Take Profitability Analysis to The Next Level – September 2014

This topic concerns financial management.

Many small businesses gauge their performance by focusing on profit margins. This is a very important measure which can indicate the need for better pricing, cost reduction, as well as better utilization of capacity or floor space. However, there is another measure that can be used to take profitability analysis to the next level.

This measure is known as return on invested capital. There are several ways to calculate this measure. Essentially, it is calculated by dividing after-tax operating (before interest) profits by net assets (operating assets less current liabilities). Monitoring this measure helps evaluate the firm’s performance on the profit side as well as the asset utilization side of the business. Better asset utilization results in a smaller denominator and thus a higher return on investment for owners.

Asset utilization can be achieved in numerous ways. Faster collection of receivables, leaner inventories, more efficient use of machinery, and better business processes are the most common. Better asset utilization can dramatically improve a company’s performance and value. An example often cited is Dell’s focus on receivables and inventory management during the 1990’s. By improving these aspects of the business, return on capital skyrocketed as did Dell’s value in the eyes of investors.

The last point should be of particularly interest to businessmen seeking investor capital or the ultimate sale of their firm. At the very least, focus on return on invested capital will improve the firm’s performance and provide the owners more profit on the dollars they have invested in their company.

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