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.
How to identify your profitability model
The DuPont formula helps you to make decisions on strategy and business model, because it combines the three components for creating value: margin, efficiency (asset rotation) and indebtedness (balance structure).
ROE = Margin * Asset Rotation * Balance Structure
This translates into:
ROE = (Profit / Sales) * (Sales/Assets) * (Assets/Equity)
You must understand which of these three elements is your true engine for creating value, and know how you must compete. You must identify your profitability model and be coherent with it. There are companies that compete through their high sales margins (Google). Others, through asset rotation (Wal-Mart) or through leverage, by using little capital and large debt (Banks).
What does the DuPont formula mean?
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 in 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 (how much it charges and how it charges it), 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 any contradictory decisions.
This article was written by Enrique Quemada, ONEtoONE President.
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