Subscribe for Our Latest Resources
"*" indicates required fields
As the end of the financial year approaches, it’s a good time to take a look at your profitability and potential tax liability for the year. There are a number of strategies which if implemented by June 30, may reduce the liability to the Australian Taxation Office (ATO).
Some individuals may be able to get a double tax deduction for contributions to their SMSF during the month of June if they adopt what’s called a ‘reserving strategy’. Once a contribution is made to the SMSF, you’ve got 28 days to allocate it to a member; in the interim you’re ‘reserving’ it until the allocation.
Basically, you can get a double deduction for your super contribution limit. That is, even though the limit is $35k, you could put in $70k (provided it is made in June) and get a tax deduction for the full $70k. The ATO has recognised this as a legitimate strategy, however you really need to dot the I’s and cross the T’s and ensure you comply by getting appropriate advice prior to doing this.
More and more SME’s are conducting research and development as a matter of course. Unfortunately, very few realise what they are doing qualifies as R&D and aren’t claiming the respective tax offset. Basically, you may be entitled to claim the offset if you are undertaking experimental activities conducted for the purpose of generating new knowledge in relation to products or processes whose outcome is unknown. If your activity is eligible you can get an extra 50% on the 30% company tax rate you currently get, meaning you get a 45% tax offset. Importantly, you can obtain the offset (or tax refund) even if you are making losses. The offset can then be used to fund your business R & D.
If you need to buy capital assets, and your business has a turnover of less than $2m, you may qualify for an immediate write off where the asset costs less than $20,000. If it costs $20,000 or more, although you won’t get the immediate deduction, depending on how much it is and what other assets the business has, you may still be able to claim accelerated depreciation on it. .
However, if you don’t need the item, don’t waste your money. Whilst you’re getting a full tax deduction, you still have to pay the after tax portion (this could be more than half, depending on what tax bracket you’re in). It also only applies if you’re a small business entity, so make sure you meet the tests for this. You don’t get the deduction if you simply own a rental property. Also, don’t forget to consider your business cash flow. If you buy 2-3 items for close to $20k each, this can add up and can affect your business cash flow. Also remember, the item must be installed and ready to use by June 30.
Business owners may be able to reduce the overall taxable income of their business by making additional contributions to superannuation prior to June 30, 2016. The maximum amount that may be contributed and claimed as a tax deduction is $30,000, or $35,000 for those who were 49 years of age or more on June 30 2015. If you are over 65 years of age, you also need to meet the work test (40 hours in 30 consecutive days).
Super contributions are only deductible if made during the year, so make sure your super fund receives the contributions well before June 30 to allow for potential bank processing delays.
If you’re currently drawing a pension from your self-managed super fund (SMSF) make sure you’ve paid yourself the minimum pension required by law. Where there is also a maximum limit (e.g. those on transition to retirement pensions),make sure you also haven’t exceeded that maximum limit.
If you don’t meet these limits, the ATO view requires that the fund must pay 15% on its earnings rather than zero. According to ATO statistics, the average size of a SMSF is about $1m. So getting this wrong could work out to be a very expensive mistake.
Taxpayers with capital gains in the current financial year should also consider if there are ways to minimise the tax on those gains.
If you’ve had a capital gain, the aim is to put yourself in the lowest possible tax bracket in order to pay the lowest possible CGT. Useful strategies can include deferring income to next year, accelerating deductions or selling assets that may have unrealised capital losses. Remember, the date of disposal of an asset is the date of the contract, not necessarily the date you settle. You may be able to sell these to a related entity if you still want to keep the asset but make sure you get advice first.
It is important for businesses to review and write off any bad debts before June 30 to ensure that you can get a deduction. Otherwise, you could be paying tax on income you are not going to receive. It is important that these bad debts must physically be written off before June 30. It is not sufficient to do this when doing your tax return several months later. As always, some form of documentary evidence of the write off (prior to June 30) is good practice. This could be by way of accounting entries processed before year end or some other form of written record such as a minute. Another requirement is that the debt must have previously been included in your assessable income. If you’re a small business and only recognise income when you’re paid (i.e. cash basis), then you won’t previously have included the debt as assessable income and therefore won’t be eligible to write it off as a bad debt.
