Margin. Net profit margin represents the relative volume of profitability against
sales where profitability is derived by deducting tax. This ratio is represented as Net profit
margin= profit after tax/revenue volume. Gross profit margin, operating profit margin and
net profit margin have increased from 2010 but decreased from 2011.
Return on equity
Return on equity highlights the net income gained in relation to the
shareholders percentage of equity. The equation of this ratio is return
on equity= net income (after tax)/ equity of shareholders. In 2012 the
return on equity is also rapidly decreased in line with margin.
Sainsbury’s current and quick ratios are far below than 1 and lesser than sector
average (appendix) but the value has increased from last year. So the liquidity has
recovered from last year but still below the par level.
The near term debt repayment capacity of a business is measured by the liquidity ratios and
the risk of default can also be inferred from such ratios by further analysis. The volume of
cash and different liquid assets are measured against the current liabilities and volume of
borrowings for short time. The liquidity ratios bring out the amount of cash and other liquid
assets present in a business to repay current liabilities and debt obligations of short period
of time if this ratio generates value above 1; it signifies that all short term liabilities are
included in the volume of liquid assets of that business. Quick ratio is used to know the
short term liquidity of a company along with the business condition. This ratio is expressed
as current assets(less inventory)/current liabilities. Another type of liquidity ratio is current
ratio which reveals a firm’s capacity to repay short run debts and is represented by the
equation: current ratio= current assets / current liabilities.
Working Capital Efficiency
The efficient management of working capital is known from the efficiency ratios which demonstrate the
management and usage pattern of assets like, inventories of a business along with the efficiency of
business in accumulating money. The amount of time needed by a business to convert the account
receivables into cash can be derived by the term collection period which is calculated through dividing 365
by the ratio of sales/account receivables. The quantity of turns present in the inventory is measured by
the sales to inventory ratio. If the value is high, it signifies decrease in sales and low value of ratio
highlights a dormant inventory of business. This ratio is reflected by the equation annual net sales divided
by inventory. Asset turnover ratio is effective in understanding the percentage of money invested in
purchasing assets for developing the sales level for a year. An output of higher percentage signifies less
aggressive sales efforts made by the business, whereas a low percentage denotes the strain on present
assets of a firm given by the same. This ratio is represented as asset turnover ratio= total assets/ net
Long term financial structure
Debt to Equity
debt to capital
Sainsbury’s leverage is above the level as 50% leverage is standard and signifies long term illiquidity also
shows the slightly higher business risk.
The economic strength of a business for long run is the great concern of the stakeholders, especially of
the creditors of long term debt as for example, financial institutions and debenture holders. To analyze
the financial position of a business capital structure or financial leverage ratios are useful.
The volume of total debt relative to the total equity is calculated by debt to equity ratio. Greater amount
of this ratio signifies a business having greater volume of expenditure for paying interest. This ratio also
analyzes the occurrence of liquidation of a business as investors and creditor will be interest to know the
negative aspects of the business in case the business starts winding up.
Debt ratio is calculated dividing total debt by total capital. In case of assured revenue generation debt is
not dysfunctional; however it may be a trouble if the business gets instable revenues. The positive aspect
of debt is it is considered as an expenditure that helps in deducting tax.
Stocks are evaluated mainly by the price to earnings or P/E ratio by the investors
measuring the stock price of a company relative to the earning per share. This ratio also
highlights the deserved value of a business in comparison to the net profit of the same. In
order to predict the business performance for forthcoming year forward P/E ratio is utilized
based on the net profit that already has developed certain expectation level. Forward P/E
would be near to the actual figure of profits, if the accuracy of prediction is high. (J
Sainsbury, 2012; FT, 2013 & FT, 2013a)