Introduction
This paper is about a compelling story leading to the
discovery and retrieval of buried treasure.
The fascinating thing is that this treasure is buried within your own
company. It lies there in the form of
hidden costs, wasted cash and seemingly attractive revenues bolstered with high
levels of working capital. This treasure
is not being mined for two reasons.
First, it is invisible to most people and by default no-one is working
on it. Secondly, the few that have an
inkling it exists can’t rally the rest of their organization to go after it in
a concerted way.
All companies, private and public, have to prepare a
set of financial statements. These
statements are complicated and were never designed to be a communication
tool. You may be surprised to learn that
few executives outside of the Chief Financial Officer truly understand
them. In fact, we asked a group of
billionaires attending a conference at MIT to calculate the cash flow statement
from the other two elements of the financial statements (the income statement
and the balance sheet). Only 1 of 30 got
it right!
This paper will allow you to interpret the financial
story in 5 readily mastered chapters.
Armed with this understanding you will be able to interpret the
fundamentals of your own or any other business as well as the Oracle of Omaha,
Warren Buffet.
As an executive or employee you will be able to use
your financial statements as a means to enroll your entire organization in
achieving higher levels of performance.
Instead of the numbers being a
story you spin, they become the story
in which everyone participates.
We will then turn our attention to converting the
financial statements into a One Page Scorecard.
Literally, they will be transformed from a mostly indecipherable set of
numbers into a compelling and easy to read treasure
map. This map will identify areas
where your business is losing or wasting money and divert it to areas where you
can maximize the best financial returns.
Together the map and the story engage the entire
organization linking your strategy through to improved operational and
financial performance. The financials
are no longer a set of lagging indicators.
They become a powerful interactive communication vehicle linked to core
competencies within your enterprise. The
net result is your employees know what actions to take on a daily basis to
deliver the maximum potential.
The Power of Story
For many millennia human beings have conveyed complex
ideas through the power of stories told around the campfire.
A belief is not an idea that you possess;
It is an idea that possesses you.
A great idea compels you and others to take
action. Consider the following quote by
E M Forster:
Fact: The Queen
died. The King died.
Story: The Queen died.
The King died of a broken heart.
There is much more drama and emotion in the same facts
when woven into a story. When you can
link your ideas into a powerful story you can move hearts, minds and even
organizations.
As Alan Kay HP Exec and founder of Xerox Parc once
said:
“Scratch the surface in a typical boardroom and we’re all just cavemen
with briefcases, hungry for a wise person to tell us stories”
All companies need to file their financial
statements. They are the ultimate
arbiter of performance. They represent
all decisions and activities over the prior reporting period. Companies invent all kinds of additional
scorecards such as the Balanced Scorecard mainly because the financial
statements are too difficult to read!
Here we show how the statements can be converted into
a story that creates an emotional experience that will ultimately galvanize a
greater number of your employees to make better decisions that improve long
term financial performance.
Meet the Characters – Revenue is Vanity, Profit is Sanity & Cash is
King!
Every good story has characters the audience can
identify with. The financial story
usually has three, Vanity, Sanity and King.
Take a moment to consider our three characters and think about which one
is in control at your company
The first of our trio is an ebullient fellow. Full of confidence and bluster, the eternal
optimist, known as Vanity. He represents
the sales revenues of the company. He
believes that if he is given the right resources and enough authority he can
win any deal, dominate any market and double the sales of the company. In fact he often believes the company doesn’t
really understand his importance and if the company were just to get out of his
way he could take the company to great heights.
His answer to any financial difficulties is to invest in him and his
team and they will sell their way out of it.
The second member is Sanity. He is all about the bottom line. For him the ultimate goal is the best
profitability for the company. No nonsense
for him, he sees the world in black and white and hates being in the red.
The third member has the grandest title, that of King. He doesn’t rule the empire but he is very
protective of the empires cash. He hates
paying out cash and will lovingly count and hoard any cash he receives. You will need to have a very persuasive
argument if you want him to fund any of your pet projects!
The Oracle of Omaha, Warren Buffet has paid special
attention to these characters:
“One of the things you will find – which is interesting and people don’t
think of it enough – with most businesses and with most individuals, is life
tends to snap you at the weakest link.
