Chapter 11
Measuring Your Financial Efficiency
In This Chapter
Understanding how well resources are being used
Knowing what investors want
Measuring how hard the assets are working
Profit and growth are important metrics but measuring how well you use resources is also critical. After all, there is no point fighting tooth and claw to increase front-end sales revenue when inefficient processes, operational waste or poor cost control wipes out all the front-end effort.
Business involves many ways of spending revenue and using resources. Financial efficiency KPIs can help to separate those options and guide decision making, so you make the right decision more of the time.
Assessing the Return on Investment
Return on investment (ROI), also referred to as rate of return (ROR) or rate of profit (ROP) is a financial KPI used to measure the efficiency of an investment. It can be calculated during or after making an investment or used in the decision-making process prior to a potential investment.
Obviously, if you can assess the costs and projected benefits associated with a particular investment before you part with any hard-earned cash, then you are better able to compare options and build a strong business case around the best investment. As a result, ROI can help management make the ‘go’ or ‘no go’ call when faced with investment decisions.
There are two types of ROI – micro ROI and macro ROI.
Micro ROI looks at particular elements within larger programmes the company is involved in. These programmes usually take anywhere from a few months to a year to come to fruition. Examples of micro ROI include:
- A social media sales promotion
- Running a staff training programme
- A print and TV advertising programme
Effectively, micro ROI can be applied to any project, promotion or investment a business spends money on or is considering spending money on, where a positive return is expected within a year.
Macro ROI is focused on the overall performance of major business initiatives that are ends in themselves rather than elements of a business function. Examples of macro ROI include:
- The installation of a new software program
- Assembly line upgrade and improvement
- Investing in a delivery fleet to manage the supply chain more closely
The return on macro investments takes more than a year to come to fruition, often several years.
ROI calculations can also be used to compare a number of different investment options in order to find the most promising one.
Every investment must yield a return
Every business wants to make sure that investments yield a return, and that the allocation of valuable resources is worthwhile, adds value and makes more money for the business. This is especially true for a publicly listed company that has obligations to deliver value to shareholders.
Resources are usually finite so you and your executive team must decide how best to spend the money it makes – often choosing between a number of investment opportunities. ROI can be a very important and useful KPI to measure in these situations to ensure that as many investments as possible yield a positive benefit for the business.
Of course you need to remember that ROI by itself is not enough to assess an investment because it does not factor in the likelihood of the expected returns coming about. It compares expected cost to expected benefits – both of which could be wrong so the more certainty you can establish around these variables the better the decision making.
Understandably, ROI is a key metric tracked by investors because it measures a business’s ability to generate positive returns on their investments on an ongoing basis.
Measuring ROI in practice
The key performance question ROI helps to answer is: ‘To what extent are we making efficient investments?’ You collect the data for this metric from the accounting data.
You can calculate ROI in a few different ways, although they all seek to compare returns to costs by calculating a ratio or percentage. Simple ROI is:
ROI = (Gains from investment – Cost of investment)/Cost of investment
To calculate the percentage you simply multiply it by 100:
ROI = (Gains from investment – Cost of investment)/Cost of investment × 100
For example, say you want to invest in an integrated marketing campaign with print adds, social media and TV. The cost of the campaign is $350,000 and the expected return is 600,000. Simple ROI is 0.71 or 71 per cent.
($600,000 – $350,000)/$350,000 × 100 = 71.43 per cent
The ROI calculation gives you an insight into how much return you will get from your investment, and obviously you want this to be a positive figure. Negative results would indicate that you are making a loss. In this example, you are making a gain of 71 per cent on your initial investment. An individual ROI calculation gives you an insight into the expected returns, multiple ROI calculations allows you to compare investments.
You can also look at ROI over specific time periods to calculate, for example, an annual rate of return, especially if the investment is made over a number of years. The formula you use for that is:
(Profit/Cost) × (Year/Period) × 100
For example, say you are considering a social media sales promotion that would run for 90 days. It would cost $175,000. Expected sales are $320,000. Profit is expected to be $145,000.
- ($145,000/$175,000) × (365/90) × 100
- 0.83 × 4.06 = 3.36 × 100 = 337% annual rate of return
ROI can be very helpful in the decision making process. That said, it’s not always easy to match specific returns like anticipated profit to specific costs like marketing campaigns.
You must also make sure you are comparing like with like and not confusing annual and annualised returns.
