Monitoring the flow of money and measuring the profitability of the business are essential tools to ensure management control. The main responsibilities of a Business Manager are:
A) Create value for the company and its customers.
B) Generate results that are in line with what was agreed by the shareholders.
Proven management protocols help those who want to improve the performance of the company, regardless of its size or turnover.
Organizations have three paths to improve their profitability:
1. Ensure strict control of expenses: it implies taking into account that companies live on what they produce, not on what they save. This alternative allows for optimizing income.
2. Improve margins by-product: it requires sensitivity to constantly measure what is happening in the market. This is the ideal alternative, but it must not be forgotten that the current competitiveness makes the possibility to improve margins less and less.
3. Increase the frequency of sales ( Generation of Money Flow or Increase in Rotation ): it means selling more, at the same time, with the same structure and the same investment. This is the path that organizations take today, which, moreover, pays a lot of attention to the effective control of expenses.
Cash Flow Generation
Cash Flow Generation is one of three indicators of a company’s ability to generate profit. It involves knowing the following:
1. If enough money flow is being generated.
2. What are the sources of money generation.
3. How that money is being used.
What does “Cash Flow Generation” mean? It is the result of the difference between the money that enters the business and the one that flows from it, during a certain period. In other words, you have to pay attention to the speed with which collections are made and revenues are managed, and how they drain from the company.
Commonly, the money generated by the company does not come in when it is needed. This lack of coordination between billing time and collection time can have a very high impact on the genuine generation of money. You have to have absolute control over the money circuit. Many people within the company believe that the latter is the exclusive responsibility of the Finance area, but the truth is that all employees should know if their actions consume or generate money.
Suppose that in the commercial area, a payment is made 15 days in advance. This will generate money sooner than expected. However, if other areas are not aware of the financial flow of the company, this “unexpected” money may be used hastily or unintelligently.
Many times, the administration of collections is not taken into account as a generator of an adequate flow. Its proper functioning is essential so that the company’s money is where it is most convenient for the shareholders: in the company itself, and not in the hands of third parties. It is very important to control the inflow and outflow of money. Dear reader, do you think that all the Managers of the company take into account the flow of money?
Return on assets: let’s look at an example
Everything in which money has been put with the expectation of return is called an “ assets ”. How much do the assets yield today? Return on investment or capital refers to the money that shareholders have invested in the business.
Suppose a person wants to start a business. Since you have no start-up capital (assets), you borrow money at 2.5% monthly interest, which is equivalent to 30% annual direct interest or 34% annual compound interest.
How can you survive on interest like this and get returns? Giving speed to the flow of money. This means controlled rotation of inventory, stocks, stocks, etc. Also, in that game speed, it is necessary to maintain an adequate profit margin for each business act (elementary and expected responsibility of each Business Manager). It’s very simple, it means that the more times you sell, the more profit you get.
Let’s see the example of a supermarket: there the stock of milk boxes is renewed every day (rotation speed), and the money invested is recovered plus a small profit margin. In this case, the return on assets is excellent. All products must circulate from the company to the customer, and the faster the better, especially considering that parked products generate very high hidden costs.
To know the turnover rate of your business, it is necessary to divide the total sales by the total stock.
Velocity = Total Sales / Total Stock
Why is rotational speed important? Because the money that remains immobilized in “unsold products” has no return. You have to achieve the greatest amount of sales with the same structure. I call this moving quickly. The higher the rotation speed, the higher the performance. In reality, the return on assets (expressed in percentages) is equal to the profit margin multiplied by the rate of asset turnover:
RETURN ON ASSETS = MARGIN X SPEED
The best companies have a return on assets of more than 10%, before taxes.
I would like to emphasize that achieving desirable performance is the responsibility of the commercial area of the company and each one of the Business Managers. Together, they must increase the frequency of the flow of money and, in addition, prepare to use it appropriately (through the responsible use of different budgets, for example).
Meaning of Margin
The Gross Profit Margin is the total money that enters the company as a result of its commercial activity, less direct costs; These are those directly related to the manufacture and purchase of inputs, products, or services.
The Net Profit Margin, on the other hand, is calculated by deducting from the Gross Profit Margin all fixed costs: administrative expenses, interest on loans or credits, and taxes.
