Category Archives: Management

FINANCIAL VIABILITY: Your Yardstick for Organization Achievement, Part 3 (last)

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

FINANCIAL VIABILITY AND THE DYNAMIC SYSTEM MODEL OF MANAGEMENT
(see also, in this journal, articles: Dynamic Management of Growing Firms-Parts 1 through 4)

Profit is a yardstick of how well the entire system functions.  When the system runs efficiently, money, time, and other resources are left over; the firm makes a profit.  Some firms watch the short-term costs so closely that long term opportunities are overlooked.  On the other hand, several consecutive quarters of the operating loss caused by recent heavy investment will test survivability.  Profit is what the firm has available to it to combat entropy and the general uncertainty of the environment.

Further, profitability is one powerfully important way to judge the efficiency of different solutions chosen to resolve the seven organization issues of the DSP model.  If coordination can be handled through direct observation by the owner, why waste money on elaborate controls and time consuming meetings with managers? If design of the machine can be done in someone’s basement, why build a laboratory?  The CEO’s challenge is to find the solution suitable to the needs of the firm at a given size and complexity.

As with profitability, cash flow is heavily influenced by the way in which each of the seven organization issues are managed.  Take resource allocation: If too much working capita is tied up in inventory, precious funds may not be available for critical opportunities and emergencies.   Poor response to other issues can also hurt cash flow.  If sales suffer from poor marketing or product selection (a market strategy issue), cash flow suffers.  If sales are strong, but overstaffing is required because of inefficient coordination, cash will be unnecessarily depleted. Poor motivation will have similar results.  Just as with profits, efficient responses to every issue will augment overall cash flow. Poor response will diminish it.

Let’s summarize key linkages between financial viability and the other organizational issues to reinforce their importance. The results are based on two or more years of profits unless otherwise noted.  In this section we also say a little about how effectiveness of the other seven DSP issues are measured.

Market Strategy and Financial Viability

We measured five components of market strategy effectiveness: (1) The CEO’s rating of direction-setting effectiveness; (2) relative size compared to competition; (3) steadiness of sales growth; (4) rate of sales growth; and  (5) total revenues. Notice that size is examined both in absolute dollar terms and in terms relative to the industry.

Market share–not absolute size in dollars–is linked to profitability. Firms that are larger, relative to others in the same industry tend to be more profitable.  This is true despite the fact that absolute size of the firm as measured in total revenues is not positively linked to profitability at all. This suggests that it is market share, not size per se, that predicts profits.

Steady growth is linked to profitability.  Firms which generate steady growth have a higher two-year ROS average than those with peaks and valleys.  Steady growth also contributes in the longer term to a better cash position in the firm.

Faster growing firms are generally more profitable. The rate of sales growth, though sometimes a profit handicap, generally predicts ROS.

CEOs of profitable firms tend to like the way they set company direction.    Finally, CEOs who rate their direction-setting strategy as effective are more likely to report higher ROS and a better cash position.

Chapter 6 explores some of the strategies CEOs use to achieve a higher and steadier rate of growth.

Work Flow and Financial Viability

Work flow is made up of two components:  (1) division of tasks and authority; and (2) coordination–assuring that everyone’s efforts and overall information fit together in a timely way and efficiently.

CEOs who are satisfied with their work flow strategies likely make a profit too. CEOs who rate the strategy for assigning work as more effective are likely to have higher ROS.  Ratings of coordination effectiveness are also connected to profitability and better cash flow.  Effective work flow is one of the most important predictors of ROS for small and medium sized firms.

Resource Acquisition and Financial Viability

Within the resource acquisition issue, we look at all types of resources: capital, information, equipment and supplies, subcontractors, managers, and nonmanagement employees.

Only ability to acquire capital is linked to profits.     The ability to obtain the resources is surprisingly weakly linked to profitability.  Only the ability to obtain capital is linked to profitability, and only during the same year.  Not surprisingly, ability to obtain capital is linked to the firm’s cash position in the same and succeeding years.  Resource acquisition is strongly linked with other aspects of organization effectiveness however besides profits.

