Return on Investment percentage (ROI), also sometimes referred to as Return on Capital Employed (ROCE), is the financial ratio that links the Profit & Loss statement and the Balance Sheet.

This ratio is calculated as follows:

$ Net Profit ÷ Net Assets x 100

(Net Assets are sometimes referred to as shareholder’s funds or shareholder’s investment.)

In the case study from article one in this series, our hardware store was making a net profit of $80,000 against a shareholder investment of $675,000. The shareholder’s investment was represented by assets in the case study Balance Sheet of $1,970,000 against liabilities of $1,295,000.

Thus the Return on Investment percentage result for the case study is:

$80,000 ÷ $675,000 x 100 = 11.85%

Many owners and managers would be pleased with a result of 11.85% based on the theorem that an 11.85% return is better than what you can get from the bank. But, remember that, as an owner or as a manager representing shareholders, you are managing an investment in a hardware store, not a bank.

A bank in New Zealand is known as a risk free investment and currently putting money in the bank would give you a maximum return of say 5%.

My experience over the last two decades in this industry as a financial management consultant is that a fair proportion of hardware and trade stores achieve a return on investment that’s less than 5%...

 

TARGETING RETURN ON INVESTMENT

So what should you be targeting as ROI for your operation? There are three components I include in working out a target ROI.

Well we have already reviewed the first component – that is the “risk free rate” (i.e. 5%).

The second component is to factor in risk. This a combination of many elements such as:

• Level of competition.
• Weather conditions.
• Government policy.
• District economy.
• National economy.

The list is endless. For myself, as a rule of thumb over the years I have used the “risk free rate” x 3, that is 15%.

The third and final component is what I call the non-negotiability factor. The concept behind this is that as a shareholder or as a manager for shareholders the business must generate a return to compensate the owners for having their money locked into the operation – it cannot simply be taken out on demand. I use the risk free rate as the benchmark that is 5%.

Thus the target Return On Investment is:

5% + 15% + 5% = 25%

Attentive readers will note that 25% is the same figure as I use as the basis for calculating the goodwill of hardware stores, for which there is more information on my website (www.petermcox.com.au).

 

LIFTING THE BAR

Returning to our case study, our ROI percentage of 11.85% is obviously under the target of 25%.

So – how to achieve the target of 25%? Well there are two components to the calculation. Let’s review the top line first.

1. Net Profit – To achieve an ROI of 25 % the operation needs to produce a net profit of $168,750 which is a difference of $88,750 against the current case study profit of $80,000.
   This would be probably not achievable in 12 months as it represents an increase of 110% but a start could be made by reviewing strategies to increase sales (without discounting!), increasing Gross Profit Margin and managing overheads.
2. Net Assets – The case study’s Total Assets are $1,970,000, while Total Liabilities are $1,295,000. Thus Net Assets are $675,000.
   I have found if you wish to increase your ROI percentage, two actions in this area will have an immediate impact – that is collecting the outstanding debtors quicker and turning stock over faster. Both these assets generally make up the bulk of shareholder’s funds tied up in the store.

 

This is the last of the four Key Performance Indicators that need to be reviewed annually and compared to prior year’s results. To summarise these are:

• Cash Cycle (November 2013 issue).
• Stock Productivity Index (December 2013 issue).
• Margin of Safety (February 2014 issue).
• Return on Investment (this issue).

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Peter Cox is a senior consultant for Macquarie Advisory Partnership based in Sydney. He has over a decade of experience training and consulting in the retail hardware industry. He conducts key-note addresses, and management and sales workshops, which are aimed at improving profitability and liquidity in one of Australasia’s most competitive retail environments. Phone 0061 438 712 200 or visit www.petermcox.com.au