I have through the years found that even senior people have a fear of finance. They would be very competent in a number of fields, but when it came to financial matters, it is as if they deliberately dumb down! And the truth of the matter is that finance is but a language you need to learn. I will try and convey financial matters in a simple way. Please do not hesitate to contact me should you want a more simpler explanation or if you differ from me.
First of all, financial management has to do with understanding and acting upon 4 issues:
- Which long-term investments need to be made? What assets should we acquire to do business with? (the asset acquisition decision – investment decision). This is also referred to as capital budgeting, where financial managers try to identify investment decisions that will deliver a higher return than the cost involved. The size of the project is important, as well as the timing and risk of the cash flows of the project. Information regarding this aspect of financial management is obtained in the balance sheet on the asset side. We also need to understand an asset as something we acquire to create a future benefit for the organization.
- Where will the company get the long-term financing to pay for the investment decision made above? Basically there are two sources of financing, i.e. equity and debt. The decision deals with the capital structure of the company and in this regard there are three issues that are of importance: What mixture of debt and equity will be the best? What are the cheapest sources of funds for the company? How and where will the funds be obtained?
Information regarding this aspect of financial management is obtained in the balance sheet on the liability side.
- The third issue deals with the way the daily activities of the company are managed. This refers to the operating activities of the company. How are the assets utilised to generate an income for the company? This is also referred to as the management of working capital, i.e. current assets and current liabilities. Information regarding this issue of financial management is obtained from the income statement.
- How do we reward the shareholders (owners) for their willingness to invest in the company? (dividend policy). Information regarding this issue is also obtained from the income statement.
It is therefore clear that the traditional financial statements, i.e. the balance sheet and the income statement provide very important information to the individual concerned with the performance of a company. However, these two statements do not reflect the actual movement in cash. To provide a more comprehensive view of the cash position of the company, the cash flow statement was developed and from 1988 companies have been compelled to also publish a cash flow statement (in South Africa in any case).
The main users of financial statement information are set out as follows:
We always need to remember that financial results are a lag. They are the result of all the actions we take or do not take within the broader realm of the business. It is therefore always important to realize that if the results of the business activities are not good, we need to look at other issues rather than purely the financial matters.
The financial results are there to create value for the owners, the shareholders. People like to tell me that the day of the shareholders are gone and that we need to talk about stakeholders. Yes, I do think that stakeholders in the broader sense are important. Here we refer to employees, management, suppliers, buyers, and society at large. However, the problem lies in the fact that if we do not have owners, we do not have a company. The owners are therefore still number 1 in my books. And we create value for them when we create value that is more than the cost of the capital we used to create that value. We will get back to this concept when we deal with issues such as Economic Value Added (EVA), which was made famous by Stern & Stewart.
If shareholder value is dependent upon the financial results, which do include issues such as profit, we need to understand that the ethos of the company and its strategic intent is important. Here I am referring to issues such as the culture and values of the organization, its leadership philosophy, and its vision and mission. If the company does not have a high performance culture with a set of enduring values, it can forget about delivering sustainable high performance.
Then we need to understand the strategy of the organization. If it is a corporation, we need to understand what industries it has diversified into, where it is competing, and in which companies it has decided to invest more. A good example would be Bidvest, a very successful diversified corporate (currently) in South Africa. It is invested, amongst others, in banking, transport, automobiles, food, stationery, and logistics. It has diversified into these industries and companies in order to cerate better value for the shareholders.
Once we understand the corporate strategy, we need to understand the business strategy. Are they following a low cost strategy, a differentiation strategy, or a best cost strategy? What do their functional strategies look like? The latter is expected to support the business strategy and need to be aligned with the business strategy. If the marketing strategy is not aligned with the business strategy, you can forget about the right customers buying the right products and giving the company the envisaged profits! The same goes for Human Resource strategy. if you recruit second-hand Beetle (the 1960’s type) salespeople to sell Bentley’s and Mercedes S-Class, whilst dressed in jeans and t-shirts, forget about making money (profit).
But how do we get to the business strategy? To develop the optimal business strategy we need to understand the challenges and opportunities in the external environment. This is where we analyse the macro-environment and the industry. We also need to get a very good understanding of the customer segments and the needs and wants of these groupings. We also need to analyse the organization’s internal environment to gain an understanding of the strengths and weaknesses of the organization. Based on this, we will design the business model and business strategies of the organization, and design an implementation plan for the organization.
It is only when the business model, business strategies, functional strategies and implementation plan of the organization are all aligned and are executed that we will see the profits we dreamt of when we created the company.
The point I want to make is that analysing the financial results of the organization without a thorough understanding of these factors are self-defeating. I have seen a company that delivered a 30% return in a given year. At first glance it would seem that it was an excellent performance. Until you realized that the industry as a whole grew at about 70%.
You also need to ask about whether the strategy and business model was sound when you analyze the financial results. A number of questions to ask could include the following:
- The market segment selected to compete in?
- The positioning selected – low cost, high value, best cost?
- The business model developed?
- The nature and intensity of the competition in this industry?
- The power of the buyers? Can they force down prices?
- The power of suppliers? Can they dictate prices and terms and conditions?
- The threat of new entrants? What will happen when they come in?
- The threat of substitute products? What will this do to the nature of competition in the industry?
- These last 5 factors are referred to as Porter’s 5-Forces model and is a valuable tool to analyse the nature of competition in the industry
- The competencies of the organization? Does it have good people that can deliver?
- The nature of leadership in the organization?
- The culture and values of the people? Have the people taken ownership and are they engaged in their activities?
These are by no means an exhaustive list of what we need to understand the financial results of the organization. We need to understand the dynamics of the industry and the environment at large, as well as the dynamics within the organization itself before we can truly make sense of the financial results, as well as know what we need to do where in order to improve the financial results.
The value proposition of the company is extremely important. This can be loosely described as the offer you make to the selected customers. The objectives and measures of the chosen strategic value proposition should also be defined by describing the offering in terms of products, price, service, relationships, and image.
Kaplan & Norton identifies four distinct value propositions:
- Doing things better or differently
- Product innovation and leadership
- Offering complete customer solutions
- Achieving lock-in (proprietary standard)
On the operational or internal business process side, Kaplan and Kaplan divided the internal processes into four clusters. They are operations management, customer management, innovation, and regulatory and social processes. Operations management processes refer to the day to day processes necessary to produce products and services and delivering them to the customers.
Customer management processes include the following:
- Selection of target customers
- Acquisition of target customers
- Retaining of target customers
- Growing the business with customers
Innovation processes refer to:
- Identifying opportunities for new products and services
- Management of research and development
- Designing and developing of new products and services
- Bringing new products and services to market
Regulatory and social processes monitors and measures a number of critical dimensions such as the environment, health and safety, employment practices, and community investment in order to continually earn the right to operate in those communities and countries.
All of these aspects are important in analysing a company’s value proposition. Getting this right is crucial for sound financial results.
This guide will continue to address the financial statements in order to ascertain how well the company has performed. A proper understanding of the results, however, does require a sound understanding of the information addressed above.
In order to assess the financial performance of the company, we need to analyse the financial statements of the company, within the strategic framework already discussed.
The next article will be about understanding the balance sheet as a statement explaining what the company has invested in, and how it has financed those investments.