Taking advantage of the record low interest rates, let’s say
you’ve just refinanced your home mortgage and have earmarked
$20,000 of the cash to invest in your kitchen and bath design
As a responsible business owner, two questions should be
addressed. First, what areas of your business will earn the
greatest return from an investment? And second, what should be the
cumulative, positive impact of these investments on your
At first blush, these may be rather difficult questions to
answer. The answers, however, can be arrived at by examining some
critical data about your business.
Your immediate reaction to the first question may be to invest in
another kitchen display from your favorite cabinet supplier who has
just come out with a gorgeous new finish. And his extra special
30-10% display discount because you’re such an important customer
makes it even more appealing. On top of that, he’s relaxed his
normal terms so you can pay in 12 monthly installments.
But before buy another display, study your most recent financial
statements. They offer the best clues to where the money should be
invested and how much of a return you should expect.
Say your company is named Signature Kitchen and Bath, and your
latest Balance Sheet and simplified Income Statement for last year
looks like the chart that I have provided at right as an
Essentially, there are two methods to calculate the potential
return on an investment in your business. The first is the “short
form,” which provides a quick, simplified answer. You merely divide
the Net Profit by the Net Worth to obtain your Return on Investment
(ROI). For example:
$30,000 (Net Profit)
$90,000 (Net Worth)
In this example, the result is a 33.3% Return On Investment
With respect to a $20,000 investment in your operation, what
this calculation says is that, based upon your most recent
financial statements, you might expect a 33.3% return or $6,660 in
the first year. In relation to other investments available, such as
a passbook savings account, certificate of deposit, mutual fund or
real estate investment, the 33.3% annual return on the investment
is very attractive.
In my judgment, for all of the effort that goes into having a
kitchen fit like a glove for a client, dealers and designers should
earn at least 33% on equity. Indeed, the best-managed firms can
consistently earn 50% or more. After all, it was not more than
three years ago that many of us were earning a 25-27% ROI on our
mutual funds with virtually no effort at all.
That this high return can come from an investment in a creative
business that you love is probably a most gratifying revelation.
But you’re probably aware of the many factors that can easily
depress the net profit and make your investment riskier and less
liquid than other options. Therefore, you should not be satisfied
with just accepting the 33.3% projection as mere fact. As a
business owner, you should more deeply understand why, and where,
your business can generate a relatively high return on investment.
And for that, you will need to digest the “long form” method of
calculating the return on investment.
Thorough comprehension of this ROI procedure requires that you
understand the following four ratio definitions and the
accompanying conceptual diagram involving these ratios:
Total Asset Turnover (TAT). This ratio demonstrates how well assets
are being controlled to get a better turnover out of
Formula: Total Asset Turnover = Sales divided by Total
2. Return on Assets: (ROA). This ratio measures profit generated
Formula: Return on Assets = % Net Profit x Total Asset
3. Financial Leverage Multiplier (FLM). This ratio measures the
strategic use of other people’s money. (The standard you should use
is 2.0 or 3.0 to 1.)
Formula: Financial Leverage Multiplier = Total Assets divided by
4. Return on Investment (ROI). This is the key profitability ratio
used by bankers, accountants, financial managers and investors to
measure a company’s rate of return. (The standard you should use is
Formula: Return on Investment =Return on x Financial Leverage
Figure 1 represents a conceptual diagram for calculating ROI via
the “long form.”
Employing information from the 2002 Financial Statements of
Signature Kitchen and Bath, you can determine the “long form”
calculation method to determine the probable return on the $20,000
ROI formula analysis
There is much that can be learned from this diagram about your
business. It may require some repeated and concentrated study, but
the resulting financial education will serve business owners well.
Understanding the various components of the ROI formula will give
you insights into which areas the $20,000 may be invested to
generate an even higher return than 33.3%.
For example, the Financial Leverage Multiplier component of the
formula is excellent at 4.44 substantially higher than the standard
of 2.03.0 that financial professionals look for. It’s the primary
reason why the return on investment for the kitchen/bath industry
is comparatively higher than other businesses.
This observation makes sense because the terms kitchen and bath
dealers generally use with clients (50% upon signing agreement, 40%
upon cabinet delivery from the manufacturer, and 10% upon
substantial completion) make this a “near-cash” business. In
effect, we use customer deposits to finance our working capital
needs, display investments and other assets whereas other
industries require short and/or long-term bank financing for these
needs. So, it’s this great cash flow that positively impacts upon
the ROI percentage.
