Strategic drivers of ROI
This ratio hierarchy explains what most entrepreneurs and business people intuitively understand. A good return (ROI) is driven by:
A high profits (driven by good margins and low costs);
B high sales (value and volumes);
C adequate or low capital employed (no idle assets).
We can relate these drivers to financial statements and models that will assist us in delivering strategic success.
1. A higher margin (selling price)/lower operating cost strategy
This strategy delivers better margins and thus a higher return (see Table 2.4).
TABLE 2.4 ROI effect of higher margins
2. Higher sales/volume strategy
This strategy, with margin reduced to 10 per cent (Table 2.5), is a classic mistake made by sales people who go for sales volume at the expense of lower margins.
TABLE 2.5 ROI effect of higher sales
The return is maintained by better utilization of the capital employed - the low-cost airlines are premised on this strategy.
3. Lower margin/higher sales volume strategy
The return can be the same as in the base model (Table 2.6).
TABLE 2.6 ROI effect of lower margins but higher sales
You can lose or give up margin as long as volume follows. Compare a low-cost supermarket with the traditional UK supermarkets: they live with lower margins and also benefit from the low-cost outlets having much more efficient (lower) capital employed, that is, simpler but yet effective stores.
4. Lower capital employed strategy - 'cheap is good!'
Properly managed, with aligned physical strategies you can end up with higher returns than the base model (Table 2.7).
TABLE 2.7 ROI effect of lower capital employed and invested
5. Life-cycle costing/whole-life costing strategy
It may sometimes be sensible to spend more on capital employed - eg low-maintenance/low-energy-consumption equipment if the cost reductions and thus higher margins over the years outweigh the higher capital employed (Table 2.8). A constraint here is finding the initial cash!
TABLE 2.8 ROI effect of higher capital employed but with lower operating costs
If not already evident, this example illustrates the point that the two sub-ratios cross-multiply to give ROI. Thus strategy drivers are also interlinked and may be contradictory in practice.
6. High gearing strategy
A funding strategy or purely financial strategy - the private equity magic!
Here the focus is not on the return the physical capital employed makes - the higher the better - but rather it is the ability to borrow that 'gears up' the return to the shareholders. As long as you can borrow (you need to have friends as the private equity folk seem to have) at a rate lower than that which the capital employed in the business delivers, you are on to a winner.
The example in Table 2.9 has 50 of capital employed, 10 of operating profit and sales of 100. Assume 40 of the 50 capital invested is funded at 8 per cent: interest on this must be paid, so net profit is down to 6.8 per cent and return to 14 per cent. However, shareholders have only to put in 10 - so their return is 68 per cent.
TABLE 2.9 Effect on shareholders return by gearing
The 6.8 per cent profit is that available to shareholders after interest has been paid.
To see just how magical gearing can be, Table 2.10 shows the above example reworked with only 1 out of 50 being equity - great if you have friends that will lend to you!
TABLE 2.10 Effect on shareholders' return of exceedingly high gearing
Capital structures and pure financial strategies are considered further in Chapter 12.
It is hoped that these simple examples are just that - the messages are clear. It would seem that many managers, and CEOs for that matter, forget or maybe do not know the results of the indisputable arithmetic of these simple models.
We cannot finish the book here - the question 'Why be in business?' has been answered but the detail and complexity (real and imagined) of the balance sheet and P&L numbers have to be understood, as do budgeting and flow forecasting to aid sensible operation and investment.
Understanding finance and the interrelationship of financial statements is essential when identifying strategies and managing delivery of strategy. The drivers for a successful strategy are to be found in the financial drivers:
- high margins;
- low costs of operation;
- high sales volume and prices;
- efficient use of assets.
- minimum necessary investment.
- efficient funding structure.
These financial drivers lead to making the most advantageous and sustainable return on investment.
Strategy in general terms and specifically in financial terms is tempered by political and other constraints - these constraints must be understood and accommodated.
In the chapters that follow, many of the financial statements and practices are relevant to more than one strand of strategy and will sometimes give rise to conflicts - such conflicts must be understood.
Revision and learning pointers
This chapter does not have any specific interpretation or calculation exercises; however, you may like to replicate the spread sheets shown in the tables above - spread sheets are great instructors.
Have a look at the accounts of your own company, competitors or any company that attracts your interest and see what they say about strategy.
Have a look at a target company's last five or more years' accounts and consider whether the strategies identified in the past have come to fruition, and if not, why not.
Thinking about and discussing the questions below may be an essential early stage when identifying what your company's or organization's strategy is to be, and understanding the constraints of your chosen strategic path.