It is worth reviewing your stock for any old, damaged or obsolete items – you can write these items off in full and get an immediate tax deduction.
Furthermore, the value of trading stock at the end of the year can have a big impact on the overall profit & tax position of a business. There are a number of options available for valuing trading stock, including valuing it at cost price, market selling value or replacement value. You can choose between these options from year to year and item to item. Depending on your circumstances, this choice can significantly increase or decrease your taxable income.
This is a potential high risk area and you need to make sure these loans are in order. Basically, where you owe money to your company (or potentially even a trust), you need to ensure that you have met the requirements of Division 7A of the Tax Act. This basically requires that you have a loan agreement in place and that you’re making the prescribed minimum principal and interest repayments. If you don’t, the ATO can deem the full amount of your loan to be a dividend, with potentially disastrous consequences. Surprisingly, this is an area that is till not that well understood by business owners.
The end of year is a good time to review your structures to ensure they still do the job. What might have been an appropriate structure when it was set up may now be a hindrance. For example, the use of trusts for running a business now needs to be reassessed in light of (the above Divisions 7A) complications arising out of the distribution of trust income to so called “bucket companies”. This can give rise to an ever-increasing layer of complexity. There are now many “rollover” provisions in the CGT legislation which mean it is no longer as hard to change structure, although stamp duty can present issues in some states.
Year end is also a good time to review your wills and estate planning generally. Everyone’s circumstances change over time and a will that worked for you a few years ago may now not give the outcome you want.
If you are considering selling your business, either now or in the future, it’s important that you understand how to value a business for sale.
The challenge for many small business owners is that emotions often play a big part in their assessment. And that’s often for good reason: a passion for whatever it is that the business makes or does, a commitment to the industry sector, or a happy way of working.
But business owners can sometimes allow their emotional investment in the organisation to cloud their financial judgement.
It’s a useful exercise to weigh up your business as just another investment that needs to make a return on capital. After all, if capital wasn’t in your business it could be invested elsewhere.
Known as the Capital Asset Pricing Model, you begin with determining a ‘risk-free rate’.
Generally you take a 10-year government bond rate (currently about 3.5 per cent) as a surrogate for a risk-free rate.
So, if you’d say your business is more risky than a risk-free rate, you’d need to achieve a rate of return higher than 3.5 per cent.
Then, if you were to invest in a broad portfolio of publicly-traded blue chip stocks, you could expect a return of between 6-8 per cent above the risk-free rate, which would be about 10-10.5 per cent (assuming a risk-free rate of 3.5 per cent and an average portfolio return of 7 per cent).
The rate of return of an owner of one business in one industry in one city, that’s not publicly traded, should be significantly higher than that so you’ll need to calculate how much more risky your business is compared with a broad portfolio of blue chip stocks.
While there are endless measurements and calculations that can be made when looking at how to value a business for sale, it’s not necessary to get “too pedantic”.
Pick a figure that’s the appropriate benchmark for your business. Let’s say it’s 20 per cent. So if you’re actually getting 2 per cent, you know you’ve got some serious work to do to improve the value of your business.
Most business owners can tell you the dollar profit they’ve made. Often they’ll say: ‘That’s a 10 per cent return’, and when you quiz them further and ask 10 per cent on what? They’ll say, ‘On my sales’.
So they might have had sales of $10 million at a profit of $1 million but that’s just one part of the equation – the profit and loss – not the balance sheet.
Every business is fundamentally the same. It’s a pot of money made up of equity funding (your own money you’ve invested) and debt funding (money you have borrowed from the bank, bank overdraft, lease equipment etc).
