The Cost of Borrowing and Its Impact Against Corporate Profitability

This is Part 3 of a Series. Go to Part 2: Core Business Profitability and Its Mathematical Derivation

The Corporate Cost of Borrowing. This can be observed by
focusing on the company's Financial Liabilities; those interest-
bearing debt the company has deliberately externally
sourced to finance business operations.

Wouldn't it be nice to know what interest rate the company is borrowing at and be able to observe how it is affecting overall corporate profitability? That is what we are about to do. The Effective Interest Rate can be observed by focusing on the Financial Liabilities of the company.

We qualify Financial Liabilities because these are those interest-bearing debt which the company has deliberately sourced externally to finance its operations, as opposed to Trade Liabilities which came about because of business operations (e.g. accounts payable).

Financial Liabilities can be observed under Cash Flow from Financing Activities while Trade Liabilities can be seen under Cash Flow from Operating Activities.

Core Business Profitability and Its Mathematical Derivation

This is Part 2 of a Series. Go to Part 1: Innocent, Unadulterated Profitability Most Businessmen and Entrepreneurs Would Readily Recognize

Profitability of the Company's Core Business Operations.
As businessmen investors, we would have to filter and qualify
general corporate profitability and be able to see through
the company's main core operations.

Our initial focus: EBITDA (Earnings before Interest, Taxes, Depreciation & Amortization). I would have to be honest that even I have been a cold skeptic of this metric in the early stages of my education in investing, but I have come to realize it recently that it is actually useful for purposes of observing Core Business Profitability. It filters the distortions of the Interest, Taxes, Depreciation & Amortization (D&A) portion and primarily focuses on innocent earnings derived from Working Capital's turnover activity.

Note: We would have to qualify "Earnings" as only those earnings derived from business operations and exclude Other Income which are derived from Non-core Business Investments. Working Capital Turnover, on the other hand, would also have to be derived using Operating Expenses before D&A to be more meaningful since, as already explained, Working Capital has nothing to do with covering D&A.

Innocent, Unadulterated Profitability Most Businessmen and Entrepreneurs Would Readily Recognize

This is Part 1 of a Series.

Gross, Innocent, and Unadulterated. Working Capital turnover
with an inculcated mark-up is that profitability most entrepreneurs
and businessmen would readily recognize and easily relate to.

The standard Return on Asset (ROA) formula is computed simply as Net Income divided by Total Assets. It's a quick easy ratio to assess Overall Asset Profitability. Singularly looking at this metric, however, lacks insight, and doesn't tell us much about the factors driving profitability, i.e. how exactly the business is achieving this return. There is a need to dissect it to have visibility and to pinpoint the drivers of profit. Further, as businessmen investors, we are particularly interested in observing the Core Business Profitability of the enterprise.

The starting point is that profitable Working Capital activity; that liquid asset turnover with an inculcated mark-up which drives gross, innocent, unadulterated profitability. It's what most entrepreneurs and businessmen would readily recognize and easily relate to. You can hear them asking "how's the mark-up in this business, and how fast is your working capital turnover?"

Return on Assets Dissected and the Diminishing Effect of Capital Spending against Core Business Profitability

This is Part 3 of a Series. Go to Part 2: Dissecting that Process which Drives Business Profitability

Magnified Mark-up Profitability diminished. The impact of the
working capital's profitable turnover can only go insofar as to
how much it weighs against overall operating assets
in which Capex Assets may take a large portion of.

So in this example of ours, what is the Return on Assets (ROA)? We would have to divide the $20,000 in profits by the total asset base we have laid out for this venture, which is $70,000 ($50,000 in working capital plus the $20,000 in transportation vehicle capital spending) to arrive at a 28.57% return. This 28.57% ROA, in itself, however, doesn't give us much insight, and for sure you would agree with me in saying that as an entrepreneur and businessman, we are interested to know what has driven this 28.57% return. Observe the following as we dissect ROA into its finer elements:

$20,000 in operating income / $100,000 in operating costs = 20% Mark-Up

$100,000 in operating costs / $50,000 in working capital = 2x Turnover of working capital

$50,000 in working capital/ $70,000 worth of operating assets = 71.43% Weight of working capital against overall operating assets

20% mark-up x 2x turnover x 71.43% weight = 28.57% ROA

Dissecting that Process which Drives Business Profitability

This is Part 2 of a Series. Go to Part 1: Return on Assets and the Drivers of Fundamental, Business Profitability

Dissecting that which drives the Profitability in
the Importation-Selling Business Model. The starting point is
selling at a Mark-up. Working Capital Turnover, then after,
magnifies this profitability effect many times, increasing
profitability even more.

