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.

Accounting as the Language of Business

We, as passive investors should be shrewd businessmen, having the technical operations of the business delegated but still mindful and prudently watchful of the state of our assets. 

This is Part 4 of a Series. Go to Part 3: Conservative Expectation on Rate of Return

The following is a portion of a letter addressing my partners which states, clarifies, and addresses the operating principle behind that private investment partnership (i.e. hedge fund) I began. I would recommend that you start your reading at the beginning.

I’m sure none of us are strangers to the basic dynamics of how a business works financially. Generally, we are faced to lay out some cash, depending on the industry, to allot for initial working capital (e.g. inventory, revolving fund, etc.) or to spend on capital expenditures (e.g. fixtures, equipments, etc.) hoping the venture would payback these outlays later on; transactions are inevitable when conducting the affairs of a business.

So Where Have All Those Free Cash Flow Gone?

This is Part 2 of a series. Go to Part 1: The Corporate Cash Hoard Theory

Flow Accumulation. Doesn't the thought of where free cash flow has been accumulating merit contemplation?

A company’s cash hoard is similar to the idea of accounting profits being accumulated in equity’s retained earnings. In this case, however, we're talking money—that is, cold hard cash, not booked accruals, or capitalized expenses. If one is so conscious about observing free cash flow and one subscribes to the idea of it being the true measure of cash profits, the more so should be with how and where it accumulates. That is, that “free cash equity” base where all those free cash has accumulated.

Remember that free cash flow tracks internally-generated earnings realized in cash. That being so, it does not give any bearing or value to booked receivable sales, booked payable expenses, externally sourced cash, as well as prepaid expenses, inventory, and capex assets which are all actual cash outlays. Following this bias on internally-generated cash, the balance sheet accounts can appropriately be reclassified as follows:

ASSET SIDE

• Free Cash Assets – they include cash & cash equivalents and non-core business investments (stocks, bonds, real estate, etc.)—these are the primary free cash flow outlets—the asset base of cash hoard.
• Capex Assets – while these are investments on enterprise infrastructures, these are actual cash outlays.
• Trade Assets – these are accounts receivables (accrued sales which are yet to be collected), and prepaid expenses and deferred tax assets (actual cash outlays).