Key Financial Indicators for Managing Companies in Time of Crisis Research Proposal

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¶ … financial indicators that can be used to help monitor a company's health and performance in the industry as well as the larger macroeconomic climate in which it competes. The first section provides a definition and description of various financial indicators that can be useful for managing a company on a day-to-day basis, including net turnover, return on equity, return on assets, equity-to-assets, earnings to operating costs, price to earnings and share price performance. The second section of this chapter provides an overview of specific financial indicators that are linked with corporate liquidity that represent some of the more important financial metrics that can help managers weather and ultimately survive financial crises including EBITDA, gross profit margin, operating cash flow as well as a discussion concerning the interrelationship between these financial indicators. A brief summary of the research concludes this chapter.

Section One: Useful Financial Indicators for Managing a Company

Net turnover

According to Shim and Siegal (1999), the term "turnover" refers to the number of times an asset such as inventory or accounts receivable is replaced during an account period which is usually one year. These authors add that, "Usually, turnover is the ratio of sales to a balance sheet item, such as sales to fixed assets. A high turnover rate is favorable because it indicates the efficient utilization of assets" (Shim & Siegal 1999, p. 476). The definition of net turnover provided by Webster's New World Finance and Investment Dictionary (2003) states that this is "a financial measurement that shows how well a company is utilizing its fixed assets. It is net sales divided by average net fixed assets. The resulting number must be compared to the net fixed asset turnover of other firms in the industry, as well as the company's historical data, in order to be relevant" (p. 439). The comparison of an individual company's net turnover ratio to the industry in which it competes can provide some useful indicators concerning market growth as well. For instance, in April 1995, the global foreign exchange market experienced a net turnover of 1.23 trillion dollars a day (after eliminating all double counting of transactions because there are two parties to every transaction) and the net daily exchange global market turnover in 1992 was $820 billion and the comparable figure in April 1989 was $590 billion representing an acceleration in the rate of growth in the market from 12% to 14% per year (Zaheer 1995, p. 699).

Return on equity

This is one of the more common financial indicators used to gauge the performance of a company. The rate of return on equity (ROE) is the ratio of net income to the average value of common equity (Harwood, Litan & Pomerleano, 1999). According to Chang and Zeides (2002), "Return on equity is earnings per share divided by equity per share, and earnings predictability is a Value Line index that calculates how well a company fulfills market analysis expectations" (p. 101). Likewise, Harwood and his associates note that, "The ROE tells common shareholders how effectively their money is being employed" (p. 99). Care must be taken in interpreting this ratio, though. As Penman (2003) cautions, "Standard formulas show that increased borrowing relative to equity typically creates higher return on equity and creates earnings growth. Yet, if borrowing is a zero net present value activity, then value is not created" (p. 77). It is also possible to present ROE figures that do not take into account important transactions that can present a false picture of corporate performance in ways that can deceive investors (White, Sondhi & Fried, 1998). In this regard Penman emphasizes that, "Add stock repurchases (at fair market value), financed by borrowing, and one levers up expected accounting returns and growth in earnings and earnings-per-share considerably" (p. 77).

Return on assets

Calculating return on assets (ROA) is a fairly straightforward matter. According to Kremer, Rizzuto and Case (2000), the ROA is calculated by taking net profit (from the income statement) and dividing this figure by average assets which are located on the balance sheet. These authors note that, "To find average assets for a given time period, you just add the assets at the beginning and the assets at the end, then divide by two" (Kremer et al., 2000 p. 57). As an example of this approach, Kremer and his associates indicate that if a firm has $1 million in assets at the beginning of a year and $1.2 million at the end, its average assets for the year are $1.1 million; in the event the company earned $100,000 in net profit during the year, the ROA for the firm would be calculated by taking this $100,000 figure and dividing it by $1,100,000, resulting in an approximate 9% ROA (Kremer et al., 2000). According to Spinard and Suter (1995), a high ROA can be partially attributable to excess capital, but Kremer and his colleagues emphasize that, "ROA is a terrific bottom line. It encompasses net profit, so it shows you whether you're doing a good job managing sales and expenses. It also shows you how effectively you're managing assets such as receivables, inventory, and fixed assets" (p. 59).

