Evaluating the performance of your firm
By Ravi Mahendra
Investors who are not financial professionals or don't have access to financial advisors can still make a reasonable assessment of the viability of their investments in listed firms by using a few performance criteria.

A challenge often faced by small investors is successfully evaluating the performance of their companies based on information available to them. The evaluation can be based on two criteria, which would be the financial and non-financial. This article, which is the first in a series, looks into the financial criteria whereas the next article will look at the sources and types of non-financial information.

Financial criteria
This is often Greek to many small investors who are not financial professionals. Larger investors on the other hand are either very experienced or tend to have an army of advisors. The tools which can be used to evaluate companies financially would be:

1. Ratios
2. Trends
Ratios
A ratio could be defined as one financial measure compared with another. The common ratios which can be used for evaluation are:

1. Profitability measures
2. Liquidity or short term solvency measures
3. Gearing or long term solvency measures
4. Management efficiency measures
5. Investor measures

Profitability measures
These ratios look at the extent to which an organisation is profitable.
Commonly used measures are:
a) Profit Margin
b) Return on Capital Employed

Profit Margin
Profit margin can be calculated as:
Profit for the period / sales for the period.
The profit can be compared with sales and a percentage can be calculated. This percentage can be compared with the organisation's target margin as well as the margins of other firms in the industry. For example, an investor in United Motors should compare its Profit Margin with that of AMW, which is a competitor.

Return on Capital Employed
This measure compares the profit for the period with the capital employed. It can be calculated as:
Profit for the Period /Capital Employed.
The capital employed should include both shareholders' funds as well as loan providers' funds. This measure will simply show an investor the return a firm is generating over the funds invested. This can be compared over a period of time and also with that of other similar firms.

Liquidity or Short Term Solvency measures
Even when a business is profitable and it runs out of cash, it has the risk of failing in the short run. Two performance measures can be used in this regard, which would be:
a) Current Ratio
b) Acid Test Ratio

Current Ratio
This is a measure of the extent to which a firm is strong in the short run. The measure is calculated as:
Current Asset/ Current Liabilities.

Current Assets are the short-term assets a firm has in its balance sheet and would include those such as Stocks, Debtors, Cash etc. Current Liabilities are the short-term dues in the balance sheet and it would include those such as Creditors, Short term dues etc. The idea with this measure is that firms should at least have enough current assets to cover their current liabilities falling due in the short run. Ideally this measure should be one that can vary depending on industries.

Acid Test Ratio
Of the current assets, Stock is regarded as the least liquid asset. This measure attempts to test whether the firm has enough current assets without stock to cover its current liabilities. It can be calculated as:

Current Assets- Stocks/Current Liabilities
There is no target number since Acid test ratios can vary across industry.
My next article will consist of the remaining set of financial ratios, the strengths and weaknesses of ratio analysis and what trend analysis is all about.

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