This is part of a series of reflections inspired by my courses at HBX, an online business school cohort powered by Harvard Business School. With Business Analytics, Economics for Managers, and Financial Accounting, I'm learning the fundamentals of business. Find the whole series here.
We are awash in data, stuck wondering: how are we really doing? As a marketer, I'm obsessed with click throughs, retweets, and conversions, but I don't often do a good job looking at the bottom line.
Return On Equity
A company's financial statements are the best way to assess the overall health of the business. It's not the numbers that matter as much as the analysis of those numbers. The easiest way to assess is with a method called the Dupont Framework, which looks like this:
The Dupont Framework breaks down a company's return on equity, the most important indicator of success. It includes measures of profitability, efficiency, and financial leverage--how much you're making, how well you're making it, and how much debt you're taking on--giving us the best picture.
Profit measures the amount of money you're making relative to the amount of money it costs to run the business. Profit margin, or the net income over revenue, tells us this. A more accurate assessment might be Gross Profit Margin, which tells us what profit is left over after subtracting cost of doing business--adjusting the profit margin for a more realistic portrait of your profit.
To measure how well a business is run, you use asset turnover. This lets you know how much inventory is going out the door compared towards the money you're making, otherwise known as sales divided by assets. An even closer way to measure this is inventory turnover: how efficiently are you shipping your product? We measure this by dividing the cost of goods sold over the average amount of inventory in your warehouse.
Other measures of efficiency have to do with payment, as many companies don't have any inventory at all. These service-or internet-based companies can instead measure accounts receivable turnover (or, how quickly they receive money for their services) or accounts payable turnover (or, how long it takes for a business to pay its vendors).
Leverage multiplies either the positive or negative effects of the other two measurements, establishing how volatile the business can be based on the amount of debt it takes on. You can measure this in two ways, either with average assets divided by average liabilities (or, how much you have divided by how much you owe) or with the debt-to-equity ratio, which measures your average liability divided by your average equity (or, the amount you owe divided by the amount of investments you're making).
Ratios are useful ways to quickly assess how well a company's doing, especially compared against another company. Rather than getting bogged down in specific numbers on a balance sheet, these quick calculations give us a better understanding of how we're performing and of what numbers matter the most.