Creating Value: The building blocks of business

1. Creating Value:The building blocks of business

2. Business objective The objective of any business is to maximise profits. In maximising profits the business looks to maximise returns for shareholders. But, how do we achieve this objective? How do we maximise profits and returns for shareholders?

3. Agenda Today, we will: • Identify three building blocks of business. • First take a high level look. • Then look at them in more detail. • Then identify and discuss the primary levers of the building blocks and how to improve business performance.

4. Basic income statement and balance sheet

5. 3 building blocks • Profit margin • Asset turnover • Capital structure or leverage

6. Profit margin Shows the number of cents profit for each R of sales. Calculated Profit x 100 Sales 1 Sales – expenses = profit To increase the profit margin • Sales ↑ and/or • Expenses ↓

7. Asset turnover Shows how many Rs of sales are generated for each R invested in assets, that is, how efficiently the assets are utilised. Calculated Sales Assets To increase asset turnover • Sales ↑ and/or • Assets ↓

8. Combining profit margin and asset turnover EBIT x 100 x Sales Sales 1 Net Assets Profit x 100 x Sales = Profit = ROA (return on assets) Sales 1 Assets Assets • ROA links the income statement and balance sheet. • ROA shows the number of cents profit for each R invested in assets. • Since Assets = Capital, ROA = ROC .

9. Capital structure or leverage Shows the proportion of capital financed by debt/ loans as opposed to shareholders equity. Calculated Capital Debt/ loans

10. Now again in more detail

11. More detailed income statement

12. More detailed balance sheet

13. Profit margin Shows the number of cents profit for each R of sales. Calculated EBIT x 100 Sales 1 To increase the profit margin • Sales volumes ↑ • Selling price ↑ • Fixed and variable manufacturing costs ↓ • Operating expenses ↓

14. Asset turnover Shows how many Rs of sales are generated for each R invested in assets, that is, how efficiently the assets are utilised. CalculatedSales Net Assets To increase asset turnover • Sales volumes ↑ • Selling price ↑ • Fixed assets ↓ • Working capital ↓, that is, the cash cycle

15. Cash cycle

16. Combining profit margin and asset turnover EBIT x 100 x Sales Sales 1 Net Assets EBIT x 100 x Sales = EBIT % Sales 1 Net Assets Net Assets Return on net assets (RONA) = EBIT% Net Assets • RONA shows the number of cents of profit for each R invested in net assets. • This is key as when we invest in assets the intention is to generate a return on that investment.

17. Return on net assets (RONA) • RONA links operating profit (EBIT) from the income statement with net assets from the balance sheet. • Profit margin and asset turnover are different for different industries, however, when combined RONA ≥ Cost of debt, otherwise you are destroying value. • Since Total Capital = Net Assets, RONA = ROCE (return on capital employed). • ROCE shows the number of cents return for each R invested in capital.

18. 3 PRIMARY levers 3 primary levers for improving business performance are: • Sales ↑ • Costs and expenses ↓ • Assets ↓ We will look at each of these in more detail.

19. Increasing sales First need to be serving a need or solving a problem, if not, why would anyone by from you? Sales = # units sold (volume) x selling price • Trade off between selling price and volume. • An increase in selling price reduces # units sold. • A decrease in the selling price increases # units sold. • Depending on the price elasticity, a 1% reduction in the selling price may result in a 10% increase in # units sold.

20. Increasing sales • Product mix – focus on selling the most profitable products. • Client mix – focus on selling to the most profitable customers and those with the most potential. • Value chain – examine and determine where the value opportunities are and decide where you should play. • Ansoff model

21. Example of furniture value chain

22. Reducing costs and expenses: fixed versus variable • Fixed costs remain unchanged irrespective of the level of production. • Examples include rental, insurance, rates and taxes, some salaries. • Variable costs change in proportion to the level of production. • Examples include raw materials, sales commission. • Companies with high levels of fixed costs are normally more risky. • The level of fixed costs is often a function of the industry. • Reducing fixed costs in the short term is difficult. • Fixed costs are often linked to fixed assets. • Objective is to keep fixed costs as low as possible.

23. Reducing costs and expenses: purchases • Purchases are the biggest cost for most businesses. • Retailers and wholesalers purchase inventory. • Manufacturers purchase raw materials. • Ensure that you have more than one supplier. • Regularly test prices to ensure you are getting the best price. • Develop relationships with your key suppliers. • Determine economic order quantities. • Take advantage of discounts on large purchases and early payment.

24. Potential purchases savings • A savings of 2% on purchases will be R120,000. • This will increase net profit 12% from R1,000,000 to R1,120,000.