Let’s take the example of the Triboli SA glassware factory. It costs $7 to produce each glass. On the other hand, the selling price is $10. In 2008, Triboli SA sold all of its production: one million glasses. A quick calculation yields a Gross Profit Margin of $3,000,000. In the same period, the company recorded fixed expenses for $2,000,000; This means that your Net Profit Margin was $1,000,000, equivalent to 10% of your turnover.
Measure performance
Performance can be measured in three ways:
– Calculating the Return on Assets ( ROA).
– Calculating the Return on Investment ( ROI).
– Calculating the Return on Capital or Net Equity (ROE).
These indicators show how much money enters the company as a result of the use of its assets, the investments made or the capital contributed by the shareholders.
Let’s go back to the example of Triboli SA. As we said, in 2008 the company registered gross sales of $10,000,000, obtained a gross margin of 30% and a net margin of 10%. To calculate its performance, we have to take other data into account: in January 2008, Triboli SA bought a new glass manufacturing line, which meant an investment of $100,000,000. In addition, at the end of the year, the reports showed assets of $70,000,000 and a capital of $40,000,000.
Now, if we want to calculate the Return on Assets, we have to multiply the net profit margin by the velocity of assets (the latter is obtained by dividing sales by assets).
ROA = M x Sales / Assets
In this case, the ROA of Triboli SA was 1.5%.
To know the Return on Investment, you have to multiply the net profit margin by the investment speed (the latter is obtained by dividing sales by investment).
ROI = M x Sales / Investment
In this case, the ROA of Triboli SA was 1%.
Finally, to calculate the Return on Capital or Net Worth, the net profit margin must be multiplied by the velocity of capital (the latter is obtained by dividing sales by capital, excluding the money that the company may have borrowed ).
ROE = M x Sales / Equity
In this case, the ROE of Triboli SA was 2.5%.
Rotation speed
Companies that do not handle this concept focus their attention only on the profit margin. To know the performance of a business, it is essential to take into account the profit margin and the turnover speed.
One of the basic principles says that the return on the company’s assets should be greater than the cost of money provided by banks or shareholders. Otherwise, shareholder wealth would be destroyed. It is important to make sure which businesses or products do not cover the cost of capital. In these cases, there are two recommended paths: improve performance or get rid of them.
Increasing the turnover speed means intelligently selling more, at the same time and with the same structure expenses. Some may see it as a real challenge, others as the only way to go.
Measure profitability in all areas.
As I said at the beginning, the main responsibility of a Business Manager is to create value and generate results, and for this, it is necessary to be aware of what is happening in the business world, the one hand, and to ensure control of internal management, on the other. These are responsibilities that concern all Business Managers, and I insist: no matter what area they belong to. Now, you can tell me that controlling the flow of money is relatively simple, but talking about measuring profitability in the “soft” areas of the company may be a bit more complicated. How do Human Resources or Planning measure their profitability? Is this possible? Yes, it is possible and necessary!
Examples to keep in mind
Let’s look at two examples. The first shows us how poor management of the Human Resources area directly impacts any profitability index of the company. At Triboli SA, one hundred operators work, and the average salary is $3,000; The average absenteeism in the industry is 3%, but in Triboli SA it reaches 12%. The main reason is the application of a very poor incentive policy, which means a monthly expense of $36,000 for the company. Taking into account the average absenteeism in the industry, we could say that the mismanagement of the Human Resources area generates an extra expense of $27,000, which directly impacts the gross margin, and consequently, the net margin, thus affecting the company’s total rate of return.
On the other hand, Triboli SA has a Planning area that deals with planning the coordination of inputs and production shifts. For some reason, an internal inefficiency in the supply of raw materials stopped the production line in a certain month. The company, then, had to compensate for the production downtime with overtime from its operators. The company’s average monthly expense in overtime is $6,000 (equivalent to 2% of the payroll). But, that month, the inefficiency in the supply of inputs meant 15% more overtime. The company then had to pay an additional $39,000 in overtime just to maintain the standard production level. As in the previous case, this direct labor cost directly affected both profit margins and, consequently, all of the company’s profitability indices.
