Strategic implications of profitability KPIs

Manisha FERNANDO

There is a common saying that businesses exist solely for profit, or the motive for existence is profit!

Obviously this day and age has proven that making profits or a 'quick buck' is quite simple if it does not reflect any ethical standards, especially since the masses are ignorant of the actual stability and sustainability of various companies and their business activities.

Yet as responsible corporate citizens, organizations are expected to follow principles of good corporate governance and adhere to accepted standards of ethical behaviours and practices.

Profits are indeed important for any business or organization unless it is by nature a non-profit oriented one.

Yet the reality is even non-profit organizations need to focus on their funding (much like income) over their operational expenses if they are to sustain.

The strategic importance of profits and the concept of profitability would vary according to the type of business, the modus operandi and the way management or the organization measures it.

Even for non-profit organizations, the funding sources are more like the 'income' with which they have to cover operational costs and manage the projects that they handle.

Choose the right indicator to measure profitability is the decisive factor that would help organizations (both private and government) to achieve their strategic goals.

In most cases, indicators are often loosely used as simple ratios to satisfy regulatory requirements or for mere comparison of financial performances among competing organizations, rather than ascertain the strategic implications faced by the organization!

Key Performance Indicators KPIs are quantifiable measurements that reflect the critical success factors of an organization's strategy, and these should be agreed beforehand ideally at the strategic planning session or period.

The Key Performance Indicator selected must always reflect the organization's goals at whatever management level - including aspects of profits.

Firstly, the concept of profit and profitability has to be identified. "Profit" simply means a business unit with a surplus of income after all expenses had been deducted, whilst "Profitability" refers to the "ability to earn a profit."

This simple definition shows that the concept of profitability is more appropriate and globally applicable to any organization, whilst 'profits' (the absolute figure) in isolation can delude the management no matter how impressive it may turn out to be!

We have several popular options to evaluate profitability, among which return on equity (ROE) and return on assets (ROA) are perhaps the most frequently used.

At first glance, these two KPIs seem pretty similar as both focuses on an organization's ability to generate income. However, strategically, these two ratios reveal two entirely different stories, and the extent of applicability for each ratio depends on the overall strategy of the organization.

Profitability from the Owner's perspective

ROE is a popular KPI in many developed parts of the world - in companies and especially among banks and financial institutes because it represents the owners' interest in the business.

The equity infused by shareholders is at maximum risk compared to other forms of capital such as debt. ROE's basic motive is to identify how effectively a company's management uses investors' money (equity), and whether the management is increasing the company's 'financial value' at an acceptable rate. The acceptable rate would vary according to the macro conditions of each market.

However, a simple form of setting a strategic target would be to bench-mark the rate as a premium (ideally) against the rate or return of a suitable investment instrument that is available as an alternative option (i.e. FD rate or the rate of guilt edged securities etc.)

Theoretically, equity capital tends to be the most expensive source of funds for any organization, carrying the largest risk premium of all funding options.

Whilst several accepted formulas for calculating the ROE are available, considering the local context ROE can be calculated as the annual Profit Before Tax (PBT) divided by the Average Shareholder's Equity multiplied by 100 percent. As the formula shows it is independent of assets, which is another reason for its popularity in more developed markets where income is generated mainly through the service industries with intangible assets. As a rule of thumb, most investors look for a ROE of at least 15 percent - but can vary from market to market.

Profitability and resource efficiency

The ROA reveals how much profit a company earns for every Rupee of its assets deployed in the business. Assets can be anything from investments, debtors (or loan book of a bank), cash holding, accounts receivable or property plant and materials.

Whilst there are several options to calculate the ROA, it is more suitable to have uniformity and use the same numerator used for the ROE under the same rationale.

ROA is measured dividing the PBT by the average assets and multiplied by 100 percent. The ROA shows how effectively an organization is taking advantage of its resources or tangible assets.

The ROA of course depends on the industry in which the organization performs.

