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CHAPTER TWO Evaluating Financial Performance You can't manage what you can't measure. William Hewlett The cockpit of a 747 jet looks like a three-dimensional video game. It is a sizable room crammed with meters, switches, lights, and dials requiring the full attention of three highly trained pilots. When compared to the cockpit of a single-engine Cessna, it is tempting to conclude that the two planes are different species rather than di~tant cousins. But at a more fun-damental level, the similarities outnumber the differences. Despite the 747's complex technology, the 747 pilot controls the plane in the same way the Cessna pilot does: with a stick, a throttle, and flaps. And to change the altitude of the plane, each pilot makes simulrnneous adjustments to the same few levers available for controlling the plane. Much the same is true of companies. Once you strip away the facade of apparent complexity, the levers with which managers affect their compa-nies' financial performance are comparatively few and are similar from one company to another. The executive's job is to control these levers to ensure a safe and efficient flight. And like the pilot, the executive must re-member that the levers are interrelated; one cannot change the business equivalent of the flaps without also adjusting the stick and the throttle. The Levers of Financial Performance In this chapter, we anal ze financial statements for the ing performance and understandin the levers of mana ement contra . e egm y studying the ties between a company's operating decisions, such as how many units to make this month and how to price them, and its financial performance. These operating decisions are the levers by which management controls financial performance. Then we broaden the discussion to consider the uses and limitations of ratio analysis as a tool for evaluating performance. To keep things practical, we will again use the fi-nancial statements for Ametek, Inc., presented in Tables 1.1, 1.2, and 1.4
32 Part One Assmi11g th~ Fi11n11ci11/ Health of the Fin11 of the last chapter, to illustrate the techniques. The chapter concludes with an evaluation of Ametek's financial performance relative to its co,n. petition. (See Additional Resources at the end of the chapter for informa-tion about HISTORY, complimentary software for calculating company ratios. Also at the end of the chapter, Table 2.5 presents summary definj. tions of the principal ratios appearing throughout the chapter.) Return on Equity By far the most popular yardstick of financial_ performance among in-vestors and senior managers is the return on equrty (ROE), defined as Net income Return on equity = Shareholders' equity Ametek's ROE for 2001 was ROE= $66·1 = 19.7% $335. l It is not an exaggeration to say that the careers of many senior execu-tives rise and fall with their firms' ROEs. ROE is accorded such impor-tance because it is a measure of the efficiency with which a company employs owners' capital. It is a measure of earnings per dollar of invested equity capital or, equivalently,