Taking advantage of the record low interest rates, let's say you've just refinanced your home mortgage and have earmarked $20,000 of the cash to invest in your kitchen and bath design firm.
As a responsible business owner, two questions should be addressed. First, what areas of your business will earn the greatest return from an investment? And second, what should be the cumulative, positive impact of these investments on your business?
At first blush, these may be rather difficult questions to answer. The answers, however, can be arrived at by examining some critical data about your business.
But before buy another display, study your most recent financial statements. They offer the best clues to where the money should be invested and how much of a return you should expect.
Say your company is named Signature Kitchen and Bath, and your latest Balance Sheet and simplified Income Statement for last year looks like the chart that I have provided at right as an illustration.
Essentially, there are two methods to calculate the potential return on an investment in your business. The first is the "short form," which provides a quick, simplified answer. You merely divide the Net Profit by the Net Worth to obtain your Return on Investment (ROI). For example:
$30,000 (Net Profit)
$90,000 (Net Worth)
In this example, the result is a 33.3% Return On Investment (ROI).
With respect to a $20,000 investment in your operation, what this calculation says is that, based upon your most recent financial statements, you might expect a 33.3% return or $6,660 in the first year. In relation to other investments available, such as a passbook savings account, certificate of deposit, mutual fund or real estate investment, the 33.3% annual return on the investment is very attractive.
In my judgment, for all of the effort that goes into having a kitchen fit like a glove for a client, dealers and designers should earn at least 33% on equity. Indeed, the best-managed firms can consistently earn 50% or more. After all, it was not more than three years ago that many of us were earning a 25-27% ROI on our mutual funds with virtually no effort at all.
That this high return can come from an investment in a creative
business that you love is probably a most gratifying revelation.
But you're probably aware of the many factors that can easily
depress the net profit and make your investment riskier and less
liquid than other options. Therefore, you should not be satisfied
with just accepting the 33.3% projection as mere fact. As a
business owner, you should more deeply understand why, and where,
your business can generate a relatively high return on investment.
And for that, you will need to digest the "long form" method of
calculating the return on investment.
Thorough comprehension of this ROI procedure requires that you understand the following four ratio definitions and the accompanying conceptual diagram involving these ratios:
Total Asset Turnover (TAT). This ratio demonstrates how well assets are being controlled to get a better turnover out of inventory.
Formula: Total Asset Turnover = Sales divided by Total Assets.
2. Return on Assets: (ROA). This ratio measures profit generated from assets.
Formula: Return on Assets = % Net Profit x Total Asset Turnover.
3. Financial Leverage Multiplier (FLM). This ratio measures the strategic use of other people's money. (The standard you should use is 2.0 or 3.0 to 1.)
Formula: Financial Leverage Multiplier = Total Assets divided by Net Worth.
4. Return on Investment (ROI). This is the key profitability ratio used by bankers, accountants, financial managers and investors to measure a company's rate of return. (The standard you should use is 15 20%.)
Formula: Return on Investment =Return on x Financial Leverage Assets Multiplier
Figure 1 represents a conceptual diagram for calculating ROI via the "long form."
Employing information from the 2002 Financial Statements of Signature Kitchen and Bath, you can determine the "long form" calculation method to determine the probable return on the $20,000 investment.
For example, the Financial Leverage Multiplier component of the formula is excellent at 4.44 substantially higher than the standard of 2.03.0 that financial professionals look for. It's the primary reason why the return on investment for the kitchen/bath industry is comparatively higher than other businesses.
This observation makes sense because the terms kitchen and bath dealers generally use with clients (50% upon signing agreement, 40% upon cabinet delivery from the manufacturer, and 10% upon substantial completion) make this a "near-cash" business. In effect, we use customer deposits to finance our working capital needs, display investments and other assets whereas other industries require short and/or long-term bank financing for these needs. So, it's this great cash flow that positively impacts upon the ROI percentage.
Conversely, the relatively low Return on Assets percentage
(7.5%) is the major formula deterrent to a higher return on
Areas to invest in
Any investment that improves the weak 3% Net Profit (Net Profit/Net Sales) or Total Asset Turnover (Net Sales/Total Assets) will yield a higher ROI.
