History free essay: Assessing the Past Performance of a Security or Asset
Assessing the Past Performance of a Security or Asset
The most appropriate methods applied in the determination of performance of a security or an asset is perhaps through ratio deliberation of historic financial data. Financial statements showing the current net worth of the entity such as the balance sheet are applied in the deliberations on performance. One of such comparisons of the balance sheet is perhaps given through the analysis of returns on equity (ROE). Under the specific ROE tools of performance determination, three main ratios are applied (Higgins 2001, p49). Firstly, profit margin obtained from net income against sales demonstrates the actual performance element with regard to income resulting from specific sales. Secondly, asset turnover is an important reflection of the sales against assets relationship which can be used to demonstrate performance. The other ROE tool is the financial leverage function that highlights the measure of assets against shareholders’ equity. ROE is therefore a fair representation of elements of the balance sheet as well as the income statement since the variables uses in these rations are picked from the two performance reports. To obtain ROE, the three ratios are multiplied to demonstrate the summary of the performance. From such an assessment, it is possible for investors to monitor the performance of the investment in which they have an interest on.
Alternatively, another important performance indicator usually applied in economics is the return on assets (ROA). Simpler in calculation than ROE, ROA reflects actual performance that every investment unit has over a particular period. One of the two ways to obtain ROA is multiplication of asset turnover with the profit margin which reflects performance with respect to total return element on assets (Higgins 2001, p37). On the other hand, net income against assets gives the same consideration. Apparently, this tool of performance is also a reflection of variables of the balance sheet as well as the income statement which account for performance over a specific period. Further asset turnover analyses through a number of control ratios enables consideration of specific asset types for clearer asset performance. Some of these control ratios include; inventory turnover, fixed asset turnover, collection period, days’ sales in cash and payables period. Liquidity ratios also assist in determination of performance which determines the management’s application of returns in furthering business and investment. In terms of operating capital requires a certain sufficiency level from non-fixed assets, too high liquidity ratio may reflect slowed performance whereas too low liquidity ratio may indicate insolvency.
Strengths of application of these ratios are mainly reflected in the management’s projections of future business to accurately determine the appropriate course of action. Perhaps many business operations are based on the reliance on historic performance records to project future environment thereby making appropriate managerial decisions. Cost accounting element of decision making enables businesses to apply past cost reflections to make decisions reducing costs and maximizing on returns (Higgins 2001, p101).
In terms of weaknesses, performance considerations based on ratios and past performance data are not the best of decision making options due to inherent inaccuracy and impracticalities. As an illustration, ROE has three inherent weaknesses that clearly get transcribed on the resulting decision. One of these weaknesses is referred to as the timing problem which is based on the irrelevance of history in business which is largely a factor of currency of operation period. In addition, the risk problem is a concept developed from the fact that return and risk are inseparable, making these ratios that heavily rely on returns to be a risky approach to base decisions. Alternatively, the value problem is reminiscent of these performance ratios of consideration which implies that the valuation on historic data is mainly on book value which is poorer a consideration when compared to the actual market value.
Due to these weaknesses that by far overshadow strengths, past financial data must be used on specific instances. The reliance on such data in making investment decisions is therefore supposed to be carefully contemplated on to factor in the weaknesses seen above. To avoid the risk element, reliance should be extended to other indications other than return intensive considerations alone. To check the timing weakness, it is important for performance considerations to be based on the most updated information, which must however be authentic to such levels as official business reports (Locke 1987, p232). Additionally, valuation of assets and securities should also be based on the most practical valuation on updated market value. The most important consideration in placing reliance on past financial data is perhaps supposed to be on the sensitivity of making investment which must be devoid of avoidable errors. In such a consideration, the best alternative must be sought in making the inferences to apply in asset and securities investment.
Higgins, R. C. (2001) Analysis for financial management. New York, NY: Irwin/McGraw-Hill
Locke, S. (1987) Performance Assessment Indexes and Capital Asset Pricing Models. Journal of Property Finance, vol. 5 no. 3 pp.230-249
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