There have been several in-depth studies that analyzed the financial performance of hundreds of companies around the world. Insights were provided by these companies into the key metrics and strategies used by the best performers. The following were found to be the most sustainable value creators, and where focus is concentrated in those companies successfully creating value. The key numbers to watch are:
- Sales
- Net income
- Cash flow from operations
- Total assets
- Total liabilities
- Total equity
Using these six key numbers, four ratios are tracked and trended:
- Asset turnover (assets/revenue)-the higher the turnover, the better utilization of assets experienced.
- Profit margin (net income/revenue)-the greater the margin, the more profits available to fund growth.
- Cash-flow yield (cash flow from operations/net income)-the higher the yield, the more success enjoyed in managing working capital (ie., current assets minus current liabilities).
- Debt-to-equity (total liabilities/total equity)-the higher the ratio, the more of other peoples’ money (leverage) being used to finance growth.
Successful organizations do well on all these numbers. If you are not doing well on the ratios, then drilling down into the six key numbers is needed.
The entire management team needs to understand how the ratios and underlying key numbers connect to value creation.
Standards of performance can be created by looking at historical numbers over time, which will reveal ranges and trends. Then look for comparable measures within your industry to see how you fare against industry peers. Follow this up by setting some annual targets for 1 to 5 years. In other words, “do what the big dogs do” whether you are local or national in scope, and whether you are for-profit or not-for-profit.
This sets the discipline for making good decisions with the goal being to achieve outstanding long-term return on investment.
Your present performance measures may have defects; and there may be no quick remedies. CFO-Pro can provide a strategic perspective on your financial performance measures. If you are interested in connecting the strategy of your company with the financial reports, and to speak to how your company intends to create value, please contact me directly at jlafferty@cfo-pro.com or 630-269-7646.
The Wisdom of Henry Hazlitt (1894 – 1993)
How is the problem of alternative applications of labor and capital, to meet thousands of different needs and wants of different urgencies, solved in a modern economic society? It is solved precisely through the price system. It is solved through the constantly changing interrelationships of costs of production, prices and profits.
Prices are determined by supply and demand, and demand is determined by how intensely people want a commodity and what they have to offer in exchange for it. It is true that supply is in part determined by costs of production. What a commodity has cost to produce in the past cannot determine its value. That will depend on the present relationship of supply and demand. But the expectations of businessmen concerning what a commodity will cost to produce in the future, and what its future price will be, will determine how much of it will be made. This will affect future supply.
The relative supply of thousands of different commodities is regulated under the system of competitive private enterprise. When people want more of a commodity, their competitive bidding raises its price. This increases the profits of the producers who make that product. This stimulates them to increase their production. It leads others to stop making some of the products they previously made, and turn to making the product that offers them the better return. But this increases the supply of that commodity at the same time that it reduces the supply of some other commodities. The price of that product therefore falls in relation to the price of other products, and the stimulus to the relative increase in its production disappears.
In the same way, if the demand falls off for some product, its price and the profit in making it go lower, and its production declines.
In an economy in equilibrium, a given industry can expand only at the expense of other industries. For at any moment the factors of production are limited. One industry can be expanded only by diverting to it labor, land and capital that would otherwise be employed in other industries. And when a given industry shrinks, or stops expanding its output, it does not necessarily mean that there has been any net decline in aggregate production. The shrinkage at that point may have merely released labor and capital to permit the expansion of other industries. It is erroneous to conclude, therefore, that a shrinkage of production in one line necessarily means a shrinkage in total production.
Everything is produced at the expense of forgoing something else. Costs of production, in fact, might be defined as the things that are given up (the leisure and pleasures, the raw materials with alternative potential uses) in order to create the thing that is made.)
— Paraphrased From Economics in One Lesson (1946)
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