Businessman Investor

Touching base with the rational business psyche of stock market investors

Monday, November 24, 2014

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

Mark-up is most basic and easily deduced by us entrepreneurs. We have costs, and we need to put a mark-up to earn money, to profit (i.e. the Mark-up). And if we're able to repeat this mark-up many times given the working capital we have, we are able to magnify and multiply this mark-up (i.e. the Turnover). Nonetheless, the impact of this profitable activity by the working capital (i.e. mark-up x turnover) can only go insofar as to how much it weighs against overall operating assets (i.e. working capital / operating assets); thus generally, the more capital intensive the business is, the lesser impact this magnified mark-up profitability has.

In summary, as a businessman investor, we are interested in our mark-up, our money's turnover, and how much capital is tied on fixed assets (i.e. capex assets). This three-step ROA dissection would reveal what's driving profitability.

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The information presented here is for educational purposes only. Under no circumstances should it be construed as a recommendation to buy, sell, or hold any stocks. If you choose to use this information, you do so at your own risk.

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