An annual rate of return is the return on an investment over a one-year period, such as January 1st through to December 31st. An annualised rate of return is the return on an investment over a period other than one year (such as 90 days in the example above) multiplied or divided to give a comparable one-year return. For example, a one-month ROI of 2 per cent could be stated as an annualised rate of return of 24 per cent (2 per cent × 12 months = 24 per cent). Or a two-year ROI of 10 per cent could be stated as an annualised rate of return of 5 per cent (10 per cent/2 years = 5 per cent).
This allows you to compare investments of different time frames. For example, if you have three investments, one over 10 years, one over 5 years and another over 2 years, the annual rate of return provides you with a figure to compare them.
There are several ways to calculate ROI which gives the KPI flexibility, but that same flexibility also means if can be manipulated to suit the user’s purpose.
Measuring the Return on Capital Employed
Return on capital employed (ROCE) is considered a key profitability KPI for investors seeking to compare investments and find the business that is making the best use of its capital to increase profit, growth and shareholder value. So whether you are an investor or an executive wanting to ensure your business looks enticing to investors ROCE is a very important metric. And that is true even if your business is not a publicly listed company.
ROCE differs from ROI because it considers debt and other liabilities whereas ROI doesn’t. As a result it is often a better indication of overall financial performance.
Understanding ROCE
ROCE compares earnings with the capital employed in the company to assess profitability. The main components used in the KPI calculation are operating profit and capital employed.
There are a number of ways to reach the earnings ratio or operating profit, but a common approach is to use earnings before interest and tax (EBIT) while capital employed is the capital investment necessary for the company to function and grow. (EBIT is a variation or part of the KPI EBITDA detailed in Chapter eight).
ROCE either uses the reported capital numbers at the end of the period in question or the average of the opening and closing capital over that period – known as return on average capital employed (ROACE).
This KPI indicates how well management have utilised owners’ and creditors’ investment. It is also commonly used as a decision-making metric, helping management decide how best to use capital between projects. Plotting this metric consistently over time illustrates an efficiency and profitability trend and helps executives and investors decide whether the business is improving or otherwise. In essence, ROCE shows you how much your business is gaining from its assets, or how much it is losing from its liabilities.
Measuring ROCE in practice
The key performance question ROCE helps to answer is: ‘How well are we generating earnings from our capital investments?’ The data for this metric is collected from analysis of the accounting data.
ROCE is usually measured on an annual basis and is an easy KPI to measure as the information needed is readily available in the accounting data. Again, you can calculate ROCE as a simple ratio number or as a percentage. This formula calculates the percentage:
ROCE = EBIT/Total capital employed × 100
It can be particularly useful to compare your ROCE to the ROCE of other companies in your industry or sector as it will give you an idea of how efficient your use of capital is against your competitors.
For example say you would like to know how efficient your business is operating in comparison to your nearest competitor. Your business has EBIT of $10 million on sales of $200 million in 2013. Your competitor has EBIT of $15 million on sales of $200 million. Initially you may be a little concerned because your competitor looks to be performing better with an EBIT margin of 7.5 per cent ($15m divided by $200m multiplied by 100) whereas your EBIT margin is only 5 per cent ($10m divided by $200m multiplied by 100).
But you decide to look more closely to capital employed to measure efficiency rather than just earnings. Your total capital employed is $50 million and your competitors is $100 million.
- Your ROCE = $10m/$50m × 100 = 20 per cent
- Your competitor’s ROCE = $15m/$100m ×100 = 15 per cent
What ROCE demonstrates is that although you’re not generating as much revenue as your competitor your business is doing a better job of squeezing value from its capital than your competitor. The higher your ROCE the better the business is at deploying the capital in the business wisely.
One drawback of ROCE is that it measures return against the book value of assets in the business. Obviously assets depreciate, which means that the ROCE will increase even if cash flow remains unchanged. As a result older, more established businesses often have a higher ROCE than newer businesses even though the newer businesses may be more efficient.
Another criticism is that ROCE can be used too stringently. Say your cost of capital is 10 per cent and you have an ROCE target of 30 per cent. You may discount potential investments that do not deliver a return of at least 30 per cent. But if the cost of capital is 10 per cent then any investment that delivers a return of greater than 10 per cent should be considered, as it is still adding value to the business.
