Too many business owners tolerate poor return on invested capital. In fact, very few owners know exactly how many dollars they have invested into each of their business sectors. Would you know off the top of your head if you are receiving adequate return on just your dealer contract business, or just the retail stores you operate? To answer this question you must know:
- Total capital invested in each business sector.
- Rate of return on that capital.
If you are not generating profit and loss statements by individual sector or divisions, you must start there. It’s vitally important to distinguish profit on each sector so one highly profitable sector doesn’t hide losses or just breakeven in other sectors.
Splitting your company financials into divisions is not as hard as it sounds. Enlist the help of your vendor as they have likely helped other companies make the transition and know the steps needed in their unique accounting system intimately.
As you segregate into sectors, you will find revenue and expenses that are difficult to assign to a particular sector, such as owner’s salary. Any expense that is not directly related to a particular sector should go into an Administrative Division. However, this Administrative Division’s revenue and expenses must be allocated at month end in an equitable manner to the other divisions. Sales and personnel hours are some standard methods to allocate administrative overhead.
So now that you know the profit of each sector, the vital question becomes, “Is that profit adequate for the capital employed for that sector?” Capital employed is defined as your investment in assets needed to run that sector. For instance, for a trucking division, capital employed would be the sum total of your real estate investment (zero if you rent), and your truck and equipment investment.
Any cost that is already accounted for in your income statement does not “count” in your capital employed. For instance, your driver’s salaries and insurance are already in your profit statement. For store operations, include your real estate, equipment, and base inventory as your capital employed, but not maintenance and repairs.
At Meridian, we are frequently asked whether marketers should value their assets at cost or present market value. The answer is market value. For example, if you paid $50,000 for your bulk plant in 1935, but the land is worth $2,000,000 today, theoretically you could sell your land for $2,000,000 and stash that money away in another investment. This market value is what makes ROCE (Return on Capital Employed) a different ratio than the old-fashioned ROA (Return on Assets).
The other question frequently asked is how loans play into the equation. Capital employed is not impacted by whether you borrowed money for the hard assets. The only role that leverage plays in the equation is a reduction of bottom-line profit if there is interest expense.
So, now let’s get to the actual ROCE calculation, which is simple math. Let’s say last year you invested $750,000 in one of your business sectors, it is still worth $750,000 today, and it produces $50,000 bottom line profit before depreciation annually. Is that an acceptable return on capital employed? By dividing $50,000 by $750,000, we find a ROCE of just less than 6.7%. Is 6.7% too low or just right? That depends upon the project.
Good ROCE, like beauty, is in the eye of the beholder and should be directly related to sector risk. As you review the ROCE for each of your sectors, you should ask yourself, “Are there investment opportunities with equal or less risk that would provide greater return?” So, for instance, if our example project with a 6.7% ROCE was a cardlock operation with risk of bad debts, or a store with risk of vandalism, theft, or employee harm, this ROCE should look too low for that risk.
What is an acceptable ROCE in our industry? A good benchmark to use is 15%. A very stable wholesale operation might border on 12%, and a start up convenience store closer to 18%, but it will be hard to go wrong if you use 15% as your benchmark.
Perform an ROCE calculation for each of your business sectors, then organize those sectors in a hierarchy from highest ROCE to lowest. You will likely find at least one sector that is falling short of 15%, and possibly more. When this happens, you should immediately do additional analysis on any sector below 15%.
Could this part of your business be brought up to 15% with some changes? Within that sector, are there specific under performing assets that could be sold to raise the overall ROCE of the sector? If not, should you be getting out of that sector? If you get out, will that negatively impact other higher ROCE sectors?
Regular ROCE analysis helps you keep your company financially healthy, making sure your all your investments, even the ones from years ago, remain economically viable.
Meridian Associates has been partnering with family-owned businesses for over 30 years to remove barriers, accelerate business growth, build their legacy, and reduce stress levels. With three, high-impact business events each year, The CEO Exchange, Women in Family Business, and The Family Business Intensive, we continually provide best practices & proven strategies that keep multigenerational businesses thriving. Discover how Meridian can help your business thrive through our combination of high impact business coaching, advisory, M&A, and precision company valuations by visiting www.askmeridian.com or calling us at 817-594-0546.
