Genesis Management Services Pty Ltd gmservices.com.au
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SERVICES
EXPERIENCE
UNIT 5. MANAGING PROFITABILITY
We have said before that the three key dimensions of financial management are profitability, liquidity and security. Our profitability measures the effectiveness of our operational management activities and is important for providing a flow of funds for benefit of the owners and for business expansion.
At this stage have a look at Schedules 1-9 of the case study Travel 'n' Tour.
Schedules 1, 4 & 6 provide a ten year history of sales volume, commission income, expenses and profitability. Notice the similarity with "Jones Travel". The expenses are not as detailed since we are using functional headings to simplify the analysis. Have a look at these figures and start to get a feel for the business. Picture it in your mind as you scan the various income and cost areas. Its always helpful to start with the bottom line Net Profit figure. Do you think that the Net Profit before Tax for 1990 is good or bad? How could you tell?
Schedule 8 sets out figures for assets and liabilities. Included also on the bottom one-third of the page is a set of figures under the heading "Balance Sheet Analysis". Have a look at these figures and see if you can work out the significance of the figures for "Return on Investment" (ROI).
Return on Investment
There are two measures most often used. The first is ROI on assets managed. This compares Net Profit before Tax with Total Assets and is a popular internal test of managerial efficiency. The second is ROI on capital. This compares Net Profit after Tax with owners/shareholders' funds and is a test most often used by outsiders, eg. lenders, prospective shareholders.
Balancing Risk & Return
Generally speaking the higher the risk the higher the return. If we can earn 10% safely with a bank we might expect at least 20% in a travel agency having in mind the risk, uncertainty and variability of the travel industry. What's the good of earning an ROI of say 30% in one year and losing all your capital in the next?
Sales Analysis
Schedules 1 & 2 are worth examining to look at figures in absolute and relative terms. Also we would like to compare these results with our budgets not only in absolute terms but in terms of mix. This analysis will prompt a series of corrective actions to deal with emerging problems and opportunities and even with a poor budgeting process.
Commission Analysis
Likewise schedules 3, 4 & 5 provide valuable insights into the importance of each segment as a commission earner and also for the respective yields. Jones Travel had no information as to the total volume of business being written and therefore it was not possible to calculate commission yields.
Expense Analysis
Notice how we can relate these functional groups to the income being generated from these expenses as resources. We could also prepare graphs to relate expenses to sales/commission levels.
Marketing Plans
Is our marketing plan working?
Does it need to be modified having in mind the information contained in our profit analysis or with other market based information?
Remember that each marketing operation, as a component of the whole marketing plan, can be separately evaluated in terms of its own unique pattern of income and costs. Sometimes we refer to doing a cost/benefit analysis for specific decision areas or profit centres.
It is important to evaluate the separate parts of a business in financial terms since each part is expected to pull its weight to generate an acceptable ROI for the total business.
Budgets
You should be able to see now the value of budgets for comparing with actuals so that variances can be analysed as we saw with Jones Travel. We can introduce not only the concept of management by exception but also "responsibility accounting". It must be somebody's responsibility to deal with the variance.
Someone should have the responsibility for explaining the variance in logical terms and for making recommendations for corrective action. This is usually done in the form of management reports. These need not be lengthy but should summarise the key issues and actions involved to improve performance.
Case Study
To help you get a better appreciation of managing profitability we would like to introduce a new case study called "Austral Travel Agency". The financial statements for this agency are set out below.
Austral Travel Agency
Profit & Loss Statement for Year Ending 30.6.90
Commission Income (5% on $2,480,000) $ 124,000
Less Expenses
Personnel 40,000
Selling 10,000
Administration (inc.leasing $5000) 30,000
Occupancy (inc.leasing $4000) 11,700
Depreciation 8,000
Interest 4,500 104,200
Net Profit before Tax 19,800
Less Provision for Tax 7,800
Net Profit after Tax 12,000
Less Provision for Dividend 5,000
Retained Earnings for Year $ 7,000
Balance Sheet as at 30.6.90
Current Assets Current Liabilities
Debtors 39,400 Bank Overdraft 1,200
Creditors 10,300
Intangible Assets Prov.for Tax 7,800
Goodwill 8,000 Prov for Dividend 5,000 24,300
Fixed Assets Long Term Liabilities
Land & Bldgs 50,600 Mortgage 27,700
Motor Vehicles 80,000
Dep. on M/V (70,000) Capital
Office Equipment 20,000 Paid up (50,000 shares
Dep. on O.E. ( 8,000) 72,600 @ $1 each) 50,000
Retained Earnings 18,000 68,000
120,000 120,000
Retained Earnings Account
Credit balance as at 30.6.89 $11,000 plus Net Profit for Year $19,800 less Provision for Tax $7,800 and Dividend $5,000 equals final balance as at 30.6.90 $18,000.
Note: The purpose of the Retained Earnings Account is to show how the profit before tax of $19,800 for the year was distributed three ways:
1 Taxation $ 7,800
2 Dividends to shareholders 5,000
3 Amount to be retained in the business 7,000
$ 19,800
The amount to be retained is added to the balance of retained earnings from the previous period. This represents the funds that have been retained since commencement of the business (ie. progressive balance of profits retained) to help the business develop financial strength.
Retained profit then is a source of funds for the business and is available for investing in a variety of ways, eg. increasing assets or reducing other liabilities. If someone ever asks you what happened to the $19,800 profit the answer is that the amount left over after taxation and dividends has been invested across the business in accordance with the formula A (Assets) = L (Liabilities).
