Understanding of business can often seem very complex, but all businesses can be simplified into its key elements. The basic building blocks that all business need to be founded on. All businesses exist to provide their stakeholders with a return. The ultimate goal is to provide a reasonable return on equity. If a business is unable to provide this then there is little point in that business existing. There are 3 key elements that tell us how to acheive the 4th.
Profit making process
1. Raising funds to finance assets (cash management)
- Funds raised by shareholders
- Money borrowed
To enhance gearing
- Increase proportion of funds that are borrowed – Be careful not to fall short of sales otherwise could negatively impact ROE
2. Turning assets into sales (cash management)
To enhance asset turnover
- Increase sales from existing assets
- Maintain current sales with fewer assets
3. Turning sales into profit (profit management)
To enhance profit margin
- Reduce costs as percentage of sales
- Cut costs – may adversely impact sales and margins.
4. Return on equity is the overall objective (1, 2 and 3 key elements and tell us how to achieve 4 which is key.
To enhance ROE
- Increase gearing
- Increase asset turnover
- Increase profit margin
- Keep monitoring to see if any given strategy is working