Assessing Financial Performance

In this lesson, you’re expected to learn about:
– judging the quality of profits
– calculating how well your investments are paying off

Introduction

Not all profits are created equally; sometimes a source of profit is volatile, temporary or uncertain, which can result in poor-quality profits. In contrast, quality profits could be where a company rents out properties and are receiving a continuing profit through these rentals, so the profit they receive is stable and continuous.

As we describe in this lesson, two primary aspects can undermine the quality of the profit listed in the financial statement: the use of different accounting methods and the sources of revenues and costs.

You can then break down each of these groups into more detailed concerns, with each influencing whether the profits a company is generating are sustainable, maintainable or retainable.

Just because a company seems to be profitable doesn’t mean that the business itself is successful or even that it isn’t at risk of going out of business.

Tackling Accounting Concerns

Despite the reputation of accounting as a field of stiff regulations and methodologies, in fact companies are given freedom to decide their preferred method of valuation on several issues.

Sometimes they’re allowed to decide the accounting period to use for a particular cost or revenue (within the parameters of Generally Accepted Accounting Practice); other times they can choose from several options the manner in which they value their costs, revenues or assets.

Naturally, with companies recording these things using differing methods, variances occur, and as a result the exact manner in which you view or interpret the financial statements also changes.

For example, a company may appear to have unusually high profits one year, until you realize that it deferred certain costs until the next year in order to better use its tax deductions; otherwise, it would’ve lost money in the current year (even though, of course, this goes against the ‘matching’ principle in which costs should be matched against their respective revenues).

With financial statements, things aren’t always as they seem. Your ability to understand the implications of the accounting decisions that companies make can be just as critical as your ability to calculate the financial ratios themselves.

Here are some of the more common accounting issues to bear in mind. 

Stock Accounting 

Three primary methods of stock accounting exist:

1) FIFO: Stands for first-in, first-out, which means that whatever stock was produced first is considered to be the first stock sold. When measuring the cost of sales, the company measures the cost of producing the first items made rather than the most recent items made.

2) LIFO: Stands for last-in, first-out, which means that the last items to become stock are considered the first to be sold. So when measuring the cost of sales, the company measures the cost of producing the most recent stock made rather than the first stock made.

3) AVCO: Stands for weighted average cost. Using the AVCO method, you calculate the weighted average cost of items held at the beginning of the year with the following formula:
Weighted average cost = Total cost of goods in stock / Number of items in stock   

The weighted average cost is then used to value goods sold. You need to calculate a new weighted average cost, however, each time more stocks are bought during the year.

* Several other methods are available, many of which attempt to use the best of LIFO, FIFO and AVCO.
During inflationary periods (when costs, overall, are increasing), using the LIFO method results in the appearance of higher costs, because the most recent stock has cost more to produce.

Using the FIFO method, on the other hand, gives the illusion of costs being lower than they really are, because the company is accounting for the cheaper historical cost of production.

The flip side to this issue is that during deflationary periods(when costs are decreasing, which rarely ever happens except in deep recessions), using the LIFO method makes the company appear to have lower costs whereas the FIFO method makes costs appear more expensive.

Neither one of these methods is inherently bad, but you do have to take these aspects into account when studying the costs, liabilities and profits that a company generates.

Note: Be sure to understand that just because a company appears to be ‘safe’ right now doesn’t mean that this situation can’t be artificially generated.

Depreciation

Several different methods of accounting for depreciation exist: the straight-line and reducing-balance methods are two popular sorts.

The method of depreciation a company chooses has an influence on the P&L account (because depreciation is included as a cost) and the balance sheet (because depreciation influences the total value of the company’s fixed assets).

Therefore, knowing what type of depreciation the company uses helps you to understand how to interpret financial statements and their respective ratios. Particularly for organizations with a large amount of fixed assets with depreciation to account for, the chosen method of accounting can have a significant impact on how those companies’ profits look to analysts who don’t consider this fact.

Sources of Cash Flows

Looking at the source of cash flows can help to determine the quality of a company’s profits. The amount of profit during any single year doesn’t tell you whether a firm can expect those earnings again in the future or even whether it maintained them consistently throughout a single period. (The latter implies that profits may have been cyclical or that the company generated high revenues during one part of the period and made no sales at all during another part.)

Although many potential sources of low-quality cash flows exist, we cover just two of the most common: temporary transactions and volatile income sources.

This discussion helps you to watch for other similar problems that may arise when analyzing financial statements and making corporate financial decisions.
1) Temporary transactions

In a lot of profit and loss accounts, you may see categories called something along the lines of ‘exceptional items’, ‘extraordinary items’ or anything indicating that the source of the cost/income isn’t to be expected in the future. Such items may include revenues from a lawsuit won or a bad debt that the company incurred.

The problem is that these things aren’t necessarily listed as separate items in the financial statements (though they often are).

Often, instead of being listed as temporary transactions, these sorts of cash flows are listed as ‘sundry income’ or ‘miscellaneous expenses’, which isn’t exactly useful when you’re attempting to evaluate the quality and duration of those revenues and costs.

If you’re a shareholder, you have the right to request information regarding those items listed in the ‘other’ categories. Doing so may also be a good idea if you’re considering investing in such a company.

2) Volatile income sources

When you’re looking at the annual report of a company, you may see that it lists just the end-of-year financial information for the current year, with the previous year for comparison and perhaps projections for the next couple of years disclosed in the supporting notes to the financial statements.

Be on the lookout for the cash flow statement, because that helps you identify where all the money is coming from and where it’s going, though often only one year at a time.

Another volatility issue to be concerned with is within-year cyclical volatility: a number of industries have extremely cyclical sales depending on the season within a single year. For example, the tourism industry is highly cyclical and tends to have a slow off-season.

