The book explains the universal laws of business, the set of fundamentals that business people successful apply everyday in every business situation.
The CEO and the street vendor
The assumption from Ram Charam is that a CEO shares the same business language and thinking with a street vendor: they need to figure out what to buy based on what they think they can sell, what prices to charge and be able to adjust the prices as needed.
The street vendor too doesn’t want to carry home what was not sold ( the inventory) because tomorrow will be of less value and because he needs the cash. The street vendor puts the best looking goods in the front, watches his competition and if needed rearranges the display or yells louder (advertising) ; maybe tomorrow he needs to change the product mix, its assortment.
He knows if he is doing well according to his cash in the pocket. If the cash is not enough to buy goods he needs to borrow it and make enough money to pay back what he borrowed plus some left over. To remain profitable the street vendor needs to check constantly his profit margin and his return on assets but also to give his customers a fair deal or they will not return. He has to be consumer focused.
The business jargon explained
Money making in business has three basic parts: cash generation, return on assets and growth.
Cash generation is the difference between all the cash that flows into and the one that flows out in a given period of time.
Cash gives you the ability to stay in business and can be a problem even for the largest companies.
Return on assets
To grow or start a business you need money: either your own or someone else’s.
That money is your investment capital. With the capital you buy products (the inventory) or a store / factory (plant and equipment ) or an account receivable from a customer who took something home but did not pay immediately.
All these things are assets, specifically tangible assets (from the Latin “you can see and touch them”). Assets that are not expected to be sold (as a factory) are called fixed assets.
There are also non tangible assets: for example insurance companies need to maintain a certain amount of cash on reserve; that cash is an asset.
How much money you can make with your assets is your return on assets.
A similar measure is the return on investment or the return on equity (the equity is the money that shareholders have invested).
An important measure is the inventory velocity: how many times does the inventory turn over in a year?
365 means that it is sold every day.
Higher it is better use of space and money is.
The formula for asset velocity is total sales divided by total assets; the faster the velocity the higher the return.
In fact return on assets is the profit margin multiplied by asset velocity.
The best companies have a return on assets greater than 10 percent after tax.
Note that the margin is the net profit margin : the gross margin (total sales minus the costs) after having paid all the interests and taxes.
Finally, the ROA has to be greater than the cost of using your own and investors’ money, the cost of capital.
Growth is vital to prosperity and makes companies attractive but has to be profitable and sustainable. The growth should generate cash and not consume it, the profit margin should improve and not getting worse.
Wealth is more than making money
Until now it has been described the basic concepts of how to make a company earn money but shareholders expects that wealth is created too, that the share is getting valuable.
Money making and wealth creation are linked through the price-earnings multiple (PE), the ratio between the price for an individual share of stock and the earnings per share.
A PE of 7 means that for every euro of earnings the stock is worth 7 times. The higher the PE more wealth is created.
Basically it represents expectations about a company’s future money-making ability (the three basic concepts cash, return on assets and growth against the competition and the future). You should therefore compare the PE ratio for a company with the average one for its industry and the general one( as that of s&p 500).
If the industry has a higher PE it means that the company is thought to under perform now or in future. Maybe the company has a higher multiple than the competitors’ but pretty low with those outside the industry; that is a sign that people think this industry has little room for growth.
Note that for new companies or start-ups which have no earnings it makes sense to compare instead the price – revenue multiple.
The bottom line
The book is great to explain the basic and underlining concepts of business making with clear examples and simple comparisons, as the one with the Indian street vendors but beside that there is not more, you feel that a lot of unnecessary stuff is there to fill the 130 pages.