As we head into the end of the year 2019, companies large and small are beginning their strategic planning and financial budgeting processes for 2020. This year, the storm clouds continue grow over fears of a potential recession heading into the new year both nationally as well as here in the San Francisco Bay Area. This is especially challenging for CFOs of small businesses as well as middle-market companies as they are more exposed to swings in revenues, profits, and cash flows.
One of the biggest challenges in the planning and budgeting process is how to evaluate various investment opportunities. It is all too easy for both large and small companies to incrementally approve budget requests that seem reasonable and, yet, over time, never seem to provide the financial or operational benefits that were promised.
A recent article in CFO Magazine highlighted how Return on Invested Capital (ROIC) is a very powerful metric to help evaluated company investments over time. Too often, the budgeting process only evaluated the projected revenues, costs, and profits associated with new projects, hiring, and investments. Too rarely does the analysis and debate incorporate the importance of investing previous capital (i.e., owner’s equity) and the need to generate acceptable returns on the invested capital.
ROIC, by looking at the ratio of pre-tax Operating Profits to the necessary capital to drive those profits, provides a way to evaluated different area and projects of a company that are competing for attention and prioritization. In other words, ROIC is more broad and inclusive of a financial measure than just profitability measures such as Gross Margin, Operating Margin, or Net Profit Margin. It really helps to understand the capital-efficiency in generating each dollar of profit for the business.
Recently released data from APQC’s Open Standards Benchmarking database shows that organizations in the top quartile (75th percentile and above) generate almost twice the percentage return on investment as organizations in the bottom quartile. The higher-performing companies (across all industries) generate a high, after-tax ROIC of 12.9% on average vs. a lowly 7.0% ROIC for the under-performing companies.
This is a very large difference in performance, and, over time, can really differentiate which company has a sustainable, competitive advantage. In addition, having a higher, long-run ROIC is a virtuous circle in that it helps provide excess capital in helping to fuel additional, profitable growth opportunities. For a small or medium-sized business wishing to grow without over-relying on debt, this can be an incredibly powerful driver of profits over time.
Fiscal and operating discipline must be utilized not only during the annual budgeting process, but also throughout the lifetime of projects that have been implemented. The way to maintain strong ROIC is by carefully vetting the assumptions in the project revenues, costs, profit margins, timing of cash flows, and required capital (both Working Capital and Fixed Assets) necessary.
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