Category Archives: Management

FINANCIAL VIABILITY: Your Yardstick for Organization Achievement, Part 2


Dr. John Psarouthakis is a Distinguished Visiting Fellow-Professor, Institute of Advanced Studies in the Humanities, University of Edinburgh, Scotland. Founder and former CEO, JPIndusries,Inc., a Fortune 500 industrial corporation. He is the Executive Editor of www.BusinessThinker.com

DIFFERENT WAYS TO MEASURE PROFIT

There are three commonly accepted ways to measure profit: as return on assets (ROA), return on investment (ROI) and return on sales (ROS). Which is best to use in evaluating your firm?
ROI (your net income divided by total equity) is an important number for managers because it is a good indication of whether you are wasting your time in the business you are in. If ROS (your net income divided by total sales) is fairly low but your need for capital is also quite limited, it will still be a very worthwhile endeavor. On the other hand, if running the business requires a heavy investment, you should weigh your use of money invested in your business against simply putting it into the bank. It is easy to become so preoccupied with sales growth that you forget to evaluate the cash you put into your business the way you would choose your passive investments. But tracking your ROI is important. It allows you to compare investments in different instruments and types of firms. Even small passive investors evaluate their investments on this basis, comparing rates of return and risk factors for treasury bills, certificates of deposit, mutual funds, and so forth. Business owners emphatically need to do exactly the same for their active investments.
Assume you are sole owner and have set aside a rainy day fund for your company. Does it really make sense to reinvest the fund in the firm or would you be better off closing this business and starting over? ROA and ROI more realistically help you to answer this question than return on sales. Many entrepreneurs get trapped psychologically, pouring more and more money into a dying business–taking equity out of homes, borrowing against life insurance policies–just to keep a doomed or marginal business afloat. Any calculation should also factor in the time you spend, compared with your likely earnings in a salaried position working for someone else.
Why then, did we use ROS as the primary yardstick for profitability? Our choice is a compromise between theory and pragmatism. Most firms we studied were privately held. Most of the CEOs were hesitant to share even return on sales figures, much less balance-sheet figures. And many were confused by the terminology of ROS and ROI. To offset the instability of one year’s profit performance, two years of data were collected from most firms.
Although ROS is not perfect, it still provides a sound basis for comparing firms. In a study of several thousand business units in 450 companies, Buzzell and Gale find not only that ROS and ROI are linked with each other, but linked in very similar ways to most of the company practices and characteristics they studied.5 The relationships differ principally in variables associated with capital intensity of the business–the investment per dollar of sales. Greater capital intensity itself is linked to lower ROI; the relationship with ROS is negligible. With this caveat, we feel comfortable that ROS provides useful insights into effective management of small, growing firms.
CASH FLOW AND NET PROFITS
We all read about highly-leveraged companies taking big risks with other people’s capital. You might think such cases are rare among small firms. But think again. Many entrepreneurs take huge risks with inheritances, college savings, bank loans, and even money for withholding taxes. Though it seems a more conservative approach, those with better cash flow are also those with higher profits and longer survival. There is something to be said for the adage: “Don’t spend what you don’t have.”
Many top performers in our study make a religion out of flexibility. They anticipate lean periods during the peak of the business cycle. Though they will expand somewhat, they accumulate cash during good years to operate comfortably in lean years. Ready cash also helps them respond to unanticipated opportunities.
One of the hardest decisions facing smaller firms is when to make a major capital improvement–purchase of a new building or a new technology. Successful capital improvements have “many fathers.” But several CEOs we interviewed regret untimely or excessive expansion decisions, especially those made in anticipation of sales that never materialize. In one typical case, a CEO built a large plant addition to handle increased orders from a key customer, a large automobile manufacturer, who pulled out just after the plant completion date. The CEO had now lost his flexibility to downsize during the next recession and struggled to find alternate business to justify the expense of the new plant.
On the other hand, consistent careful incremental expansion of just one or two trucks a year by a trenching firm is proving sufficiently competitive. He enjoys profit levels well above industry norms. The large fleet he has gradually amassed has helped him to attract and maintain utility company clients, which provide the firm with steady profitable work.
Managing one’s cash flow thus does not mean a zero-growth strategy, but does require careful attention to available cash, not just paper profits.

The (other) deleveraging: What economists need to know about the modern money creation process

Manmohan Singh is a Senior Economist at the IMF in Washington DC.  He continues to write extensively on topical issues including  deleveraging in financial markets, rehypothecation of collateral, and counterparty risk in OTC derivatives. He was the first to identify the role cheapest-to-deliver bonds as a proxy for recovery value in CDS instruments.

Peter Stella is Director of Stellar Consulting LLC providing macroeconomic policy advice and research to central banks, governments, and private clients in Asia, Europe, the United States and Latin America.

This article is republished from and in accordance with the policy ofVoxEU.org

The world of credit creation has shifted over recent years. This column argues this shift is more profound than is commonly understood. It describes the private credit creation process, explains how the ‘money multiplier’ depends upon inter-bank trust, and discusses the implications for monetary policy.

One of the financial system’s chief roles is to provide credit for worthy investments. Some very deep changes are happening to this system – changes that surprisingly few people are aware of. This column presents a quick sketch of the modern credit creation and then discusses the deep changes are that are affecting it – what we call the ‘other deleveraging’.

Modern credit creation without central bank reserves

In the simple textbook view, savers deposit their money with banks and banks make loans to investors (Mankiw 2010). The textbook view, however, is no longer a sufficient description of the credit creation process. A great deal of credit is created through so-called ‘collateral chains’.