Then you give your customers credit terms (accounts receivable/debtors), you invariably have stock you invest that money in (you’ll get credit terms from your suppliers, so you’ve got to take off creditors); you may have some plant and equipment that you need; and you may have bought some goodwill. That’s your pot of money.
So when looking at how to value a business for sale, what you need to be measuring your profit against is that pot of money, not your sales. You don’t say I made $1 million in profit and $10 million in sales therefore it’s 10 per cent. That’s the wrong thing to look at.
Some of our clients are achieving a return on capital of as much as 90 per cent.
When a business owner understands the concept of the pot of money and they can see that if they reduce the size of their pot – in other words, the amount of capital invested in the business – and keep their profit the same, then the return on their capital goes up.
The valuation multitude that someone will pay to purchase your business is dependent on risk i.e. how likely is it that your business will continue to produce the same level of revenue and profit in the years to come. The following comes into play when assessing this risk:
Generally a prospective buyer will pay between 1.5 and 3 times the return on capital.
The first step is to understand your current return on capital and then to come up with a plan to improve this. The second step is to address any risks in your business that might act as a deterrent to prospective buyers.
MGI South Queensland has a team of experts ready to help you understand how to value a business for sale. Contact our business valuation services team in Brisbane or the Gold Coast for assistance today or download our business valuation guide to get a head start.
The economic challenges of the last few years have brought with it a never-ending number of corporate collapses. I was recently asked why businesses fail. Is it the time of year? Is it that businesses are growing too fast and did this come down to the ego of the owner or chief executive? Or is it that management just doesn’t get it? My answer was, yes to all of the above. Let me deal with each of these.
I think it can be the case that for some businesses the run-up to Christmas is their best time for sales. This brings with it the wish or hope that “if we can just get through Christmas everything will be OK”. Unfortunately, unless the fundamentals of the business are sound, the festive season’s trading doesn’t end up being the panacea that may have been hoped for.
If a business looks like a dog, behaves like a dog and barks like a dog – then it’s probably a dog, no matter what time of the year.
As the saying goes – turnover (sales) is vanity, profit is sanity and cash flow is reality.
Unfortunately, based on my 30 years’ experience, sales growth can often be driven by the ego of the owner or chief executive. Here’s how – “look how good I am”, “we’ve doubled sales in three years”, “business is booming” – all mindsets that feed the ego. And this is fed by the media, with a growing stream of stories about this month’s fast-growing business, only to be next month’s corporate collapse.
What many of these businesses fail to realise is that a fast-growing business is in dangerous territory. There is often a focus on growing the top line (sales). There is less focus on whether the business is profitable and even less focus on how the growth is going to be funded – the cash flow.
Fundamentally, there is only one reason businesses fail – they run out of cash. You can have all the sales you like, but if you don’t have cash you’re out of business. There seems to be this mistaken belief that sales growth will magically fund itself.
A business owner said to me recently: “You know, we don’t know what we don’t know.” What he meant was that he was blissfully unaware of the key things he needed to know in order to run a successful business.
He had no idea whether his business was performing well. He had no key business performance metrics on which to assess performance. Clearly not all businesses are like this but it begs the question whether failed businesses are measuring and managing the key aspects of their business.
As mentioned previously, there is only one reason businesses fail – they run out of cash. There are three reasons they run out of cash – they grow too fast, they use operating working capital to buy long-term assets (e.g. plant) or they simply aren’t profitable. The key is to ensure you don’t fall into one of these three categories by undertaking good business hygiene.
The sad part is that in the vast majority of cases, business failure can be prevented if owners and chief executives focus on a few key parameters. Here are my key parameters to prevent your business becoming a statistic:
If you aren’t being provided with this information and managing it properly, you’re flying blind.
Grant Field works as a business advisor with a number of high growth companies assisting them to achieve a sustainable high growth performance. For more information on our business advisory or accounting services please contact us.
