Now your business is successful, where is your happiness? You have worked so hard to…
Two Success Strategies; Happiness and Return on Equity
Your two success strategies, happiness and return on equity (ROE), in this particular order, will always provide you with long-term success.
It is important you are happy to learn and create every day. Yes, I do mean with a smile on your face. Only you know how you feel about how and what you think and what you do. Go to ‘fun’, don’t go to ‘work’. Assuming you passed this happiness test, read on.
2. Return on equity (ROE).
A term used for how to objectively measure the financial success of your learning, creativity, choices and ‘hard fun’, i.e. work.
For example, I was engaged by the board to complete a financial trend analysis of a $20 million sales organisation with 50 plus people. The 4-year average ROE to June 2012 was -1.9%. By comparison, a better return is achieved in 4% risk-free term deposits. No complexity at all and a full 4 years to be more productive and creative sitting under a tree and thinking about the future, not trying to do the future. Incidentally, I also provided easy strategies to immediately achieve 5% ROE and some slightly significant strategic alignment decisions to achieve 12% ROE.
At this point, I don’t blame you for thinking, “I am not going to enjoy this part” but hang in there as I think ROE is the world’s most important financial measure; from my experience and formal qualifications.
Measuring and calculating ROE.
The ROE formula is:
ROE is 25% and each $1 of equity (cash, not debt) invested is achieving a $0.25 return (after tax) which is greater than $0.03 (3%) invested in risk-free term deposits.
You should know what your ROE is and focus on increasing ROE by:
- Increasing sales, gross profit margins, net profit margins and decrease expenses.
- Decrease current assets by increasing the velocity of turning sales into cash.
- Increase asset turnover by decreasing capital intensity in fixed assets.
- Increase leverage (creditor resources) only up to easily serviceable levels.
- Maximise free cash flow available for shareholders for reinvestment into productive assets, other businesses, dividends and buybacks for shareholders and not negatively impact any of the above strategies.
Sustainable ROE and sustainable sales growth rates.
We have calculated ROE (25%) and now we are planning to our sustainable sales growth.
In the example, we are paying a $50,000 dividend from profits ($50,000 / $100,000 = 50% dividend payout ratio).
The remaining $50,000 is retained profits in the business.
Therefore, the business’s sustainable sales growth rate is 12.5%, as calculated below:
By paying dividends to yourself it reduces cash in, and the sustainable sales growth of your business.
You have heard the phrase, “They are victims of their own success.” It describes rampant sales growth rates, unsustainably funded. The only way to solve it is to slow sales growth and radically focus on your business’s cash flow to increase ROE.
Forecasting next year’s sustainable sales growth rate.
Continuing with the same example:
We calculated ROE (25%) and sustainable sales growth rate (12.5%).
Therefore, next year’s forecast sales are limited to $1,125,000 ($1,000,000 X 12.5%).
However, you decided to forecast $1,200,000 in sales or 20% sales growth ($1,000,000 X 20%).
You must fund $75,000 additional sales ($1,200,000 forecastless $1,125,000 sustainable = $75,000).
You can achieve a sustainable sales growth rate of 20% and fund $75,000 of additional sales by decreasing your dividend from $50,000 to $20,000. This will retain $80,000 in profit for next year’s sales growth, as illustrated below:
What is your business’s ROE and sustainable sales growth rate?
In a Small Business if you are not achieving significantly high ROEs then ask some serious questions. I discussed some of these questions and answers in my previous articles, Step outside your business to see the bigger picture and Want to grow your business with confidence?
Improving ROE should always be your first choice to achieve future sustainable sales growth.
Congratulations, if you have read this far, you just ‘passed’ a Master in Finance unit hack; if you calculated your own businesses ROE and sustainable sales growth rate, then you just got a ‘distinction’.
If you have any question’s feel free to leave a comment and I’ll do my best to answer them for you.
“The opinions expressed by Smallville Contributors are their own, not those of www.smallville.com.au"
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