Converting Your Financial Statements into a Treasure Map!

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:

1. 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?
2. 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?
3. 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?
4. 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.
5. 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:

1. Does our business make money from other people’s money?
2. Are the risks we take well founded?

Companies exist to create value for their owners.  They can be funded in only two ways:

1. Debt.  Which we may borrow from a bank or other financial lender
2. 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:

1. Reducing sales for 23% to 15% but having a price protection strategy of 6% points
2. A small reduction of 3% in COGS equivalent to last years demonstrated practice
3. Managing Accounts Receivable with the same rigor we did last year (down to 46 days)
4. 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!