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Are you beating your bank account?

There is one question that I insist on asking over and over again every time I meet an entrepreneur or someone who just set up operations in China. Are you beating your bank account with the profits from your business?

Many CEOs incorrectly answer this question by telling me their gross or net profit margin. Indeed, many are able to quote this figure very quickly as much of their time is spent negotiating with customers over prices for their goods and services. This number is a handy way to quantify their firm's added value. Invariably, depending on the relative intensity of the competition, their figure is in the middle to low teens, if they are lucky. Some are even middle single-digit figures. Of course, these profit margin figures are very important as they feed directly into the company's bottom line in real-currency amounts.

"But," I always end up saying, "that is not what I am asking." My question alludes to something even more fundamental than the profit margin. Namely, because you are the owner of your company, I want to know if your firm is generating a rate of return that is better than if the money just sat in the bank. Using finance jargon, what's the return on equity or better yet, what's the time weighted rate of return?

If we turn back the clock, we note that business owners were faced with two choices well before they started their businesses: either to leave their investment capital in the bank or to invest it in a business of their liking. By opting to invest in a business which they also manage, they are implicitly making a bet that they can beat a "boring" bank account.

From this point of view, we are not talking about figures in the midteens any more. In fact, we are looking a lot higher. Finance has taught us through Nobel-prize winning equations that return and risk are essentially inseparable. High returns are usually accompanied by high risk, and vice versa. This has been shown through countless academic studies involving many different asset classes.

Businesses, especially privately held businesses, are certainly not as tradable as a stock listed on some major exchange. But business owners in China must remember that they are fundamentally investors in one of the most exciting economic stories in modern times. They are not only investing their capital, but also their time. Much of the reason for the excitement lies with the vast opportunities available for those who are willing to accept the inherit risk involved. Hence, from the risk/return point of view, the return on invested capital, compared to that "boring" bank account, should very well be anywhere from 30 percent to even 100 percent. In fact, after clarifying my question, many CEO's are very comfortable in 40 percent-60 percent range. Beijing entrepreneurship is really booming!

Writing on finance and economics for the last 18 years, David Seto, CFA splits his time between Hong Kong and Beijing where he reads Chinese Classics and tries to revive his defunct band, Scarbelly. Any comments on his columns can be sent to dseto@btmbeijing.com.