ROI Ratios
It must be ironic that I have spoken at length about ROI, perhaps ad nauseum, yet I haven’t told you how to calculate it. Well, you’re in luck! That is what we are about to do!
Return on Investment is the ratio, expressed as a percentage, of the annual profit earned divided by the initial investment made to generate that profit. Below is the general formula:
The key point is that a business or opportunity that generates a lot of profit relative to the investment needed is very valuable. We can use 10% as our benchmark. I would like to bring up two other points.
We want to maximise ROI over the long term. A high ROI for only one year will not take advantage of compound growth. The longer compounding goes on, the greater its effects are evident.
Secondly, we are trying to maximise our ROI per unit of risk –a quantitative and qualitative assessment.
The quantitative – how many dollars are being “risked”. If you bet the house and lose, you lose the house. Smaller bets (investments) allow us to experiment without risking a substantial investment in a dud project, or business line. How much of your money, or “equity”, are you risking in this investment?
Qualitatively, we need to assess how risky the activities we invest in are. Qualitative risk assessment is intangible but very important for a business as these characteristics provide insight into how volatile sales and costs are.
How stable is revenue/customer demand? Can customers easily delay purchases? How easy is it to switch vendors? What are the barriers to entry? What are the risks that we cannot provide the good or service profitably? What happens if input costs rise quickly? Can you pass on higher costs to the customer without reducing sales?
Minimising “unit of risk” aids a long-run average ROI. The more stable our revenues and costs are, the more predictable our annual profit is. Thus, less risk our profits are as our profits are higher.
So, without further delay. Let’s get to it!
Business Quality ROI – Return on Tangible Assets
To assess business quality, we need 1) What core assets a company needs to conduct business 2) The cost of core assets & 3) The amount of profit the core assets produce annually?
We want a business that “makes more with less”.
ROTA shows the amount of profit generated relative to assets used – business quality!
So… What are tangible assets? Let’s get the vocab nailed down.
Tangible assets: have a finite monetary value and normally have physical form. A good test to see if an asset is tangible is if the value can be counted. Tangible assets are not “abstract”.
Tangible Assets are what a business uses to generate profits. Therefore, the value of the tangible assets equals the investment needed.
Working Capital refers to the current assets and current liabilities on the balance sheet.
Current assets represent an investment businesses need to sustain to generate profits.
For example, Charlie must buy, and have inventory to sell biscuits to his customers. If he runs out of inventory, he can’t sell anything. Charlie must always hold, and therefore invest, an amount of money in inventory – cash “tied up” in inventory.
A similar thing happens to Charlie with Accounts Receivable. While Charlie is entitled to the cash from his sales, he lets customers pay on a delay. By allowing a delayed payment, Charlie effectively gives a loan to his customers to purchase his biscuits which is paid off when cash is received. Therefore, an Accounts Receivable amount of the balance sheet is an investment of cash – money “tied up”.
N.B. Generally, we include all cash held on the balance sheet in current assets. However, if a business has excess cash – more cash than the business would ever reasonably need – we exclude it because the excess cash isn’t “core” to conducting business and therefore generating profits.
For liabilities, companies delay paying suppliers, vendors, and employees. Charlie (as well as most businesses) doesn’t pay salaries daily, but biweekly/monthly. Suppliers and vendors are often paid 30 days after the invoice is received. Delays in payments stop money from going out the door. Here business owners are effectively getting interest-free loans. Current liabilities counter investments made in current assets. Therefore, we subtract current liabilities from current assets to arrive at working capital.
In our calculations of Current Liabilities, we exclude the current portion of long-term debt because it is used for funding purposes not for working capital (involved in running everyday operations).
NWC is the amount of money a business needs for current day-to-day operations.
The second part of the Tangible Assets is Net PP&E. In addition to NWC, a company must have fixed assets such as real estate, plant, and equipment to produce their goods and services. We use Net PP&E as it represents the most up-to-date value of the PP&E.
