What if the most important number and predictor of long-term success was also a number that you didn’t measure or even manage decisions based on it?

Unfortunately, it’s a situation that is quite common today.

The accumulation of many seemingly small (and large) investment decisions that leaders make leads to the primary measure of a CEO – return on invested capital. How much capital has been invested in your business, and what’s the return on that? Some of the most successful CEOs of all time have been primarily guided by this measure. 

Ensuring that these decisions are well-considered and actually create high-impact results is where leaders should focus.

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EPISODE TRANSCRIPT

Please note that this episode was transcribed using an AI application and may not be 100% grammatically correct – but it will still allow you to scan the episode for key content.

 

00:13
Brad Giles
Hi there. Welcome to The Growth Whisperers, where everything that we talk about is building enduring great companies. My name is Brad Giles, and today I’m joined by my co host, Kevin Lawrence in Vancouver, Canada. G’day Kevin. How are things today in your part of the world?

00:28
Kevin Lawrence
They’re good. It’s dark, it’s the end of the day, but we’re coming into our spring and our winter, and it’s getting excited. We had actually the other day we had like a little sample of spring and it was really exciting. Sometimes when it happens, we’re like, is this real? Is this not real? But yeah, it was real. So, yeah, we’re into the best season of where we live. Well, like a lot of places, the.

00:54
Brad Giles
Summertime, I reckon seasons are just the right amount of time. After 90 days, you’re ready to move on.

01:03
Kevin Lawrence
Yeah, I would suggest if there’s a little novelty and it’s awesome. Although I’m never quite I don’t need summer to move on. I think summer could extend longer than it does here in where we are in Vancouver. It’d be nice if it extended, but hey, we live where we choose to live, where our families chose to live would be another way of looking at it, but yes.

01:24
Brad Giles
Yeah, that’s true. Tell me, we like to start with a word or phrase of the day. What might be on your mind this morning? Kev.

01:33
Kevin Lawrence
Perspective. Perspective is the word and from so many things, the most important thing as leaders and humans is to be able to have the right perspective in different situations. And there’s infinite perspectives you can have. When you have the right perspective, it enables you to generally do the right things and to generally feel good about the things that you’re doing. Perspective ability to shift your perspective or have perspective on your perspective, but it’s really to see things from outside yourself from a bigger picture view. It’s important to just everything and how important it is and how I appreciate things that allow me to be able to have so many different perspectives on issues through the other great people I’ve worked with and the things that I’ve learned.

02:29
Brad Giles
Yeah, awesome. So for me, it would be multiply.

02:34
Kevin Lawrence
Now, thinking in addition nine times nine.

02:40
Brad Giles
Yeah, very much so. Thinking about people and their capability and really you’re multiplying their capability. It’s of the Liz Wiseman stuff.

02:53
Kevin Lawrence
Okay.

02:54
Brad Giles
Yeah. Someone doesn’t have the capability, they’re at zero or close to zero. You don’t have a lot to actually multiply. Making sure that people are capable of succeeding in the role, that they understand how to succeed in the role and that they want to succeed in the role, that’s the raw multiplier that we have as leaders that we’re trying to work with. If those numbers aren’t there, you don’t have much to multiply against.

03:24
Kevin Lawrence
I like that. So you can take. I like that. Okay, I’m not even going to try and push smash those together. Let’s get into what we’re talking about today. Speaking of multiplication and perspective, what we’re talking about today, the most important number that CEOs rarely measure, especially entrepreneurial CEOs, is their learning because it’s almost a more advanced skill. Let’s call it an advanced perspective, and it’s a special type of multiplication. Really what we’re getting into today is really understanding return on capital as a key measure in business. It is considered to be the number one measure of a CEO. For example, if Brad and I were each given $10 million to build a company, and five years later, brad is making $10 million a year off that initial $10 million of capital, and I’m making five. Brad has double the return on capital at that point in time than I do.

