Why it pays for firms to be lean and mean

world of today, quite simply, “survival of the fittest and meanest”.
It looks like most companies in Zimbabwe today need to be lean and mean in order to deliver some value to the investor.

Given the prohibitive cost of debt finance most companies have resorted to reducing their debt levels and ploughing back all their earnings into the business.
Thus, the shareholder’s equity has become a very significant contributor to the total assets base of the company. But is the shareholder getting value for their money?

It appears that most companies are struggling to deliver value for their investors without drastically cutting costs and, inevitably, product and service quality. In other words, they have to make the hard choice between the customer and the investor.

Though quite pertinent, the notion of lean management did not emanate from the world of finance. James Womack, Daniel Jones and Daniel Roos have produced a series of books on lean management in recent years: The Machine That Changed The World (1990), Lean Thinking (1996) and Lean Solutions (2005).

The idea of lean management, therefore has its roots in the world of production, especially those employed by successful Japanese organisations such as Toyota but now the term itself is almost a clichë in management circles.

Yet in the investment world, being lean and mean is about efficiency and survival and far from being a management clichë. A study of the DuPont Return On Assets (ROA) and profit margins in the financial statements released by some companies in Zimbabwe this year shows a clear drift in this direction. The DuPont ROA captures the relationship between the operating margin (OPM), the total assets turnover (TAT) and the return on assets (ROA) in the following equation:

The ROA, is the ratio between the operating earnings and the total assets, thus, it measures the basic earning power of the company’s assets.
How is the company using a dollar of assets, and therefore a dollar of the investors’ money, to create earnings? The earning power of the assets is driven by the operating margin (OPM) and the total assets turnover

(TAT). The OPM is the ratio between the operating earnings and the revenues and tells the investor the amount of earnings that the company is generating from a dollar of sales.
The TAT is the ratio of sales to total assets and measures the efficiency with which the company is using its assets to generate revenues.
If the TAT is relatively higher than the OPM, the implication is that the ROA is being driven mainly by assets utilisation rather than operating margins. In other words, for the company to deliver some value to the investor, it has had to reduce the assets base from which the earnings are being generated.
This means that a dollar of assets is now being used to generate more revenues that before.
This is especially important if the margins are very low and cannot be improved.

Applying the DuPont equation to some financial reports published in 2005 shows that the earning power of most companies’ assets was being driven more by assets utilisation rather than operating margins. Table 1 contains some equations derived from the data released by Art Corporation, Seed Co, Pelhams, Tractive Power and Zimbabwe Sugar Refinery.

Pelhams posted the highest ROA of 65 percent by combining relatively high margins of more than 37 percent with greater assets utilisation.
This high performance was sadly negated by distribution, administration and other operating expenses as well as interest payments, resulting in negative earnings per share.

ZSR, with very low margins at 5 percent, was able to post the same ROA as Tractive Power using a very high rate of assets utilisation of 347 percent.
The average ROA for 2005 was 30 percent with average operating margins of 19 percent and an average TAT of 180 percent.

Clearly, by 2005, most companies had set on a mean path, investing relatively little on the asset base and using that low asset base to create revenues. Why? Because margins were relatively low.
This trend continued to 2006 as shown in Table 2.

Though the earnings are still largely being driven by rates of assets utilisation, which are relatively higher than operating margins, the path to mean and lean is clearly becoming more desperate and harder. Pelhams, in particular, appears to be in dire straits, US$100 of sales can only generate US$9 in earnings and US$100 of assets are required to create sales of US$51.

Thus, a paltry US$5 in earnings is being generated from a US$100 investment in assets. This, combined with high operating expenses as well as high interest payments, again lead to negative earnings per share.

The average ROA for 2006 was 17 percent, far much below the 2005 figure of 30 percent, a drop of 43 percent. Average operating margins were slightly higher, at 21 percent and assets utilisation rates fell to alarmingly low levels compared to 2005, at 76 percent. In fact, they fell by 58 percent. Clearly something needs to be done here. It is only through severe cost-cutting measures and a drastic reduction in borrowings that these companies were able to deliver something to the investor. Let’s look at what the shareholder is getting for their investment in these companies. We can do this by calculating the net income margin (NIM), which is the ratio between the income attributable to shareholders and the revenues (see Table 3).
Seed Co was the highest performer for both years. From US$100 of sales, it managed to deliver a net income of US$18 to the shareholder in 2005. This improved slightly to US$20 in 2006. As for Pelhams, however, shareholders lost US$14 for every US$100 of goods sold in 2005 and a further US$23 in 2006.

On average, the companies were able to deliver US$3,20 to shareholders for every US$100 of goods sold and a further US$9,60 in 2006.
The implication of these developments is that most companies in Zimbabwe must use low-cost production methods, combined with low investments in the asset base in order to compensate for the generally low margins.

The question that needs to be answered is, what happens to product and service quality?
These surely must have suffered as companies try to deliver some value to the investor.