People start and grow organizations for a myriad of reasons. One of the often stated reasons is to “make more money” and, in the case of nonprofits, “to grow and perpetuate the cause.” Financially-savvy people might state “to improve ROE (Return on Equity)” or “ROI” (Return on Investment), yet most business owners only possess a vague understanding of what this truly means.
The essence of my work with clients revolves around ROE by phrasing the question in simple terms: How do we get more out of what we have?
Technically, ROE is simply net income divided by equity (or investment). But do you know how it is derived? Basically, there are three elements that drive ROE:
Total Asset Turnover – the amount of sales derived from the company’s assets.
Net Profit Margin – how much the company keeps out of what it sells.
Equity Multiplier – how much debt the organization uses relative to owners’ investment in the company (equity).
Total Asset Turnover
Total Asset Turnover is what finance people call an efficiency ratio, measuring how much production (revenue) an organization derives from its assets. While every industry has its own benchmark for success, the higher the ratio, the better.
To increase your total asset turnover, measure the effectiveness of your largest assets. For retailers, the goal is to rapidly sell inventory over and over again. For companies with investments in equipment and real estate, the idea is to maximize revenue from these fixed assets.
Another, less used method for maximizing total asset turnover is to actually decrease total assets while maintaining or increasing sales. For retailers, it means carrying less inventory in smaller locations. For manufacturers, it’s outsourcing certain production capacity to other companies with underutilized facilities. For restaurants, it’s opening less expensive locations or finding low-cost venues for selling food.
During these economically challenged times, this is becoming a popular strategy. A recent Wall Street Journal article even featured high-end chefs who are operating “lunch trucks” (you know, the ones that usually sell donuts, soda and old sandwiches) to sell their gourmet food. Whether by choice or not, there is little doubt that this business model enjoys a higher ROE with the emphasis on reducing initial investment requirements. Another benefit is that companies can sell assets to increase cash flow or reduce outstanding debt.
The Masters of Total Asset Turnover – Some Examples
One of the grandmasters of total asset turnover is the specialty grocery store, Trader Joe’s. Not only do their stores turn their inventory every 7 days, which is unheard of in the grocery business, but their smaller stores require less investment on a unit by unit basis.
Wal-Mart takes it a step further. They don’t even own most of the inventory they keep in stock. Instead, the vendors own the inventory. This reduces the company’s per store investment and risk. The company enjoys the same sales with less investment in assets.
Net Profit Margin
The second element of ROE is net profit margin, which is in essence, is what you keep out of what you sell.
While each industry is different, most companies operate on razor thin margins. Consumers are often shocked to hear that the average grocery store only keeps $1.25 from each $100 sale made.
For all its simplicity, many people lose focus when it comes to net profit margin. Business leaders often obsess over total sales while giving little concern to the bottom line. No one goes out of business by increasing their profit margin, but many have gone under from increasing sales. It’s what you keep, not what you sell. The media is no help. During the holiday shopping season, all one hears is “sales are up over last year”. How about profit margins?
The Balancing Act – ROE Nirvana
Here’s where ROE gets challenging. Total asset turnover and net profit margin are often at war with each other. An easy way to increase total asset turnover is by lowering your prices. The only problem is that you run the risk of hurting your company’s net profit margin.
So how do we find ROE nirvana? The answer is simple: Sell high-margin products at high volumes. Sounds simple, but the execution is far more difficult.
The trick is finding the optimal balance between the two. While there are no easy answers or secret formulas to maximizing ROE, the following tips should help your company maximize ROE.
- The main driver for ROE? Always work to increase perceived value on the part of the customer. New Ferraris represent a good value because customers perceive them as containing superior exotic experience and prestige.
- A higher profit margin may be a good thing. Or not. If you’re a restaurant with a food cost of 25% while your industry average is 32%, how did you do it? If you did it by simply increasing prices, you may get into trouble if consumers perceive you as a poor value (see tip #1) and will say (to paraphrase Arnold) “I won’t be back”.
- Your core strategy should drive your ROE decisions. Trader Joe’s ROE strategy is to turn over inventory quickly by selling unique private-label food items at a small markup in small (low investment) locations. As of this writing, Apple Computer’s cheapest notebook computer is $1,000. They don’t care about market share; they care about higher gross profits for each sliver of market share.
- An easy way to increase ROE is to improve service quality. This increases customer purchase frequency, retention, gross sales and allows you to increase profit margins by raising prices. One of the reasons Apple is so profitable is that one gets the feeling that if you get into trouble with your iPod or MacBook, you can have one of the “geniuses” in their stores help you with a problem.
- Differentiate yourself. What can you provide that others can’t? Or, what can you do well that others will gladly pay a premium for?
- What assets should be liquidated (even at a loss) that could free up capital which could be invested more efficiently?
- Provide incentives for performance. Frederick Winslow Taylor, the original management consultant and author of Scientific Management in 1911, developed systems that would provide 60% more compensation to superior-performing workers.
- Analyze every product/service you sell against percentage of total sales, gross profit margin per item and synergy between items. Keep the best, dump the rest.
- Excess inventory reduces total asset turnover and leads to carrying assets that are depreciating before your eyes, thereby forcing the company to sell at a lower price later (and hence, lower profit margin).
- Conversely, little inventory (or immediate access to it) means your customer will go elsewhere, which brings no sale at all.
- Carefully consider adding new products or services to your existing mix. Adding new items can increase operational complexity resulting in increased training costs, higher errors rates and potential degradation of your brand.