The main objective of every business enterprise is to earn profits, which is necessary for ensuring a company's survival and growth. Therefore, profitability becomes the foremost metric when you analyse the performance of any company or organisation. While everyone is mostly concerned with whether a company is profitable or not, for business managers and investors, profitability has a different context. They need to analyse profitability using various elements, such as sales revenue, capital employed, competitor performance etc.

In the upcoming video, our faculty Marie-Lys will introduce you to the basic profitability framework used for running a business. This framework helps in building ratios for analysing the performance of any company.

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In this video, you learnt about the framework that can be used to build ratios and analyse the performance of a company, which is illustrated below.

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The capital raised is invested to run the day-to-day operations of a company. The raised capital is employed in the following resources:

Resources	Description
Fixed assets	Tangible assets Intangible assets
Operating working capital	Money required to fund the operating cycle. Operating working capital = Accounts receivable + Inventory - Accounts payable

You also learnt about the operating cycle, which is illustrated in the image given below.

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Now that you know how this business framework can be used to build ratios, in the upcoming video, our faculty will introduce you to the key ratios that help in analysing the performance of a company.

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As you learnt in this video, the main stakeholders of a business are the shareholders. They are interested in comparing the net income with the owner's equity to ascertain their return on investment. This measure is called return on equity (RoE).

However, the net income of a company is highly dependent on the operations of a company. Therefore, it is quite important to first determine the operating profit margin of the company.

Another important aspect that needs to be determined is the resources employed by the company in generating the operating profit. Therefore, the operating profit of a company needs to be compared with the resources employed by the company in order to determine the efficiency of the company. This measure is called return on capital employed (RoCE).

In the next segment, you will learn about the economical balance sheet of a company.

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Transcript of the Video:

How does a business work? When we want to start a business, usually we start by raising funds.
Who from? Shareholders and bankers who are the fund holders of our companies. And then what
do we do once we have that money? Of course, we invest it.

Invest it in what? It's interesting to dig deeper into this analysis here and ask ourselves, how
should the capital invested by shareholders and banks be employed?

I mean, which long-term resources does a company need to run its day-to-day business? Well,
you may think about fixed assets, property, plant, and equipment, buildings, machines, trucks,
computers, whatever.

And sometimes intangible assets as well. Like Goodwill, patents may arise. But that's not enough.
If for example, you want to start a small pizza food truck in your neighbourhood and you only
raised enough cash to purchase the nice vintage foot truck.

Yes, you will buy it, but then you will not have a dollar left to start to run your day to day business.
To go to the supermarket, purchase food and start to transform this foot into pizzas and maybe
start to grant credit to customers, and so on and so forth.

So, we need more cash to run the day to day business, then simply to finance the fixed assets.

So, we need more cash because there is a delay between the day we have to pay for the raw
material we need in the production process, and the day we collect our last dollar from our
customer.

If we look at what we call the operating cycle, it looks a bit like this. Usually you start by
purchasing some raw material that is delivered to you at one point in time.

And you're likely to pay for that raw material a little later. Then, as soon as the raw material is here,
you hold it in inventory.

You will hold a bit of raw material inventory. Then you will have essentially work in progress
inventory. And towards the end of the process, you will hold finished goods inventory.

The idea is that you don't keep the finished goods inventory for too long, but you quickly find a
customer to whom you're going to sell and deliver the product.

The day the customer takes the ownership of that product, you issue your invoice and the
customer will pay you a little later.

So, there is truly a delay between the first dollar out when we pay the suppliers and the last dollar
in we cash in from customers.

This time period is what we call the cash to cash period. And during the cash to cash period, we
need to have planned ahead of time for enough cash to survive.

Because gradually there will be more and more cash flowing out of the business and we're still
waiting desperately for the customer to pay.

So, if we've not planned for a buffer of cash before we start the operating cycle, we're likely to go
under, I mean, we're likely to go below zero cash wise and that's the definition of bankruptcy.

