It’s All About Profit. Right?

When I review financial performance with managers of middle-market private companies I find, with few exceptions, that their focus is almost exclusively on their income statements. “It’s all about profit,” they say. “It’s all about the bottom line.” In practice many chase revenue, even unprofitable revenue, but most understand that profit is necessary and that increasing it is a good thing.

It turns out, however, that it isn’t all about profit. Profit is very important, but there’s more to it than that. And some of the pieces of the puzzle can be found on the balance sheet. Here’s one example I often run through with businesses I work with:

Suppose we have Company A and Company B, both in the same industry and making similar products. They each have $10 million in revenue and $1 million in profit. Company A creates its profit with $10 million in assets (machinery, accounts receivable, inventory, etc), while company B creates the same profit with only $5 million in assets. Which one is creating more value?

Hopefully it’s clear to see that Company B is creating more with less and would have a higher market valuation. Its owners only needed to invest only $5 million to create their profit, while the owners of Company A needed to part with twice as much to get that same profit. While several metrics give insight into how much value a company is creating, and no single metric gives the whole story of a company’s performance, two of them can be particularly insightful: Return on Assets and Return on Equity. Both give insight into how efficient a company is at using its resources to create profit. We’ll focus on Return on Assets here and Return on Equity in a future post.

Return on Assets Return on Assets (ROA) measures how efficient management is at using the assets at its disposal to create profit, regardless of how those assets are financed. Put another way, for every dollar of assets being used in a business, ROA tells us how many dollars are created. So, a company with an ROA of 9% is creating $.09 of profit for every dollar of assets it has deployed. It’s a good high-level measure for measuring how efficient management is, especially managers who might not have control over how financing factors. The simplest and most common formula for calculating this is: ROA = Net Income / (Average Total Assets). Because Net Income includes interest payments and therefore would be different between a highly levered and lightly levered company that otherwise have the same operating efficiency, it’s best to correct for that. We’re trying to get to a true operating scenario as if there weren’t any financing at all. But we can’t simply add back interest expense. Interest is deductible, and the tax situation changes if the interest weren’t there. To account for that we have:

ROA = (Net Income + Interest expense net of income tax savings) / Average Total Assets

Or..

ROA = (Net Income + (1-tax rate) * interest expense) / Average Total Assets

If we are dealing with an entity that pays taxes, then we are done. However, if we are dealing with one of the majority of middle-market businesses that benefit from pass-through taxation (S corps, most LLCs, partnerships), we have arrived at a mismatch. We’ve just added back interest expense net of income tax savings to a net income that didn’t include tax expense in the first place. To arrive at a true after-tax ROA number, which is what would be calculated for our company’s larger peers or by investors considering which investment to make, we need to adjust net income to what it would have been if the company did need to pay tax.  (In reality the tax liability is there. It’s just that because of a difference in IRS treatment, it ends up on the tax return of the owners of the company instead of the company itself.) To make this final adjustment we end up with:

ROA = ((Net Income – (Net Income * tax rate)) + (1-tax rate) * interest expense) / Average Total Assets

If the company’s financial statements properly reflect economic value, we now have an accurate picture of the efficiency of management and their ability to utilize company assets to create profit. But alas, most companies in the middle-market have numerous distortions in their financial statements that don’t cause them not to reflect economic value. This is true even with audited financial statements. Accounting and tax rules don’t always match economic value rules. More on Return on Equity, distortions in financial statements, and the qualitative factors regarding all stakeholders in a business that indirectly drive all of this in other posts coming up soon…