{"id":22997,"date":"2019-12-31T15:17:00","date_gmt":"2019-12-31T14:17:00","guid":{"rendered":"https:\/\/www.gbcc.eu\/profitability-is-risky-depends-on-the-human-factor\/"},"modified":"2022-03-16T08:52:59","modified_gmt":"2022-03-16T07:52:59","slug":"profitability-is-risky-depends-on-the-human-factor","status":"publish","type":"post","link":"https:\/\/www.gbcc.eu\/en\/22997\/profitability-is-risky-depends-on-the-human-factor\/","title":{"rendered":"Profitability is risky & depends on the human factor"},"content":{"rendered":"<\/span> 11<\/span> Min.<\/span><\/span>\n

Trying to assess profitability by comparing a number from the profit-and-loss account (P&L) to a reference value inevitably leads to the wrong measures.<\/strong><\/p>\n\n\n\n

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Table of contents:<\/h2>\n\n\n\n

1. Is being \u201cprofitable\u201d and generating \u201cprofitability\/returns\u201d synonymous?<\/a><\/p>\n\n\n\n

A. Can you judge profitability based on revenues?<\/a><\/p>\n\n\n\n

B. Liquidity as the basis of a profitability assessment<\/a><\/p>\n\n\n\n

C. The relationship between \u201ccapital investment\u201d and \u201cprofitability\u201d<\/a><\/p>\n\n\n\n

2. Are typical measures appropriate to increase profitability?<\/a><\/p>\n\n\n\n

3. The relationship between \u201crisk\u201d and \u201creturn\u201d<\/a><\/p>\n\n\n\n

4. The human factor is left out of consideration<\/a><\/p>\n\n\n\n

A. The relationship between \u201crisk\u201d and the \u201chuman factor\u201d<\/a><\/p>\n\n\n\n

B. The relationship between \u201cprofitability<\/em>\u201d and the \u201cmindset<\/em>\u201d of the people involved<\/a><\/p>\n\n\n\n

5. Process management is the key to higher profitability<\/a><\/p>\n\n\n\n

6. The relationship between \u201chierarchies<\/em>\u201d and \u201cprofitability<\/em>\u201d<\/a><\/p>\n\n\n\n

A. Managerial tasks are not necessarily organised hierarchically<\/a><\/p>\n\n\n\n

Conclusion<\/a><\/p>\n<\/div><\/div>\n\n\n\n

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Let’s start with a clarification:<\/p>\n\n\n\n

1. Is being \u201cprofitable\u201d and generating \u201cprofitability\/returns\u201d synonymous?<\/a><\/h2>\n\n\n\n

Being \u201cprofitable\u201d usually means being able to achieve a (sustainable) profit. Profit is an absolute value. It is calculated as total revenue minus total expenses and appears on a company’s P&L.<\/p>\n\n\n\n

\u201cProfitability\/returns<\/span>\u201d is a relative value for assessing the economic success<\/em> of your company. For this, value \u201cA<\/em>\u201d is set in relation to reference value \u201cB<\/em>\u201d. For the \u201csales return<\/span>\u201d calculation for instance, two items from the income statement<\/em> are typically set in relation to one another: the operating result<\/em><\/abbr> or EBIT<\/em><\/abbr> in relation to sales<\/em>.<\/span><\/p>\n\n\n\n

I’m not<\/em> happy with such formulas. When it comes to choosing which key figures you can use to assess the profitability of your company with, then I prefer to apply the following:<\/p>\n\n\n\n

Ultimately, calculating the profitability based on P&L values<\/em> is a vain endeavour<\/em>.<\/strong><\/p>\n\n\n\n

<\/div>\n\n\n\n

1.A. Can you judge profitability based on revenues<\/em>?<\/a><\/h3>\n\n\n\n

The main problem is that you are showing revenues<\/em> in the P&L simply because you have submitted an invoice. Absurdly enough, no account is taken of whether and when the money is actually received from this invoice.<\/p>\n\n\n\n

