Profit Planning When the Chips are DownWritten By: GARRY BARTECKI
Article Date: 09-03-2007
Copyright(C) 2008 Associated Equipment Distributors. All Rights Reserved.
Are your sales and margins down while operating expenses are up? Here's a little trick we call Financial Engineering.
When we ask dealers what they expect for the rest of the year, this is what I hear: Sales down, gross margin percentage down and, of course, operating expenses up. Keeping in mind that "sales down" in this market is not as bad as it sounds, there is still no doubt that some planning is required to keep the ship afloat at close to current levels, meaning current returns on ROA and ROE. A slowdown in sales with increased margin pressure makes me think about the profit planning model that appears in the annual Cost of Doing Business Report. You will find it on page 10 of the general report. The model is stated as:
EBT X Asset Turnover = ROA X Financial Leverage = ROE
You remember this, don't you? If you don't, please dig up your copy of the CODB and look it over. A short review of the formula along with the definitions will get you back on track.
Take a few minutes to see how the formula works in terms of maintaining ROE. You can then use your current and projected balance sheets and income statements to predict both ROA and ROE, make adjustments and then recalculate the returns to see how your results were affected.
- EBT = Earnings Before Tax
- Asset turnover = Annual Sales / Total Assets
- ROA = Return on Assets
- Financial leverage = Total Assets / Shareholders Equity
- ROE = Return on Equity
To help you with this process, AED has prepared an Excel worksheet using an industry format into which you can drop your historical and projected figures to calculate ROE. Fill in all the blanks and you are on your way to adjust your business plan. Keep the final version on file and you can continue to update the worksheet as you see fit. Or, you could track historical data on one file and do your projections on another, which is what I suggest. The link to this worksheet is www.aednet.org/codb/tools.cfm.
To keep ROA constant you need to keep the profit on your income statement and your investment in total assets at current levels, which may be hard to do with sales and margins dropping and inventory increasing. Just remember the need to manage both the income statement and balance sheet. It will take some doing working with turnover rates, etc., but you can get pretty close based on your historical operating stats.
Applying the expected scenario you would expect lower earning before tax unless expenses are reduced to compensate for the decrease in margin dollars. Looking at the formula you can see that if EBT decreases without a corresponding decrease in assets, ROA will decrease along with ROE. On the other hand, if you understand the need to manage the balance sheet as well you could cut back on purchases, reduce inventory levels, sell off excess assets with a goal to bring Total Assets in line with EBT to keep the ROA constant. Sounds like magic, but it works. Believe me.
Moving ahead to the next piece of the puzzle, you can tell that shareholder equity will not increase at the same rate as in the past if sales and margins drop. Assuming you reduced assets to keep ROA in line, financial leverage will decrease if shareholder equity holds firm, and if financial leverage decreases ROE goes down and not up. To increase ROE you need to increase the ROA enough to offset the negative effect of reducing total assets on your ROE calculation.
Take out a calculator and run the equation using a simple example. Start with $100 in assets and $30 in equity - a pretty standard result for dealers. That gives you a 3.33 financial leverage figure. If you now reduce your assets by $10 you have $90/$30 or a 3.00 factor. Since ROA is multiplied by financial leverage to get ROE, the lower factor of 3.00 will reduce ROE.
All that being said, dealers need to maximize earning and minimize assets to hit their desired ROE. To offset the negative effect noted above, asset turnover would need to increase in order to increase ROA along with lower financial leverage to keep ROE constant.
We call this exercise "Financial Engineering," and it really is just that because it takes some effort and expertise to make it work the way you want it to. Working with available AED models helps with the process and makes planning easier.
These are the types of exercises we go through at our annual CFO conferences. The second program for this year is scheduled to take place on Sept. 25 and 26 in Dallas. Along with financial analysis, we have in-depth discussions regarding tax issues (of which there are many), financing alternatives, valuation methods, managing insurance costs, the "lean" sales process, etc. It is a fun-filled, two-day program to teach dealers how to manage their business and improve operating results. There is limited space, so check with Pat Novak at AED to see if we still have room.
All kidding aside, the CODB provides industry- specific benchmarking data to help you manage the income statement and balance sheet. Keep in mind the High Profit Dealers in the survey represent 25 percent of the reporting participants, which should tell all of you that "You can do it, too!"
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