Business executives and leaders are responsible for setting and executing strategies that provide shareholders with a return on their investment. Too often, leaders make business decisions that are based on the way a spreadsheet looks as opposed to making business decisions based on a strategy that makes the numbers on the spreadsheet look good.
Unfortunately for many organizations, leaders of businesses, leaders of people, leaders of process, and individual contributors don’t have the Business Acumen skills to make the right decisions that positively impact the drivers of business performance. Pulling the wrong levers and drivers of the business not only negatively impacts business results, it also will inevitably negatively impact total shareholder return.
In addition to wanting a return on their investment, shareholders also would like to know where their money is and what it is being used for. Knowing where their money is helps investors determine if their investment is a sound one, or if they’ve made a mistake.
Even more unfortunately, many business leaders also don’t have the business acumen skills to know where the money given to them by their shareholders is. There is nothing nefarious or illegal going on; they simply don’t have the skills and tools needed to understand that the assets of the company – and the assets they use to execute the strategy of the business – were provided by the investors of the business (not the executives setting budgets). The balance sheet of a business organization shows that assets (what the company owns) is equal to the liabilities (what the company owes) plus the owners’ equity (how the assets were financed.)
In order to better understand the basic business acumen drivers that explain where the shareholder’s money went, I will share ideas and insights on three important concepts:
Return on Assets (ROA)
Assets are the primary expenditure of the shareholder’s money. They include cash, accounts receivable, inventory, and property, plant, and equipment. Typically property plant and equipment are the most extensive and expensive uses of the shareholder’s money. What shareholders really want to know are the answers to the following questions:
- Are your account’s receivables too high?
- Are your inventories low enough?
- Are you driving the most revenue and profit from your property, plant, and equipment as you can?
The most common metric of answering these questions is Return on Assets. Return on assets is defined as net income divided by total assets. Companies will benchmark their ROA against industry norms, averages and the goals and targets set forth in the strategy. Leaders are expected to drive the highest ROA they can.
Return on Capital Employed ROCE
ROCE provides insights into how efficiently a company uses the capital available to it. Basically, ROCE is equal to earnings before interest and taxes (EBIT) divided by capital employed. The capital employed is the total amount of assets plus revenue less the current liabilities. The higher the ROCE, the more efficient it is using its capital.
Debt to Equity Ratio
The debt to equity ratio is the direct relationship between the amount of debt taken on by a company relative to the equity invested by shareholders. If a company takes on more debt, that also creates more risk for the shareholders; they will want to know why more debt? What are the leaders using the debt for? Is it to add more capacity or are the leaders doing a poor job using the invested equity to drive revenues and profit.
In summary, these financial terms may sound complicated and hard to understand but they answer a very simple question that is asked by all shareholders and investors; “where’s my money?” Do your people know how to answer the question?