04:28
Kevin Lawrence
He gets twice the juice from the fruit. He’s considered to be a better CEO or better juicer or better at getting a return on capital if he’s able to do that year after year. It’s not just how much you make, it’s how much you make based on how much capital you are using to make it. Basically, if the return is the income statement, maximizing the profitability divided by the balance sheet in simple terms, or how much capital you’re given, it’s really leveraging the income statement in context of the balance sheet or making profit in context to how much cash you’re using to make that profit. And it’s a super important piece. We get so lost in profitability and so lost in what we’re doing, a lot of people don’t even look at it. That’s kind of what we’re digging into a bit more about today.

05:25
Brad Giles
Makes me think about a statement that Peter Drucker said that a manager’s job is to be efficient, but an executive’s job is to be effective. How do we operate as effectively as possible with the capital constraints or with the capital that we’re given? That’s what it is. That’s what a great leadership team does. That’s what I like to say to the leadership teams that I work with. Ultimately, everything comes down to given the balance sheet that you’re delivered, all of the intellectual property, the assets, the cash, a great leadership team maximizes the output from that. The return on that maximizes the output.

06:14
Kevin Lawrence
In context of that versus just maximizing the output. That’s why a lot of times as companies grow, executives get so focused on profitability that it often really hurts the cash flow or they end up using more capital and they don’t realize it along the way. You actually look at the return on capital measures, and it’s often on the weak side or the low side which we’ll get into. Before we do, if you haven’t subscribed yet to the podcast, please subscribe and share it with people right? This is episode 159. We’ve done this a couple of times, and we’re sharing the best we have, and we’re happy for you to share it with others, but please subscribe, give it a rating or a thumbs up if you haven’t just yet. One of the things to put in context, as we’re talking about this, we got to remember a business produces profit based on an amount of capital, and that’s called return on capital.

07:07
Kevin Lawrence
Well, you’re competing against it because you could just take the capital and throw it in the stock market. You could throw it in some old mutual fund or give it to investment manager. You could buy a chunk of real estate or in today’s day and age, you could just leave it in your checking account and get a reasonable amount of interest. Unfortunately, some people will better today leaving the capital in their checking account, not in their business. What we want you to do is to learn and get perspectives on making sure that not only should you not leave your capital in a checking account or savings account instead, or should you invest in a real estate or the stock market you are actually deserving of and are an optimal place for your and other human other people’s capital. That’s kind of what we’re getting into, is that to really make sure it’s an exceptional place for your capital to grow.

08:00
Kevin Lawrence
There’s a great book, and Brad and I talked about this in our Top books episode we did probably five episode ago.

08:07
Brad Giles
Yeah.

08:07
Kevin Lawrence
What was that episode? I don’t remember the name of that episode. Brad, if you happen to we can call I do.

08:13
Brad Giles
Just use some filler words for a moment. Kev.

08:15
Kevin Lawrence
Okay. Do a little song and dance. Here he is. Come on. Go ahead, Brad.

08:24
Brad Giles
This is how prepared we are today, right? Episode 155 the Nine Books Every CEO Must Read It’s one of these top nine books.

08:32
Kevin Lawrence
Excellent, excellent. Top nine books. This is what it’s called, The Outsiders, and it’s eight unconventional CEOs and their radically rational blueprint for success. 1 second here, the essence of the book is the ultimate measure of a CEO’s performance is return on the pool of cash. They’re given return on invested capital almost all but one of those CEOs you probably haven’t heard of because they’re not in the limelight. They’re not worried about that. They’re grinding it out, providing unbelievable returns for their shareholders over time. And so it’s books called The Outsiders. It’s amazing. It’s a game changing book because it really brings the return on invested capital to life. One of my clients india, we started looking at this probably four or five years ago, and we read this book, and we started looking at the whole business through return on invested capital. We looked at it overall, and then we started looking at it by unit and then by investment.

