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J. Sadakkadulla
S. Subbaiah

PROFITABILITY as a measure of performance is widely accepted and used by bankers, financial institutions, management, company-owners and other creditors as they are interested in knowing whether or not the firm earns substantially more than it pays by way of interest and/or whether it is in a position to repay the principal at maturity.

Of late, a number of performance measures has been developed and used for evaluating organisations. For instance, Added Value, developed by John Kay, measures the difference between the comprehensively accounted value of a firm's output and that of the input cost. Stern-Stewart developed and promoted the concept of Economic Value Added (EVA), which is the quantum of economic value generated by a company in excess of its cost of capital, that is, EVA = Income Earned - (Cost of Capital x Investment).

Similarly, McKinsey used Economic Profit (EP), defined as capital invested multiplied by the spread between return on investment and cost of capital. That is, EP = (ROI - r) x Capital Invested, to measure the performance of organisations. However, these measures have their own inherent weaknesses. EVA does not measure present value and its application to projects with longer gestation period is limited. Similarly, Economic Profit does not distinguish between capital-intensive and service-oriented firms. The Added Value method requires comprehensive auditing of a firm's inputs and outputs which could be costly and time consuming.

Even the traditional ratio analysis suffers from certain limitations. The disadvantage of employing Return on Investment (ROI) alone as a method of evaluation is that there could be hidden assets leading to inflated ROI. For companies with intangible investments such as R&D, the cost of capital involved is not properly indicated as book ROI is biased upwards. Similarly, profit margin as a performance measure suffers from lack of clear comparison vis-à-vis growth/reduction in sales.

Accordingly, a comprehensive index has been designed by the authors to evaluate organisational performance, taking into account operating profit to working funds (OPWF), return on assets (ROA), operating profit margin (OPM) and net profit margin (NPM) which are widely employed for measuring the financial performance, and the same is presented below:

Performance index

1/4 (OPWFb/OPWFB+ROAb/ROAB+OPMb/OPMB +NPMb/NPMB)

Where:

OPWFb and OPWFB: Operating profit as a ratio of Average working of a Company (b) and the concerned industry average (B).

ROAb and ROAB: Net profit as a ratio of average total assets of a company (b) and the concerned industry average (B).

OPMb and OPMB: Operating profit as a ratio of sales of a company (b) and the concerned industry average (B).

NPMb and NPMB: Net profit as a ratio of sales of a company (b) and the concerned industry average (B).If the score of an organisation based on the above model works out to 1, it means the company's performance is equal to that of the industry average and if it is more, the performance is better than the industry average. The model has been employed to rank the performance of some listed banks for 1999-2000 using composite Performance Index (see Table for results).

However, in the fast changing scene of banking sector reforms and consolidation, any ranking system cannot be treated permanent.

Similarly, the parameters chosen for the ranking will significantly alter the ranks among banks.

The rankings have taken into account only the financial performance indicators and did not consider the size and diversity of operations of banks. Subject to this limitation, the performance index (PI) model provides a pointer to the relative financial performance of banks.

(The authors are officers with the RBI. The views expressed are personal.)

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