The two biggest weak links in my experience: I’ve seen more people fail
because of liquor and leverage – leverage being borrowed money”.
Jack Welch has the following advice:
“Number 1, Cash is king. Number
2, Communicate. Number 3, Buy or bury
the competition.”
We assert that all three characters need to play a
balanced role in order to generate enough wealth to have the ability to buy or
bury your competitors.
Our
fundamental conviction is cash matters.
Companies
exist to create value for their owners.
This enables them to attract additional investment in their company
(equity capital) to fund its growth.
Without this investment companies ultimately stagnate or perish to more
aggressive competitors.
Investors
invest with cash and expect superior cash returns. Most companies place too much reliance on
performance using the singular lens of profitability. They are infatuated with growth at all
costs. As we shall see revenue growth
quality can determine whether cash is consumed or released.
Successful
companies manage both the income statement and the balance sheet. They have learned how to effectively make
money by using other people’s money (return on Capital Employed).
The 5 Chapters of Your Financial Story
You
can communicate the story of your business in 5 easy to digest chapters:
- Growth Quality
- Did the
sales achieved by Vanity create superior financial performance? If Vanity
was given more cash by the King could we have achieved higher growth?
- Profitability Performance
- Does Sanity
believe Vanity’s deals represent good growth? Did they enhance or erode margin? Did they help strengthen our brand in
the market or does Sanity think we discounted unnecessarily in order to
win the business?
- Working Capital & Fixed
Capital Utilization
- Did we have
to fund Vanity’s success with additional working capital-did we need to
hold higher inventories for example in order to guarantee timely
deliveries; did we need to build an extra production line or put on a
weekend shift to meet these needs?
- Cash flow management
- The King
not only counts the cash at the end of the year, he needs to make sure
the business has enough to pay monthly salaries, your suppliers, the bank
and others lending you money. Is
your cashflow sustainable and is it predictable so that the King will not
be surprised and have to run to the bank to borrow at an unnecessarily high
interest rate.
- Return on Investment
- The
ultimate question which Vanity, Sanity and King are held accountable
for. Did they make money from
other people’s money? The company
either borrowed money from their shareholders (this is known as equity)
or banks (this is known as debt).
If we borrow at say a 6% rate of interest and we make 5%
return—not good! If we made a 18%
return it means for every dollar we borrowed we got three in
return—sweet!
It
is important to understand that these are story elements and influence each
other. It is sometimes hard to fathom
how the income statement and the balance sheet interact with the statement of cash
flows.
In
our story it is easier to understand that Chapter 2, Profitability, and our
character Sanity, is influenced by the quality of the work undertaken by Vanity
in Chapter 1. The combination of the
first two chapters manifests in the working capital aspects of Chapter 3. The activities of both Vanity and Sanity plus
the working capital needs determine whether the King is happy with his cash in
Chapter 4. The last Chapter looks at the
combined efforts of our three principals and tells us not only are we making
money from other peoples money, but how much risk are we taking on in doing so. For example, if we are borrowing at an
average cost of debt of 6% and we make 18% return we can see that this is a
lower risk than borrowing at 6% and only getting say 10% in return.
Warren
Buffett looks at this risk in this way:
“There is a huge
difference between the business that grows and requires lots of capital and the
business that grows and doesn’t require capital.”
Creating the
Treasure Map and the Compass
In
the following illustration we have taken the standard financial statements of a
company with revenues of $3.7billion and depicted them on the left hand
side. On the right hand side we have
recast the same numbers but within our story context and the 5 chapters. This acts as a compass giving us directions
in which to sail to discover more about our opportunities. As we look at the chapters the story emerges
and reveals areas of opportunity, the hidden treasure locked in the business.
Few
people can take the left hand side and draw meaningful insight. However, the right hand side tells a story
and gives us clues we can explore. We
easily see that Vanity has been very busy.
He had a revenue growth challenge of 15% and has handily come in over
budget.
Sanity
is feeling a little mystified. Vanity
has been celebrating in the board room and all of his sales team has gone for a
week to the beach in Cabo St Lucas for meeting their 100% sales club target.
