Professor Salvatore Cantale on the active role of the finance function in generating value
“How business should talk to finance,” interviewed by Paul Hunter,
Finance for Non-finance People
In January 2016, 26 executives from 18 companies participated in an event aimed at demystifying finance for non-finance people and highlighting the influence that managers from different areas of the business can have on the overall financial performance of their companies. Participants left with a better view of what finance is all about and important insights on how to successfully partner with their own company’s finance department.
The financial side of business decision making
Finance is really quite straightforward: Once you understand the language, the rationale behind seemingly complex terms becomes clear. For example, a credit default swap, or CDS, is merely an insurance for an underlying loan.
Despite growing liquidity resulting from rock bottom – and in some countries even negative – interest rates aimed at fostering economic growth, companies are finding it increasingly hard to manage financial pressures in terms of both raising capital and finding worthwhile opportunities to invest.
In this controversial environment, big international companies have been stockpiling their cash holdings for three main reasons: to ensure they have emergency funds to continue operations in an unstable geopolitical environment and turbulent commodity markets; to maximize tax efficiencies; and to make sure they have cash available to keep up with competition in terms of mergers and acquisitions. According to an article in The New York Times Magazine,1 in January 2016 American companies were holding around $1.9 trillion in cash (including short-term investments), of which Apple held over $200 billion, Microsoft held over $100 billion and Alphabet, Google’s new parent company, held around $80 billion.
These growing financial constraints combined with rising shareholder activism are making it even more complex to manage companies. Every business decision relating to strategy, operations, marketing, sourcing or any other area has financial consequences and will impact the firm’s profit and loss statement and balance sheet. For example, managers looking to increase business efficiency must consider all the knock-on effects that any actions will have on the company’s financial statements. For example, take a toy manufacturer, which operates in a highly competitive and seasonal industry. Its busiest period is the second half of the year due to peak events such as the start of the new school year, Thanksgiving and Christmas. From an operational perspective, seasonal business is inefficient because during the first semester, production is almost at a standstill whereas in the second semester it usually runs at full capacity. Spreading production evenly across the year may substantially improve operational efficiency, but since most sales occur during the second half of the year, the company’s inventory as well as the debt required to finance the additional production during the first semester will increase, and that translates into higher risk, thus making it even more difficult to raise financing.
Difficulties in Raising Capital
Despite expansionary monetary policies in most countries as well as steadily growing corporate cash holdings, many big brands are finding it hard to attract investors and raise capital. They need to consider not only where they can reach more active potential investors but also where their company has high potential to expand its revenues. For instance, Prada, an Italian fashion company, listed its shares on the Hong Kong Stock Exchange, purportedly to be closer to its growing, high-potential Asian markets. In June 2011 it raised $1.91 billion by listing 20% of its shares in Hong Kong, valuing the company at about $10 billion, i.e. 23 times its 2011 earnings. In contrast, in September 2014, a large Chinese e-commerce company launched an IPO on the New York Stock Exchange and raised a record $25 billion for the 14.9% of shares, valuing the company at around 22 times its 2013 earnings.
The finance side of value creation and value capturing
In the business world, value creation and value capturing reflect management effectiveness. Yet measuring these is quite challenging. Generally speaking, value created is the difference between the perceived value of a good or service minus the cost of producing (delivering) it, whereas captured value is the difference between the price at which a product or service is sold and the costs associated with producing and delivering it. Measuring perceived value – i.e. value created but not captured by the company – is complicated, but value captured can easily be measured in finance. Thus, when considering any major business decision, be it a potential investment or a new business model, it is useful to work out the financial calculations (i.e. pro forma financial statements) for each alternative to make it easier to understand and compare the long- and short-term revenues, costs and risks associated with each option.
To determine whether a company will be able to create value from an investment, two important things need to be calculated and considered: the cost of capital and the income it will generate. When a company borrows capital, it is has to pay a fee (e.g. interest). The total fee is referred to as the weighted average cost of capital (WACC). The income that is generated as a result of investing capital is called return on invested capital (ROIC). The WACC should obviously be lower than the ROIC. The economic value added (EVA) of capital is the difference between the return it generates and its cost, all multiplied by the amount of the invested capital (IC), i.e. EVA = (ROIC – WACC) * IC.
Another ratio commonly used to measure return on capital is return on equity (ROE). This is a very noisy performance indicator that combines three ratios: profit margin, which measures business efficiency or value created; asset turnover, which measures the efficiency of asset utilization or potential; and leverage ratio, which measures a company’s debt burden (see Figure 1). Raising capital in the form of debt has two major advantages: first, it has a lower required rate of return than equity (for the lender, debt is considered less risky than equity because in case of bankruptcy, debt owners will recuperate their investment before equity owners); second, interest on debt is tax deductible. So when a company reports an increase in ROE, it does not necessarily signify an improvement in business or asset efficiency. It could just be the result of pumped up debt, which is referred to as leverage. This was the case before the 2008 financial crisis when companies were reporting continuous growth of ROE but achieving this through intensive borrowing at cheap rates and in a loosely regulated environment.
From you to financials
Finance is just a set of tools that are often misused and misunderstood, and blamed when the company fails. To better understand the financial consequences of everyday business decisions, managers should understand how their decisions affect the company’s financials.
Figure 3 illustrates how a company’s business model and its strategic drivers can affect its profit margin and ultimately its ROIC. For instance, decisions made by Procurement will affect the cost of goods sold, inventories, accounts payable, etc.; Marketing’s decisions on prices, product mix and production volumes will affect sales, general and administrative (SGA) expenses, etc. Besides being aware of the financial implications of their decisions, managers should also focus on increasing the efficiency of the resources under their control.
Finance is straightforward once you grasp the language and logic behind it. It provides analytical tools that can help managers make better-informed decisions, all of which will somehow affect financial performance. Higher risks should bring higher returns, but growth does not necessarily result in value creation. Value is only captured when investments generate higher returns than the cost of capital (be it debt or equity) required to finance them. It is thus important for managers to explore the consequences of various options, because what may appear to be a logical solution to improve efficiency, could in fact turn out to be more costly when all parameters are taken into account.
Finance for Executives
A Practical Guide for Managers
1- A. Davidson. “Why Are Corporations Hoarding Trillions?” The New York Times Magazine, January 20, 2016. http://www.nytimes.com/2016/01/24/ magazine/why-are-corporations-hoarding-trillions. html (accessed March 29, 2016).
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