Gauging Return on Equity (ROE)
Companies can either finance their operations through equity (investments from shareholders) or by debt (borrowing money). This metric focuses on equity and measures how much profit your business is creating from the money invested by shareholders.
Many analysts consider ROE as the single most important KPI for investors and the best marker of management performance.
As expected with profitability and efficiency KPIs, the higher the better. Companies with high ROE are better able to grow the business without turning back to shareholders for more capital or incurring debt.
Why should you measure ROE
Shareholder equity is an accounting creation that represents the assets created by the paid-in capital of the shareholders and the retained earnings of the business.
ROE is particularly useful because it looks behind the bluster and sanitised propaganda of annual reports. As legendary investor Warren Buffett pointed out some years ago, achieving higher earnings year on year is not actually that hard. You could stick your cash in a high interest account or sack half your workforce and your figures would look fabulous, but those actions tell the investor nothing about efficiency and how well the business manages their capital and uses it to create value.
A business with a high return on equity is more likely to be one that is capable of generating cash internally. If your company has a high ROE then it is demonstrating a good profitability and efficiency track record.
Measuring ROE in practice
The key performance question ROE helps to answer is: ‘How efficiently are we using the investments that shareholders have made to generate profits?’ The data needed for ROE comes directly from the income statements of the business.
Shareholder equity is calculated from the balance sheet by taking total assets and subtracting total liabilities. This leaves the amount of equity owned by the shareholders. Again, you can calculate ROE as a simple ratio number or as a percentage. This formula calculates the percentage:
ROE = (Net income for period in question/Average shareholder’s equity over same period) × 100
Say for example your net income for 2013 was $11.5 million. Your shareholder equity at the start of 2013 was $48 million and $52 million at the end of 2013. Your average shareholder equity for 2013 was $50 million (£48 million + $52 million / 2).
ROE = 11.5/50 × 100 = 23 per cent
To get a sense of whether your ROE is good or bad you need to compare it to other companies in your industry.
In years gone by a ROE of 20 per cent plus was considered very good and achievable. Realistically however these figures are probably unsustainable and certainly CEOs have been issuing repeated earnings revisions in an attempt to recalibrate inflated expectations around return.
Understanding Return on Assets (ROA)
All businesses must invest in assets such as property, machinery or equipment in order to generate a return. It’s obviously crucial to invest in the right assets – ones that will maximise income and assist growth and profitability.
Return on Assets helps you to work out how profitable your business is in relation to the assets it controls. As such it is another financial metric that is designed to expose corporate efficiency.
If the ROA is low it indicates that the income has been low compared to the amount of assets the business.
Why does ROA matter to companies?
ROA provides investors or would be investors with a good idea of how effective a business is at converting the money it has to invest into net income.
Anyone can make a company look good if they throw enough money at it. If you consider some of the technology start-ups of the late 1990s, just before the dot.com bubble burst, they generated huge investment from expectant shareholders. But even though they were swimming in cash they were not able to convert that investment into income or long-term, consistent shareholder value.
Measuring ROA in practice
The key performance question ROA helps to answer is: ‘To what extent are we able to generate profits from the assets we control?’ The data needed to calculate ROA comes directly from the income statements of the business and it is usually calculated every year, but reported on a rolling quarterly basis (that is, calculated for the past four quarters, each quarter).
ROA = (Net income for period in question/Total assets at end of period) × 100
The problem with this formula is that it can be too simplistic. For a start, businesses fund their assets through equity finance (selling shares to shareholders) or debt finance (borrowing money). If a business borrows more money then it will usually result in higher interest rates and the simple ROA formula does not account for capital costs. Plus it can be misleading. Say you owned a fleet of delivery vehicles for 11 months of the year and then decided to sell them all in December. The income for the year in question was earned using those delivery vehicles. Yet come December they are not part of the business or included in total assets even though those assets were integral to earnings, therefore distorting the ROA.
To account for these problems a more accurate formula would therefore be:
ROA = (Net income for period + Interest expenses in period)/Average assets during period × 100
For example say your company earned $15 million in net income in 2013. The cost of capital during the same period was $1 million. Your assets at the start of 2013 were $20 million and $25 million at the end of 2013. Your average assets would therefore be $22.5 million ($20m + $25m/2).
ROA = $14 million/$22.5 million × 100 = 62 per cent
There is no benchmark for ROA as it varies significantly between industries. It is therefore most useful to compare ROA with similar businesses.