Surplus generated: This is the first question to be answered by us. This is possible through the preparation of our personal income statement wherein we start with our revenues and then keep subtracting all the expenses incurred by us in a year. The excess of our total revenue over the total expenses would give us the surplus amount generated. We can also compute the various profit margins such as operating margin and net income margin for this year and compare this over the previous three years to get to know the trend in our profitability.
Return on equity: This question follows the computation of the net income earned by the individual in 2013. One needs to know the change in net worth or owners’ equity figure. Absolute change in the networth figure does not communicate a clear picture about the wealth generated by the individual. Hence return on equity (ROE) can be computed for this year and the previous three years to have an understanding of the trend over this period. Higher profits are meaningful only when they get reflected as a higher ROE figure.
Cash conversion cycle: Cash conversion cycle indicates the number of days taken by an individual to convert every rupee that goes out of his pocket into cash inflows. It is computed by subtracting the day’s payables from the sum of day’s inventory and day’s receivables. The lower the cash conversion cycle the better is the working capital management of the individual. Again one can compare this year number with that of the previous three years to know the trend in the parameter. One can prepare the statement of sources and uses of cash to know where he needs to concentrate to have a better cash management.
Asset turn: Asset turn over or asset turn is a measure to gauge the investment utilisation of the entity (here it is an individual). It is computed by dividing the total operating revenue by the total assets employed by the individual. Higher asset turn indicates higher profitability as every extra use of the asset gives an additional surplus and lower asset turn indicates lower surplus or losses as lower utilisation of assets gives higher costs (for instance depreciation) compared to the revenue generated by the assets. One can decide to sell an asset as it gives a higher cost than that of its revenue, i.e loss.
Liquidity & solvency position: Liquidity position can be assessed by computation of acid-test ratio. Higher the acid-test ratio, better is the liquidity of the individual. Solvency position can be evaluated with the help of the debt-equity ratio. Lower the debt equity figure, better is the solvency of the individual. One can compute the interest cover to find out the number of times his operating earnings can be used to meet the interest obligations. Higher the interest cover, better is the performance of the individual. These measures can also be computed for the previous years to know the trend.
Conclusion: If one can compute the above stated numbers and compare it with the previous figures, this exercise would offer clarity in her financial journey to create wealth. Remember what gets done is what gets measured.
* The writer teaches accounting & finance courses at IIM Ranchi