Evaluating Your Business Like an Investment
When you are running a business it is easy to get lost in the day to day and not step back and look at things like an investor. However, doing so can profoundly impact your strategic planning and ultimately, your company's growth and value.
Let’s take a look at how you can think like an investor:
Return on Invested Capital
Just like when you invest in the stock market, you should be measuring the return on the capital you invest into your business and actively working to improve them. Per Greg Crabtree’s book Simple Numbers 2.0: Rules for Smart Scaling, a business should be achieving a minimum of 50% return on invested capital (ROIC) and the average across most industries is 75%. These figures highlight the importance of not just earning a profit, but generating substantial value from the resources committed to your business.
What Is Invested Capital
Invested capital is the money you or investors have put into your business to make it run. Debt is not invested capital as this is money that has to simply be paid back by profits or by you injecting more invested capital in the future. Understanding the full scope of your invested capital is the first step toward improving how it works for you.
Impact of Owner’s Compensation on ROIC
An owner’s salary can greatly impact the ROIC of a company as it does change the net income of a company. But many times the sweat equity of a business gets overlooked when calculating the return on investment. If your owners are collecting a below market rate of salary then the difference should be included in their invested capital to determine their ROIC.
How To Calculate Your Return On Invested Capital
(Cash Invested + Sweat Equity + Retained Earnings)/ (Pretax Net Income - Tax)
In this case pretax net income would include normal book depreciation of assets but it should not include accelerated depreciation simply taken for tax deferment.
How to Improve Your Return on Invested Capital
Improving your ROIC means making smarter decisions that increase profits and efficiency while optimizing the use of assets. Here are four strategies to consider:
Change Profitability: Look at your pricing strategies, cost management, and product or service offerings. Small adjustments can lead to significant improvements in profitability, thereby enhancing your ROIC.
Change Capital Requirements: Analyze how your capital is deployed. Reducing inventory levels, optimizing receivable collections, and managing payable terms can free up capital and improve ROIC. Efficiently managing your capital reduces the need for additional investments and improves overall returns.
Chasing Tax Savings Can Negatively Impact Your ROIC: While taxes do reduce net income for purposes of the ROIC calculation, many entrepreneurs hurt their return on invested capital by chasing tax savings. It's essential to consider the long-term impacts of decisions aimed solely at reducing taxes. Sometimes, these decisions can lead to reduced profitability or higher capital costs, which can adversely affect your ROIC.
Watch Out For Over Capitalization: Investing more capital than necessary in your business can dilute returns. It’s crucial to critically assess each investment decision to ensure it directly contributes to generating higher returns rather than merely inflating your asset base. If you cannot effectively deploy the capital in your business, then you may be better off deploying it in a different business or investment.
Viewing your business through the lens of an investor and focusing on ROIC can revolutionize your approach to management and operations. By carefully assessing the returns generated by each dollar invested, you can make strategic decisions that not only boost your financial performance but also position your business attractively for potential investors or a future sale. Remember, the goal is to maximize returns on all forms of capital invested, ensuring sustainable growth and enhanced profitability. Get started with us today!