Businessman Investor

Touching base with the rational business psyche of stock market investors

Sunday, November 23, 2014

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.

This whole process, however, doesn't come about if we don't have money in our hands in the first place. All businessmen and entrepreneurs would agree that generally speaking, it takes money to make money. We need money for sure to be able to cover the $100,000 costs mentioned above. Let's say money that we have for this venture is only $70,000. And not only that, for this whole importation-to-sale process to be logistically possible, we also need to spend on some transportation vehicle to transport our computer electronic goods, so we have to set aside $20,000 for this. Thus, we are only left with $50,000 after this capital spending on the vehicle.

So the big question is: how are we able to spend $100,000 on operating costs when we only have $50,000 of working capital left in our hands? Simple, we don't do it in one big spending; rather, we repeat the money-making process in batches. We would need to repeat the process by utilizing the working capital twice in order for our $50,000 liquid money left to cover the $100,000 in operational costs which would, in turn, mark us up 20% or in dollar amount terms, $20,000 in profits. We have thus effectively dissected what drives profitability in a company's core business operations. Continue to Part 3: Return on Assets Dissected and the Diminishing Effect of Capital Spending against Core Business Profitability

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