Do you understand your profitability model?

The profitability model explains how a company makes money while creating value for the client at the same time. The business model should not only help you to serve your client distinctively, it must also pursue that the company gain a high return for shareholders.

The DuPont formula helps you to make decisions on strategy and on the business model, because it combines the three components for creating value: margin, efficiency (asset rotation) and leverage (balance structure).

ROE = Margin * Asset Rotation * Balance Structure

?This translates into:

ROE = (Profit / Sales) * (Sales/Assets) * (Assets/Equity)

You must understand of these three elements which is the true engine for your creation of value, and you will know how you must compete. You have to identify your profitability model and be coherent with it. There are companies that compete through high sales margins (Google). Others, through asset rotation (Wal-Mart) or through leverage, by using little capital and large debt (Banks).

Margin (Profit / Sales): tells how much money I make as profit for each dollar I earn. It′s the result of income minus expenses. Anything that lowers costs and increases income improves the margin.

Efficiency (Asset rotation): allows you to know how much money you make for each dollar in your balance. There are companies that make money by rotating merchandise several times a year. If you have a low margin for each product unit you sell, but sell it many times, you end up making a lot of money. This is what happens to large supermarkets.

Balance structure (Assets/Equity): allows you to make money with a smaller investment, since cost of debt is lower to the cost of capital.

Return on equity (ROE) is the result of the income model, the cost structure, the margin per customer and the speed of use of resources.

Once you have chosen a profitability model, shape your business model in alignment with it and don′t take decisions that contradict such model.

You must understand which your profitability model is, and not stray from it in your human resources, incentives, strategy, investment decisions... because, if you do, you′ll create contradictions, and misalignments that will make you less efficient.

@EnriqueQuemada

Book: How to Maximize the price of my company

www.onetoonecf.com