25. Reducing costs and expenses: labour • Labour is another significant cost for manufacturing companies. • The objective is to increase productivity. • Improve business processes. • Establish performance and productivity standards. • Compare actual performance with the standards. • Ensure staff are properly trained and qualified for the position. • Use bills of materials and job cards. • Reduce rework and scrap. • Net result is a reduced production cycle and thus costs. • Are there opportunities to outsource?

26. Reducing assets • Assets consist of: • Fixed assets • Working capital (current assets – current liabilities) • Fixed assets: • Property • Plant • Equipment • Motor vehicles • Current assets: • Stock/ inventory • Debtors/ accounts receivable • Current liabilities: • Creditors/ accounts payable

27. Reducing assets: fixed assets • Fixed assets, like fixed costs, are difficult to reduce in the short term. • A function of the industry the business operates in. • Assess the level of vertical integration in the value chain. • Determine where the value is. • What assets should we own and how do we control the rest?

28. Example of furniture value chain

29. Reducing assets: working capital • Management of working capital is critical to a business. • Look to reduce the cash cycle. • Working capital objectives: • Reduce inventory days – reduce the time between buying and selling inventory. • Reduce receivables days – reduce the time between selling inventory and receiving payment. • Extend payables days – extend the time between purchasing and paying for inventory.

30. Reducing assets: operating and cash cycles Accounts receivable period Operating cycle Buy stock Sell stock Receive payment Stock period Accounts payable period Cash cycle Pay for stock

31. Reducing assets: operating and cash cycles Accounts receivable period Operating cycle Buy stock Sell stock Receive payment Stock period Accounts payable period Pay for stock Cash cycle

32. Reducing assets: inventory management • Inventory holding costs consist of: • Carrying or storage costs • Ordering and shortage costs. • There is an inverse relationship between carrying/ storage costs and ordering/ shortage costs. • Carrying costs increase with inventory levels, while ordering/ shortage costs decline. • The goal of inventory management is to minimise the sum of these two costs. • In manufacturing companies improving and thus reducing the production cycle, will reduce inventory levels.

33. Reducing assets: ABC inventory management Divide all inventory items into 3 or more groups in terms of: • Inventory value • Order lead time • Consequences of shortages and • Managerial effort. The logic is that a small quantity of inventory might represent a large portion of inventory value.

34. Reducing assets: ABC inventory management • A group comprises all high value inventories. • Stocks are kept to a minimum. • Items are strictly monitored and tightly controlled. • Precision ordering is important. • B group items are of medium value. • Require average-scale monitoring and control. • C group inventory comprise basic, inexpensive items. • Items are ordered in large quantities to ensure continuity of supply. • Monitoring and control is of least importance here.

35. Reducing assets: receivables Controlling receivables is key to any business. • Establish a receivables policy which covers: • Who you grant credit to. • Credit assessment. • Collection policy. • Close monitoring of accounts and swift action on overdue accounts is crucial. • Offer cash discounts. • Increase down payments.

36. Reducing assets: payables Extending payables. • Negotiate better terms with your suppliers. • Extend payment without losing supplier goodwill or trade discounts. • Cash discounts are usually attractive and worth taking advantage of.

37. Capital structure or leverage Shows the proportion of capital financed by debt/ loans as opposed to shareholders equity. Calculated Total Capital Debt/ loans Since Total Capital = Net Assets Total Capital = Net Assets Debt/ loans Debt

38. Capital structure or leverage: why use debt? Total Capital = Equity + Debt • Debt is cheaper than equity and thus reduces the cost of capital. • The value of the business is increased. • Shareholder returns are increased. • However, as debt levels increase so does risk and thus the return demanded by shareholders – return on equity (ROE). • Leverage increases ROE where RONA or ROCE ≥ cost of debt. • But what happens if RONA declines or interest rates increase?

39. Calculating return on equity (ROE) Profit x Asset x Leverage = Margin Turnover EBIT x Sales x Net Assets = Sales Net Assets Equity EBIT x Sales x Net Assets = EBIT = ROE SalesNet Assets Equity Equity Kept it simple and ignored interest and tax ROE = NPAT (net profit after tax) Equity

40. Business objective The objective of any business is to maximise profits. In maximising profits the business looks to maximise returns for shareholders. ROE = Profit margin x Asset turnover x Leverage ROE = RONA x Leverage ROE = NPAT Equity

41. REFERENCES • Andrews, A & Black, T. 2002. Who moved my share price? Jonathan Ball Publishers. • Slywotzky, A & Morrison, D. 2002. The profit zone. Three Rivers Press. • Ward, M & Price, A. 2006. Turning vision into value. Van Schaik Publishers.