Other Miscellaneous assets are assets that a business uses but are not common, or significant. We should include them in the calculation but pay little attention to them.
Tangible Assets area what the a business uses to generate profits.
A higher ratio of profits to tangible assets invested in the business shows a higher quality business because it uses capital more efficiently.
If there are irregularities on the balance sheet – e.g. a temporary, unusually large inventory balance, we can average Tangible Assets with the previous year to smooth the calculation.
Excluding Intangible Assets
ROTA shows the productivity of physical assets irrespective of scale. If we know a business will double next year, the ratio of profits relative to assets used would have to be the same.
If a company has intangible assets, however, it will scale without the added investment needed. If Coca-Cola wanted to double its capacity tomorrow, it would not need to spend all the money it has ever spent on marketing since its founding in 1893. The intangible assets scale without extra investment.
Capital Efficiency Ratio - Return on Invest Capital
The Capital Efficiency ROI measures how effectively an owner uses his, and other people’s money, to generate profit. Assets are purchased with money from the owners (equity), and creditors (debt) – the Invested Capital. Therefore, if we calculate the profit relative to the money used, see the return on invested capital. The ratio differs from ROTA because it focuses on the funding as a whole. The Capital Efficiency ROI indicates how well the owner uses capital.
Owner’s ROI - Return on Equity
Owners’ ROI, or Return on Equity, is an extension of the Capital Efficiency ROI, however, we focus only on money contributed by owners.
To fund assets needed to conduct business, an owner can use their own (equity), and other people’s (mostly debt) capital. If a business owner can use a third party’s people’s capital, they in turn “conserve” their own – a higher Liability Funding Ratio.
Using more of another party’s money to generate while using less of your own money to make the same profit sounds like a good deal. Wait a second… Doesn’t this sound familiar?
Think back to ROI. See how liabilities can be advantageous. If an owner increases liabilities, instead of equity, the business uses someone else’s cash to fund their balance sheet to generate profits.
After all the interest has been paid (the cost of third-party capital), all the leftover profit goes to the owner. As a result, liabilities are “working” for the business owner.
As a result, the owner can artificially increase their own ROI, Owner’s ROI, by using a greater proportion of liabilities – this is the effect of using leverage.
We include interest expense in the calculation for annual income in this scenario because the Owner’s ROI ratio is dependent on the capital structure – the way the balance sheet has been financed. The two prior ratios were balance sheet agnostic. ROTA focused on tangible asset purchases, while the CER ratio analysed the total capital invested in the business irrespective of who funded it.
One may be tempted to conclude that it’s best to fund as much of your balance sheet with liabilities as possible to take advantage of the leverage. Funding a balance sheet with liabilities, however, adds risk.
In the short term, one can increase liabilities by taking on debt and boosting the Owner’s ROI. If you default on your loan, however, you can lose your business and your investment. The aggressive use of leverage to increase the Owner’s ROI will destroy your long-run ROI.
You must be able to pay back your debt with the cash flow of a business. Using Solvency Ratios based on the last year’s Net Debt to EBIT, or EBITDA, or EBIDA-CapEx are helpful. But what happens if there is a recession? Can you still maintain the ability to pay down debt and interest during an extended downturn? How much did revenue and profit fall in the business’s worst year?
By not maximising the Owner’s ROI in the short-term we can maximise the long-term Owner’s ROI. In business, aggressive behaviour in the short term leads to failure over time. One-in-a-thousand-year events occur regularly as the world has many variables. Leverage with bad luck means your business is toast!
I recommend taking a conservative approach. Avoid using debt. Carry a bit of excess cash as a cushion. Look at naturally occurring Current-Liabilities – is there wiggle room to delay payments further, and boost liabilities funding sustainably?
BUT ensure you can easily pay down all obligations in good times, AND BAD. Many businesses and owners can use this to their advantage, while others take on too many liabilities and go bankrupt.
As business owners, we want to maximise our ROI per unit of risk over the long run.