Sanity
is concerned that profitability (expressed as EBIT or Earnings Before Interest
and Tax) as a percentage is less than the year before. Consider, if we had just got the overall
profit number from the income statement of $450 million, which was better than
the $400million the previous year, Vanity’s celebrations would have not been in
question.
The
King is beside himself with worry. He’s
scratching his head wondering how the net cash flow is a negative $270million! He wasn’t expecting that, hadn’t planned for
it and is not altogether clear how it happened.
So we grew by 23.3% and cash is leaving the business???
The
compass has given us pointers—let’s go on a treasure hunt!!
Chapter 1: The Growth Quality Story
Revenue
growth or depletion has a story quality in of itself. It can be anything from a greek tragedy
through the Heroes Journey where all manner of obstacles and dragons have been
slayed for Vanity to ultimately make the numbers.
Revenues
can be grown in three ways:
- by
increasing the number of sales made
- receiving
higher prices for those products and services that have been sold
- by
acquiring new companies or products/services
We
will ignore acquisitions in this treatment.
We see from Chapter 2 that Sanity is bothered by the fact that
profitability has not grown in line with this revenue increase. Good financial discipline would say that
superior revenue growth happens when profit growth is in excess of revenue
growth. So we would expect in a great
company that profitability should be up 23% or more versus the 12% we see. This gives us a clue to look at what may be
happening to our costs or to our market pricing.
Chapter 2: Profitability Story
There
are two factors that influence the profitability.
The
equation is simple: revenues – cost of goods sold (COGS) = profit.
Margin
is a way of expressing profit as a %. In this example we have seen margins
erode from 13.33% last year to 12.16% this year. This gives us two nuances to our profit
story.
Margin
destruction occurs in only two ways
1. We reduced our prices (either intentionally
to win more business or through response to competition)
2. Input prices (COGS) increased by a proportion
greater than our ability to pass these on via price increases to our customers.
Chapter 3: Working Capital
Story
The
third chapter in our story concerns the balance sheet. This represents the financial condition of
the business. This means among other things,
keeping assets and liabilities in proportion to sales revenues (Vanity’s
domain) and the expenses of the business (Sanity’s concern). It also ensures we manage the King’s cash.
The
working capital story examines how much money the business uses to support
every revenue dollar we make. In this
case, for every dollar of revenue that Vanity sells, we consume nearly 21 cents
just keeping the business operating.
Working
capital has 3 elements:
- Accounts
Receivable (money we expect to receive from our customers for service or
products rendered)
- Accounts
Payable (what we have to pay our suppliers)
- Inventory
(the goods and services we have in house which we need to provide product
and service to our customers in a timely and competitive fashion)
There
is a startling story in this example as we see working capital has increased
from 14 cents for every hard earned dollar of revenue to nearly 21 cents. This difference is the King’s lament as it
has to be funded by our cash flow (and in part a key reason why the business is
consuming cash).
Chapter 4: Cash Flow Story
The
King is out for blood as nearly $271 million of cash is leaving the
business. The company is profitable and
growing but we are not managing that growth in a way that optimizes our cash
needs.
Let’s
talk about the areas of dysfunction….Andre I need more on this section
Chapter 5: Return on
Investment Story
This
chapter is the summation of the preceding four and answers two fundamental
questions:
- Does
our business make money from other people’s money?
- Are
the risks we take well founded?
Companies
exist to create value for their owners. They
can be funded in only two ways:
- Debt. Which we may borrow from a bank or other
financial lender
- Equity. This is the money the shareholders or owners
have in the business
They
are looking to drive a superior return from these investments. This can be represented as Return on Capital
Employed.
In
this case ROCE is 25%. In simplistic
terms if we can borrow money at approximately 7-8% interest we can convert it
to a return of 25% or in other words, for every dollar we borrow to grow our
business we generate $3 in return.
However,
our story has a richer contest. We see
ROCE has fallen from 31% to 25%.
The
equation for ROCE is:
ROCE
= EBIT/ Net Operating Assets
We
can express it in a different way:
ROCE%=$EBIT/$NOA
So
we see that ROCE shows how income statement performance and balance sheet
performance combine together.
To
make the story quite simple, ROCE = EBIT/NOA.
Therefore we need to do more EBIT using less Operating Assets!