09:37
Kevin Lawrence
It’s so steeped and deep in the DNA now we talk about it with everything. It’s part of every conversation. Not even just myself and the three directors, but at the executive team level, it’s part of our view. By the way, we found some things we really didn’t like, and we came up with some freaking brilliant moves that we never would have made before. We only found them and what were doing in the business. We didn’t pay attention. We found these little pockets of brilliance, these pockets of spectacular return on invested capital, but they were counterintuitive. Now that we understand it, we can better optimize it. And our strategy has evolved. There’s been a couple of notable moves in our strategy because of our understanding this and because of our drive for this, because we’re creating a better business by pulling different levers than we thought we would.

10:41
Brad Giles
Can you give us an example of a counterintuitive idea?

10:46
Kevin Lawrence
Yes. Take a project that you’re going to do and you’re going to make a lot of money on and let’s get a partner involved with us. Let’s just say I’m making up these numbers. These aren’t real numbers, but sure, if were going to do a project and were going to make $20 million on it, let’s bring in a partner and only make ten, we’ll give them half the profit. That’s counterintuitive. Wait a second. We’re going to give away half of our profit? Are you crazy? Are you blah, blah? Well, son, let’s do some math here. Let’s do some quick math. If we bring in a partner who puts up all of the money and we put up zero on a project that would provide a boat of 40%, I’ll say this one, even 25% return on invested capital annually, but we have no capital in it.

11:51
Kevin Lawrence
If we put up all the capital, we get 40%. If we put up, let’s just say almost no capital, we get like a 14 million% return on invested capital.

12:05
Brad Giles
That’s not bad.

12:06
Kevin Lawrence
We get half the profit without any cash. Do you understand now why we give away half? Sorry if I sound condescending, I’m just trying to play. The reality is it’s like, well, if you don’t put up any capital but you still get half the return. D***, that’s good. By the way, in this model, you also reduced your risk dramatically. Not only do you so you get half the return, notably less than half the risk, and your return on invested capital just went to the moon.

12:44
Brad Giles
That’s good.

12:47
Kevin Lawrence
And that model works. If you go do more projects, yeah. If you don’t and you have a whole bunch of capital sitting on the sidelines, it doesn’t work because it enables you to do more with less risk and dramatically better return.

13:03
Brad Giles
Love it. Love it. One of the interesting ideas here is that if you’re in the leadership team, either you’re the leader or you’re a leadership team member. You may think about competition as being the competitors who sell the same product, but one of the founding ideas here is that in actual fact, there is another competitive element, which is the return on capital, on invested capital that the owners and or shareholders are getting. Because they’re looking at this business and they’re saying, hang on, I could get 30% if I went with this other investment, and I’m only going to get 15% or whatever number it is if I keep this money in the business. There is another layer of competition that’s occurring at the shareholder level because the shareholders want to get the best return that we can. That they can, yes.

14:02
Kevin Lawrence
It’s a more advanced way of thinking for a lot of business people. As a business gets bigger, you need to think about it because there’s more capital tied up in a business. There’s a whole other piece of this, by the way. It’s not just about maximizing returns, it’s about using less capital. It’s about having less capital inventory or in products or locked up in a business. So there’s many levers to get here. The key thing, first thing, number one, we get our five points is we like to have some points, but is you got to know your number. You got to figure out your number which ties into .2 and get granular, just like you would with profitability. You want to look at it by product or by location or by investment or by whatever it is your business is broken up into. You really want to know your number and just know where you stand because again, your alternative is the stock market, a savings account, a treasury bond or whatever it happens to be.

15:00
Kevin Lawrence
Obviously we want to outperform those dramatically and good businesses consistently produce 20, 30% as a nice place to be and it should be 20 or 30% based on the risk in a lot of businesses, obviously there’s some that do way more and those are even better. I talked about that client and we found the one thing I want to tell you, though, is that it does flush out some ugly things. There’s some things when you start to look at it, and especially when you start to use this for decision making, you realize that when you start to take into account the balance sheet or capital, some decisions just don’t make sense. You got to give yourself some permission that hey, not everything needs to make complete sense financially. There’s room for we’ll call them pet projects or whatever it happens to be.

