Businessman Investor

Touching base with the rational business psyche of stock market investors

Tuesday, November 25, 2014

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?"

Reviewing my earlier definition of Working Capital Turnover which is Operating Expenses divided by Working Capital, I realized it isn't as meaningful as I hoped it to be, my reason being that by standard definition, Depreciation and Amortization (D&A) are components of Operating Expenses. Naturally, Working Capital is not at all utilized in covering D&A; Depreciation is expensed against Tangible Capex Assets (i.e. property, plant, and equipment) while Amortization is expensed against Intangible Capex (i.e. trade rights, concessions, etc.); both are expenses against Capex Assets and intuitively have nothing to do with Working Capital. This realization prompted me to do further dissection of the components of ROA and led me to even ponder more about the natures of Interest and Taxes and how they impact fundamental, Core Business Profitability.

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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