The ROAs of banks for example are some of the lowest ratios in the Sri Lankan market, whilst the ROAs of several diversified blue chips in the manufacturing and retail segments are quite high.

Strategic implications - financial leverage

The obvious strategic difference between these 2 KPIs is the implication of liabilities or more specifically the level of financial leverage or debt. Liabilities can be anything from borrowings, to deposits (if it's a bank) or creditors or payables if it's a retailer or wholesaler.

Typically, the balance sheet fundamental equation shows assets = liabilities + shareholders' equity. Therefore, when a company has zero debt, its shareholders' equity and its total assets should be the same (i.e. ROE would equal ROA) - which is rarely seen in the practical world.

In business, companies use a combination of both equity and debt capital. By infusing debt capital (by way of bank loans or borrowings from public etc.), a company can increases its assets with the new cash inflows whilst reducing the need for equity.

In such instances, organizations that have been solely dependent on the ROE to boast of profitability would benefit (i.e. due to lower equity levels).

But the danger is that when organizations are too focused on the ROE alone, they are bound to mis-manage their debts strategically.

Such companies may deliver an impressive ROE without actually being effective in using the shareholders' equity to grow the company! Perhaps one of the key reasons for the failure of several large financial institutes in the US and EU markets was the greater dependency they placed on the ROE neglecting the element of prudent debt management.

The mortgage backed securities they created multiplied the debt proportions whilst posting impressive profits and ROEs!

In contrast, the denominator of the ROA equation is Assets, which is theoretically equal to the aggregate of both debt and equity.

Therefore a company that relies on this ratio is benefited in compelling their management to analyze how well the both forms of financing are used. In addition, if organizations were focused on profitable growth, yet again the ROA would prove to be a comparatively better KPI.

Strategic implication - business analytics and risk

However, when using certain types of business analytics in strategic perspective, the ROE concept is important because it can be applied to any line of business or product - irrespective of whether its on-balance sheet or off-balance sheet - a useful consideration for businesses when they develop pricing mechanisms or where they wish to achieve a competitive advantage in processes or delivery mechanisms.

The risk implications of these two KPIs are different too. The ROA can be risk-adjusted up to a point only either using regulatory guidelines or prudent business practices.

Yet, even a well risk-adjusted ROA target would not include components of unexpected losses which are normally expected to be covered by equity capital.

In contrast, ROE uses equity as its divisor, which can even be risk-based capital, indicating that the element of risk is to a greater extent automatically adjusted. In addition, to the economic capital associated with unexpected losses, there are also regulatory capital requirements left out in the ROA.

ROA or ROE?

This article highlights only a few strategic aspects such as the business requirement, the level of financial leverage and risk when selecting the ROA or ROE as a strategic KPI. Given the pros and cons, it is prudent to use both ROA and ROE despite their complimentary differences to obtain a clear picture of management effectiveness in running the business profitably.

In conclusion, if the ROA is sound and debt levels are at a reasonable level, a high ROE is an indicator that managers are doing a 'great' job and the organization is efficient.

On the other hand, if ROA is low and the company is carrying a significant debt, even a high ROE is misleading, and the directors would have to pay special attention in view of the impending disaster for the company in the near future.

But always bear in mind, for any business, the industry norms and benchmarks for ROA or ROE can always be improved using analytical tools such as product and customer profitability analytics as well as activity based costing techniques.

As Arthur Miller once said, "Don't be seduced into thinking that that which does not make a profit is without value", since there are several other critical success factors that makes a 'great organization besides the aspect of profitability this article emphasizes!

(Fernando is a banker with experience in corporate and business strategy, strategic planning and market research. He has experience in change management and developing performance management systems. He has a Commonwealth Executive MBA from the Open University of Sri Lanka; is an Associate of the Institute of Bankers (AIB), Sri Lanka, and is a Member of the Association of Business Executives (ABE), UK. He also has Diplomas in Management and Human Resource Management.)