What is Operating Performance & Which Ratios Measure Operating Performance?
Imagine you’re looking to invest into a company. You want to be sure that they are operationally efficient and that the management is investing into assets that successfully produce revenue. Operating performance ratios are calculated to provide you with that information. They tell you exactly how much return is generated from all or specific assets. In this article we will explain:
1. What is Operating Performance?
2. Which Ratios are Used to Measure Operating Performance?
3. How to Calculate Operating Performance Ratios
1. What is Operating Performance?
Operating performance measures results relative to the assets used to achieve those results. The focus of determining Operating Performance is on how well assets are converted into earnings, and how efficiently resources are used to generate revenue. A business with excellent performance ratios can generate a high level of sales with relatively few resources, and generates a high level of cash inflows. Due to the large variations in assets and sales across different industries, comparing with companies in the same industry is essential, as with all financial analysis.
2. Which Ratios Measure Operating Performance?
Fixed Asset Turnover
Fixed Asset Turnover calculates how efficiently a company is producing sales from it’s fixed assets. Fixed assets consist of land, buildings, factories, furniture, and equipment and is summarized on financial statements as plant, property, & equipment (PPE). Net Fixed Assets (Or Net PPE) is calculated by adding the capital expenditures then subtracting the accumulated depreciation from the gross value of PPE. Thankfully Net PPE is shown on the balance sheet so you won’t have to worry about figuring out accumulated depreciation.
In almost all circumstances, a higher Fixed Asset Turnover is better. It indicates that the firm is managing their fixed assets more efficiently. There is no ‘one-size fits all’ ratio target, rather determining whether or not the company is performing well depends on comparisons with industry averages and looking at the historical trend of a company’s Fixed Asset Turnover. A low Fixed Asset Turnover ratio is a concern, especially for firms with lots of fixed assets (Such as manufacturing companies). It’s not always bad, the firm may have just made heavy long term investments to modernize their processes, but a low FAT is reason to investigate. If a firm’s FAT is trending lower over time, they are probably over-investing in fixed assets. A sign of poor management.
Here is the equation for determine Fixed Asset Turnover:
Equation: Fixed Asset Turnover = Revenue Net / PPE
Where Net PPE = (PPE year(T) + PPE Year( T-1)) / 2
Similarly to FAT, the Asset Turnover ratio can often be used as an indicator of the efficiency with which a company is deploying its assets in generating revenue. With this ratio, we look at the revenue created compared with the value of total assets. So rather than looking solely at PPE, with this ratio all assets are taken into account. These include cash, short-term investments, inventory, receivables, and long-term investments. This enables analysts to get a more holistic view of how all assets at the company’s disposal are being managed. Higher is better, in a similar vein to FAT.
Companies in different industries tend to have vastly different Asset Turnover ratios. For example, in an asset heavy industry such as raw material extraction we would expect a lower Asset Turnover, whereas in a high sales and low asset industry such as retail we would expect to see a higher Asset Turnover. This again illustrates the importance of comparing the ratio for a specific company to the industry average.
Equation: Asset Turnover = Revenue / Total Average Assets
To calculate Total Average Assets, add Total Assets for the year you are investigating and the year prior, then divide the total by two.
Other Useful Ratios
Sales Per Employee
Sales per employee enables investors to see the value that management draws from their staff. This analysis can be done on a departmental, functional, or total company basis. Employees are one of the most important assets that the company has and are often the primary drivers of revenue generation. Thus, this ratio is particularly valuable when analyzing “people businesses” such as consulting, software, and banking companies.
Equation: Sales Per Employees = Revenue / Number of Employees
Where can I find these numbers? Revenue is found on the Income Statement. The number of employees is a little more complicated and is dependent on the type of company. Publicly listed companies will report this information in their annual report, mid-size companies will typically list this information on their website. LinkedInis also a good resource to determine employee headcount, simply go on the company’s profile and look in the employee section.
Below is an example of finding Microsoft’s 2019 headcount by using the Ctrl + f function in word. You can download the report here.
So we’ve learned that operating performance measures the relative return of revenue against asset investments. It is measured by calculating the Fixed Asset Turnover and Asset Turnover ratios, and sales per employee gives analysts a good indication of management resource use. We believe in learning by doing and that’s why Financial Modeling Prep offers free downloadable financial statements of all SEC listed companies. Search your favourite company using the search bar and get analysing!