Entrepreneur’s Diary #109 – How High Should a Company’s Return Be?

Euro_centThis is also one of the questions with no easy answer. The answer depends on far too many parameters and influence values. And one of those factors are certainly also the entrepreneurial goals, such as sustainability and common good economy (Gemeinwohl-Ökonomie).

It is frequently discussed and I am frequently asked: What is the “right” return for an enterprise with a certain concept and in a certain area? I also keep seeing absurd numbers set as obligatory values. For many enterprises, those numbers are utopia. Consequently, I want to use this article to try and give some reasonable advice.

If, on reading this now or on starting to read what follows, you get bored, then I would recommend you continue with the next paragraph written in bold letters, which is under the heading “All Bullshit?”.

First and foremost, let me again define the term “return”. We distinguish between return on sales and return on capital. They both tell you in per cent how high the proportion of the return is profit, or how much of the capital you gain from. That sounds fairly easy, doesn’t it?

One piece of information:
People often totally forget the trivial fact that even a small sales return might well mean a huge capital return. After all, the return is supposed to be many times the capital. And if I have a return of, for example, fifty times the used capital, then this means I get a capital return of 100 % for only 2% sales return! In the 1950ies and 1960ies, for instance, the German economy mainly focussed on the capital return – and it is surprising what low numbers (sometimes even in the low one-digit per cent range) were considered good results in trustworthy companies, such as Siemens and VW.

Second piece of information:
Well, basically, it is difficult to determine the “correct” absolute number for the profit (what exactly is the profit and how high is it?), since it is the profit per sale. More often than not, both the term and the reference are not clearly defined. Consequently, you usually take the EBIT (earnings before interest and taxes) for calculating the sales profit.

Third piece of information:
But the last profit contribution from the business statement, too, is a valid and yet not easily calculated basis. If you use it, the employee and/or director bonuses are already part of the salary and as such have been subtracted. Yet those were only due because the “profit strength” of the enterprise was very high, better than the EBIT, which has been reduced by the success premiums paid to the colleagues. The question arises if one should not, at least mentally, add them to the result.

Fourth piece of information:
“Investments“, into products (which, when we are talking software development, must be considered costs for services, rather than investments in the bookkeeping sense) reduce the EBIT in the bookkeeping sense. After all, the software that has been developed may/need not appear on the balance sheet in our company. The same is true for some other investments into the future you cannot put on your balance sheet, for instance training programs and the reputation of the enterprise. They minimize the profit, yet they are important “investments” into the future of the enterprise.

Fifth piece of Information:
I, however, propose that you should see this as your duty that goes without saying as an entrepreneur and that you first consider the profit as “return power of the enterprise”.as seen in the last contribution margin. The rest (all the measures taken with a view of the future or all the things that probably would not have happened if you had had less return, such as extensive trainee programs, team building, success parties, luxury and also investments in your own tools and the like) will be stored “mentally” for further reference.

Sixth piece of information:
When judging the situation of the enterprise, I can certainly virtually add to the return. On the other hand, I will subtract hidden costs and risks of the enterprise. Being the entrepreneur myself, I will know best what these are. Apart from and on top of the actual numbers, this is the best way to judge where the enterprise is standing.

Seventh piece of Information:
As far as the actual numbers for the profit (the return) are concerned, many factors play a role. The size of the enterprise may need to be considered. There might be critical numbers below optimum. Small firms, in particular, can be organized in such a lean way that they can render a high profit. Because you have a high awareness of costs and only little infrastructure and administration, everybody assigns to the account, much is just done in passing and what remains is done by the boss, anyway.

Eighth piece of information:
Of course, your sector is also a determining factor. If you sell mass products wholesale, an extremely small turnover return means a huge profit. And if you are into services or niches, your profit might well break away, with the result that you have not enough to make a living.

Ninth piece of information:
Usually, growth will cost money and therefore decrease your return. Consequently, you can never regard the return isolated from the growth. Growth is not a value per se, but a sensible organic growth is probably something natural and necessary for all enterprises.

