Or, does our corporate strategy really necessitate that we have lower turnover than Red, Inc.? How does our strategy influence the manner in which we allocate family resources to productive assets?.sufficient? Does the market perceive our family business to be a premium provider? If so, are we pricing our services appropriately, or are we leaving money on the table? Given our corporate strategy, is a 100 basis point premium in profit margin to Red, Inc.Do the performance differences revealed by ROIC correspond to our stated corporate strategy? In other words, given how our family business has elected to position itself in the market, do the components of ROIC make sense?.can begin to formulate some probing questions for their next meeting: With this knowledge in hand, the directors of Blue Corp. has a less efficient mix of assets, but more profitable operations. However, Red, Inc.’s higher turnover (2.5x) was offset by a lower profit margin (4.0%). Assume that Blue Corp.’s primary competitor, Red, Inc., also generated a 10.0% ROIC. Our example company, Blue Corp., earned a 10.0% return on invested capital on the basis of its turnover (2.0x) and profitability (5.0%). As a result, the median ROICs for the two sectors are broadly comparable despite the sectors’ having very different individual return components.īreaking down the overall return into its component parts is helpful for discerning the “why” of performance within a particular industry.īreaking down the overall return into its component parts is helpful for discerning the “why” of performance within a particular industry as well. However, health care providers tend to wring more profitability out of each dollar of revenue (medical care tends to be expensive). Relative to industrial companies, health care providers are very asset-intensive (real estate and expensive medical diagnostic equipment). Exhibit 3 compares the various components for large companies in the health care and industrials sectors. For example, Chapter 4 of Mercer Capital’s 2019 Benchmarking Guide for Family Business Directorspresents turnover and profitability data by industry for a group of publicly traded companies. All else equal, higher profit margins result in a higher return on invested capital.Įxamining ROIC through the lens of turnover and profit margin begins to lay bare how the family business’ industry and strategy influences financial performance. Revenue is essential, but only profits fuel family returns. Profit margin reveals how efficiently the family business converts revenue to profit. In other words, how well have management and the directors allocated family resources to a portfolio of business assets that produce revenue? All else equal, the more revenue generated per dollar of invested capital, the higher return on invested capital will be. Turnover measures how much revenue each dollar of invested capital generates.When we look at it this way, we can see that ROIC is the product of turnover and profit margin. As shown on Exhibit 2, by inserting revenue into our calculation of ROIC, we end up with two distinct components that each have a story to contribute to the overall ROIC narrative. But if we take a quick peek under the hood, we can learn a lot more about why ROIC is what it is. Return on invested capital is valuable enough as a free-standing metric. Why Has Historical Performance Been What it Has Been? Because ROIC is scaled to the size of the company, it also facilitates comparisons with available peer benchmarks. Because it is expressed in the form of a return, ROIC facilitates comparison to the performance of alternative investments that may be available to the family. ROIC measures the efficiency with which management is using family resources to generate income for the family. The basic calculation of ROIC describes how much NOPAT the business generates per dollar of invested capital: Return on invested capital correlates income statement performance (in the form of net operating profit, or NOPAT) with the balance sheet resources used to generate that performance (in the form of invested capital). In this week’s post, we will dig a little deeper with ROIC, demonstrating how we can use ROIC to answer the “what,” “why,” and “how” questions for your family business. In last week’s post, we introduced return on invested capital (ROIC) as a comprehensive performance measure for family businesses. The best performance metrics address not just “what” performance has been in the past, but reveal the “why” behind that performance and give direction for “how” to improve performance in the future.
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