So, we certainly don't want to go there and we need to plan for enough cash to fund our operating
cycle.This amount of money that we need to fund the operating cycle to cover the cash to cash period is
what we call the working capital.

Actually, the operating working capital, because it's the working capital that is here to support our
day to day business.And this operating working capital comes from the fact that we have to fund the credits to
customers.So, we have to fund our accounts receivable, also inventories require cash to back the business.
The only thing that minimises a bit are a need for cash is the supplier credits.

So, the formula for operating working capital will be accounts receivable plus inventory, minus accounts payable.
And that's it. Basically, once we have enough money to pay for the fixed assets and the operating
working capital, we are ready to start the business.

So, in order to answer the questions at the top, we can say that in order to fund our day-to-day
business, I mean our operations.The day-to-day business is what we call the operations in finance, we need fixed assets and
operating working capital. That's what we call the capital employed in finance.

So, the invested capital is shareholders' and bank's money and the capital employed is equal to
the invested capital, but represents where we have invested shareholders' and banks' money, and
the capital employed will be equal to fixed assets plus operating working capital.

So, back to our framework here, where do we invest? We invest in the capital employed. So, we
invest in fixed assets and operating working capital. That's what we need to run our operations.
And hopefully, running the operations, we're able to generate a profit from the operations. That's
what we will call the operating profit or the operating income or the EBIT.

We will use it to reward first, the banks to whom we owe some interest expenses because we had
previously borrowed money from them.Second, we will have to pay taxes to the government on our profits. And third, if anything is left, it
belongs to shareholders.

Shareholders will be free to decide either to take a dividend out of the company if they want to
have a liquid reward on their investment, liquid meaning in cash. Or they may also decide to leave the remaining profits inside the business. In that case, this profit
will become a retained earning and will be available to grow their business.

That is, to grow the capital employed, buy more machines, grow the credits to customers, grow the
work in progress inventory if we want to do more business, and so on and so forth, so as to
generate more sales and more profit next year.

So, this framework, I think describes pretty comprehensively how a business works and we can
use it in order to build some ratios to analyse the performance of the company.Who's going to be interested in building ratios? Well, first, the shareholders I think. The
shareholders are going to ask, you know, hey, how much profit was generated for us.

This is measured at step three on the graph here. And they're likely to compare these to the
amount of money that belongs to them in the company.

Shareholders' money here is at the top. That's what we call owner's equity in the balance sheet.
So, shareholders will be interested in that type of ratio, looking at the net income, vis-a-vis the
owner's equity.

But before going to shareholders' performance, what I want to highlight on this graph is that look,
the performance that is delivered to the shareholders in the end is first rooted in the operations.

How will the shareholders manage to have a very good net income at step three on the graph?
Well, only if operations perform well and are able to generate a very good operating income.

So, the performance delivered to the shareholders is really rooted in the performance delivered by
the operations. And therefore, before jumping to shareholders' point of view, it's important to measure and
understand the performance delivered by the operations.

Typically, look at the profits. So, look at the profit from operations, ask ourselves how much profits
did the operations generate out of a dollar of sales. That will be the operating margin. We'll come back to it in a minute. But it's not enough to look at
that.

It's not enough to be satisfied with a certain level of profit made. If I show you an income statement
and I tell you, I generated an operating income of $3,600, okay, you will say cool. But you may immediately raise a second question. $3,600 of profit, that's great. But what are the
resources you employed to generate that profit?

You're going to tell me, did you utilise $10,000 of resources or a $100,000 or $1,000,000. Come
on, if you utilised $1,000,000 of resources to generate only $3,600 of profits, that's a very poor
performance.

So, you want to see what were the resources involved in generating the profit from the operations?
What is the profit from operations, vis-a-vis the resources employed to run the operations. And
we're going therefore to look at what we call the return on the capital employed, more to come in
the next video.