Case Study Illustrative Analysis
We will now proceed to calculate some profitability ratios for the Austral Travel Agency.
Commission Yield
124,000 x 100 = 5%
2,480,000 1
In other types of businesses we would compare Gross Profit with Sales Turnover to determine Gross Profit margin.
Net Profit Margin
net profit before tax x 100 = 19,800 = 16%
commission income 1 124,000
This calculation is very useful for budgeting and indicates the efficiency with which operating costs are controlled when compared with commission yield.
Return on Total Assets
This is an ROI measure on assets managed (assets employed) which is very useful for measuring management efficiency. Assets provide a resource base (together with human resources) for generating business activity and profit. Since management is responsible for effective use of resources it follows that we should compare profits with resources.
net profit before tax x 100 = 19,800 = 16.5%
total assets 1 120,000
We don't usually assess middle management performance on capital employed since these managers are not normally involved in how the business is funded. Top management and the Board of Directors may look at Net Profit before Tax compared with Capital since this will also include an assessment of the efficiency with which funds are managed, eg. how well the funding requirements of the business are balanced between internal funds (Capital) and external funds (Current & Long Term Liabilities). Top management may well be expected to try to use other people's money as much as possible in order to maximise ROI on Capital.
Return on Net Worth
This is an ROI measure as well and represents the return on capital or net worth (Assets less Liabilities). For a company capital is referred to as shareholders' funds in the Balance Sheet. For a sole trader it is referred to as "proprietorship". Some people also refer to it as "equity".
Net Profit after Tax x 100 = 12,000 = 17.6%
Shareholders' Funds 1 68,000
Shareholders' Funds represent the net investment in the company by equity holders. In our example we have 50,000 shares with a paid up value of $1 each representing $50,000. The retained earnings of $18,000 represents profits re-invested rather than distributed as dividends or paid out as income tax. The retained earnings belong to the shareholders and they often measure profit compared with their total current stake in the business (original capital plus retained earnings).
Profit per Employee
Some firms like to measure profit efficiency by comparing profit with the number of employees. In this case we will compare Net Profit after Tax for two employees.
12,000 12,000 = $6,000 per employee.
2
EBIT
This expression refers to earnings before interest and tax. In our example it would be $24,300 calculated as follows:
net profit before tax $19,800
add back interest 4,500
EBIT $24,300
This EBIT figure is sometimes used for ROI calculation purposes. It is useful when comparing the performance of one firm with one borrowing structure with another with a different level of borrowing’s. By excluding interest we can look at the underlying management performance. Excluding interest acknowledges that our interest costs will vary in accordance with our financing decisions for raising funds, whether by issuing shares, or borrowing on debentures, notes or mortgages. We will talk about EBIT later on.
Fixed asset turnover
This ratio looks at the efficiency with which fixed assets (long term assets) are used to generate sales and/or commissions and therefore profitability.
2,480,000 = 34 times (compared with sales)
72,600
124,000 124,000 = 1.71 times (compared with commission)
72,600
For every $1 of fixed assets we can generate $34 sales and $1.71 of commission.
Total Asset Turnover
Likewise we can look at the efficiency with which total assets are used to generate business activity.
2,480,000 = 20.6 times (compared with sales)
120,000
124,000 124,000 = 1.03 times (compared with commission)
120,000
For every $1 of total assets we can generate $20.60 of sales and $1.03 of commission. Like the fixed asset turnover ratio this ratio is vvery useful when graphed to give a trend or compared with an industry average.
The Du Pont Chemical Company was the first to highlight asset turnover as a critical factor for determining ROI. This particular ,method of analysis highlights the interdependence of "asset turnover" and "earning power". Both turnover and earning power when multiplied together gives the ROI, eg. total asset turnover (1.03 times) multiplied by net profit margin (16%) equals 16.48% which corresponds with the 16.5% calculated previously for Net Profit before Tax compared with Total Assets.
The idea here is that our asset base provides resources for generating business activity. The higher management's productivity for generating business volume, the higher the net profit will be. The other factor of course in the equation is management's efficiency to convert this business volume into profit through expense management (which includes human resources).
Earnings per Share (EPS)
net profit after tax = 1,200,000 cents = 24 cents per share
no. of shares 50,000
Dividend per Share (DPS)
dividends = 500,000 cents = 10 cents per share
no. of shares 50,000
Earnings Yield
If we know what the estimated value or market price of each share is we can calculate earnings yield which is very important for an existing or prospective shareholder because it represents a true ROI from their perspective. For the purpose of this calculation let us assume the estimated market price is $0.85 per share.
earnings per share = 24 = 28%
estimated market price per share 85
Dividend Yield
Dividend per share = 10 = 11.7%
estimated Market Price per Share 85
When shareholders are looking to invest money in a company they like to have a reliable assessment of future cash flows for earnings and dividends. For a public company this will greatly influence the quoted market price per share.
Price/earnings ratio (P/E Ratio)
estimated market price per share = 85 = 3.54
earnings per share 24
Notice that this is just the reverse of our earnings yield but is very important when prospective shareholders are trying to work out the value of a share when they know what the earnings per share forecast is. By using a pre-determined P/E multiple (in this case 3.54) they can work out that $0.85 is a fair price. If the going P/E ratio were 5 then the market price would be estimated at $1.20. The same approach is used by commercial investors in property. By looking at the expected net rentals and using a pre-determined multiple an offer price or valuation can be determined.
Copyright © Bill Wright 1994