Can you measure management effectiveness?

Hi there,

The success or failure of an organization depends on how effective the management is. The management team of a company is responsible for propelling the future growth in the right direction. It also responsible for administering and controlling the business activities and accounting for the results. An ineffective management at the top results in failure of the company. Such is the importance of management.

So, one has to measure the effectiveness of the management before purchasing a stock. It’s all about finding answer to one single question- Are they doing the right thing?

How do you go about finding answer to that question? To be more specific, how would you assess whether the management utilizing the available resources in the best possible way? How well is the company being run relative to others in its sector and the market as a whole? The answer lies in finding three important ratios -

  • .Return on assets
  • Return on investment ( ROCE)
  • Return on equity ( ROE)

ROE and ROCE was discussed in the earlier posts, so I don’t want to repeat the whole thing here. What remains to be explained is return on assets.

RETURN ON ASSETS

Return on assets is calculated by taking the net income and dividing it by the total assets.

  • ROA = Net Income / Total assets

ROA is a very effective tool . For example – If the total assets of Company as per the balance sheet is Rs 10 million and if it has earned a net income of Rs 20 million , the ROA would be 2 (20 / 10) . It means, for every Rs 1 in assets, the company has made a profit of Rs 2. So , higher the ratio, the better it is.

This ratio should be only used to compare companies in the same industry. The reason for this is that companies in some industries are more asset-insensitive i.e. they need expensive plant and equipment to generate income compared to others. Their ROA will naturally be lower than the ROA of companies which are low asset intensive – like IT service industry.

A single period ROA of a company will not tell you the whole story. You have to check the ROA for the past years and check if it’s showing an increasing trend. An increasing trend of ROA indicates that the profitability of the company is improving.

By measuring the management’s effectiveness,  you will be able to make reasonable comparison between the company and its peers from the same industry or sector.

Before I close, here’s some more thoughts about using ROE, ROCE and ROA.

  • In order to make a clear view of the company’s management effectiveness use all the three ratios mentioned.
  • With ROE you get an idea about how the management is using the money given by the shareholders.
  • ROCE would reveal how the management is utilizing the total capital employed, which includes loans and other debt funds.
  • ROA is a totally different take. It measures the number of times earnings generated using the assets of the company.
  • The basic balance sheet equation is  assets = liabilities + Equity.  So, if there were no liabilities in a company’s balance sheet , the ROA and ROE would be same. In other words, If the ROA and ROE of a company are different, the reason is the presence of liabilities or loan funds in the balance sheet.
  • If a company has loan funds, ROE would be more than the ROA.  How?  A company buys more assets by taking loans, but since equity = assets – liabilities, a company decreases its equity by increasing debt. So, when debt increases, equity shrinks, and since equity is the ROE’s denominator, ROE,  gets a boost. Hance the presence of debt in a company’s balance sheet boosts the ROE in relation to ROA.

That’s about measuring management effectiveness.

Bye for now!!

Have a nice day!!

You may like these posts:

  1. Balance sheet components: Liabilities and Equity.
  2. Understanding ROE & ROCE.
  3. Evaluate debt-Understanding Current and quick ratios

1 Response to “Can you measure management effectiveness?”

kala

July 30, 2012 at 7:15 pm

Thanx John, this really helped me out with my assignment :-)

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