Your wealth engine

We refer to your business as a WEALTH ENGINE when it can meet two critical criteria. The first is achieving a high return on equity (ROE). The target will be different for different styles of business depending on how capital intensive the business is and its risk profile.

The other criterium is the reinvestment ratio (RIR). This is the proportion of net profit after tax that is reinvested into the business. Once again, the appropriate proportion will vary depending on a range of factors. The key requirement is that a high proportion of profits are invested back into the business and the reinvested funds achieve a high return on investment to support the achievement of a high ROE.

Even for early-stage businesses, management should be determining how that business can achieve wealth engine status and how long it will take to achieve that status.

Management style

To successfully manage your wealth engine, you need to have an investment analyst’s approach. This requires a lot more focus on the balance sheet numbers than most management teams apply.

Return on equity is a measure of net profit after tax divided by the equity (or net assets) in the business. That is a P&L measure divided by a balance sheet measure. So, both are critical in achieving the target performance level.

If management has a longer-term focus and sees its strategic plan from an investment perspective, it will be more likely to achieve the milestone targets needed to drive the wealth engine successfully. Developing a longer-term plan that clearly sets out the ROE targets and that clearly sets out the reinvestment amounts will provide a clear capital budget from which to create a much more valuable business.

The 5-Year planning outlook

When planning the capital investment strategy, a five-year outlook period is a timeframe that supports more structured investment consistent with the business’ growth strategy. When ROE targets and reinvestment ratios are applied, a business can establish the capital budget for the 5-year period.

The capital budget will be applied to three main categories of investment. These are:

  • The working capital growth budget
  • The capital maintenance budget (equivalent to the level of amortization and depreciation), and
  • The growth budget

Applying a level of debt funding as well will enable capital budgets to be increased and may help to achieve higher ROE outcomes as debt funding does not increase the net assets.

Achieving or maintaining your wealth engine status

When the capital budgets have been established, the planning can then be done with the appropriate context. Management has a clear understanding of the level of investment funding it has to work with. Management also has a clear guide on what return on investment it needs to achieve from those capital investments so that it can achieve the target ROE from its growing investment in the business.

The key difference to the standard way that most privately owned businesses are managed, is the focus on growing the ROE and growing the net asset base on which the ROE is based. Most privately held businesses focus on profit and cash management.

These can be considered incidental requirements in a wealth engine business. Profit is a key driver of return but must be seen from the perspective of return on equity. Cash is the essential life blood of the business but must be at the right level to maintain liquidity while not diluting the return on equity.

Growing your returns on an ever-increasing investment base will see you controlling a wealth engine that generates more wealth for its owners.

Ask your CFO or advisor to implement the “ceefo Wealth Engine Program” and support you to establish and maintain your own WEALTH ENGINE.