Business
Basics
for
Engineers
by
Mike Volker

PERFORMANCE vs HEALTH

Contact: Mike Volker, Cell:(604)644-1926, Email: mike@volker.org

You may be a great performer, but...

I always like to tell the story of a fellow I knew who was regularly seen jogging vigorously around town. He often ran competitively and was known for his speed and stamina. One day, while jogging, he suddenly dropped dead at the age of 40. It turned out that he had a congenital heart defect. What can we conclude about his performance? What about his health? Whereas he was a great performer, he was obviously not in good health. One of his key assets, his heart, just wasn't "worth" what it may have appeared to be. On the other hand, in terms of performance, he was great! Companies are like this. They may be great performers, but have a weak balance sheet. A company could have a very strong balance sheet but be a lackluster performer.

Financial Performance

Performance is always measured over a time period. Corporations typically report their performance on a quarterly basis. Internally, companies track their performance on a monthly basis (some companies may even do this weekly or daily - or at least track certain performance figures, like sales, on a frequent basis). The so-called Annual Report is a requirement (imposed by governments and securities regulators) whereby firms disclose their financial results on an annual basis - along with various other bits of information which may be of value to shareholders.

The most important measure of performance is the Bottom Line. This is called the bottom line because it is the bottom line which appears on a Profit and Loss Statement, also called an Income Statement. The bottom line shows the amount of Net Profit (after taxes have been paid) which the business has generated during that particular reporting period. This number reports what the company has earned during the stated period of time. These earnings are sometimes stated on a per share basis. This allows one to compare to other companies by comparing their respective Price/Earnings ratios. Or, one could compare companies by comparing their respective earnings expressed as a percentage of sales or as a percentage of capital invested. For example, company ABC's earnings were 6% of revenues as compared to 5% for the industry average. Or ABC's return on investment for the period was 25% (i.e. earnings as a percentage of capital invested) as compared to its main competitor which only returned 22% to its investors.

There are also non-bottom line numbers which are often important and need to be studied. These would include gross margins (percent gross profit) or perhaps various expenses, such as Research and Development expressed as a percentage of sales. If we are producing communications systems with gross margins of 45% and R+D expenditures of 9% and our competitor is achieving gross margins of 52% and R+D expenditures of 8%, we better figure out what we're doing wrong.

In making comparisons to other companies, one should be careful not to compare apples with bananas (like comparing Apple to Microsoft). The companies should be in the same business (e.g. systems, software, hardware, communications, etc, etc). In any event, depending on our management position in the organization, we will focus on those performance measures which are important to us. The sales manager will be sensitive to overall sales, sales expenditures, and gross margins. The production manager will be concerned with cost of sales, gross margins, and operating expenses. The VP Engineering will be concerned with development costs, unit costs, and margins. And, the CEO will worry about everything.

Financial Health

A company's financial health is measured by taking a snapshot of its assets and liabilities at one moment in time, usually at the end of a reporting period - such as at the end of a quarter or fiscal year (what's a fiscal year?). How much cash is in the bank? How much is owed by the customers? What are the debt obligations - to banks, suppliers, and others? How much capital has been invested? How much has the company earned (or lost) to date (this item comes from the Profit and Loss statement and is called retained earnings - that is the company's total earnings (net of any dividend payouts) since its inception.

Financial Health is reported on the company's Balance Sheet. Balance Sheets and Profit and Loss statements must always be considered together. One measures health and the other measures performance.

Just as blood flows through the veins of a person, cash flows through the veins of a company. Although a company's balance sheet may look strong (i.e. lots of assets and few liabilities), the most important asset is cash and short term deposits, followed by cash to be realized within one month (e.g. getting paid on recent sales). The cash-on-hand obtained from the balance sheet can be divided by a company's monthly expenses to determine a rough estimate of how long the company can survive at its current level of operation. Developing companies, such as biotech ventures, generally have sufficient cash on hand that they can operate for years before having to generate income from sales.

For More Information....

There are many examples of financial statements and performance reports. The reader is urged to read the financial media for regular reports on companies. Many firms now have their financial reports on web sites. In Canada, public companies are required to file their financial reports on a quarterly basis and these can now be conveniently found on the SEDAR website. For U.S. companies, such information can be found on the EDGAR website. Most public companies publish their financial reports on their own corporate websites as well. Not long ago, it wasn't so easy to get this wealth of timely information. Isn't the worldwide web wonderful?

Gimme the numbers! With respect to reading and understanding financial statements, the Canadian Securities Institute has a great publication which explains the numbers.

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