What follows next are five key suggestions:
- A Professionally Prepared Three-Year Budget. Hiring a business
consultant to work interactively with you in this endeavor can do
much to change the way an owner looks at his business and plans
properly for growth. It can also lead to several immediate,
significant changes. For example, the consultant may prove that you
don't have to lose control if your lone payroll installer becomes a
Savings: Payroll taxes, worker's compensation insurance, and employee benefits estimated at $10,000.
Consultant Investment: Approximately $2,500.
Impact on Business: Selling and Administrative (S&A) expenses are reduced by 0.75%, increasing the net profit by the same percentage. The Return on Assets now becomes 9.375% (3.75% x 2.50) instead of 7.5%. When multiplied by the same FLM of 4.44, the ROI for the business jumps to 41.6%a 25% improvement.
- Vehicles To Market The Value Of Your Services. Words alone will
not convince savvy consumers that your people, and the services
they perform, represent an extraordinary value. That's because
everyone promises good service. You must furnish proof in the form
of signage, brochures, specialized merchandising and the like. The
more of these tools you use, the greater the perceived valued and
the greater opportunity to earn a higher price for your projects.
Again, here, a consultant can be instrumental.
Gross Profit Increase: Minimum 3%, or $30,000.
Marketing Investment: Approximately $6,000.
Impact on Business: Net Profit directly increases by $24,000 to $54,000. The ROA now becomes 13.5% (5.4% x 2.50) instead of 7.5%. When multiplied by the same FLM of 4.44, the ROI for the business dramatically increases to 59.9% an 80% improvement.
- Management Software. Imagine a management software program that
tracks leads, ordering details, project management info, cash flow,
break even points, commissions, etc. to streamline your operations.
Networked among staff members, it will prevent embarrassing delays,
increase productivity and morale, and save the cost of a part-time
Savings: Estimated $10,000 in salary.
Software Investment: Approximately $2,000.
Impact on Business: S&A Expenses are reduced by $8,000, increasing net profit by 0.8%. The ROA now becomes 9.5% (3.8% x 2.50). When multiplied by the 4.44 FLM, the ROI for the business improves to 42.2%a 27% enhancement.
- Diversification Display(s). With a sluggish economy,
diversification is important. Furniture grade closets are a
burgeoning business among upscale clientele. So are media centers
and home offices. These are the kind of displays that can generate
add-on sales and be promoted to past kitchen customers. Remember,
however, that commissions and payroll taxes are variable expenses
associated with a sales increase.
Net Profit Increase: $3,000 on a $100,000 sales increase.
Display Investment: $4,000.
Impact on Business: The Net Profit percentage doesn't change ($33,000/$1,100,000). However, the Total Asset Turnover increases to 2.72 ($1,100,000/$404,000), making the ROA now 8.17% and the ROI on the business 36%a 9% improvement.
- Buying Group Membership. At $650,000, the Cost of Goods Sold is
your company's greatest expense. Of that total, about $550,000
represents Material Purchases. If just $200,000 of these materials
can be purchased from vendors offering deeper discounts and volume
rebates, substantial dollars can drop directly to your company's
bottom line with even more in future years.
First-Year Savings & Rebates: $11,000.
Buying Group Investment: Approximately $5,000, covering membership fee, conference expense and display changes.
Impact on Business: Net Profit increases 0.6%, elevating the ROA to 9% (3.6% x 2.50) and the ROI on business to 40%a 20% increase.
Collectively, the $20,000 investment made in these five areas of
your business is likely to generate a combined return of
approximately $48,500 or 242%. Other factors remaining equal, the
cumulative impact of these investments can improve the Net Profit
to 7.55% and the Total Asset Turnover to 2.72. When multiplied
together, the projected Return on Assets would be a robust 20.5%,
leading to a 91% ROI for your business.
Understanding the Return on Investment concept is, indeed, the critical key to financial success in the retail kitchen and bath design business.