We start from two principles: credit creation is money creation, and short-term credit is generally extended by private agents against collateral. Money creation and collateral are thus joined at the hip, so to speak. In the traditional money creation process, collateral consists of central bank reserves; in the modern private money creation process, collateral is in the eye of the beholder. Here is an example.

A Hong Kong hedge fund may get financing from UBS secured by collateral pledged to the UBS bank’s UK affiliate – say, Indonesian bonds. Naturally, there will be a haircut on the pledged collateral (i.e. each borrower, the hedge fund in this example, will have to pledge more than $1 of collateral for each $1 of credit).

These bonds are ‘pledged collateral’ as far as UBS is concerned and under modern legal practices, they can be ‘re-used’. This is the part that may strike non-specialists as novel; collateral that backs one loan can in turn be used as collateral against further loans, so the same underlying asset ends up as securing loans worth multiples of its value. Of course the re-pledging cannot go on forever as haircuts progressively reduce the credit-raising potential of the underlying asset, but ultimately, several lenders are counting on the underlying assets as backup in case things go wrong.

To take an example of re-pledging, there may be demand for the Indonesia bonds from a pension fund in Chile. As since these credit-for-collateral deals are intermediated by the large global banks, the demand and supply can meet only if UBS trusts the Chilean pension fund’s global bank, say Santander as a reliable counterparty till the tenor of the onward pledge.

Plainly this re-use of pledged collateral creates credit in a way that is analogous to the traditional money-creation process, i.e. the lending-deposit-relending process based on central bank reserves. Specifically in this analogy, the Indonesian bonds are like high-powered money, the haircut is like the reserve ratio, and the number of re-pledgings (the ‘length’ of the collateral chain) is like the money multiplier.

To get an idea on magnitudes, at the end of 2007 the world’s large banks received about $10 trillion in pledged collateral; since this is pledged for credit, the volume of pledged assets is a good measure of the private credit creation. For the same period, the primary source collateral (from hedge funds and custodians on behalf of their clients) that was intermediated by the same banks was about $3.4 trillion. So the ratio (or re-use rate of collateral) was around 3 times as of end-2007. For comparison to the $10 trillion figure, the US M2 was about $7 trillion in 2007, so this credit-creation-via-collateral-chains is a major source of credit in today’s financial system. Figure 1 shows the amounts for big banks in the US and Europe.

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The Authors

Manmohan Singh is a Senior Economist at the IMF in Washington DC.  He continues to write extensively on topical issues including  deleveraging in financial markets, rehypothecation of collateral, and counterparty risk in OTC derivatives. He was the first to identify the role cheapest-to-deliver bonds as a proxy for recovery value in CDS instruments. Manmohan has led workshops for the IMF on strategic asset allocation and regulatory proposals to official sector policy makers. His articles have regularly appeared in Financial Times, Wall Street Journal, Euromoney, RISK, Journal of Investment Management, etc. His work experience covers several countries including U.K., U.S., Chile, India, Japan,Hungary, Poland,the Gulf countries and more recently peripheral Europe.

He holds a Ph.d. in Economics and a MBA from Univ. Illinois (Urbana-Champaign). He received his B.S. (magna cum laude) from Allegheny College, Pennsylvania. He was previously with ABN Amro Bank’s emerging market syndicate team (Amsterdam/London).

Peter Stella is former head of the Central Banking and Monetary and Foreign Exchange Operations Divisions at the International Monetary Fund. Currently Director of Stellar Consulting LLC providing macroeconomic policy advice and research to central banks, governments, and private clients in Asia, Europe, the United States and Latin America.

 

FINANCIAL VIABILITY: Your Yardstick for Organization Achievement, Part 1

Dr. John Psarouthakis is a Distinguished Visiting Fellow-Professor, Institute of Advanced Studies in the Humanities, University of Edinburgh, Scotland. Founder and former CEO, JPIndusries,Inc., a Fortune 500 industrial corporation. He is the Executive Editor of www.BusinessThinker.com

Most employees, the media, and even entrepreneurs measure success by sales and sales growth. Most “lists” like INC 500 and FORTUNE 500 rank companies this way. In earlier articles we discussed pitfalls of this approach. But if banners and plaques are not a good measure of success, what is? Seasoned business owners realize that profits and asset growth provide better assurance of a firm’s long term survival and ability to thrive. Liquidity, or the availability of cash, is also a hallmark of the well-run business.1

ASSESSING YOUR FINANCIAL VIABILITY
What does financial viability mean? How well does your company stack up? By taking a few minutes to answer the following questions, you get a quick feel for this issue.

I. Liquidity and cash flow:
Question 1. Liquidity. How would you describe your current cash position (cash in the bank, whether obtained by a bank loan, retained earnings, or from start-up capital):
[1] Significant liquidity, available for major investment–e.g., a new plant, building, large piece of equipment
[2] Some liquidity, available for minor investment–a new truck, smaller piece of equipment, office equipment
[3] Little liquidity, available only for high priority items to keep current operations going
[4] Very little liquidity– difficult to cover even essential items to keep current operations going
The median firm in our study reported “some” liquidity ([2] above). Yet 45 percent report having “significant” liquidity.
Question 2. Has your level of liquidity hampered business operations any time during your firm’s growth? If yes, in what way?
Question 3. Was there any particular reason that your cash position has been unusually good or poor in the past few years–purchase of a building or a large drop in sales or profitability for instance?
II. Profitability
Question 4. Subjective rating of profits. What has your profit picture been like for each of the past five years? Rate your firm for each year separately:
Continue reading FINANCIAL VIABILITY: Your Yardstick for Organization Achievement, Part 1