How Do You Know if You're Good?

One of the most effective ways of assessing financial performance and making good decisions is by determining your return on investment, or ROI. A good understanding of the ROI will help you go a long way in making the right choices in business and in life. Here’s what it is, and how you can benefit from knowing how to figure it out.

The ROI is a financial formula used to determine, as its name would imply, the return on a given investment. In other words, it is used to calculate how profitable one particular investment choice is compared to other possible investment choices. Here is the formula:

ROI = (Gain from Investment – Cost of Investment) / Cost of Investment

Here’s a simple example of how this formula is used. Suppose you’re faced with a decision on whether to invest in ‘Decision A – Buy New Equipment’ or ‘Decision B – Upgrade Old Equipment’, and you have already determined your cost-benefit analysis that the potential gains and costs of each decision.

Suppose that the potential gain from Decision A – Buy New Equipment is $10,000 and the cost of the new purchase is $2,500. The ROI in this simplified example would then be: ($10,000-2,500)/2,500, or 3.0.

Now suppose that in the alternative decision, Decision B – Upgrade Existing Equipment, the anticipated gain from the decision is $8,000 and the cost of the upgrade is $1,500, the ROI of this alternative decision would be: $6,500/1,500, or 4.33. The decision to upgrade the existing equipment yields an ROI significantly higher (44%) than the decision to purchase new equipment, thus the upgrade decision would be the choice to make.

If you’re not comparing two or more decisions, but only looking for whether or not to make one particular decision, the ROI formula would indicate that it’s wise to proceed only if the ROI is greater than zero. But this makes sense, since you’d never want to invest in something which costs more than it yields, would you?

If you’re new to understanding financial performance formulas, you might want to begin by reading a quick primer on financial ratios.

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A Quick Primer on Financial Ratios

Whether you’re looking at your own company’s own performance and financial situation, or at that of other companies for opportunities to invest, financial ratios are a very useful thing to understand. This article will serve as a guide to understanding some key financial ratios such as: current ratios, quick ratios, debt and debt-equity ratios, as well as asset turnover and profitability ratios.

Remember that while financial ratios provide a measure to benchmark one company with another, they do not tell the whole story of the company – true performance information must also take into account the management practices of the firm.

Liquidity – Current Ratio

The current ratio, also known as the working capital ratio, is a measure of a firm’s ability to satisfy its short-term financial obligations. Simply put, this is the ratio of the company’s current assets to its current liabilities. A high current ratio (relative to that of similar companies) indicates a greater ability of your company to pay back its short-term debt obligations.

Current Ratio = Current Assets / Current Liabilities

Liquidity – Quick Ratio

The quick ratio is perhaps a more reflective measure of a firm’s liquidity. Unlike the current ratio this measure only includes assets which can be sold off quickly. (The current ratio on the other hand, includes such items as inventory, which often takes long periods of time to liquidate). Thus, the current assets considered in the quick ratio are cash, accounts receivable and notes receivable; the amount of inventory is taken out of the equation.

Quick Ratio = (Current Assets – Inventory) / Current Liabilities

Financial Leverage – Debt Ratio

In addition to short-term liquidity measures such as the ones above, it is of course also important to examine the long-term solvency of the company with financial leverage ratios such as the debt ratio and the debt-to-equity ratio. The debt ratio is equivalent to a firm’s total debt (e.g. its long term debt obligations such as long-term leases, etc) over its total assets.

Debt Ratio = Total Debt / Total Assets

Financial Leverage – Debt-Equity Ratio

The debt-to-equity ratio measures how much debt a firm is carrying relative to its total equity, or total net worth. This is the ratio of the total dollars attributed to the firm by creditors (the total debt) over the total dollars held by owners (total equity). A rising D/E ratio indicates the firm is becoming more highly leveraged by relying more upon debt to finance its operations, and that any new debt should be limited and better controlled.

Debt-Equity Ratio = Total Debt / Total Equity

Asset Turnover – Inventory Turnover Ratio

The inventory turnover ratio measures the firm’s ability to move its products. Keeping inventory for an excessive period of time creates extra costs, thus having a faster inventory turnover can lead to a more positive cash flow and a reduction in inventory storage costs.

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory (for the period)

Profitability – Gross Profit Margin

The gross profit is a measure of the total sales, minus the cost of the goods sold over the total sales. It is a useful measure in determining the percentage of profit per sales.

Gross Profit Margin = (Total Sales – Cost of Goods Sold) / Total Sales

Profitability – Return on Assets (ROA)

The return on assets ratio measures how the company’s income is being derived by its total assets. In other words, this ratio shows you how well the company is using its assets (e.g. machinery, land, equipment, etc) to increase its profitability.

ROA = Net Income / Total Assets

Profitability – Return on Equity (ROE)

Like the ROA ratio, the return on equity ratio measures how the company is earning its profits. Unlike the ROA which uses the total assets as a measure, this ratio shows how profitability is being derived from shareholder equity. The ROE measure is thus an important one for the company’s shareholders; it shows them the number of dollars of income earned by the firm for every dollar invested in stock.

ROE = Net Income / Total Equity

Hopefully this primer was helpful in explaining some key financial ratios. In the coming weeks, there will be more ratios uncovered here for the purpose of conducting investment analysis. Stay tuned.

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How and why to do a cost-benefit analysis

The other day I came across an interesting article on the reasons why you should do a cost-benefit analysis. The article provides an example scenario and shows you how to run the numbers when doing this type of assessment.

Author F. John Reh explains, that the cost-benefit analysis need not apply only to financial situations, but rather to any decision that involves some sort of capital outlay:

"Although a cost benefit analysis is most commonly done on financial questions it can be used for almost anything. Not sure whether that proposed marketing campaign is a good idea? Do a cost benefit analysis. Worried about which health care plan to select for your employees? Do a cost benefit analysis. Should we outsource our call center to India, Jamaica, or Canada? Do a cost benefit analysis."

Read the full article here.

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