To identify these issues, you often have to resort to evaluating the company’s quarterly reports (financial reports that are issued every three months). These reports can help you identify something that’s going on within a single year that may not be easily identified in the annual reports.

[Optional] Cost of Sales
Assessing Investment Performance
Much of corporate finance is focused on how you get money and how that money is then used. Thus, companies are concerned about whether or not they’re using their money effectively. Of course, all sorts of different views exist on what constitutes the effective use of money but the general idea is that any money spent needs to generate value for the company.

This aspect is usually determined by whether or not the spent money creates a positive return on investment. If you spend money on something, you hope that it contributes to the creation of revenues greater than the amount spent; otherwise, that particular purchase is contributing to your company losing money.

However, determining whether a company is successfully using its money to invest in assets and operations isn’t always easy.

Let’s explore some useful methods.

Employing conventional evaluations of success

You can measure the degrees of success companies are generating in numerous ways. In this lesson, we’ll see a few methods for evaluating the success of standard capital investments as well as financial or portfolio investments.

Assessing the value and price of an investment
Your ability to compare the actual returns against the projected returns is a huge part of your ability to establish what success is and whether you’ve been successful in your investments.

Put simply, if you analyze the value of something and fail to extract the value from it, you’ve failed either in your assessment of its value or in your attempt to extract that value. If you extract equal or greater value from that expenditure than anticipated, you’ve succeeded.

You can measure the degree of failure or success in these cases simply as the percentage over or under the projected rate of return. If you’re expecting 10% returns and you get 20% returns, you’ve succeeded by a margin of 200%, which may result in a big, end-of-year bonus!

Arithmetic rate of return

The arithmetic rate of return on a specific asset is a spot measurement that measures only the total rate of return over the life of the investment, as shown below:
You take the value of your asset at any point in history, subtract your purchase price to determine your gain or loss and then divide that by your purchase price to determine the rate of return (R). This simple calculation provides important
information about how well you’re using your purchases, assets, investments etc.

For those assets that don’t increase in value but produce things of value (such as machinery), you can include the value produced as a part of your value at time, t.

Average rate of returns 

The average rate of returns starts with the arithmetic rate of return (see the preceding section) and measures that for every year you’re dealing with (the years you’re including in your calculation).

You add up the rate of return from each year, and then divide it by the number of years you’re measuring to get the average rate of returns.

Time-weighted rate of returns 

The average rate of returns distributes all returns equally so that the rate is the same each year. Using the time-weighted approach gives you a better understanding about how performance changes by weighting the returns from each year being included. You carry out this calculation as follows:

This method of determining your rate of return is more accurate than the previous two methods because it accounts for changes in the rate of returns over time. The equation may look intimidating, but it really isn’t. Here’s the procedure:

1. Find the arithmetic rate of returns from each year and add 1 to each.
2. Multiply the answers together.
3. Divide your answer from Step 2 by 1/n, where n is the number of years.
4. Subtract 1 from the value in Step 3.
5. Multiply the value from Step 4 by 100 to get your answer as a percentage.

Risk-adjusted return on capital 

The return on capital assets generated per unit of economic capital is called the risk-adjusted return on capital (RAROC):
RAROC = Rate of return + Economic capital   

Economic capital is the amount of liquid assets that a company needs to keep on hand so that it can handle risk concerns: credit risk, liquidity risk and so on. Therefore, the RAROC method of calculating the rate of returns accounts for risk generated by measuring the amount or return per unit of capital the company must keep on hand to compensate for the additional risk generated. This is a measure that is used by banks in particular.

Perusing portfolio manager evaluations

Another concept that you can use with any expenditure or investment is generally applied to evaluations of the success of investment portfolio managers. These evaluations involve the actual returns, risk and average market returns.

As with evaluating the estimated price and value of assets compared to the market, the degree of success is also evaluated in such a manner.

Alpha

To help understand some of these analyses, we begin with the ratio alpha (α), which you calculate as shown below.

This equation may look familiar, because it’s almost identical to the CAPM equation we saw last week — with just one key difference: you start with the actual returns on an investment and then subtract the value of the investment as calculated by the CAPM model.

This equation tells you that alpha is equal to the amount of returns generated (R) over the market anticipated returns based on the level of risk (Rf) over the market average returns (Rm) (usually measured using some related index or other benchmark) and the risk-free rate.

Hedge fund and other portfolio managers are often evaluated on their ability to generate a consistently high alpha value on a given portfolio, or some variation of alpha.

Sharpe Ratio 

The Sharpe ratio is a way to look at the returns of an investment or portfolio, which measures the amount of returns for each unit of volatility that’s generated in a portfolio. In other words, higher returns and lower volatility mean more returns per unit of volatility.

Here’s how you calculate the ratio:

All you need to worry about is that it’s a measure of variability: a higher σ indicates a wider dispersion among the rates of return.   Other than that, basically the equation says that any returns over the risk-free rate are divided by the amount of dispersion of those returns, to give you the Sharpe ratio.

Measuring performance this way incentivizes portfolio managers to take risk but ensures that they’re generating greater returns for the portfolio than volatility.

Sterling Ratio 

The Sterling ratio is very similar to the Sharpe ratio, but instead of measuring risk using dispersion of returns, it measures risk using the average drawdown* of the portfolio.

You calculate the Sterling ratio in the following way:

Drawdown is an economic term that means a decline from peak performance.
Therefore, you take all the major drawdowns (losses of value) of the portfolio, add them together and then divide the sum by the number of drawdowns.

As a result, this calculation rewards risk of lost value but only if the returns on investment are higher than the risk incurred.

[Optional] Basic vs. Diluted Earnings Per Share
Jim Rohn