This article has been modified from the original in August 2023 and originally appeared in The Sydney Morning Herald, The Age, WA Today, Canberra times and Brisbane Times.
So often we read or hear in the media about the latest fast-growing business. Everyone seems to focus on the growth of the business but what is the real measure of business success? When I review the financial performance of a business, the primary measure I look at is Return on Capital Employed (ROCE). Generally, if this rate of return isn’t high enough it is usually a sign that some things aren’t quite right in the business.
ROCE is a key performance measure because it focuses on the relationship between the inputs and outputs of the business. In accounting speak; the inputs of a business are included in the balance sheet – things like stock, debtors, creditors, plant & equipment etc. The outputs are included in the profit and loss statement – things like sales, cost of sales (or margin), expenses etc.
At the end of the day, ROCE drives business value. If you want to increase the value of your business then focus on increasing your ROCE. Business benchmarking is a great way to see how you compare to other businesses in your sector or industry. And working with a business coach can help you get some external perspective and identify the low hanging fruit to improve your profitability.
Give the business growth team at MGI a call and let us help you improve your ROCE.
Just like in our own household, waste costs the average family business tens if not hundreds of thousands of dollars every year. However, the business owner doesn’t just incur the yearly cost, but the multiple of that cost when a business is sold. So how do you identify and reduce business waste to grow your bottom line?
Let’s assume that through a waste audit we can identify $100,000 in yearly cost savings in your business. Let’s also assume that you’re getting close to selling your business. As businesses are generally sold for a multiple of earnings (i.e. profit), it follows that if you can cut $100,000 in costs, then you’ll increase profits by the same amount. If the business is sold for say five times profit, then that’s a cool half a million dollars in your back pocket – certainly nothing to be sneezed at!
Reducing waste may not sound overly exciting, but it can pay real dividends. And a point to remember: this is money that is coming straight out of your pocket!!!
I use activity based costing (ABC) as a means to explain what I mean by waste. ABC is a simple concept. In any business, people do things, whether this is loading a truck, operating a machine, using a computer. This is called ‘Activity’. In the course of “doing things” scarce resources are consumed e.g. the person’s time, the cost of the machine etc. Each of these has a cost, whether it be the wages of the employee or the operating costs of the equipment. ABC is about allocating the cost of those resources to cost objects. This could be a particular product or service.
So, whether we like it or not, these costs are embedded in the products or services businesses sell. If the cost of your product or service is not competitive in the marketplace, think about undertaking a waste audit. It may enable you to reduce your costs and become more competitive.
Over the years I’ve worked with many businesses to identify waste. I work through a process to identify and quantify waste in each of the above areas. We then assess this against the ease of fixing the problem. We start with the bigger the potential cost savings that are the easiest to fix.
In my experience, it is only once you get on the “waste train” and embrace it, that it stands out and becomes easier to identify. It’s as if a light bulb goes on in the mind of the business owner. The “penny drops” and a whole new mindset takes hold.
If you’d like an external review of your business to identify how you can reduce business waste and start to grow your profits even further, let me shout you a coffee and have a chat.
There’s an old saying – profit is opinion, cash is fact. That’s because despite making a profit, some businesses still don’t have enough cash to pay the bills. At the end of the day, a lack of cash will kill a business.
Since the GFC, banks have been paying increased attention to the cash flow position of their business customers – more particularly ‘free cash flow’. So what is free cash flow?
Regardless of size, the principles of running a business are the same. Simplistically, a business is just a pot of money. That “pot” gets invested in holding Stock, providing credit to customers (Debtors) and acquiring Plant & Equipment. In return, the business usually gets credit from its suppliers (Creditors). Each year as the business grows so does the size of this “pot” – more stock, more debtors and more plant and equipment.
