Overview
Operating performance refers to evaluating a company’s ability to utilize its resources efficiently. It can be measured in terms of assets and equity sources.
The focus of operating performance analysis is to analyze the efficient use of resources to generate sales. Another way of looking at operational performance is the conversion of sales into net profits.
Key Operating Performance Ratios
Analysts can use several operating performance ratios to analyze the sales and profits of a company. Broadly, these ratios can be categorized in terms of asset utilization and profit maximization.
Operating Efficiency Ratios
Let us first consider a few key operating efficiency ratios.
1) Asset Turnover
Asset turnover indicates the efficient utilization of assets to generate sales.
Formula:
Asset Turnover = Total Sales / Total Assets
Example:
- Sales of ABC company = $ 20 million
- Total Assets = $ 80 million
Asset turnover = 20/80 = 0.25 times
Explanation
The company ABC generates $ 0.25 in sales for every $1.0 of assets. It can be either very high or very low depending on the industry a company operates.
A high asset turnover ratio means a company is fully utilizing its assets to generate sales and vice versa. However, the ratio should be compared for the companies within the same industry and similar sizes.
2) Fixed Asset Turnover
Some analysts use the figure of fixed assets instead of total assets to get a clearer picture of the operating performance of a company.
Formula:
Fixed Asset Turnover = Total Sales / Fixed Assets
Example:
- Sales of ABC company = $ 20 million
- Fixed Assets = $ 60 million
Asset turnover = 20/60 = 0.33 times
Explanation
The fixed asset turnover ratio is suitable for companies with large fixed assets such as manufacturing, automobile, construction, and so on. It is not a suitable ratio for companies in the service industry.
The use of fixed assets instead of total assets gives an indication of the operating performance of a company using its long-term assets. However, a company with aged fixed assets may show a high fixed turnover ratio but may not sustain it for long.
3) Operating Cycle
The Operating cycle refers to the time taken by a company to receive inventory, turn it into finished goods, and convert them into sales. Thus, it represents a complete operational cycle of the company from purchases to sales.
Formula
Operating Cycle = Inventory Period + Accounts Receivable Period
Or
Operating Cycle = 365 / (cost of goods sold ÷ Average Inventory) + 365 / (credit sales ÷ average accounts receivable)
Explanation
Companies with shorter operating cycles are more efficient in operations. A shorter operating cycle means faster conversion of inventory investments into sales. It also means the company can generate sufficient cash through operations to meet its short-term obligations.
4) Equity Turnover
The equity turnover ratio is used by shareholders to evaluate sales against their equity investment. It shows the ability of a company to utilize equity investment to generate revenues.
Formula
Equity Turnover = Total Sales / Shareholders’ Equity
Example
- Total sales of ABC company = $ 30 million
- Shareholders’ Equity = $ 90 million
Equity Turnover = 30/90 = 0.33 times
Explanation
It means the company ABC is generating $ 0.33 per $ 1.0 of shareholders’ invested equity.
This ratio can be very high for highly leveraged companies with a small proportion of equity investment. Contrarily, companies funded with equity investment will show a very low equity turnover ratio.
Operating Profitability Ratios
Analysts can use a few operating profitability ratios to interpret the efficiency of a company. Return or profit is the bottom line for a company and its shareholders. However, analyzing profits at different stages and through different measures can provide detailed information about a company’s operational efficiency.
5) Gross Profit Margin
Gross profit is the measure of sales less direct costs to produce those sales for a product or service. It considers only direct costs related to the production of a product or offering a service.
Formula
Gross Profit Margin = Gross Profit / Revenue
Gross Profits = Revenue – direct costs
Example
- Revenue of a company ABC = $ 500 million
- Direct Costs = $ 300 million
Gross Profit = $ 500 – $ 300 = $ 200 million
Thus, Gross Profit Margin = 200/500 = 0.40 times
Explanation
Gross profit margin is a great tool to analyze the direct costs of production. However, direct costs would vary by industry. Managers can use gross profit margins to analyze the pricing strategy of the company as it is directly affected by sales generated as well.
6) Operating Profit Margin
The operating profit margin includes the operating costs as well as administrative expenses. It further refines the profitability measure of the company as compared to sales generated.
Formula
Operating Profit Margin = operating profit / revenue Or
Operating Profit Margin = EBITDA / Revenue
Example
From the above example,
- Sales of company ABC = $ 500 million
- Gross Profit = $ 200 million
- Administrative and selling expenses = $ 50 million
- Operating Profit = $ 250 million
- Operating Profit Margin = 250/500 = 0.50 times
Explanation
Operating profit margin includes selling and administrative expenses into account as well. These are indirect expenses that affect the profitability of the company. Thus, analyzing operating margins provides further clarity about a company’s operating performance.
7) Net Profit Margin
Net profit margin is one of the most widely used operating performance ratios. It evaluates the bottom line of a company; net profit.
Formula
Net profit Margin = Net profit / Sales
Example
Continuing with our example above,
- Gross Sales = $ 500 million
- Direct Costs = $ 200 million
- Administrative and selling Costs = $ 50
- Interest, Tax, Depreciation = $ 100 million
Net Profit = 500 – (200+50+100) = $ 150 million
Net Profit Margin = 150 / 500 = 0.3 times
Explanation
Net margins also vary by industry. Service industries such as IT companies have high net margins. Contrarily, the retail industry has a very low net profit margin.
Profit margins can change drastically with the operating and financing decisions of a company. Thus, analyzing operating profitability with trend analysis is a better choice rather than evaluating a standalone figure.
8) Return on Assets
Return on assets measures the efficiency of a company to turn assets into profits. It can be used with variations for both numerator and denominator. Some analysts use the EBTIDA amount, others use free cash flows.
The use of total assets in the formula includes debt and equity resources.
Formula
Return on Assets = EBTIDA / Total Assets
Example
Continuing with our example above, EBTIDA of company ABC = $ 250 million
Total Assets = $ 600 million
Return on Assets = 250/600 = 0.41 times
Explanation
Return on assets measures the ability of a company to utilize its total assets to generate profits. The ratio will vary widely across industries.
9) Return on Total Equity
Some analysts use the return on equity measure instead of total assets. It is to use a refined measure that provides useful information to shareholders for their invested equity.
Formula
Return on Total Equity = Net Income / Total Equity
Total Equity includes ordinary shares, preferred shares, and reserves of the company.
Example
Suppose Net income of ABC company = $ 150 million Total Equity = $ 350 million
Return on Total Equity = 150/350 = 0.42 times
Explanation
Return on total equity is the rate of return on investment for shareholders. It is a useful measure for shareholders to evaluate their investment returns with industry comparisons.