Let's say we are an importer-seller of computer electronics. Throughout this process, we are very mindful of the process in making profits. The starting point is selling at a certain mark-up from related costs. We surmise all related costs, from the cost of the items themselves, to the costs of importation/ shipment, transportation/ communication expenses, employee pay/salary, rent, electricity, etc. All of these costs would have to be covered by adding a Mark-up. While some people would look at this profitability as a percentage of revenues (net profit margin), I find it more intuitive if we express this operating profit as a percentage of all costs. That is to say if all operating costs throughout the year in this importation business is at $100,000, and we profited $20,000 in this whole process, then we, as businessmen, have effectively set a 20% mark-up (i.e. $20,000/100,000) on our costs.

Return on Assets and the Drivers of Fundamental, Business Profitability

This is Part 1 of a Series.

Balance Sheet, Income Statement, Cash Flow, ROE, Current Ratio, Debt-to-equity ratio, etc...

Stop! Just close your eyes for a moment...

Amidst the confusion these financial terminologies may cause you, ask these simple, innocent, basic questions to put yourself in the proper mindset, proper framework: How exactly is the company making money? How profitable is it? And what exactly is driving its business profitability?

Return on Assets (ROA) sheds some light on measuring
fundamental business profitability. It doesn't discriminate on
equity alone, but all assets regardless of financial structure.

The fundamental, economic profitability of a business model... this, from the very eyes of a prospecting businessman investor is most essential. The company's bread and butter, so to speak, has to be seen and understood after all, even before committing capital. It maybe oversimplification for me to say this, but fundamental business profitability can be assessed by looking at the Return on Assets (ROA) which mathematically is Net Income divided by Total Assets. I emphasize "business profitability" because ROA is able to filter out the effects of debt financing. Profitability is not discriminated on equity alone; rather, it assesses overall asset profitability, i.e. how much rate of return is derived from total assets, regardless whether financed by debt or equity. In contrast to the Return on Equity (ROE), it doesn't include the financial leverage component which can amplify a company's good performance.

Flipping a Stock versus Indefinite Ownership

Stock flipping? Why not just indefinitely own it to take
advantage of its underlying compounding power... forever?

On one hand, there's the strategy of appraising a stock and arriving at an intrinsic value. If the current market price is selling below this "fair" value, then it's a signal to purchase the stock. After acquiring some shares, the "investor" would be waiting for the market to correct itself and price the stock at the level of the intrinsic value. Upon its appreciation towards the fair level, the "investor" would then sell the stock to realize an immediate capital gain. It becomes a relentless pursuit, since liquidation forces one back to a cash position, which requires to identify yet again another bargain candidate to exploit.

The Stock Price Tag being Dictated by Your Required Rate of Return

Stock Price Tag. The price a rational investor pays for a
stock would have an implied rate of return. Because the 
price one pays dictates his rate of return. Or put in another 
way, one's required rate of return dictates the fair price to pay. 
A price tag is not appraised just for the sake of it.

When someone appraises a stock and assigns a fair price tag for it, what exactly does that imply? To most of us, it's fairly intuitive: it just means that it should be bought at or below that price. Simple enough, isn't it? But let's say you are indeed able to buy it at that price, what's next? What should be the expectation?

My criticism of simply appraising a stock for the sake of it is that it loses track of why one is appraising it in the first place. My personal view is: a fair price should be appraised based on an expected rate of return. I cannot further stress the importance of this point.

A rational investor and capitalist buys a stock because first and foremost, he expects a certain rate of return from it. So yes, that is where it should all begin. A rational investor, even before buying into a stock position, should have a set required rate of return. This is the very basis of stock appraisal. Because the price one pays dictates his rate of return. Or put in another way, one's required rate of return dictates the fair price to pay.