Tenth piece of Information:
If you are into services, growth will happen either by working more hours or through adding persons, i.e. more employees. It gets harder and harder to increase the hours. So you will need more employees. It is rather costly and time consuming to find new employees. Young employees, such as graduates from universities, often need long adjustment phases and training on the job. A head hunter (which is something I usually would not recommend) who provides you with “finished” new employees, too, costs a lot of money and therefore minimizes the returns. But finished employees, too, will initially make the degree of capacity smaller.

Eleventh piece of information:
As you can see, return and growth belong together. And growth will cost money. Consequently, it seems rather logical that there is an inverse correlation between sales return and sales growth. And a “healthy” firm can probably only get its old profit through growth breaks.

Mind you, sometimes it might make sense to have a negative growth or a negative return. For instance if changes in your environment make it necessary.

Twelfth piece of information:
So, talking actual numbers, you could actually put x per cent growth in relation to a return change y (which is often negative with a strong growth). A very rough rule of thumb (formula) might be that the growth should always be considerably higher than the decrease in return.

If, compared to the previous year, the growth of a service providing firm was 10% while the sales return remained stable, then this is a rather good sign. If the growth increased by 10 %, you might well get a decrease in returns of y %, for instance 2 %. This might well be quite acceptable.

And it is the talent of the entrepreneur to see to it that the gradient of the sales growth is higher than the negative gradient of the sales return, i.e. that x > y remains or gets valid.

Mind you, all this is only true for a pre-defined “sustainable development” in the enterprise, for instance in the sense of “common good economy“ (Gemeinwohl-Ökonomie). Of course, if you are interested in short-term results, you can sometimes make a huge profit through depletion. But you should be careful not to damage too much of the substance.

Thirteenth piece of information:
Another formula, especially for start-ups, has been developed in the USA: 40%-Rule. The advice is:
Your annual revenue growth rate + your operating margin should equal 40%!
In other words, the sum of growth and operating margin should always be critical. See also the following comment:

This means you can build the sum of growth and return. So if I have 10% return, I should have 30% growth. And for 5%, I get 35%? That sounds logical, doesn’t it? And you can even apply it for negative numbers: If I have a negative return, (-10 %), I will have to have 50% growth. Perhaps in order to build up a particularly strong market position and thus attract the attention of an investor.

All bullshit about the return?

Regardless of the fact that I believe my ideas are quite reasonable, or else that they are backed by quite good sources, I believe that the “return question” is the totally wrong approach in terms of entrepreneurship. The question: How good is my return if compared to other enterprises? Is more like a game – if everything is running so smoothly that there is nothing better or more urgent you need to do.

What is truly important is the entrepreneurial culture. To what extent does it create a “sphere” for teamwork that is innovative, instead of making people ill? Does the enterprise give people a chance to actually participate? Is there a meaningful purpose that is not polluted by bureaucracy? How do the employees see themselves? (Everybody is a champion)? How to recruit the right persons for your enterprise?

Those are the important questions you permanently need to find answers to. They also call for never ending work. And that can only function if you have the right kinds of persons by your side. And if you employ the good ones.

That is what has absolute priority. It goes without saying that those considerations do not absolve the entrepreneur from taking the “business component” seriously and to always carefully and skilfully keep in mind what the connection between “the numbers” and “the development of the enterprise” signifies.

But if you take good care of this, the high “return” will be a natural result. And more likely than not, you will then gladly notice that, as a general rule, your results are better than those of the competition on the market.

And then you have to answer a totally different question:

How to distribute the good results:

  • How much do you need to keep as reserves?
  • What share do the people in the enterprise get?
  • What remains for the shareholders?

But this is a totally different matter. And, as I see it, it is a very enjoyable task.

RMD
(Translated by EG)

P.S.
Many of the ideas in this article were motivated by Elmar Jürgens. Many thanks to Elmar.

P.S.1
For more articles of my entrepreneur’s diary, click here: Drehscheibe!

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