15-minute exercise that could tell you whether you will be in business next year
By: Hugh Sutherland
Why this Topic?
Carrier accountants will be working hard on their budget forecasts for the 2021/2022 financial period, pondering over how to achieve shareholders’ expectations in what is probably the most challenging period in SA's history. Economic uncertainty, financial hardship resulting from Covid-19, possible upsurge in unrest following election results, will no doubt all have catastrophic effects on the SA economy. One thing is certain however; the effects of soaring Government debt, questionable electricity power supply and high unemployment, all seriously affecting SA's Macroeconomic Growth - which will be with us for considerable time to come.
However whatever the outcomes, shareholders want their investment expectations met by C-level executives, so what are they looking for? Here is a short list of probabilities:
Justification for investment relative to risk/return expectations
Adequately researched information supporting probability forecasts
List of the three most crucial performance indicators used in setting budgets
When to consider fall-back strategy plans
A red line drawn for immediate “removal-of-the-bales” [voluntary closure]
No doubt, all of the above are time consuming tasks but there are several ways to quickly assess possible outcomes following these probabilities, so these will be the focus of this discussion Topic.
Only shareholders can prescribe acceptable risk/return ratios for their investment but surprisingly, many fail to do so as they prefer to see what comes up in the budget presentation based on optimistic projections for improvement over previous financial results. Many shareholders do this without really considering the sensitive issues affecting budget forecasts. In other words, they don’t fully relate to the key rationale affecting budget forecasts.
One cannot simply prescribe a number without considering the Macroeconomic forces influencing trading results, especially in a service industry such as road transport. These need careful consideration when talking Return on Capital Employed before Interest and Tax (ROCEBIT). Why ROCEBIT you may ask? Well in accounting, there are many ways to express Profit so what are we really talking about?
Road transport, as we all know, is a highly capital-intensive business per unit of Revenue (somewhere around R0.48/R1.00), so it’s preferable to measure return on capital employed before interest and tax (ROCEBIT). This is a critical assessment as CEOs seldom have the say in how investments are leveraged, which infers that shareholders are really the only people who control the Cost of Capital - not CEOs.
COST of CAPITAL
The Return, expressed in terms of an interest rate that an organisation is required to pay for the Capital used in financing its activities. This will vary according to the type or types of capital employed (e.g. Equity Capital, Loan Capital, or some mixture of the two) One approach to establishing the cost of capital is therefore to compute a unique “weighted average” cost of capital for each organisation, based on its particular mix of capital sources. (Oxford dictionary of Business and Management - fifth edition)
Now one can see why it is important to use what is termed “Profit on Capital Employed” to measure the effectiveness of C-level executive management. This is a very different measure than Profit on Sales and Sales as a percent of Capital Employed.
Having served as non-executive director on many Boards, I find it amazing that shareholders are mainly focused on accepting budget forecasts based on historical performance. Few accept that no two financial periods operate under the same trading conditions as previous years. They fail to understand the effects of a myriad of changing circumstances that influence future trading performance.
For any budget forecast to be meaningful it needs to be set against probable scenarios influenced by both the prevailing Macro and Microeconomic environments - the outcomes of which are based purely on probability.
So, how are all these done in only 15 minutes? Go for the jugular; Measure Profit before Interest and Tax (PBIT), as a percentage of Capital Employed!
Take care of two other primary performance measures: Profit on Sales % and Sales as a measure of Capital Employed. These critical ratios should be constantly monitored in real-time – not left to hurried quarterly Board meetings. These three critical assessments should not take more than five minutes each!