when it comes to profitability. Sure, you want to go after higher profits right but if you don't understand the amount of invested capital that is required to earn those profits, then you're really skewing your reality. This podcast, boosting your Financial IQ, is about business financial literacy, strategies for profitability and the principles taught at byfiqcom. My hope is that you'll apply the lessons learned and that we can work together soon in my mastery program. Enjoy the show and don't forget to subscribe. If you're running a business, I have a question for you Is your company actually making money? What I'm going to share with you is going to surprise you, so let's go ahead and jump right in.

So I wrote a book this is my second book. It's called Outsizing, and in the process I did a study of the construction industry, where I evaluated 363 companies. The reason why I chose the construction industry is because I had proprietary data which allowed me to compute economic profit, which is entirely different from accounting profit. Now, accounting profit has accruals and other items in it that doesn't necessarily represent the true economics of the business. In other words, you could have profit in there, but it doesn't really represent the economics of the business. Okay, for example, let's say, with your accounting profit. You have PPP money in there, so you have other income, or you have a gain or sale on a loss of a piece of equipment, or you have other accruals. Well, that doesn't necessarily tell you whether or not your business is actually creating value. That's why it's important to compute economic profit. That's where you take your net operating profit after tax and you account for invested capital. All right, so I'm not going to get into the nerdy mechanics of this, but just understand in invested capital you have working capital and you have investments in property, plant and equipment. That's just from a high level that will give you the true economic profit of your business.

So let's go back to my study. So I looked at the construction industry 363 companies. I lined them all up based on their economic profits, all the way from the lowest amount, the negative amount of economic profit that they're earning, to the highest amount of economic profit. Then I divided them in tenths, in deciles, so I had 36 companies, 36 companies, 36 companies, so on and so forth, to break out the 363 companies into these deciles, into these segments, and guess what I found? What I found is going to completely surprise you. Surprise me, I mean. Maybe it won't surprise you, because we know of the Pareto principle, which says that 80% of the results come from 20% of the inputs or the outputs, and the same thing is true.

With my research. Here's what I found the top 20% of companies earned 83% of all the economic profit and the top 10% of companies earned 64% of all the economic profit in this pool. But, more importantly, besides the companies in the lower deciles that were losing money, everybody else was right in the middle, making practically zero economic profit. But then I expanded my research into other industries and I found the same exact curve right. So you have the losers on the left. They're not actual losers, they're just losing money. Everybody else is just playing to play.

And then the top 20% is earning the majority of profits. So what does that mean for you? If you're listening to this and you're discouraged, you're like, oh my gosh, steve, we're probably earning zero economic profit because we have no cash. Things are tight, we're just not doing well. Well, guess what? Join the majority of businesses out there. Business is hard, right, I don't want to discount that, but it doesn't mean that you have to stay here, right. So that's the key If you're earning zero economic profit or close to it. If things are tight, you're struggling with payroll or paying the bills, you're tapping into your line of credit. Trust me, I've been there. I've been there before. I can feel your pain. The key is not to stay stuck.

So how do you move into the top deciles? That's where strategy and finance come together to help you to drive greater value. You just can't go out there and work harder and rely on sheer grit and work ethic to get you through. Heroics won't save you. I've tried that before. It doesn't really work and it's not sustainable. Or you can't just go and make cuts haphazardly in your business, because Maybe you'll cut yourself to death in the long term. So you have to be really careful. So that's why I pose the question are you really making money in your business?

Now, there's a difference between profit and cashflow. So I'm gonna talk about this and then, at the very end, I'm gonna reveal the most important metric that you'll be paying attention to when it comes to measuring the economic performance and viability of your company. So stay tuned to that. But first let's talk about the difference between profit and cash flow. Profit is great, right? So on the income statement, if you look at revenue. You subtract out your costs, you'll arrive at profitability. But profit doesn't tell you the full story and you've probably heard this before and I say it all the time because it's so important. But 70% of companies that go bankrupt, they're actually profitable when they close their doors and they go bust because they run out of cash. So cashflow is king. So profit just tells you how well a company is pricing its services, at what cost it's fulfilling those products and services and, ultimately, is it making a profit or a loss.

But there are components that are on the balance sheet that are not displayed on the income statement. That will help you to tie this economic picture all together in a nice pretty package with a little bow on it. So on the balance sheet there are two things. First, you have working capital, which is essentially the difference between your current assets and your current liabilities, and you have your investment in net property, plant and equipment right. So when you go out there and you buy a truck or a trailer or a piece of machinery or a building, whatever it may be, to provide the services or products of your business, those are recorded on the balance sheet, not on the income statement. So if you go buy a $50,000 truck that's not going to be deducted on your profit and loss statement to show you the true economic profit of your company, because it's capitalized, it's recorded on the balance sheet.

