I wanted to highlight the excerpt below, from the book The Outsiders, because through my experience looking at a lot of small companies, I think a focus on cash return on capital would make a huge difference in a lot of places. I think too many companies feel the need to ‘do something’ and invest money opening new stores, new plants, etc. without properly considering whether or not a good economic profit and cash return is being realized. Sales and profit dollars get the attention, but those numbers don’t mean all that much if the capital invested to achieve those sales and profits isn’t considered in the return equation.
Consider the scenario where two restaurants are opened and both restaurants generate $3 million in sales and $200,000 in EBIT. You can’t tell which is better if you don’t know how much capital went into getting them open. If it took $1.5 million to get the restaurant open, then the return is pretty average. If it took $400,000 to get the restaurant open, then the return is pretty great, even though the EBIT margin was less than 7%.
Now the short excerpt from the book:
When Anders and Mellor began to implement their plan, General Dynamics was overleveraged and had negative cash flow. Over the ensuing three years, the company would generate $5 billion of cash. There were two basic sources of this astonishing influx: a remarkable tightening of operations and the sale of businesses deemed non-core by Anders’s strategic framework.
More generally, they discovered that plant managers carried far too much inventory and hadn’t been calculating return on investment in their requests for additional capital. This changed quickly under Mellor’s watch, and he and Anders moved decisively to create a culture that relentlessly emphasized returns. Specifically, as longtime executive Ray Lewis says, “Cash return on capital became the key metric within the company and was always on our minds.”