WORKSHEET #24: Identifying Shortfalls in Financial Performance

Step 1:

Calculate the Return on Investment (ROI).

If measuring at the company level, calculate Return on Equity (ROE):

  • Obtain the profit after tax for the Company

  • Divide the profit after tax by the total shareholders’ equity

If the Company is using Return on Net Capital Employed in its ROI calculation:

  • Obtain the earnings before interest and taxes (EBIT) of the Company

  • Calculate the Net Capital Employed (NCE) for the Company one of two ways:

    • Obtain the sum of total interest-bearing debt, both long-term and short-term, plus all forms of equity, including preferred shares and shareholders’ equity

    • Subtract the free liabilities from the total assets of the Company. Free liabilities include all non-funded (i.e., non-interest bearing) liabilities, such as accounts payable, wages payable, taxes payable and reserves.

  • Divide the EBIT by the total Net Capital Employed of the Company

If the Company is using publicly available business segment data:

  • Obtain the operating profits of the business segment

  • Divide those operating profits by the allocated assets of the segment

Step 2:

Evaluate the Company’s capability in managing People and Purchases costs.

Using the figures above for operating profits and capital or assets and the total sales for the Company or the business segment, calculate the operating margin (i.e., Return on Sales, ROS) for the business.

  • Find the operating profit for the business

  • Divide that operating profit by the sales for the business

Compare the Return on Sales figures to those of the Company’s peers in its industry.

Compare the Company’s ROS to the median operating margins for the U.S. public financial markets.

Step 3:

Measure the Company’s results in managing capital or assets.

Using the capital assets and sales figures employed above, calculate the capital intensity of the business.

  • Obtain the capital (NCE) or assets used in the business

  • Divide those assets or capital (NCE) by the sales in the business

Compare the Company’s capital intensity to those of its peers in the industry.

Compare the Company’s results to the median measures for capital intensity in the U.S. public markets.

Step 4:

Find the industry’s low cost competitor.

Obtain the Company’s Return on Investment in each of the last three years.

Compare this measure to the same measures for all of the peer competitors in the industry.

Determine the low cost competitor by determining the company with the highest return on investment over the last three years.

Step 5:

Determine the combined changes in operating profits and Net Capital Employed that would allow the Company to match or exceed the Return on Investment for the low cost competitor. Then set the Company’s targets:

Subtract the Company’s operating margin from that of the low-cost company, measured by the Return on sales percentages.

Multiply the difference in operating margin times the Company’s total sales to arrive at the profit increase required to match the ROS of the low cost competitor.

Subtract the low cost competitor’s capital intensity from the Company’s capital intensity. Multiply the difference times the current sales of the Company. This produces the reduction in total capital required for the Company to match the capital intensity of the industry’s leading return company.

Modify these operating profit and capital intensity targets, as appropriate, for the Company’s competitive aspirations in the industry over the next three years.

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