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It is vital for a Company to have a robust reporting framework that is designed to measure and track financial and operating metrics that are critical to health and growth of the Company. As reporting frame-works go, it is not a one-size fits all. Different companies, based on the industry they operate in or the stage of growth they are in or their funding status, may need to track and optimize different variables. For instance, you will find VC-funded startups prioritising growth metrics (growth in users, growth in revenue), sometimes even at the cost of profitability.
However, for any company not falling in the VC-funded startup bracket, that wants to achieve sustainable growth, the target metric to move would be Return on Investment (ROI). ROI is calculated as the operating profits available to the Capital Providers i.e EBITDA over Average Capital Employed i.e. how much return does the business provide on the capital invested. This is the marker for whether you should continue running the business at all. If this metric is not likely to be significantly better than the risk free rate available in the market (such as interest on say FD’s or Govt Bonds), you are better off investing your money in those risk free instruments than in the business. The practical way to improve this ratio is to to measure, track and relentlessly try and improve the ratios that contribute to ROI.
This approach was first developed by the American Chemical Company Dupont to analyze its financial performance, eponymously known as the Dupont Analysis. In this blogpost, we explain this very popular framework for performance analysis and why it remains the best framework for not only analysing performance but also as a basis for sound Management decision making.
ROI is a simple combination of profitability and capital efficiency – Profitability metrics like Gross Margins, EBITDA Margins etc and Capital Efficiency metrics such as Turnover Ratios and Cash Cycle determine the ROI of a Company. Based on the industry in which a Company operates, certain ratios are market determined and there is little that a Company can do to improve over market determined values. For ex, in the commodities space like cement or steel industries, gross margins are dictated by market and there is little that a Company can do to improve the gross margin over market values. Hence it become important to define, measure and track the other variables that contribute to ROI. Consequentially, it is important to break ROI down to its component parts.
ROI is expressed mathematically as EBITDA over Average Capital Employed. This can further be broken down as EBITDA over Revenues (Profitability) and Revenues over Average Capital Employed (commonly known as Turnover Ratios).
The Chart above is an example of a Reporting Framework that we built for one of our clients in the consumer e-commerce space. The profitability metric of EBITDA margin can further be broken down into Gross Margin over Revenues Minus Overheads over Revenues. Gross Margins are further broken down into gross margins of each product category (to arrive at optimal product sales mix), gross margins of each sales channel (to optimize channel sales mix) and so on. Overheads are driven by a different set of drivers. Each aspect of Overhead spending is analyzed and drivers determined. The most important of the metrics i.e. the ones that have a far greater impact on overall profitability are used to compile the dashboard of contributing metrics to profitability.
Capital efficiency can be broken down into the inverse of sum of turnover ratios – Fixed Asset Turnover Ratio and Working Capital Turnover or Cash Cycle (the sum of inventory days and average collection period less average payment period) – how efficiently are you utilising your fixed and working capital. Again, the drivers are analyzed and the metrics with the greatest impact on capital efficiency is used to compile the dashboard of contributing metrics to Capital Efficiency.
To understand profitability, one has to break down and understand the components of profitability. This exercise in itself will lead to better decisions on critical areas such as pricing, product mix, distribution strategy etc, which I shall try and explain in the following paragraphs.
Profitability i.e. EBITDA over Revenues (EBITDA Margin) can further be broken into Gross Margins (Direct Revenues minus Direct Expenses) Minus Overheads (Indirect Expenses) over RevenueGross Margin is a vital variable – it measures the fundamental profitability of the business). It is defined as the sales price of a product or service less the direct costs required to manufacture the product or deliver the service. It can be broken down further into
As explained above, measuring Gross Margin will give the Management a basis for taking decisions on pricing, product mix, channel strategy etc. Unfortunately, in the majority of SME’s this is a poorly defined and rarely tracked variable. At Unmaze, we believe, the Gross Margin must be defined well and we use a system of Tags and Indexes to ensure that Gross Margin is tracked at the Company level (and in many cases, even at an engagement level or transaction level) – so the Management can make informed decisions to improve this variable.
