Non-finance people often wonder, ‘What is there to understand about profit?’ One must know how to make and how to sell. Profit is the result. I am not at all underestimating the importance of the ability to make and sell. If you don’t know how to make and sell, you can never make profit. But if profit is the automatic result of making and selling, then two organisations that know equally well how to make and how to sell should also make the same profit, isn’t it?
But that never happens. Pick any two businesses (motor car manufacturers, hotels or the construction business) more or less of the same size, similar capital investment and even similar sales, the profit will not only be the same but it is also possible that one of them is making profit and the other losses. This is because profit is the result of finance management.
But if profit is the automatic result of making and selling, then two organisations that know equally well how to make and how to sell should also make the same profit, isn’t it? But that never happens.
What drives profit?
I will give you three drivers of profit. Profit in any business is the result of the optimisation of the following:
- The cost of capital
- The proportion between performing and non-performing assets, and
- How long in the year the performing assets actually perform
Let’s examine all three.
1. The cost of capital:
The capital invested in any business is usually a combination of the contribution made by the owners (equity), the outside lenders (loans) and also that which is borrowed in kind (the creditors, supplying goods and services on credit). It is important to remember that each of these has a cost. The outside lenders’ cost is the most obvious, that is, the interest rate. The cost of suppliers’ credit is couched in the price quoted (which has a built-in interest component). The owners’ contribution is often mistakenly considered to be free of cost, when, in fact, it is the most expensive source of money (at the very least it should be taken at twice the interest levied by outside lenders). Taken together, one can arrive at the weighted average cost of capital.
2. The proportion between performing and non-performing assets:
If a business makes a list of all the assets that it owns, with a little effort, it will be able to classify all the items into two types, viz. Performing Assets (PAs) and Non-Performing Assets (NPAs). NPAs should not be mistaken to be non-essential. NPAs simply mean those assets that do not earn. So NPAs can be further broken up into essential NPAs and non-essential NPAs. It is the biggest crime to possess non-essential NPAs.
3. How long in the year the performing assets actually perform:
Even Performing Assets do not perform throughout the year. If a business runs for six days in a week, the assets do not perform for 52 days in a year. If one follows a 5-day week, the assets don’t perform for 104 days. If one runs a holiday resort in Goa, it probably performs for 3-4 months in a year.
Don’t buy a new plant just because you have reached full capacity. If you are running just one shift a day, you have not reached full capacity yet. Sweat your assets.
How to use these three drivers to improve profit:
There is scope for improvement on all three fronts.
On the cost of capital front: Some sources of capital are more expensive than others. If the capital composition was made up of a relatively larger proportion of cheap money and a smaller proportion of expensive money, the average cost of capital can be reduced.
On the cost of PA: NPA front: Almost all the assets appearing on a balance sheet are a result of the actions of people who do not even recognise themselves as finance persons. The decision as to which machine should be purchased, of what capacity, of what make etc. is taken by people with technical backgrounds. The volume of inventory to be held is a decision of the materials manager. Debtors are the result of the actions of the sales people. Each of these people usually consider themselves as non-finance persons.
If everybody in the organisation recognises that finance management is their responsibility, if the organisation takes the effort to impart finance literacy amongst all its personnel, if everybody in the organisation understands the concept of cost of capital, if everybody recognises the crime of possessing a non-performing asset and if financial prudence is exercised at the time of acquisition of the assets itself, the organisation can possess a relatively larger proportion of PAs as compared to the NPAs.
On the utilisation of the PAs front: That an asset is a performing asset is not enough. It has to perform. I don’t understand why organisations are shut for a day or two every week. Do, by all means, give your employees an off, but why should the organisation be shut. Don’t buy a new plant just because you have reached full capacity. If you are running just one shift a day, you have not reached full capacity yet. Sweat your assets.
Consciously work on these three fronts and I can virtually guarantee that your profit will go up even with the existing turnover. And now, with a perfect balance sheet at your disposal, try and increase turnover too, and you will see dramatic improvements in the bottom line.