Conversely, the relatively low Return on Assets percentage
(7.5%) is the major formula deterrent to a higher return on
Areas to invest in
Any investment that improves the weak 3% Net Profit (Net Profit/Net
Sales) or Total Asset Turnover (Net Sales/Total Assets) will yield
a higher ROI.
What follows next are five key suggestions:
- A Professionally Prepared Three-Year Budget. Hiring a business
consultant to work interactively with you in this endeavor can do
much to change the way an owner looks at his business and plans
properly for growth. It can also lead to several immediate,
significant changes. For example, the consultant may prove that you
don’t have to lose control if your lone payroll installer becomes a
Savings: Payroll taxes, worker’s compensation insurance, and
employee benefits estimated at $10,000.
Consultant Investment: Approximately $2,500.
Impact on Business: Selling and Administrative (S&A) expenses
are reduced by 0.75%, increasing the net profit by the same
percentage. The Return on Assets now becomes 9.375% (3.75% x 2.50)
instead of 7.5%. When multiplied by the same FLM of 4.44, the ROI
for the business jumps to 41.6%a 25% improvement.
- Vehicles To Market The Value Of Your Services. Words alone will
not convince savvy consumers that your people, and the services
they perform, represent an extraordinary value. That’s because
everyone promises good service. You must furnish proof in the form
of signage, brochures, specialized merchandising and the like. The
more of these tools you use, the greater the perceived valued and
the greater opportunity to earn a higher price for your projects.
Again, here, a consultant can be instrumental.
Gross Profit Increase: Minimum 3%, or $30,000.
Marketing Investment: Approximately $6,000.
Impact on Business: Net Profit directly increases by $24,000 to
$54,000. The ROA now becomes 13.5% (5.4% x 2.50) instead of 7.5%.
When multiplied by the same FLM of 4.44, the ROI for the business
dramatically increases to 59.9% an 80% improvement.
- Management Software. Imagine a management software program that
tracks leads, ordering details, project management info, cash flow,
break even points, commissions, etc. to streamline your operations.
Networked among staff members, it will prevent embarrassing delays,
increase productivity and morale, and save the cost of a part-time
Savings: Estimated $10,000 in salary.
Software Investment: Approximately $2,000.
Impact on Business: S&A Expenses are reduced by $8,000,
increasing net profit by 0.8%. The ROA now becomes 9.5% (3.8% x
2.50). When multiplied by the 4.44 FLM, the ROI for the business
improves to 42.2%a 27% enhancement.
- Diversification Display(s). With a sluggish economy,
diversification is important. Furniture grade closets are a
burgeoning business among upscale clientele. So are media centers
and home offices. These are the kind of displays that can generate
add-on sales and be promoted to past kitchen customers. Remember,
however, that commissions and payroll taxes are variable expenses
associated with a sales increase.
Net Profit Increase: $3,000 on a $100,000 sales increase.
Display Investment: $4,000.
Impact on Business: The Net Profit percentage doesn’t change
($33,000/$1,100,000). However, the Total Asset Turnover increases
to 2.72 ($1,100,000/$404,000), making the ROA now 8.17% and the ROI
on the business 36%a 9% improvement.
- Buying Group Membership. At $650,000, the Cost of Goods Sold is
your company’s greatest expense. Of that total, about $550,000
represents Material Purchases. If just $200,000 of these materials
can be purchased from vendors offering deeper discounts and volume
rebates, substantial dollars can drop directly to your company’s
bottom line with even more in future years.
First-Year Savings & Rebates: $11,000.
Buying Group Investment: Approximately $5,000, covering membership
fee, conference expense and display changes.
Impact on Business: Net Profit increases 0.6%, elevating the ROA to
9% (3.6% x 2.50) and the ROI on business to 40%a 20%
Collectively, the $20,000 investment made in these five areas of
your business is likely to generate a combined return of
approximately $48,500 or 242%. Other factors remaining equal, the
cumulative impact of these investments can improve the Net Profit
to 7.55% and the Total Asset Turnover to 2.72. When multiplied
together, the projected Return on Assets would be a robust 20.5%,
leading to a 91% ROI for your business.
Understanding the Return on Investment concept is, indeed, the
critical key to financial success in the retail kitchen and bath