Are you making enough from your business – a way to measure this
A ratio that can be used to determine whether you are getting an adequate return from your business is Return on Capital Employed (ROCE).
ROCE is calculated as follows :
Let me ezplain further. EBIT means the net profit of a business before interest and taxes. The capital employed can have a number of different meanings however it is the capital necessary to make the business perform. It is commonly represented as total assets less current liabilities or fixed assets plus working capital.
Now before I go onto an example with every ratio it is not perfect. The assets figures in the financial statements are usually represented at cost or even depreicated. This means if the business is using assets purchased many years ago then the ROCE would be better than a business using assets purchased recently everything else being the same. Thus we need to be careful with this number but it is still very useful. We can make adjustments by valuing the assets at their current value to get a better idea of the true ROCE.
So lets look at an example:
|
|
ABC Pty Ltd |
XYZ Pty Ltd |
|
Operating Profit |
100,000 |
150,000 |
|
Total Assets |
500,000 |
1,200,000 |
|
Current Liabilities |
150,000 |
150,000 |
|
Capital Employed |
350,000 |
1,050,000 |
|
ROCE |
28.57% |
14.28 |
The return of both companies is above what could be obtained from investing the proceeds in shares etc but don’t get caught by a larger profit must be better. ABC has a small profit but is using the assets more effectively and thus is a better managed business.
What is the ROCE of your business? Is it sufficient? If not what are you going to do to look at ways to improve it?
The need to manage growth (yes some businesses are experiencing growth)
Even in these tougher economic times there are still businesses that are experiencing significant growth. Whilst we always want growth it comes with its own set of challenges.
Systems and procedures come under stress. Often new procedures are added on an ad-hoc basis in reaction to situations arising. In isolation each of these procedures may make sense but taken together it may end up a mess. Also these ad-hoc systems can suck the life of the team morale. Given these potential problems it is necessary to sit down and look where the business is going and put in place the systems for the business necessary for when it is much bigger than now. By taking this time the impact of the systems on the culture of the firm can be properly considered. The hardest thing in business is to maintain the great culture that is place as the business grows.
In a growing business cashflow is king. (This is always the case in any business but in a growing business it becomes supercritical). So with this it is critical to know what is happening in the numbers. If all that is measured is the daily/weekly bank balance and then the monthly profit and loss statement / balance then the business can easily run into trouble. I do not propose that a business should measure everything that moves. What I am saying that in a growing business it is important to measure what is important to the client and also measure the items that affect working capital. So what it is that is important to a client and how do you measure it. This will vary from business to business however to give an illustration of a financial advising firm – the best ways to measure whether clients are happy is to measure the number of referrals. Unhappy clients will not refer, only happy clients will.
Unfortunately many small businesses do not know what their working capital needs are. It is necessary to measure debtors days, stock turns, creditors days, cash balances and whatever else in your business that impacts on working capital. How much working capital is needed to fund the sales growth? What happens if the customers become just a little slower in paying? As business growths because of the stress on the sytem it is an unfortunate consequence that debtors days can extend. This can be because not enough time is spent on chasing up outstanding income. However the greatest reason for the debtors extension is usually because there has not been enough screening of customers.
The measurement of working capital and it’s various component parts is not something to be done once a month but rather at a minimum every week.
There are other challenges that come from growth but these two (systems and cash) are the two most critical. Also these apply to any business even if due the current economic situation there is not a lot of growth.
Cash is King
Whether we in Australia go into a technical recession or not is somewhat irrelevant. There is no doubt there has been a significant slowdown in our economy. This is likely to continue for some time into 2009. So what does this mean to business. There is a couple of important consequences however here I will only cover one. ( will expand on the other consequence in a future blog post).
Cash is king.
A business must pay particular attention to cashflow when the economy turns. There will be greater pressure from clients who delay their payment a little more than normal. Also creditors may be on the back of small / medium business to ensure that they collect their money earlier than usual.
So this is a time for business to review there credit terms, look at their systems to ensure prompt collection of debtors and review any options with respect to creditors. It is critical to understand in detail the working capital requirements of the business and be measuring this regularly. Working capital shortage can cruel a profitable business.
What is your working capital cycle? How long does it take from the moment work is in the door, stock on the floor until you have the cash from your clients? Are there any ways to reduce this timeframe?
Remember – measure what matters – cash is king.
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