Overheads – Direct expenses that go into manufacturing a product or delivering a service make up the expenses used to calculate Gross Margins. All other expenses are classified as Indirect Expenses or Overheads i.e. expenses that are necessary but not directly related to the manufacture of the product or delivery of a service. A crucial differentiating factor of Overheads is that they are largely fixed in nature. While direct expenses vary directly in proportion to Revenue, Overheads will be more fixed in nature (will also grow with revenues but not quite at the same rate). This is what is called Operating Leverage in financial terms. Keeping Overheads low is great because in a fundamentally good company, when the company grows with healthy gross margins, the absolute gross profit increases and has fewer Overheads to recover.
To summarize, on the profitability side of ROI, we try and understand the business of the Company to break down profitability margins to its drivers (which will include common accounting ratios as well as company-specific variables defined for the specific needs of each company) and and measure and report on these metrics to constantly push the management to improve on these values.
Capital Efficiency is perhaps the least understood of the factors contributing to ROI and probably the metric where most Corporates record sub-optimal values.
What is Capital Efficiency? Mathematically, it is expressed as Revenue over Capital Employed i.e. how much revenue one is able to generate with a given Capital Amount. The higher this value, the better is the capital efficiency. Colloquially speaking – are you generating “more bang for the buck”.
Capital Employed can further be broken down into Fixed Assets and Working Capital. So more revenues generated per unit of Fixed Assets (FA Turnover Ratio) and more revenues per unit of working capital will improve overall Capital Efficiency.
Fixed Asset Turnover or the Revenues per unit of FA is easy to understand. All other things being equal, if one Company with a given amount of Fixed Assets runs 3 shifts, it will generate more revenue than a Company running 2 shifts with the same set of Assets. So how much productivity you can squeeze out of your fixed assets determines your Fixed Assets efficiency which are impacted by no of shifts being run, downtime for repairs and maintenance, productivity of the Fixed Assets etc and when benchmarked against Industry – this variable can help Management understand what improvements could be made (such as purchasing upgraded Machines or creating a maintenance schedule to reduce downtime etc)
Working Capital Turnover or Revenues over Working Capital is perhaps the most critical single variable that impacts SME’s. Mathematically Working Capital Turnover is the inverse of the Cash Cycle.
Working Capital Turnover = Revenue / Working Capital
Working Capital Turnover = 1/ (Working Capital/Revenue)
Working Capital Turnover = 1/ ((Receivable/Revenue)+(Inventory/Revenue)-
Working Capital Turnover = Inverse of ((Avg Collection Period + Avg Inventory Days – Avg
Payment Period)) i.e. Inverse of Cash Cycle
Cash Cycle is the period of time taken to realize cash from a typical sales cycle. To explain in simple terms – Say you place an order for Inventory – It arrives at your facility (when the expense and liability is accounted) on Day 0, from when you have a 2 week credit period i.e. you pay your supplier 15 days from receipt of inventory i.e. on Day 15. It takes 60 days from receipt to process the inventory to become a finished product and it takes a further 15 days to ship to your customer – i.e your customer receives the goods on Day 75. These 75 days are Inventory Days. Your client pays you one month after you ship the goods to him i.e. on Day 105. You overall cash cycle is 90 days after reducing your credit period of 15 days – (75 days of inventory, 30 days collection period less 15 days payment period) i.e. it take you a total of 90 days to realize cash from a batch of sales or in other other words, your working capital turnover is 4 times (360 days / 90 days). If you extend the same calculation to all your sales (by calculating these metics based on average values) – then you have the average cash cycle of the Company.
By optimizing each variable in the cash cycle, the Management can improve the capital efficiency. For ex-
Inventory – By implementing Just in Time inventory practices, management can reduce time of inventory holding, thereby speeding up the cash cycle.
Receivables – Management can use cost of working capital Loans as a benchmark to offer early payment discounts to customers to bring down average collection period.
Payables – Management can negotiate better credit terms with suppliers with larger sized orders etc to increase the average payment period
Cash cycle is also borne out by the most important Accounting Report of all – the Cash Flow statement which will show the impact of the cash cycle. A company with a long cash cycle will have poorer Cash Flow from Operations than a Company with a shorter cycle. More on this in our upcoming blogpost on why we think the Cashflow statement is the most important Accounting Report for any Company at any stage in its lifecycle and how to read it.
To summarize – ROI can be broken down as a combination of Profitability and Capital Efficiency. Understanding the contributing metrics for these 2 variables and the drivers for each of those metrics is critical for the Management to make good decisions to move the needle on ROI.