So you could be looking at the profit of your company and you're like, wow, look at it, we have a healthy bottom line. But then you look at your bank account or your line of credit and you're like your line of credit's going up and our bank account is near zero. The reason why it's like that is because you're not accounting for working capital and investments in your property plan equipment. That's why I love free cashflow. Now, if you want a shortcut to calculating free cashflow, you could just go to the statement of cashflows, look at cash from operating activities and subtract out your capital expenditures and investing activities, and that will give you your free cashflow. That's just a shortcut, but essentially what I'm saying is this if you have profit, you have to account for your invested capital, which is made up of two things your working capital and your investments in net property, plant and equipment. Right, so those two things together will give you invested capital and will tell you the true economic picture of your business.

All right, which leads me to my last point. This is really, really important. I'm going to illustrate this with a story and then I'm going to drive home the metric that you should be paying attention to in your company. All right, so let me give you the story. Let's say there are two companies. All right, one company earns $100,000 in profit and the other company earns $200,000 in profit. They both do the same amount of revenue. Which company is more attractive? The one that does $100,000 in profit or the one that does $200,000 in profit?

Now you may be listening to this and you're like Steve, there's got to be a catch here. It can't be that easy, because obviously you'd want to go after the company that's making more profit the $200,000, right Now, this is where the picture is incomplete. I was sitting in a conference a while back and this instructor was talking about this very scenario and he's like guys, which one is it? And everybody's like it's the $200,000 profit company. And he's like yes, that's correct. You know, you want to maximize profits. And I just smiled to myself. I didn't say anything, but I thought that's completely incorrect.

So I'm glad you're listening to this right now, because let me set the record straight when it comes to profitability. Sure, you want to go after higher profits right. But if you don't understand the amount of invested capital that is required to earn those profits, then you're really skewing your reality. Let me explain. So let's go back to the example. One company makes 100 grand in profit. One makes 200 grand in profit. What you don't know is that the company that's making $100,000 in profit every single year only took $10,000 to get started, whereas the company that's making $200,000 a year took $2 million to get started.

Okay now, which one would you choose? Well, obviously you'd rather choose the one that only took $10,000 of startup capital and I'm simplifying things. There's a lot of other factors, but just follow along with me because then you could put $10,000 in, make a hundred grand off that, and then you could take the hundred thousand and you could reinvest it in the business right, and grow it even more. You could scale it even more, especially with that type of ratio. Or you could take it and then go invest in something else, whereas with the other company you just piled in $2 million. It's going to take you 10 years of profitability to earn your investment back. Right, because you're earning $200,000 a year, but it took you $2 million to earn that. So $200,000 a year times 10 years is $2 million, just to break even.

That's the important thing I want you to hear. So the metric are you ready for the metric? The metric is return on invested capital. Now, there's some nuances here because it doesn't work for all companies. For example, let's say you're an asset light company like a software business or professional services, sometimes return on invested capital doesn't work, so therefore you have to use economic profit as a measure. So just know that it doesn't always work. But for the majority of companies, return on invested capital is a really critical metric to pay attention to. Here's the math Net operating profit after tax. In other words, you just want to take your profit that you earn from your core operations, eliminate everything else that is outside of your core operations in the figure and then take this after tax. Now if your organization doesn't pay tax, like you're an LLC or you're an S corporation and you're treated as a disregarded entity in the United States, then just apply an effective tax rate to get to an after-tax number. Then what you're going to do is you're going to divide your net operating profit after-tax, your NOPAT, by your invested capital.

Invested capital is made up of two things Working capital remember the difference between your current assets and current liabilities. There's some nuances here. You have to take out excess cash and you want to subtract out your interest bearing debt from your current liabilities, right? So current assets minus excess cash, current liabilities minus interest bearing debt. That will give you your working capital. And then look on your balance sheet at your net property, plant and equipment. So when I say net, it's your gross property, plant equipment, all your investments in trucks, equipment, your building, et cetera right. All your assets there less your depreciation, right? So take your net property, plant equipment, add that to your working capital. That's your invested capital. And then when you take your net operating profit after tax and you divide it by your invested capital, you end up with return on invested capital, also known as ROIC.

So let me give you some numbers here to put this into practice. Let's say a company is earning $100,000 a year and they have a million dollars in invested capital. Well, $100,000 in profit divided by a million in invested capital is 10%. Therefore, this company would have a return on invested capital of 10%. Now compare return on invested capital with the operating profit of the business. Maybe the operating profit is 15% or 20% or higher, whatever, but maybe the return on invested capital is a lot lower. When you compute the return on invested capital and you bring this KPI into your business, you'll understand how much invested capital has to go into the business in order to earn those profits, because, remember, you can't just look at profits in isolation. That's a huge lesson that will be invaluable as you run your company.

And if your head is spinning because I just threw out a bunch of terms and I was talking a lot about finance and I got really excited and I went kind of fast, don't worry, I was there once too this stuff will stick the more you listen to it. And if you need help with this in your business, if you're like Steve, just come in and help us to understand our numbers better, especially our return on invested capital and our cashflow, and help us to build forecast out. That's what we do, so you can always learn more and connect with us at C and we can walk you through our system. But nonetheless, I want you to apply these things in your business, because when you do, I know the upside is enormous. So best of luck to you. Thanks for tuning in and until next time.