6

Performance drivers

The chapter reviews the drivers of:

• Return on investment
• Profit margin
• Asset turnover

The key drivers of ROTA

ROTA is a key tool in directing management’s day-to-day activities. It provides a benchmark against which all operations can be measured. However, as a single figure it simply provides a target. To be useful in decision-making it must first be broken down into its component parts.

We will do this in two stages.

• First, we will divide the main ROTA ratio into two subsidiary ratios.
• Then we will divide the subsidiary ratios into further detailed constituents.

ROTA is calculated as:

We can relate ‘sales’ to both EBIT and TA to produce two subsidiary ratios:

1. Profit margin (or margin on sales)

Profit margin identifies profit as a percentage of sales and is often described as the net profit margin. It is a well-known measure and almost universally used in the monitoring of a company’s profitability.

2. Asset turnover

Asset turnover looks at the total sales achieved by the company in relation to its total assets. This measure is often less emphasised in the assessment of company performance. However its contribution to ROTA is just as powerful and important as the profit margin.

It is simple mathematics to show that the product of these will always combine to the value of ROTA.

This first split is so important that we will take the risk of over-emphasising it here. The formula is:

This uses numbers from Example Co. plc.

The importance of this interrelationship of ratios is difficult to exaggerate. To repeat our logic so far:

• ROE is the most important driver of company value
• ROTA is the most important driver of ROE.

Therefore, the ratios that drive ROTA are:

• Profit margin (margin on sales percentage)
• Asset turnover (sales to total assets ratio).

Illustration of the interrelationship between profit margin and asset turnover

Figure 6.2 shows some typical values for companies with vastly different profiles (using illustrative numbers).

Example A

Example A shows typical figures for a distribution-type company, where low margins, e.g. 5 to 7%, combine with a high asset turnover, e.g. 2 times.

Example B

In Example B the opposite applies. Very high margins and low asset turnover are typical of companies that require large quantities of fixed assets. The telecommunications sector typically generates sales margins in the region of 25%. However, their enormous investment in fixed assets with correspondingly low asset turnover means that this margin is only just adequate to make a reasonable return on total assets.

Example C

Example C demonstrates fairly average figures, with margins at 10% or more, and asset turnover values somewhat greater than 1. Quite a number of medium-sized manufacturing companies have this kind of pattern. The difference between success and mediocrity in this type of business is often less than 2% on margin and a small improvement in asset turnover.

It rests with the skill of each management team to discover for itself the unique combination of margin and asset turnover that will give their company its own particular, and successful, market niche.

Drivers of operating performance

ROTA typically averages around 12.5% (plus or minus 5%) across industries. Please recognise that this is an average and there will be a wide spread of results within every industry. Whereas it is possible to see an average across industries, the subsidiary ratios of profit margin and asset turnover vary widely across different sectors.

A rule of thumb would be that a profit margin of approximately 10-%, combined with an asset turnover of between 1.3 and 1.5, would be where many Western companies would find a comfortable and profitable position.

The key drivers of profit margin and asset turnover

We have now derived two most important ratios that drive return on total assets, ‘profit margin’ and ‘asset turnover’.

It is on these two drivers that managers must concentrate in order to improve performance. However, these ratios cannot be operated on directly. Each is dependent on a whole series of detailed results from widely separated parts of the operation. These in turn can be expressed in ratio form and all that managers need is a system that will enable them to identify and quantify these subsidiary values so that they can:

• set the target value for each ratio that, if achieved, will deliver the required overall performance level
• delegate the achievement of these targets to specific individuals.

The system outlined in the following pages achieves this end. It will be seen that it incorporates all the main elements in both the profit and loss account and balance sheet. Each of the elements is a performance driver and must be managed accordingly.

Drivers of profit margin

The drivers of profit margin (or margin on sales) are the cost items in the profit and loss account.

At its simplest, we can say that the margin is what is left when the total operating cost is deducted.

If the margin were 10%, the total cost would be 90%. The margin can be improved only if this 90% can be reduced. To reduce the figure, we must know its component parts. So, the next stage is to identify the separate cost elements and see what percentage each of the main cost elements bears to sales (see Figure 6.3).

Figure 6.3 shows the development of the left-hand side of the model, which is concerned with profit and loss values. The four main cost elements that accumulate to total operating costs are identified as materials, labour, factory overheads and admin/selling. These large cost groups are used as an example: in practice they would be broken down into much more detail.

In the bottom half of the diagram, each cost element is shown expressed as a percentage of sales. For instance, the first box shows that materials is 38% (material cost of $426 over sales of $1,120 multiplied by 100). The sum total of all the costs is 90%, giving a margin of 10%.

If management wishes to improve this margin, then one or more of the cost percentages must fall. For instance, if the material cost percentage could be reduced by two points, from 38 to 36%, then, other things being equal, the margin percentage would improve by two points to 12%. This margin of 12% would then combine with the sales to total assets ratio of 1.4 times to give an improved return on total assets of 16.8% (that is, 12% multiplied by 1.4).

These cost ratios allow managers to plan, budget, delegate responsibility and monitor the performance of the various functional areas under their control. They can quantify targets for all areas, and calculate the effect of a variation in any one of the subsidiary ratios on the overall performance.

