Measuring the Performance of a Firm

The flow of money in a company is much like the flow of water in a network of pipes or the flow of electricity- in an electrical circuit, as illustrated in Figure 6.3. In order to measure the performance of a water sy-stem, we need to determine the flow through the system and the pressure in the system. For an electrical circuit, the analogous parameters are current and voltage. Flow and current are referred to as through variables, and are measured with respect to time (flow is litres per second and current is amperes, which are coulombs per second). Pressure and voltage are referred to as across variables, and are measured at a point in time.

The flow of money in an organization is measured in a similar way with the income statement and balance sheet. The income statement represents a through variable because it summarizes revenues and expenses over a period of time. It is prepared by listing the revenues earned during a period and the expenses incurred during the same period, and by subtracting total expenses from total revenues, arriving at a net income. An income statement is always associated with a particular period of time, be it a month, quarter, or year.

The balance sheet, in contrast to the income statement, is a snapshot of the financial position of a firm at a particular point in time, and so represents an across variable. The financial position is summarized by listing the assets of the firm, its liabilities (debts), and the equity7 of the owner or owners.

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