Businessman Investor

Touching base with the rational business psyche of stock market investors

Saturday, November 22, 2014

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.

But the next questions is: What's driving this corporate profitability? To assist in answering this, I would personally propose to even further breaking down ROA into two components: Core business profitability; and Non-core business profitability.

Core business profitability is computed as follows: Operating Income / Operating Assets

Non-core business profitability is computed as follows: Other Income / Other Free Cash Assets

The rationale behind separating profitability into two is to determine really where profitability is coming from and this gives us a better understanding of how the business is allocating its assets to generate profits. Core business is self explanatory; it traces how much rate of return is the business able to make from its core business operations, i.e. its business model. We delve into this because of the fact that the business may also be investing in other assets or investments that has nothing to do with its core business operations, and deriving profits from there.

Operating income are income purely derived from the company's core business. If the company makes and sells computers, then we just look at income derived from this making-and-selling process, i.e. the business' core operations. We filter it out from profits made from non-core business activities such as money made from trading stocks, non-recurring gains from sale of real estate property, etc. Because if the objective really is to understand and assess the fundamental, profit-making capacity of the company's business model, then this filtering, indeed, is really necessary.

Operating assets would primarily involve two components; these are: working capital and capex assets. I would define Working capital not simply as current assets less current liabilities. Rather, I would define it as cash & cash equivalents and trade assets (i.e. inventory, receivables, prepaid expenses, deferred assets). This is that liquidity in the firm which it utilizes to cover all related operating expenses to keep it running. Capex assets are outlays on tangible enterprise infrastructures, or intangible rights/concessions which enables and facilitates core operations. It may involve factories, office buildings, tools and equipments, royalty, trade rights, etc. In summary, operating assets are all those assets involved in carrying out the company's core business operations. Continue to Part 2: Dissecting that Process which Drives Business Profitability

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