Return on Sales (Profit/Sales) answers the question, “How much of every sales dollar did we keep as profit?”
||ROS > 8%
||< ROS <=8%
||< ROS <= 4%
||ROS <= 0%
Between 0% and 4%, while the company is at least making a profit, it is not bringing in sufficient new equity to fund growth. The industry is growing at about 15% per year. The industry consumes about 15% more capacity each year, which arrives in the form of plant expansions and new products.
Therefore, as the simulation begins, an average company would add about $12 million in new plant each year. If half that or $6 million was funded with bonds, an average company would need about $6 million in new equity. Therefore, if the company does not have the profits, it must either issue $6 million in new stock, or $12 million in bonds, or not grow to keep up with demand. Worse, if it has no profits, its stock price falls, making it difficult to raise equity through stock issues.
This ignores investments in automation, which also require a funding mix of equity and debt.
In the opening round of Capstone® companies have an excess of assets, and that can convert idle assets into productive ones. Therefore, do not worry too much if the company’s profits are low. But after year 3, expect that idle asset cushion to be gone. Profits become critical because those companies with profits can grow, and those without cannot.
What if profits are negative? The company is destroying equity. Its stock price has plummeted, making it more difficult to raise equity. All of the problems described above are now accelerated. In short, trouble.
How can companies improve ROS? Here are a few questions to pose.
- Can you raise prices?
- Can you reduce your labor costs? Your material costs?
- Can you forecast sales better and thereby reduce your inventory carrying expenses?
- Have you pushed your promotion or sales budgets into diminishing returns?
- Can you sell idle plant to reduce depreciation? Alternatively, can you convert idle plant into some other productive asset, like automation or new products?
- Is your leverage too high, resulting in high interest expenses. (See leverage.)