SELF TEST #24: Identifying Shortfalls in Financial Performance
Test #1:
How does the Company know that it has achieved a low-cost position?
Answer:
The Company achieves a low-cost position when it has the highest Return on Investment in its industry.
Test #2:
How does a company measure Return on Investment?
Answer:
There are three measures of Return on Investment. The first is Return on Equity (ROE). This measures the Company’s after tax profits divided by total shareholder’s equity. The second is Return on Net Capital Employed (RONCE). Return on Net Capital Employed is the Company’s earnings before interest and taxes (EBIT) divided by the Company’s Net Capital Employed (NCE). Net Capital Employed is the sum of total debt plus all forms of equity. The third measure of Return on Investment occurs where the Company has business segment information. This measure is Return on Assets (ROA), which is the ratio of operating profits divided by total allocated assets.
Test #3:
When would a company use each of the various measures of Return on Investment?
Answer:
Roughly speaking, a company would use the Return on Equity measure when it wishes to evaluate its total cost performance, including its tax and financing tactics. It would use Return on Net Capital Employed to evaluate the performance of the operating managers of the Company. Return on Net Capital Employed excludes consideration of taxes and capital structure. It would use Return on Assets when it is evaluating its relative performance in a line of business.
Test #4:
Companies in an industry charge somewhat different prices for their products. Wouldn’t a difference in pricing affect Return on Investment?
Answer:
Yes, a difference in pricing does affect Return on Investment. Higher prices may lead to better returns, lower prices to lower returns. However, pricing is not an exercise done in a vacuum. A company must price to reflect its standing with the customer compared to competition. Companies do not discount unless they feel they have to do so. Price premiums, as we saw in the Pricing section of StrategyStreet, are the result of competitors having to discount against the company with the price premium rather than a case of a company successfully charging a premium. All companies in an industry operate in the same pricing environment. Those discounts that occur in the industry reflect another form of marketing and sales expense to enable the discounting company to sell its products. As a result, the company with the highest Return on Investment has the industry’s lowest total costs.
Test #5:
Do the industry’s largest competitors usually lead their industries in Return on Investment?
Answer:
No, the industry’s largest competitor is more likely than smaller competitors to lead its industry in Stable industries. It is less likely to lead its industry in a Hostile industry. Even in a Stable industry, the likelihood that the industry’s market share leader leads its industry in Returns on Investment is less than 30%.
Test #6:
What are reasonable targets for Return on Investment?
Answer:
The primary target a company should seek is to be the low-cost competitor in its industry. This would yield the highest Return on Investment in its particular industry. As a general set of benchmarks, the Company would be able to compete well for capital providing it beats the median performance of industry leaders in the U.S. public markets. These median returns are 13% for ROE, 15% for RONCE and 11% for ROA.
Test #7:
What measures would a company use to evaluate its relative position on operating costs, that is costs of People and Purchases?
Answer:
The Company would usually use a measure of operating margins. Operating margins, at the company level, measure Return on Sales, which is calculated as earnings before interest and taxes divided by total sales. In line of business reporting, the Return on Sales measure is the ratio of operating profits divided by segment sales.
Test #8:
What are median figures for operating margins?
Answer:
The median operating margin for businesses in the U.S. public markets is 8%. The median operating margin at the business segment level is 9%.
Test #9:
How would the Company measure its capability at using capital?
Answer:
The Company would measure its Capital Intensity compared to competition. It could measure this Capital Intensity by evaluating one of two ratios. The first measure applies to a company level. It is Net Capital Employed to sales. Net Capital Employed includes the sum of total interest bearing debt plus all forms of equity. The second measure applies to a business segment level. It is the ratio of total allocated assets to sales.
Test #10:
What levels of Capital indicate that an industry is capital intensive?
Answer:
Any industry that has a Capital Intensity greater than the median for the companies in the U.S. public markets would be capital intensive. At the Company level, the median Capital Intensity, measured as Net Capital Employed divided by Sales, is 62%. For business segments, the median Capital Intensity, measured by Allocated Assets divided by segment sales, is 87%. Companies that require more than $.62 in capital to produce a dollar of sales are Capital Intensive. Business segments that require more than $.87 of capital to produce a dollar of sales are Capital Intensive.