In times of crisis, we tend to ask ourselves critical questions. This is often called to “stop along the way”, however; the most important thing is to start reflecting and solving the questions that derives towards making the best business decisions.
The financial best practices tell us about creating value by improving profitability over equity (Net Profit / Equity) hence, the profits once distributed (dividends) represent personal assets in the hands of the shareholders; and that is, value creation achieved by the company you own. The more profits an organization is able to distribute for every dollar invested by a shareholder, the more profitable it will be and the more value it creates.
The key question here is: what factors affect the profitability of the company’s equity I own? Each company has a particular answer to this question, however; there are some basic principles that apply to all types of companies and that best serve to analyze the factors that directly impact the profitability on equity. Let’s explore them.
The first factor is the capacity of each dollar invested by shareholders in equity (mainly capital stock and retained earnings) to generate assets. This is provided by the trust that third parties such as banks and suppliers have in the company and, therefore, lend money or sell raw materials and finished products on term / credit. This is positive up to a certain level and up to a certain cost.
Another factor is the capacity of each dollar invested in assets (inventories, accounts receivable, fixed assets, etc.) to generate sales or income. The assets will be more profitable to the extent that they can generate more sales or income; which is different from a company that makes huge investments in a vacant lot that does not generate sales. A successful business rather invests the same amount of money in inventories that generate sales, or in a fleet of vehicles to distribute the products it markets.
Finally, the capacity of each dollar obtained from sales or income to generate net profits. This has to do with the elements of the business’s costs and expenses (costs of the merchandise, salaries, rentals, interest, insurance, taxes, etc.). Sales will be most profitable with lower costs and associated expenses; as well as better inventory and accounts receivable turnover.
The above briefly describes the ability of a company to create value for its shareholders. The effective application of these elements is critical to positively impact the return on equity and consequently towards the shareholder’s dividends.
Evaluating general conclusions based on these great aggregates, allow us to effectively analyze the value creation of each company and define the best action plan towards achieving the organization’s goals.