When managers talk about record profits, they often leave out one crucial detail that would allow shareholders and owners to view their performance in a more honest light: the change in capital at work in the enterprise.  This seemingly small detail is actually one of the most important numbers any analyst, executive, owner, or lender needs to know.

Assume you own a beverage stand that sells lemonade in the summer and hot cocoa in the winter.  This small business earns 10% on assets.  You decide you have better things to do than work the counter, so you turn it over to a professional manager.  The day you handed over the keys, your beverage business had $10,000 in capital (okay, it’s a really nice stand) and generated $1,000 in profit.

The next year, you come back and the stand has earned exactly what was expected. You decide to reinvest the $1,000 profit back into expansion so your business now has $11,000 in assets.  The next year, when you come back to check on performance, logic tells us that your company should have made $1,100 in profit because you increased the money at work ($11,000 assets x 10% return on assets = $1,100).  Should your manager be able to boast of record profits?  Should he or she be rewarded and get a bigger salary or stock options because they increased earnings 10% when you, by reinvesting profits, gave him 10% more capital to work with at the start of the year?  Of course not.  You were the one that gave up what you could have spent in order to expand, why should they be rewarded for doing a mediocre job?  A great manager is one that increases a firm’s return on assets without the use of leverage or increasing risk.  Think of someone like Tony Nicely at GEICO who has generated breathtaking gains in productivity per employee.

Taking the illustration one step further, let’s assume that the next year, you come back to find that your manager borrowed $15,000 to expand even more rapidly, resulting in $1,000 interest expense and total assets of $27,600 ($11,000 starting assets + $1,100 return on original assets + $15,000 assets paid for by borrowed money + $1,500 return on borrowed money – $1,000 interest expense).  In this case, profits would skyrocket to $1,600 from $1,100, representing a gain of approximately 45.5% in one year.  Yet, to generate that return, you had to increase assets by nearly 151%, substantially increasing your risk in the event of a bad economy or hitting an unexpected bump in the road.

The point is, that increasing profits 45.5% in the scenario I just described requires no managerial talent whatsoever.  None.  Zero.  It is nothing more than retaining money from the owners, who could have used it to buy things they wanted, donate to charity, or fund other projects, and piling on risk by increasing debt.  It’s financial engineering.  That’s not to say having an optimal debt structure can’t be a brilliant move; it can.  It’s just that most investors are blinded by a management team that somehow magically reports bar charts marching toward the sky without taking the time to examine that actual return those same managers are earning on money that was kept from the owners by retaining capital.

The lesson: Always examine 1.) the total capital at work in a business, 2.) how the capital base changed throughout the year, and 3.) the return management is earning on total capital at work, especially when compared to competitors in the same industry.