The fact is, only money that has actually been received is relevant because only then you can use it to settle employee salaries and supplier invoices.<\/p>\n\n\n\n

<\/div>\n\n\n\n

1.B. Liquidity<\/em> as the basis of a profitability assessment<\/a><\/h3>\n\n\n\n

A key figure that can be determined relatively easily by the accounting software would be the \u201coperating cash flow\u201d<\/a><\/span>.<\/p>\n\n\n\n

In other words, the liquid funds<\/em> generated by the business activity as the difference between payments in<\/em><\/abbr> and payments out<\/em><\/abbr>. This figure might have to be adjusted for the imputed costs.<\/p>\n\n\n\n

I also eliminate the change in \u201caccounts payable<\/em>\u201d and take this into account elsewhere.<\/p>\n\n\n\n

If you are in breach of contract and leave the due supplier invoices unpaid, then you will be rewarded<\/em> with an increase<\/em> in operating cash flow. In my opinion, this reduces the informative value of this indicator to absurdity!<\/p>\n\n\n\n

A more sensible formula for assessing the sustainable \u201csales\u201d profitability of the company is this:<\/p>\n\n\n\n

Profitability = adjusted operating cash flow in relation to the total payments made by your customers.<\/strong><\/p>\n\n\n\n

Is this indicator sufficient to fully assess the economic success of your company? Unfortunately, no.<\/p>\n\n\n\n

<\/div>\n\n\n\n

1.C. The relationship between \u201ccapital investment<\/em>\u201d and \u201cprofitability<\/em>\u201d<\/a><\/h3>\n\n\n\n

Let’s take a company with sales of \u00a31 million and an operating cash flow of \u00a3200k. In this case we can calculate a very respectable and comfortable sales return of 20%.<\/p>\n\n\n\n

Let’s assume, however, that the company had to invest \u00a320 million in advance to create the conditions for this. In the context of capital expenditures, the \u00a3200k now appears to be a ridiculous return on investment.<\/p>\n\n\n\n

In simple terms, this company could be described as \u201cprofitable<\/em>\u201d, but not necessarily as generating an adequate return<\/em>. It is therefore advisable to take into account the capital required <\/strong><\/a> for the business when considering profitability:<\/p>\n\n\n\n

Profitability = adjusted operating cash flow in relation to your company’s operating capital.<\/strong><\/p>\n\n\n\n

<\/div>\n\n\n\n

2. Are typical measures appropriate to increase profitability?<\/a><\/h2>\n\n\n\n

How can you increase<\/span> a company\u2019s profitability?<\/a> Now, the premise introduced at the beginning of this article, which stated you can determine profitability as a simple ratio, is taking its toll. Because this basic premise often leads to incorrect measures.<\/p>\n\n\n\n

You almost inevitably direct your attention to the fastest possible increase in the value you have placed in the counter: EBIT, adjusted operating cash flow, etc, despite the complex-causality of causes and effects.<\/p>\n\n\n\n

Therefore, you may try to reduce costs by laying off employees or relying on cheaper but poorer-quality suppliers. As a rule, increased costs are only achieved due to a drop in productivity and an increase in defects.<\/p>\n\n\n\n

Alternatively, you may invest in risky growth strategies to increase sales. Risky because with every \u201cwrong\u201d customer that you acquire expensively in the course of expansion, you increase the company’s risk and jeopardise the company’s productivity and profitability.<\/p>\n\n\n\n

Speaking of \u201crisk<\/em>\u201d, this is a crucial component to consider.<\/p>\n\n\n\n

<\/div>\n\n\n\n

3. The relationship between \u201crisk<\/em>\u201d and \u201creturn<\/em>\u201d<\/a><\/h2>\n\n\n\n

In an illustrative example, let’s look at the following two suppliers. Both have sales of \u00a31 million and an operating cash flow of \u00a3200k.<\/p>\n\n\n\n