The increase in the size of the pot has to be funded from one of two sources – debt or equity. Usually, it is funded from after tax profits (or equity) and after payment of any dividends to the owners. If this profit is not sufficient to fund the increase in size of the pot then this results in negative free cash flow. Banks are concerned about this because if the extra funding isn’t coming from the business profits then it has to come from the bank or from new or existing shareholders (by way of increased share capital). For most privately owned businesses, the latter is usually not an option – which leaves the bank to fund the shortfall.
This means the growth rate of the business is not sustainable (sometimes called “over trading”). Whilst it may be okay for a year or two, eventually it will catch up with you. Over trading has ruined many potentially good businesses.
Apart from the level of stock and debtors blowing out, there are three real reasons why a business will feel the pinch on cash flow.
Some tips.
One of the reasons businesses run out of cash – and generally go broke – is that they grow too fast.
What a paradox – the business is growing too quickly and is therefore too successful for its own good!
Not surprisingly, in situations like these you also find that the largest “creditor” of the business is the Australian Taxation Office, due to either unpaid GST, PAYG withholdings, employee super or all three. In other words, the business has used the ATO as a banker. The obvious question is – why?
The broader answer is very simple – lack of access to alternative funders.
A typical family-owned business usually only has two sources of funding – the owners or the bank – and the latter option is generally only available if the owners have “bricks and mortar” security (i.e. their home).
Where the business owner has little or no equity in their home and/or the funding needs of the business exceeds the amount they can borrow against their home, the options tend to be very limited. Banks may still lend something against the assets of the business (e.g. stock and debtors), but the size of this facility is often a fraction of the assets pledged as security and the facility may not increase as the cash flow needs of the business increase.
Children taking over a business from their parents may also lack the amount of capital (or property security) needed to grow the business.
Family-owned businesses are also reluctant to call in a “white knight” (a friend with cash) or venture capital provider. In any case, the latter are generally not attracted to smaller “mum and dad” family businesses. This therefore only leaves two sources of funding – business creditors and the ATO. Business creditors tend to get looked after as the business owner wants to ensure supply of raw materials to their business, which just leaves the ATO.
One often overlooked source of funding may be to “borrow” against the debtors of the business through a debtor finance arrangement (previously called factoring).
Traditionally thought of as a lender of last resort, debtor finance companies should not be overlooked as a source of funding for growing businesses, provided the business is profitable. The latter point is crucial, because it is no use accessing cash flow (from anywhere) if the business is not making money. The cash will soon run out and the business will go broke. This was also another reason provided in my previous article about why businesses don’t have cash – they don’t have a cash flow problem, they have a profitability problem. A lack of cash is the symptom, but a lack of profitability is the cause.
Assuming the business is profitable and growing, debtor finance provides an opportunity to borrow against the debtor book, particularly where it is a high quality debtor book. Generally, debtor financing companies will advance a percentage of the debtor book (e.g. 75% or 80%) for those debtors who have been outstanding for less than 90 days.
So, why don’t more family-owned businesses take up debtor financing?
I suspect there are a number of reasons for this. One reason might be the perceived stigma. Often, debtor finance companies will require that the arrangement be disclosed to the customers of the business and collection of the outstanding debts is handled by the debtor finance company. Whilst this needs to be carefully managed, I do see a “good news story” in here for the business and that story should be “sold”. The business is growing! Every business owner understands that a growing business needs to fund cash. So should your customers.
Secondly, the business is “outsourcing” its debtor management, thereby enabling the owners to focus on doing what they do best – build the business. You may also find that your debtors are better managed (and more likely to pay on time) when there is greater focus applied.
Another reason may be because debtor finance is generally a more expensive form of funding than traditional bank finance secured by a property. This is not surprising – it’s more risky. If the business owner had property to put up as security then they wouldn’t need debtor finance. So it is important to understand what the cost of funds will be. Even if the effective cost of funds is (say) 15%, provided the business is making a return on capital employed (ROCE) of greater than this then they are in front. In other words, if the ROCE for the business is, say, 25% then the business owner is still in front by 10% once the financing cost has been paid. Would you rather make 10% of something or 100% of nothing?
