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Understanding your return on assets
Take a look at the balance sheet of your business. Look at the assets section and perform this exercise. Total the cash on hand, money in checking accounts, inventory, and the current value of all the other assets. With this dollar amount in mind, take a visit through your community to visit as many banks as possible. Sharing the total of the assets from your business, ask the banker what is the rate of return you could get from the bank if you were to deposit that amount in the bank.
Most likely you are going to hear a number that is fairly low. It is a number that has a one to the left of the decimal point. If the banker tells you the interest rate of return is 1.2% you are not going to be surprised.
The second part of this exercise is to take that same total of your assets and ask yourself what is the rate of return you are receiving from your business. Most business owners cannot determine what that rate of return is. It is interesting that if we were to take money to a bank we would want to know what that number is, but we do not know the rate of return for our own business. Worse yet, most do not know how the rate is calculated or what they can do to increase the rate of return.
Today, we will show you how to perform the math behind the return on your assets and most importantly help you to see where you can improve the rate.
While logic would imply that you would simply compare the total of your assets to the net profit of the business, there is a bit more to it than that.
With the assets, your profit and loss statement likely has them divided into two groups. One is referred to as ‘current’ and the other is ‘long term’ or fixed. While the two are considered as one, it is important for determining your correct return on investment that you are using all of the assets for the calculation.
The first step is that we need the number that appears in the line titled, ‘total assets’. We need to make one change in this number as the inventory represents the total of your inventory at year end. Instead we need to know the average amount of inventory in your business. We determine that number by taking the inventory amount from the previous twelve monthly balance sheets, adding them together and dividing by twelve. The result is your average inventory. This number should be used instead of the inventory from the year end balance sheet.
We also need the total of your sales for a year. The total sales should include all types of sales, cash, credit and charge, and should be net of all returns and refunds.
The last information we need for making this calculation is the total of the operating expenses for the year. Now we are ready to see how well your assets are performing for you as we use some sample numbers.
A business has $500,000 in annual sales; the cost of goods sold is $300,000 resulting in a gross profit of $200,000 or 40%. From the 40%, the business has operating expenses totaling $150,000, which are 30% of sales. This leaves a net profit of $50,000 or 10%. From the number of financial statements this writer has reviewed for garden centers, the 10% is commendable.
There are two items that can change the opinion of commendable. One is the category of wages and how much the owner is paying themselves. The second is that of the rent or mortgage payment. When the owner of the business owns the property they occupy, the amount of rent paid is also a factor to be considered.
If the total of the assets is $300,000, our business has an asset turnover of 166%. This number is determined by dividing your gross sales by the total of the assets. The final step is dividing your net profit, stated as a percentage, by the asset turnover percentage. The result is 6%. Compare this number to what we were expecting the bank to offer (1.2%), and our business owner is likely to be pleased, again depending on the wage for the owner and the rent/mortgage.
Perhaps more important that being pleased with the number is having the understanding how you can affect the number to either maintain it or improve it.
The first place you would look is the inventory. When you can produce the same or more sales on less inventory, you are going to increase the turn. Unfortunately, too many small businesses think what they read and hear in the media about big business applies to them. The strategy of holding onto as much cash as possible is the wrong way to make money. Cash sitting in a checking account cannot improve the return on assets. Cash that is spent to purchase inventory that turns can increase the return on investment.
Instead of letting money sit in a checking or savings account, our owner needs to look at the current customer and consider what other items not currently stocked, could be sold to that customer. Investing money in these additional categories of merchandise would allow the money to have even more opportunities to provide a return on that asset (cash).
Other assets should be examined as well. Anything owned by the business that is not being used to make the staff more efficient, increase sales, or decrease sales, are candidates to be sold. Moving that nonproductive money into something that addresses these issues, or into inventory, has the potential of increasing the return on the assets of the business.
In the case of situations where the business is located on property that is owned by the business, there should be an examination of the relationship between the two. As an example, a business could be located on a property that is of a higher value than necessary.
The necessary return on investment for the down payment and outstanding balance of a mortgage may be much higher than the building can produce. Speaking in generalities, when the total occupancy cost for the business is getting into the double digits as a percentage of sales, it becomes more difficult for the business to be profitable.
The person as the owner of the property and the business should look at the two as being separate entities. The property must have an occupant that can afford to pay a rent that will cover the investment in the property. The business can only pay a rent that is a reasonable percentage of the gross income.
This exercise should be a regular part of the work of the owner of the business. If the owner plans to retire, they calculate how much money they have and what the rate of return will be for the assets they invest. As the business is often the biggest asset the owner has, shouldn’t the owner know how that asset is performing?
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|This article is copyrighted by Tom Shay and Profits Plus Solutions, who can be reached at: PO Box 1577, St. Petersburg, Fl. 33731. Phone 727-464-2182. It may be printed for an individual to read, but not duplicated or distributed without expressed written consent of the copyright owner.|
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