15:48
Brad Giles
Oh, gambles it is.

15:51
Kevin Lawrence
I mean, there’s some people that based on this in a stagnant or low demand market, a lot of people wouldn’t want to buy real estate if there’s not big appreciation right? If you’re in a market where there’s appreciation, it’s different. So everyone’s got different. It’s a brutal number and it helps you make notably better decisions.

16:15
Brad Giles
Yeah, there’s one leader owner that I work with, he works in the business. He owns the business as a sole owner. He made the comment, what I do is I invest in real estate development, and then I take the money that I get from that and I invest it in this business. Now, that’s just a comment, and it was supposed to gain a laugh, but I don’t think that the leaders really appreciated just how cutting it was about the failure of the business to compete with the other investments that the leader had. And I think they just thought, ho. Yeah, that’s funny. It’s been a tough market and something else. It can be that this is the competition that we’re talking about that we need to perform.

17:08
Kevin Lawrence
Yes. If your number and get granular on it, the next thing is to start to get reporting on this. You see how your decisions play out and really see how it play. Training your team to understand it, that is critical because a lot of people do not understand it. Some people barely understand an income statement. To understand how it correlates to the balance sheet or getting a return on cash, you got to train people on it, start reporting on it. Your CFO often gets involved in helping to bring this to life. One of the organizations that we did this in and done it many, but the CFO would run classes, he would do capital basics, and they would go and train people on this. They would show the models, they would get them to work with some things to test it out. Basically even they did with all the execs and the senior leadership team and some of the managers just to start getting their mind around it so they could have eyes open to it.

18:07
Kevin Lawrence
When it was part of the reporting, everyone could see it and understand it. I’ve already gave the example here of some of these ideas that started to come out of the team, like, hey, let’s make sure we take on partners. Almost always take on partners because it dramatically increases our return. As we shared before, it takes away a lot of the risk because.

18:31
Brad Giles
It’S all of the little decisions that we make along the way, all of the decisions that create that return. When you compound that over multiple years, like you said at the beginning, that’s the difference between a good or a great output or return for the shareholders. That’s kind of one of the reasons that we’re here, if not the main reason.

18:53
Kevin Lawrence
I read this great report. I won’t use the actual names, but there was two heavy equipment companies in North America which would be well known names by people that deal with heavy equipment. I read this report from analyst on the two companies and it got down to the core of it. They were both seen as being great, but One was considered in the end and stock price reflected it to be twice the company others were, even though they were the same size.

19:24
Brad Giles
Wow.

19:26
Kevin Lawrence
Because One had double the return on capital.

19:28
Brad Giles
Yeah.

19:29
Kevin Lawrence
The CEO of one had made a whole bunch of decisions that might look good and they were able to beat their chest and be proud of what they’re doing. The end of the day, the ultimate measure. The one company, year on year, crushed the other one in terms of return of capital. Now, they were both competitive in the market and they both compete. They weren’t equal competitors, but they were both two big competitors. Yeah, but one was twice the effective machine that the other was from that lens. Market reflected that and that’s that competition.

20:00
Brad Giles
There’s a business, the business that I work with, the owners own two businesses. They’re kind of somewhat related and they look at one business and it’s got a certain return and the other businesses has a much lower return. It’s hard to not say we need to invest more in the business that produces a better return. It’s just market dynamics.

20:26
Kevin Lawrence
We had another one where we started doing this. We looked at the profitability at a deep level and return on invested capital. We had a 45 year old business and we had to shut down the part of the business that the whole thing was based on because when we looked at from a profitability and a return on invested capital perspective, the one we shouldn’t have been in it five years ago. Now, it took a couple of years to do it, a lot of change because were based on a certain thing. The next business that were in was where the future was and it’s actually where were even the present was, and we had to kill off the old business. And again, it’s fine. You don’t have to do these things overnight. When you start analyzing it and it says, no, we got to make this work, okay, let’s try.

