A business must do two things;
- Generate profit
- Generate cash flow
The first stage of the profit making process it to…
- Raise funds to finance assets (cash management)
What assets does the business need in order to trade?
How are these assets to be financed?
- Funds raised by shareholders
- Money borrowed
To enhance gearing
- Increase the proportion of funds that are borrowed – Be careful not to fall short of sales otherwise could negatively impact ROE and also watch the cost of borrowing (interest rates) if these increase could negatively impact ROE also.
- Increased debt will make a positive contribution to a firm’s ROE only if the matching Return on assets (ROA) of that debt exceeds the interest rate on the debt.
- Turning assets into sales (cash management)
To enhance asset turnover
- Increase sales from existing assets i.e.
- expand store (asset) trading hours
- utilise assets better
- rent out unused office space
- Maintain current sales with fewer assets i.e.
- reduced account receivables from 30 days to 14 days
- reduce inventory levels or get rid of obsolete inventory
- buy used (less expensive) infrequently used equipment
- rent or lease infrequently used equipment rather than purchase
- subcontract out specialised jobs not routinely done
- Turning sales into profit (profit management)
To enhance profit margin
- Reduce costs as percentage of sales i.e. higher sales on same costs or costs rising less than sales are rising
- Cut costs – may adversely impact sales and margins.
- 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
For more about business, check out our business guide.