The Basic Story
Our
visual scorecard has created a simple story that will intrigue the
organization:
There
is an organizational dysfunction between Vanity and Sanity. Yes we have grown by 23% but profitability
has been eroded.
We
are running our business less efficiently than we have in the past. For every hard earned dollar of sales revenue
we are consuming 21 cents of it within our operation.
The
combination or our eroding margins and our working capital inefficiency means
whilst we are a profitable enterprise we are consuming vast amounts of cash
which is upsetting his Lordship the King and is causing angst amongst our
shareholders.
We
know the risk profile of our business is sound and we can attract additional
investments to grow but we have to investigate why our efforts are not
generating an even higher return on investment.
This
is a better message to engage the organization than the one they may derive
form the complexity of the financial statements which might be perceived as
sales went up 23% and profit is up to $1.4 million. Let’s continue doing more of the same.
Finding the Treasure Chest
and Counting the Booty!
Armed
with the story elements we can examine our Visual Scorecard to determine the
treasure that is hidden and can be realized by some simple strategies. We call this treasure “Gross Potential”.
Let’s
look at the key elements
First,
we can look at how sensitive our performance is to price variation. If we click on revenue growth we see options
to vary revenue growth and price. Vanity
insists that if he had the right resources he could have made a 30% sales
growth. If we punch this in and look at
the net impact we see for an additional 7% sales increase or about $200,000 in
value:
·
EBIT rises less than 1%
·
We consume $6.6million more cash
·
ROCE improves by 2%
This
does not impress the King.
If
we reduce sales from 23% to 15% and raised prices by 6% we see that total
revenues are about the same but look at what it does for the other elements of
the financial story:
- EBIT
rises more than 3%
- Working
capital is reduced
- Cash
flow is $105million better!
- ROCE
is up 2% (rather than down 6%)
So
Vanity has to focus more on holding price rathe than giving business away and Sanity
is happy and the King has a better cash position whilst we have a better
financial risk and return in our business.
Let’s
look at Chapter 2. We see our COGS has
risen in percentage terms. If we just
hold COGS at the same level we did the previous period (representing just a
3.83% reduction):
- $115
million in cash is generated
- ROCE
is up 8%
Chapter
3 is always a fruitful avenue
We
see receivables days have increased form 46 to 55. We have already demonstrated we have the
organizational behaviour to operate at 46 days.
If we reduce receivables to this level the net change values are:
- We
get $930 million more cash in our bank
- ROCE
increases over a percentage point.
We
also see our inventory has shot up from 88 to 122 days. There may be good reasons for this such as we
are supporting a new customer segment and we wanted to make sure we had stocks
on hand. But did we truly understand the
consequence of this decision. It may have helped Vanity grow sales but at what
cost. Well, by changing the inventory
days back to the preceding period levels we see that this decision costs us:
- Nearly
$222million in cash requirements
- 3.4%
erosion in ROCE
In
many cases we don’t even consider inventory and its balance sheet
implications in our calculations and so
we don’t fully appreciate the impact it has on the King’s cash and the risk it
burdens our business with.
Now
in Chapter 4 let’s look at The king’s empire and see if we can’t make sense of
why net income is up $260 million yet we consume $270 million in cash.
If
we look at the cash flow statement we see …..
So
let’s apply these areas of improvement to see the picture of Gross Potential
and The Treasure Map
We
applied the following impacts:
- Reducing
sales for 23% to 15% but having a price protection strategy of 6% points
- A
small reduction of 3% in COGS equivalent to last years demonstrated
practice
- Managing
Accounts Receivable with the same rigor we did last year (down to 46 days)
- Focusing
on our inventory holdings and reducing back to last years levels of 88
days
Value
of the Booty:
- Revenues
are about the same
- Profitability
is up 7%
- Every
revenue dollar only consumes 8 cents less in working capital
- Cashflow
is up $500 million
- ROCE
has shot up to 47%
Now
you can develop the right strategies and management systems to reinforce the behaviours
that enhance financial discipline and collect the treasure in your
business. Day to day decision making is
forever changed as your employees are armed with better information and are
acting in a way that directly impacts the ultimate arbiter of performance, the
financial statements!
