Dr. John Psarouthakis is a Distinguished Visiting Fellow-Professor, Institute of Advanced Studies in the Humanities, University of Edinburgh, Scotland. Founder and former CEO, JPIndusries,Inc., a Fortune 500 industrial corporation. He is the Executive Editor of www.BusinessThinker.com
DIFFERENT WAYS TO MEASURE PROFIT
There are three commonly accepted ways to measure profit: as return on assets (ROA), return on investment (ROI) and return on sales (ROS). Which is best to use in evaluating your firm?
ROI (your net income divided by total equity) is an important number for managers because it is a good indication of whether you are wasting your time in the business you are in. If ROS (your net income divided by total sales) is fairly low but your need for capital is also quite limited, it will still be a very worthwhile endeavor. On the other hand, if running the business requires a heavy investment, you should weigh your use of money invested in your business against simply putting it into the bank. It is easy to become so preoccupied with sales growth that you forget to evaluate the cash you put into your business the way you would choose your passive investments. But tracking your ROI is important. It allows you to compare investments in different instruments and types of firms. Even small passive investors evaluate their investments on this basis, comparing rates of return and risk factors for treasury bills, certificates of deposit, mutual funds, and so forth. Business owners emphatically need to do exactly the same for their active investments.
Assume you are sole owner and have set aside a rainy day fund for your company. Does it really make sense to reinvest the fund in the firm or would you be better off closing this business and starting over? ROA and ROI more realistically help you to answer this question than return on sales. Many entrepreneurs get trapped psychologically, pouring more and more money into a dying business–taking equity out of homes, borrowing against life insurance policies–just to keep a doomed or marginal business afloat. Any calculation should also factor in the time you spend, compared with your likely earnings in a salaried position working for someone else.
Why then, did we use ROS as the primary yardstick for profitability? Our choice is a compromise between theory and pragmatism. Most firms we studied were privately held. Most of the CEOs were hesitant to share even return on sales figures, much less balance-sheet figures. And many were confused by the terminology of ROS and ROI. To offset the instability of one year’s profit performance, two years of data were collected from most firms.
Although ROS is not perfect, it still provides a sound basis for comparing firms. In a study of several thousand business units in 450 companies, Buzzell and Gale find not only that ROS and ROI are linked with each other, but linked in very similar ways to most of the company practices and characteristics they studied.5 The relationships differ principally in variables associated with capital intensity of the business–the investment per dollar of sales. Greater capital intensity itself is linked to lower ROI; the relationship with ROS is negligible. With this caveat, we feel comfortable that ROS provides useful insights into effective management of small, growing firms.
CASH FLOW AND NET PROFITS
We all read about highly-leveraged companies taking big risks with other people’s capital. You might think such cases are rare among small firms. But think again. Many entrepreneurs take huge risks with inheritances, college savings, bank loans, and even money for withholding taxes. Though it seems a more conservative approach, those with better cash flow are also those with higher profits and longer survival. There is something to be said for the adage: “Don’t spend what you don’t have.”
Many top performers in our study make a religion out of flexibility. They anticipate lean periods during the peak of the business cycle. Though they will expand somewhat, they accumulate cash during good years to operate comfortably in lean years. Ready cash also helps them respond to unanticipated opportunities.
One of the hardest decisions facing smaller firms is when to make a major capital improvement–purchase of a new building or a new technology. Successful capital improvements have “many fathers.” But several CEOs we interviewed regret untimely or excessive expansion decisions, especially those made in anticipation of sales that never materialize. In one typical case, a CEO built a large plant addition to handle increased orders from a key customer, a large automobile manufacturer, who pulled out just after the plant completion date. The CEO had now lost his flexibility to downsize during the next recession and struggled to find alternate business to justify the expense of the new plant.
On the other hand, consistent careful incremental expansion of just one or two trucks a year by a trenching firm is proving sufficiently competitive. He enjoys profit levels well above industry norms. The large fleet he has gradually amassed has helped him to attract and maintain utility company clients, which provide the firm with steady profitable work.
Managing one’s cash flow thus does not mean a zero-growth strategy, but does require careful attention to available cash, not just paper profits.