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?"
Interest somehow distorts profitability of business
operations, since it is not an operational cost, but rather, a cost of financing, a cost of borrowing money, and has nothing to do with the fundamental economic processes within the business model. If we are to uncover the true, underlying, earning power of
the company's business model, then we would have to exclude it in the early
stages of dissecting or deriving ROA (will be demonstrated).
Tax, on the other hand, is a function of both Operating
Income and Other Income (i.e. Non-core business income). That is to say,
Operating Income is not the sole variable determinant on deriving the Tax
amount since Other Income is also taxable. Thus, similar to Interest, it would
have to be excluded as well in the first steps of deriving ROA. Continue to Part 2: Core Business Profitability and Its Mathematical Derivation
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