The return on assets indicator helps develop a useful picture of what is taking place in the real world rather than merely presented an abstraction of reality. In this regard, Kremer and his associates emphasize that, "ROA helps you evaluate what is really happening when your profit moves in one direction or the other. If your profit has risen but ROA has declined, for instance, it means your assets have grown faster than your profits. That's usually a sign that you're not managing your assets effectively" (2000, p. 59). Beyond these useful attributes, the ROA can also provide some valuable indications of how a company is measuring up compared to others competing in the same industry. For instance, Kremer et al. add that, "ROA has one other big advantage: it allows a company to compare itself to competitors in the same industry. Profit levels and cash flow can differ widely from one company to another. But ROA is a kind of universal solvent for companies in the same business: it shows how much profit a company is earning for a given level of total assets." (2000, p. 59).

Even with a highly useful metric such as ROA, though, care must be taken to avoid an overreliance on this single indicator in isolation from its use with other relevant financial indicators. As Kremer and his colleagues point out, although the temptation may exist to just use ROA by itself, there are distinct limits to what this financial indicator can provide. Noting that the ROA is more complex than some other metrics thereby making it difficult to interpret by those without financial training, Kremer and his associates point out that ROA should not be used in isolation is that, "It too is an abstraction. The numerator (net profit) has drawbacks. The denominator (average assets) depends on how accountants value inventory, how they depreciate fixed assets, and so on. ROA is a good measure; it just isn't perfect -- and it still doesn't tell you how much cash you netted last month!" (Kremer et al., 2000, p. 59).

Equity-to-assets

According to Rosen (2003), "The equity-to-asset ratio is a measure of leverage, with higher values indicating lower risk" (p. 967). The asset/equity ratio shows the relationship of the total assets of the firm to the portion owned by shareholders, also known as owners equity. The asset/equity ratio indicates a company's leverage, the amount of debt used to finance the firm. A company's asset/equity ratio depends importantly on the industry in which it operates, its size, economic conditions, and other factors. There is no ideal asset/equity ratio. A relatively high asset/equity ratio may indicate the company has taken on substantial debt merely to remain in business. But a high asset/equity ratio can also point to a company that is wisely "trading on the equity." In other words, there is a high asset/equity ratio because the return on borrowed capital exceeds the cost of that capital. At some point, however, an asset/equity ratio can reach unsustainable levels, as the additional debt ratchets up interest costs and the deteriorating financial position puts the firm in jeopardy. By the same token, a low asset/equity ratio can indicate a strong firm that needs no debt, or an overly conservative company, foolishly foregoing business opportunities (Asset/equity ratio, 2009).

Earnings to operating costs

The earnings to operating costs ratio is calculated by taking net income from financial operations, adding income from equity investments, commission income, net income from securities transactions and foreign exchange dealings plus other operating income and dividing this amount by the commission expenses as well as administrative expenses and depreciation plus other operating expenses involved (Financial indicators and key ratios, 1998).

Price to earnings

The price-to-earnings ratio method relies on information reported on the income statement as well as on comparable industry information for adjustment purposes (Link &… [END OF PREVIEW]

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APA Format

Key Financial Indicators for Managing Companies in Time of Crisis.  (2009, September 29).  Retrieved February 17, 2019, from http://jk193.com/subjects/paper/key-financial-indicators-managing-companies/8346721

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"Key Financial Indicators for Managing Companies in Time of Crisis."  29 September 2009.  Web.  17 February 2019. <http://jk193.com/subjects/paper/key-financial-indicators-managing-companies/8346721>.

Chicago Format

"Key Financial Indicators for Managing Companies in Time of Crisis."  Essay.  September 29, 2009.  Accessed February 17, 2019.
http://jk193.com/subjects/paper/key-financial-indicators-managing-companies/8346721.