I have certainly seen debtor financing used to beneficial effect by one second-generation family business client, where the children (who recently took over the business) had little or no “bricks and mortar” security.
Clearly, in a perfect world having access to an unlimited supply of cash is utopia. However, we don’t live in a perfect world and business owners frequently have to deal with imperfection. The challenge for business owners using any sort of funding, but particularly debtor financing is to know the key financial parameters of their business.
The Federal Government has indicated that they are very keen to support innovative businesses. There are a number of funding options available by way of government grants for businesses that can meet the Government qualification requirements.
If your company has been “experimenting” to try and solve a problem in your business for which there was previously no useable solution you may be eligible to claim those activities under the Research & Development (“ R &D”) Tax Incentive. If you believe your company may qualify you need to register with AusIndustry. That body will determine if your process meets their innovation requirements and, if you are successful, will provide you with a registration number that is then incorporated into your company’s income tax return where you make your claim for the Tax Incentive. There is a separate round of incentives each financial year. Registration is undertaken in the months following the end of the year during which you incurred the costs. Therefore you need to first incur the costs and then seek the incentive after the end of the financial year.
For the 2017 financial year the rates of assistance under the R&D Tax Incentive are 43.5 per cent for eligible entities with a turnover under $20 million per annum and not controlled by a tax exempt entity and 38.5 per cent for all other eligible entities.
The incentive is obtained either as a refund of cash in circumstances where the company has no taxable income or as a rebate of tax where the company does have taxable income.
The R & D Incentive is complex and you should seek advice to assist you to make the appropriate claim. You should be particularly aware that the applicant for grants must be a company.
The Federal Government also operates an Entrepreneurs Programme that provides assistance to innovative businesses. Of particular interest is the Accelerating Commercialisation Grants, which is a merit based programme that encourages and assists small and medium businesses, entrepreneurs and researchers to commercialise novel products, processes and services.
This grant provides up to 50% of expenditure to a maximum of $1 million and includes access to an expert network as well as access to promotional opportunities. More details can be found at https://www.business.gov.au/assistance/accelerating-commercialisation.
A recent addition to assistance available is taxation incentives for investment Innovation Companies. Unlike the R & D Tax Incentives, this scheme is available to persons who invest in companies that qualify. The system is designed to encourage high net worth taxpayers who qualify as “sophisticated investors” to investment in innovative businesses.
The incentives include a 20% non-refundable carry-forward tax offset on investment in eligible companies, capped at $200,000 per investor, per year and a 10 year capital gains tax exemption for qualifying investments held for at least twelve months. For further details of this scheme refer to http://www.innovation.gov.au/page/tax-incentives-investors
You should also be aware that there is also a raft of incentives and assistance available from the various State Governments around Australia. Your local MGI firm will be able to provide you with more specific details.
I was recently asked by a client whether they were holding too much cash in the business. My answer was – it depends.
It depends on a number of things as well as the reasons for the cash build up. There are economic, commercial, financial and structural issues to be considered.
As a general rule, having plenty of cash on hand is a good thing particularly for those businesses in cyclical industries such as the resource industry. Such industries can have downturns which can last many years, so having plenty of cash on hand is important. Even if you’re not in a cyclical industry, it pays to have access to cash for a “rainy day”. After all, there’s only one reason businesses go broke and that’s because they run out of cash.
Also, if you’re a fast-growing business you’ll need all the cash you can get your hands on. Cash is king and high growth businesses are in danger territory. Having the necessary cash to fund that growth is crucial.
However, sometimes cash just builds up over time from a prolonged period of profitability. In this case, it begs the obvious question as to the need for the cash, particularly if the cash is simply sitting in a bank account earning nominal interest. To me, this is an obvious sign of a lazy balance sheet. If there is ample cash to fund your working capital needs and there are no obvious plans to use the capital to grow the business then I would argue that the surplus cash should be returned to the shareholders of the business.