21:12
Kevin Lawrence
When you try to make it work and you can’t move the needle and you see, you got to invest more capital. By the way, just as a side note, there’s also why there’s a thing called the Capital Light business. There’s capital heavy, where you invest the capital and you get the return on it. Capital Light or asset Light sorry, asset Light, they call it, is when you’re almost brokering things. So, for example, there’s a business I worked with in the US. Their Asset Heavy businesses, they had a whole fleet of service trucks running around fixing equipment all around the US. That was the traditional business. The Asset Light one was someone that says, I got an idea. I’ll go help out the Walmarts of the world, they call us, and we’ll facilitate the stuff getting fixed with all of these companies across the country that have all of these trucks.

22:07
Kevin Lawrence
It’s Asset Light, it’s brokering and using other people’s capital that’s at work. Those Asset Light businesses get a very high valuation sometimes because there’s no capital. There’s almost no capital tied up. Someone might have $100 million of trucks and equipment, and you’ve got a call center with some people on it. There’s other versions of it to go and dial in this number. The idea here is, understand how you’re performing based on the capital you’re using and to take it into account with all of your decisions, because all.

22:43
Brad Giles
Of those decisions compound over time to create sometimes a massively different output. Focusing on what is that output, and how are the decisions that I’m making today connected to that? Or maybe even you have got some decisions that you need to make. Well, how is that going to contribute to your ROIC, your return on invested capital?

23:06
Kevin Lawrence
Right. So, going back to the word perspective at the beginning that I was at the end of the day, this is a different perspective to bring to your business. Many people are focused on their profitability or their EBITDA or their cash flow. And that’s good, and it’s of you. The other is the return on capital. Return on invested capital, which gives you a second, slightly more sophisticated view to look at your business. All are good, but this gives you another dimension to look at on your investments and all of your decisions to help you build a better machine over time. You got to know where you stand and know your number. Granularly got to get some better reporting and start to include it in decisions. You got to say no to a lot of stuff that stops working and making enough to do it instantly, but your model will continue to pivot and change and hopefully get stronger and stronger.

23:59
Brad Giles
Very good.

24:00
Kevin Lawrence
Very good.

24:01
Brad Giles
Return on invested capital. It’s really the thing that is, as we said at the title, it’s the most important number that CEOs rarely measure, but should measure, because this can help to help you to make the right investment decisions moving forward, which is one of your key responsibilities. Good. Hope that you’ve enjoyed the episode today. Make sure that you think about what’s your ROIC and how can you begin to utilize that in your business. A couple of key points here. Get to know your number today. Get Granular. Just like with profitability by location, by product, by investment. Make sure that you can track it as a business monthly or quarterly, and get your team to understand it, and then put it when you’re making investment decisions make. That one of the key criteria that you’re analyzing. Say no to the things that no longer add up, and this will compound up over time.

25:05
Brad Giles
So, good chat today. Yeah. Hopefully we’ve given you a bit of a different insight through an accounting lens, perhaps, but such an important lens. Hopefully you’ve been able to stick through this because this is what creates the real results that we talk about, that help you to endure. So you can find us on YouTube. If you would prefer to see our smiling faces, that would be if you just search the Growth Whisperers. You’ll find us there, obviously. We’d love for you to like and subscribe wherever you listen, be it on audio or video. You can find Kevin and his interesting weekly newsletter at lawrenceandco.com and myself and my interesting weekly newsletter evolutionpartners.com.au, where we both dig into various topics related to building enduring great companies. I hope that you have enjoyed the episode today and yeah, we certainly have. We look forward to chatting to you again next week.

26:13
Brad Giles
Do enjoy your week. Take care.