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:
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.
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:
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