The results achieved by different managers, products and divisions can also be compared and the experiences of the best passed on to the others to help them improve. We must recognise, however, that there are operating factors that the model does not cope with. The variables of selling price, volume and product mix, which have such a powerful impact on profit, are not easily distinguished from other factors in the model.

Drivers of asset turnover

The drivers of asset turnover (or the sales to total assets ratio) are the separate assets in the balance sheet.

Asset turnover can also be broken down into its component parts. We identify the main groups of assets straight from the balance sheet and we then express the ratio between each group and the sales figure as shown in Figure 6.4.

In Figure 6.4 it will be seen that just as the subsidiary values of the left-hand side were derived from the profit and loss account, so these right-hand elements are taken from the balance sheet. Each of the main asset categories is related to sales.

The three major asset blocks in most enterprises are:

• fixed assets
• inventories (stocks)
• accounts receivable (debtors).

The value of each in relation to sales is shown in the subsidiary boxes. For instance, the ratio for fixed assets is 2.5 times (from sales of $1,120 divided by fixed assets of $440). Note that the sum of these separate values does not agree with the sales to total assets ratio as did the sales margin on the other side with the operating costs. This is because they are expressed differently. If the reciprocals of the values are taken, the link will become clear.

To managers, this display shows the importance of managing the balance sheet as well as the profit and loss account. For instance, if the total assets could be reduced from $800 to $700, through stronger credit control, for example, then the sales to total assets ratio would move up from 1.4 to 1.6 times. The effect on the return on total assets would be to increase it from 14% to 16%. If, in addition, the profit margin was increased by 1% to 11%, then the new return on total assets would be almost 18% (11% × 1.6). The original value of 14% for ROTA is an average value whereas a return on total assets of 18% represents an excellent performance.

In these areas, production managers can work with finance and marketing departments to quantify targets for stock holdings and accounts receivable. The impact of an increase in fixed assets caused by a major capital investment project can also be assessed in profitability terms.

The complete operating profit model

The complete model is shown in Figure 6.5. It gives a very powerful insight into the drivers of good performance. It enables managers and functions to work better together as a team. It helps with the definition of responsibilities, delegation of authority and target setting. It provides a powerful framework for a management information system. However, there are a number of issues the model does not highlight.

First, a business normally deals not just in one product, but in a broad range. Cost percentages are averages of the cost elements of the individual products. For management control, it is not satisfactory to work with averages because favourable movements in one product will mask adverse movements in another.

Second, a cost percentage, such as materials, can vary for two totally different reasons:

• a change in the absolute material cost per unit
• a change in the unit selling price of the product.

The model, however, cannot distinguish between these two causes, despite the fact that one of the most effective ways to reduce the cost percentages is a price increase.

Third, the model does not cope very well with changes in volume, which can be one of the most powerful ways open to a company to improve performance. A volume increase will certainly be picked up by the sales to total assets ratio – a 10% improvement in volume would move this ratio up from 1.4 to 1.54 times. Additionally, due to fixed costs, the volume change is likely to have an effect on the profit margin as well. When volume increases fixed costs are spread over a larger number of sales units, increasing the profit per unit.

Fourth, those who are perceptive will have noted that this ratio is dependent on the valuation of the assets in the balance sheet. Difficulties can arise when we compare different businesses or divisions because of factors such as the age of plant and different depreciation policies.

Model variations

Many business ratios appear under different names, or are calculated differently, and this can cause some confusion. In the set of ratios we are looking at here, there are two that appear under a number of different guises.

Sales to accounts receivable

This ratio is commonly expressed in terms of days’ sales and the method of calculation is shown in Figure 6.6. Instead of the formula we have been using here of sales over accounts receivable, the alternative is to show accounts receivable over sales and multiply the result by 365. The answer represents the average number of days credit customers take before paying off their accounts.

This ratio is often referred to as ‘debtor days’ or the ‘collection period’. The concept of the number of days outstanding is easy to understand. The number is very precise, which means that a slippage of even a few days is instantly identified. Also, figures can be compared with the company’s normal terms of trade and the effectiveness or otherwise of the credit control department can, therefore, be monitored.

This ratio will vary according to local and industry business practice as well as geographical location. Averages in the US and UK are usually around 40 days. Debtor days elsewhere in the EU are typically higher. Japan is known to have low levels of debtor days.

Companies will vary their methods of calculation to reflect their own business circumstances and to provide answers that make sense to them in particular. For instance:

• VAT may be included in the debtors but not the sales figure and this distortion will have to be removed.
• When there is a heavy seasonal variation, the monthly figures calculated in the normal way may not be very helpful and so the company may work, not on an annual sales basis, but on quarterly sales figures that are annualised.

Sales to inventories

This calculation is similar to the one above and is also known as inventory days or stock days. The link of inventories with sales is not so close as that of sales with accounts receivable. It may, therefore, be linked to purchases or material usage, whichever gives the most useful guidance.

This ratio will vary according to the nature of the industry (for example, manufacturers are likely to hold more inventory than a service business), location and proximity to transport networks and relationships with suppliers.