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.

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.