What if our company made an annual profit of R20 ZARM?
Surely that sounds instantly like cause for celebration! – Or does it?
When training managers of varying levels, in some of South Africa’s prestigious companies, there is general agreement that a R20 ZARM profit is impressive by any standards. When training groups of workers the reaction is no different. R20 ZARM is a huge amount of money and therefore it constitutes a great profit! I need to share that before we get to talking about profit, we have already spent a lot of time understanding that profit is essentially the difference between Sales/Revenue and Costs/expenses. There is also by now general agreement that we need high sales and low costs if we are to make a good profit. We have also dealt with what happens to profit, once a business has made one – Tax, Dividends and Retained Profit are now also understood. So far so good…
Assessing the quality of the profit is the next challenge! What most learners of finance have to understand fairly early on is that R20 ZARM is just a number. It is a quantity measure. In order to measure the quality of the profit figure, one has to do a simple ratio calculation which, by the way, anyone who has done grade 5 maths can do and which we do daily in our heads without giving it a second thought.
It’s a simple productivity calculation that says: “How much did I put in and how much did I get out?” So, if I got out R20 ZARM, what was put in in order to generate that R20 ZARM profit? Well, businesses need and use resources in order to generate profit. Resources that are used up in the process can be loosely defined as costs. Resources and stock that are always on hand, such as machinery, vehicles, property, plant and equipment are referred to as assets.
As long as I tell them we made a profit, everything should be ok!
In order for a business to acquire the assets that it needs, it has to get funding from somewhere. The business looks to its shareholders and other sources of funding to raise the required amount. It follows that the bigger the business (from an asset point of view) the more funding it would require. Clearly, the providers of capital generally do so either in return for a fixed or variable (but guaranteed) return in the form of interest bearing loans, as in the case of shareholders, they risk their money in expectation of a return which, in their view, outweighs the risk inherent in investing.
It’s a simple productivity calculation that says: “How much did I put in and how much did I get out?”
To get back to the R20ZARM… What if the business needed assets of R500 ZARM and was able to raise funding from the shareholders for that amount? So, the shareholders put in R500 ZARM. They got out R20 ZARM (per annum). The calculation we need to do is the basic ROA one, which simply says: divide the profit (what you got out) by the Assets or the investment you made (what you put in) and multiply by 100 to arrive at a percentage. This simple calculation shows that the answer is 4%. So for every Rand invested in assets, the business produced a return (profit) of 4 cents. Anyone can see that these shareholders would have been better off putting their money in a savings account (which is not a great place to put it – but at least a safe place) where the risks are minimal. We all know that there are no guarantees of company performance and that shareholders thus require a much bigger return that the safe, risk free rate.
So where does that leave us? How do I get my managers to understand that even though the profit figure might look impressive, we may have very unhappy shareholders and that all profit is not necessarily good profit? How does that affect how I run my business and what information I share with my staff?
Check back in a while when we will explore this further…