Profit Making Process

A business must do two things;

• Generate profit
• Generate cash flow

The first stage of the profit making process it to…

1. Raise funds to finance assets (cash management)

What assets does the business need in order to trade?

How are these assets to be financed?

1. Funds raised by shareholders
2. 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.

 

2. 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

 

3. 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.

 

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

For more about business, check out our business guide.