Articles

Profitability Matters

I’m not going to discuss about the definition of profitability and other ratios here.

We all know ‘Profitability’ is the ability of generating profit. In simple words, managing profitability has to do with managing two aspects of a business:- How much can we make from what we have?

How fast can we do that?

Finally, it all rolls up to an organization’s efficiency & effectiveness with respect to its core & enabling processes.

There’s nothing ground breaking about these facts.

What differentiates the best from the rest is in using measures of profitability to decide on which projects to focus.

Even then, it’s not mistake-proof. Have you come across the following situations

• Projects improved efficiency of a unit/product, but overall profitability didn’t improve
• Projects improved efficiency of a process with high defect rate. So essentially, the process has started producing defects faster
• These situations portray poor decisioning on project selection.

Have you seen projects aimed at improving following ratios

• Return on Assets
• Profit Margin
• Asset Velocity

I haven’t seen many doing projects to improve them.

Lets understand these ratio better.

RoA is a very common measure and doesn’t need explanation. It is the percentage of the after-tax income as compared to the total assets of the company.

Calculation: Return on Assets = Margin x Asset Velocity

Here’s what you can try

Based on industry benchmark, you can figure out if your organization needs improvement on ROA. Even if ROA is at par with peer group, consider benchmarking Asset Velocity & Margin.

Asset Velocity is a measure of how fast your assets make you money, and it is among the most powerful concepts in creating long-term wealth and cash flow.

It is commonly called as Asset Turnover Ratio.

Companies with low profit margins tend to have high asset velocity, those with high profit margins have low asset velocity. For example, Banks have low asset velocity and high margin while Retail Companies have high asset velocity and low margin.

Calculation : Asset Velocity = Revenue / Total Assets

Asset Velocity is an operational metric and so you can look for ways to improve it.

For example, a company with $370 Mn profit, 22% margin & 0.09 Asset Velocity will have a ROA of 1.97%. If the Asset Velocity increases by 0.01, that translates into an additional profit of $70Mn and a ROA of 2.4%. Isn’t that a huge lift!

Improving Asset Velocity in turn, would mean reducing inventory, increasing efficiency or utilization, outsourcing, shorter recovery cycles for receivables, reduce defects, reduce process variation, etc.,

It makes lot more business sense to work on projects that will directly impact profitability!