If the business is privately owned, the funds can usually be lent back to the business at a later date should the need arise.
Asset protection might be another reason to return surplus cash to shareholders. Leaving the cash in the business means that it is potentially at risk of claims from creditors or other parties. Once it is paid out to shareholders then it is generally no longer at risk in the business.
Having excess cash in a business is just like having a beach house in a business. You wouldn’t do it. Similarly, if you’ve sold a significant asset that is no longer needed and you have cash from the sale that is not needed to fund or grow the business, then it should probably be returned to shareholders who may have a more productive use for the funds.
If you’re actively measuring and managing the financial drivers of the business you’ll soon realise if you’ve got excess cash. This is because you’ll start to experience the symptoms of a “lazy” balance sheet – a falling return on capital employed (ROCE). More cash means you have to make an appropriate return on that. If it’s only earning 2%-3% then your ROCE will start to fall and you should see that trend starting to develop.
More importantly, a “lazy” balance sheet can often lead to other “lazy” practices. If there is ample cash, your team may not be as motivated to chase payment from debtors. As debtors take longer and longer to pay, the risk of default increases which means you may end up with more bad debts. Ultimately, these will come home to roost. Similarly, ample cash may mean your team are not as motivated to maintain appropriate stock levels, which could result in a blow out in inventory.
Sometimes these “lazy” practices manifest themselves into a business threatening culture from which the business may find it hard to recover. The cash stockpile gets run down due to the lax attitude. Couple this with ballooning stock holdings and debtor book and you may encounter a “perfect storm” that you never saw coming and it may be too late to avoid.
So, the appropriate amount of cash to have on hand is all about balance. Not too much, not too little. Keep an eagle eye on your ROCE, working capital burn rate and free cash flow and you should have ample cash to fund the business.
I’m often asked by business clients whether a certain dollar profit is good. My answer is always the same – it depends.
The fact is, no one can tell you whether a specific dollar profit figure in isolation is a good result or not. It’s just like asking someone whether the $1,000 in interest you received from the bank is a good return. You can’t answer the question until you know how much they had invested in the bank – and so too it is with a business.
In my experience, the problem is that very few business owners have any idea of how much they have invested in the business. Without this vital piece of information you only have half the picture. This is also often the case in the financial press, with banks often being criticising for the “obscene” profits they make without asking one vital question – how much did they have invested in the business and what rate of return is that?
Once you know what the ROCE is for your business, then you can assess whether this is sufficient for the risk you’re taking.
We all know that you can get around 3% investing in supposed “risk free” ten year government bonds so why would you accept this rate of return in your business when it is certainly not risk free. Similarly, we all know that, over the longer term, you can expect a return of around 10%-12% investing in a portfolio of publicly traded blue chip shares. Sure, returns since the GFC have taken a hit, but I’m talking about the longer term.
Therefore, why would you accept this rate of return in your business when it is more risky than a portfolio of publicly traded blue chip shares? This starts a discussion about how much more risky your business is and what you can do to reduce that risk. Is 20% return enough? Is 30%?
It also starts a discussion about how to improve the financial performance of your business.
It follows from our Big 3 ratios above that ROCE is a function of Profitability and Activity. Therefore, the key to increasing ROCE is to understand whether it is your Profitability that is poor or your Activity, or both. More importantly, if you made changes to one of them, which one would give you more “bang for buck”. That is, a small change in one area may have a multiplied effect. The key is knowing what the “driver” is for your business.
Why not try to assess the ROCE for your business using the formula below? Feel free to contact me if you get stuck.
ROCE = Net Profit/Sales x Sales/Total Assets
This formula can be further simplified to:
ROCE = Net Profit/Total Assets
Of course, it is simplistic to say that all of your business problems will be solved by simply concentrating on only these three ratios. But it is an easy start. There are many other financial ratios that are important in running a business, including liquidity ratios and measuring free cash flow.