Metrics: Operating Performance (#31)
/In this episode, we discuss the most essential operating performance metrics for a business, with a emphasis on how to discern the performance of an organization’s core operations, how changes in fixed expenses will alter profits, and whether financial reporting fraud may be present. Key points are noted below.
Operating performance is all about the net results of your company. Examples of operating performance are the gross margin and net profit measurements, which pretty much everyone uses. The trouble is that no one uses anything else, and there are some other ways to look at operating performance.
Sales to Operating Income Ratio
A good alternative measurement is the sales to operating income ratio. This is the same thing as the net profit measurement, but you strip out any income or expense that’s unrelated to your core operations. This means removing gains or losses from asset sales, as well as any changes in reserves, and also take out any interest income or expense.
The intent of this measurement is to strip out all of these non-operational items that muddy the waters and keep you from seeing how the company is actually performing. If you don’t have large amounts of these non-operational items cluttering up your income statement – then don’t bother with it. But if you do, this really should be the preferred measurement to use instead of net income. Obviously you can’t use it for external reporting, but it’s a good one for internal management reports.
Core Operating Earnings
Now, here’s a much more complicated version of the same concept, which is called core operating earnings. Standard & Poor’s came up with this one. They start with the income figure, and then modify it to arrive at the earnings of a company’s core operations. Here’s how it works:
You begin with net income, then add back stock option expenses, and restructuring charges, and pension expenses, and purchased R&D expenses, and asset write-downs. Then, you subtract out any goodwill impairment charges, and gains or losses from asset sales, and pension gains, and merger and acquisition expenses, and litigation expenses, and any gains from hedging activities. That’s eleven different changes to the net income figure, which may seem like a lot. On the other hand, as I go down that list, I can see that five of them would have applied to my company in just the last few months. So you may want to try it, and see if you get a more realistic view of how your company is doing.
Sales Margin
Here’s a measurement you can use to replace the gross margin, and it’s called the sales margin. This one is the gross margin, minus all sales expenses, divided by sales. Basically, it dumps all of your sales expenses into the cost of goods sold, so the only expenses not included in the cost of goods sold are administrative. This is a good measurement if you want to track margins by product line, and if your sales expenses are fairly easily traceable to those products. It’s also useful if most of your sales expenses vary with sales volume – which can happen if the sales people are paid mostly on a commission basis.
The sales margin is really useful when you have a product line where customers require lots of intensive hand holding by the sales staff. In this case, it makes a great deal of sense to charge the sales expense directly to that product line, just to see what your margins are really like. And they could very well be negative.
Operating Leverage Ratio
Here’s another measure to consider – the operating leverage ratio. This one compares the amount of fixed expenses to operating income. It’s really useful when you’re considering getting rid of variable expenses and substituting fixed expenses instead, such as when you replace manufacturing workers with a robot.
The measurement is sales, minus variable expenses, divided by operating income. If the ratio goes up, then you’re adding to your base of fixed expenses, which probably means that your breakeven point just went up, and that means you’re more likely to lose money if sales decline.
Quality of Earnings Ratio
And let’s do one last measurement, which is the quality of earnings ratio. This one compares the reported earnings level to cash flow from operations. If the two numbers are fairly close, then the reported earnings level is a fair reflection of how the company is actually doing.
To calculate the quality of earnings, subtract cash flow from operations from net income, and then divide by your average assets for the reporting period. If the net income and cash flow numbers are about the same, then the result should be close to zero – which is good. Any number higher than about 6% indicates a low quality of earnings.
On this measurement, keep in mind that there may be a good reason for a difference between net income and cash flow – but, that different should be a one-time event. So if the ratio is fairly large for multiple reporting periods, there’s probably some accounting trickery going on.