Performance measures normally aim to assess an entity on a single parameter. We measure the financial performance of organisations/individuals on parameters such as profitability, efficiency, working capital, liquidity and solvency measures.
But the problem in this individual parameter-centric approach is that it fails to consider the differences in the individual/entity?s overall performance. For instance, one may perform very well in the profitability metric, while the performance may be not be so good in the liquidity and solvency metrics. Hence, there is a need to arrive at a composite performance metric.
What do we intend to measure? Let?s first define what investors or lenders or other stakeholders intend to measure about an entity?s performance. Conventional wisdom states that the stakeholders would like to measure three aspects of a company ? profitability, liquidity and safety. All of us are stakeholders of our own entity; hence, we should measure whether we are perceived to be profitable as an operating entity, to be liquid enough to run our day-to-day operations and to be safer to lend money by the lending institutions.
Measuring performance
Profitability: We can measure the profitability of Pulkit Zeeshan, a management trainee in a bank, by computing his operating profit margin. Operating profit margin is calculated by dividing the after-tax operating profit by his operating revenue. His operating revenue is R24 lakh and total operating expenses are R8 lakh. His income-tax expense is R6 lakh and, so, his operating profit is R10 lakh.
His after-tax operating margin would be 41.67%, i.e., (10/24)*100. Note that this calculation does not consider his other income. Also note that we are taking the after-tax operating income as we intend to measure the operating profit of Pulkit after he meets the obligatory expenses.
Liquidity: The objective of the liquidity measure is to assess the ability of an individual to meet his short-term obligations in time. We can measure the liquidity of Pulkit using the conventional measure of acid test ratio. Let us assume that his total monetary assets are R3.6 lakh and his current liabilities are R3.6 lakh (including the current portion of long-term loans). Then, his acid test ratio would be 1 time or 100%.
Solvency: The solvency measure aims to assess the ability of an entity to meet its long-term obligations in a sustainable manner. Debt to equity is the most widely used measure to evaluate the solvency of an organisation/individual.
Here, the term debt can include either only the long-term debt or both long-term and short-term borrowings (i.e., current liabilities) or only the interest-bearing debt (both short- and long-term) and equity is his net worth.
Rationality suggests that we consider debt as interest-bearing obligations. Let us assume that his interest-bearing debt is R24 lakh and equity is R48 lakh. So, his debt-equity ratio would come to 0.5 times.
Invested capital turnover: Two individuals may produce the same amount of absolute profits, but may differ in terms of the resources/assets used by them in earning the reported amount of profits. Let us assume that the invested capital (i.e., sum of owners? equity and long-term debt) of Pulkit is R70 lakh and the after-tax operating income is R10 lakh on the reported revenue of R24 lakh; another individual namely Nitesh Palit reports an after-tax operating profit of R10 lakh whose revenue and invested capital are R18 lakh and R36 lakh, respectively.
Here, the invested capital turnover is calculated by dividing the revenue by the invested capital. It is 0.34 times (24/70) for Zeeshan and 0.5 times for Nitesh Palit (18/36). So, Nitesh Palit uses his investment at a higher magnitude compared to that of Pulkit.
In fact, if we multiply the after-tax operating margin of Pulkit with his invested capital turnover, we will get his return on invested capital. In the composite financial score, let us take the above stated three parameters, i.e., RoIC, Acid test ratio and solvency for constructing the composite financial score. Let us give equal weights to all the three parameters as identified above and compute the weighted score for Pulkit (see graphic).
Here, we have taken all the figures in number of times (i.e., 14% is taken as 0.14 and so on) and the composite score of Pulkit is 0.5464. Is he better than others? This question can be answered by arriving at the scores for his comparable individuals.
In this example, we have considered only three parameters for computing the composite financial score by giving equal weights to the considered parameters. But one can argue that safety is more important than liquidity while lending money to an individual. Hence, the weights can vary according to the importance of the identified parameters. On similar grounds, one can add more parameters or delete some of these three for arriving at a composite financial score.
The writer teaches accounting and finance courses at
IIM, Ranchi