Financial Statements & Ratios
Return On Investment
Return on investment is the most meaningful way to evaluate overall business profitability. It is important to understand how return on investment is calculated and how it can be improved. There are two distinct return on investment measures: Return on Assets and Return on Net Worth. Return on Assets looks at the economic viability of the store. Return on Net Worth , or return on owner equity, examines the return being generated for the store’s owners. Both have their own value in analyzing performance. These two return on investment ratios are driven by three performance ratios: Profit Margin, Asset Turnover and Financial Leverage . These represents a different strategy, or profitability pathway, to improve return on investment. These five ratios can be presented in the Strategic Profit Model . The model is simply a graphical representation of return on investment. The model for the typical core hardware store is shown below.
Return on Owner Equity
Path 1 Profit Margin
Path 2 Asset Turnover
Path 3 Financial Leverage
Return on Assets
X
=
X
=
33.1 %
9.6%
2.3
22.1%
1.5
Profit Before Taxes Net Revenue
Net Revenue Total Assets
Profit Before Taxes Total Assets
Total Assets Net Worth
Profit Before Taxes Net Worth
The Strategic Profit Model for the Typical Core Hardware Store
Path 1 : Profit Margin = Profit Before Taxes ÷ Net Sales x 100 The first, and most important, profitability pathway is profit margin management. In the figure above, a profit margin of 9.6 percent means that for every $1.00 of sales the business was able to produce 9.6¢ in profit before taxes. Profit margin focuses on sales productivity, gross margin management and operating expense control. Path 2 : Asset Turnover = Net Sales ÷ Total Assets Asset turnover reflects the sales the store produces per dollar invested in assets. The ratio of 2.3 means that the store is able to generate $2.30 in sales for every $1.00 in assets. If a store's cash, accounts receivable, inventory, property, equipment, and all other assets can be used as efficiently as possible, then a maximum amount of sales can be generated from a given asset investment. Return On Assets = Profit Before Taxes ÷ Total Assets x 100 Return on assets (ROA) is the direct result of the first two pathways; profit margin multiplied by asset turnover. This measure of performance is a good indicator of the store's ability to survive and prosper. The pre-tax return on assets ratio should at least equal the cost of capital. For the typical core hardware store ROA is 22.1 percent. Path 3 : Financial Leverage = Total Assets ÷ Net Worth Financial leverage measures the total dollars of assets per dollar of net worth. The ratio measures the extent to which the store uses outside (non-owner) financing. The higher the ratio, the more the store relies on outside financing. The ratio of 1.5 times suggests that for every $1.00 in net worth, the store had $1.50 in total assets. Return On Net Worth = Profit Before Taxes ÷ Net Worth x 100 The end result of the three profitability pathways is return on net worth. It is seldom possible to generate an adequate rate of return on net worth by emphasizing just one profitability pathway. Each pathway should be examined carefully for improvement opportunities and then trade-offs made in order to increase overall profitability. An improvement plan should not be based upon any single measure of performance, but be developed with the complete picture in mind, i.e., the impact on return on net worth. The typical core hardware store has a return on net worth of 33.1 percent; that is, for every $1.00 of net worth, the store produced 33.1¢ of profit before taxes.
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