Human Relations and Financial Viability

Though they overlap somewhat, we look at five components of human relations effectiveness:  (1) morale: overall job satisfaction and commitment of employees; 2) goal integration: consistency of organization and individual goals; (3) a consistent view of the mission by CEO and managers; (4) a consistent view of values; and 5) how effectively values are shared.

Morale and profits are linked.  Consistent with a

decades-old but controversial hypothesis, we find a clear link between morale and profits.6   The firm’s cash position is also reported to be better in the same year but does not seem to be influenced in following years by the level of morale whereas profitability is also higher in subsequent years.

Companies with strong corporate cultures are more profitable.  CEOs and managers were queried about values emphasized within the firm.  In strong corporate cultures, where CEO and managers report the same values, the firm is more profitable.  Similarly, where CEOs and managers share a similar understanding about the firm’s mission and direction, ROS is higher–though here we find a “lagged” effect, an influence delayed by six months or a year.

CEOs who can communicate their values head more profitable firms.  Finally, CEOs who rate the way in which they communicate their values as effective also tend to run more profitable firms.

Resource Allocation and Financial Viability

We look at resource allocation from a few different angles:  how well people and material are allocated across departments; the quality of budget information (how quickly and accurately you get it); and the effectiveness of the allocation strategy (how well it is working).

Certain aspects of resource allocation are strongly linked to profits, though less so with our measure of cash flow.

Effective resource allocation strategy is linked to profit. CEOs who rate their resource allocation strategy as effective also report higher ROS.  The better able the firm is to assign people to the right departments in the right numbers, according to its managers, the more profitable the firm is likely to be.

Managers (other than the CEO) were also asked to rate the firm’s ability to assign equipment, dollars, and material so that all work groups have sufficient resources to operate.  Though not related to profits, these were positively linked to cash flow.

Public Relations and Financial Viability

Effective public relations and profits are linked. Our focus on public relations was fairly limited in the research study: We asked  CEOs and managers to rate their company’s reputation and image in the community.  This rating is linked to both ROS and cash flow.

Technical Mastery and Financial Viability

Technical mastery and profits are linked.  We identify four components of technical mastery:  technical performance of employees; technical skills of employees; productivity–the firm’s ability to meet schedules and fill customer orders on time; and quality of the services and/or products the firm provides.  All four aspects link to ROS and cash flow.

                          IN SUMMARY

Financial viability is the key to company success.  Few firms survive long without sufficient profits and cash flow.  This chapter reviews different ways to measure profits.  It also provides a quick overview of the linkages between financial viability and the other seven issues of the Dynamic System Planning Model.  In the remaining chapters of Part II, we pay individual attention to each of these seven issues, in turn.

FOOTNOTES

1 Cecil J. Bond, Hands-on Financial Controls for Your Small Business (Blue Ridge Summit, PA: Liberty Hall Press, 1991).

2 James L. Price and Charles W. Mueller, Handbook of Organizational Measurement (Marshfield, MA: Pitman Publishing, 1986), pp. 128-30.

3 Robert D. Buzzell and Bradley T. Gale, The PIMS PRinciples: Linking Strategy to Performance (New York: The Free Press, 1987), pp. 135-62.

4  Bryan E. Milling,  Cash Flow Problem Solver: Procedures and Rationale for the Independent Businessman (Radnor, PA: Chilton Book Company, 1981) and Bond, Hands-on Financial Controls for your Small Business, are two excellent sources that are written in plain language.

5 Buzzell and Gale, The PIMS Principles, discuss pros and cons of ROS and ROI at length, preferring ROI since it “relates results to the resources used in achieving them” (p.25).

6 Rensis Likert, New Patterns of Management (New York: McGraw-Hill, 1961).



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.

To read the entire article please click or copy and paste the link: http://bit.ly/P8Pfrg

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.