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Source:Higgins,R.AnalysisforFinancialManagement.10thed.McGraw-HillIrwin,2011
ThefirstprincipleinacommonMBAfinancetextbook
“Acompany’sfinancesandoperationsareintegrallyconnected.”
Whyisoperationsundervalued?
• “Inourcompany,operationsisnotglamorous.Dealsare.”
• Operationsisabranchofengineeringrequiringadifferentskillsetandmindset
• Topmanagers– whoenteredthroughfinance,strategy,ormarketing– areignorantaboutoperationsanduninterestedinlearningmore,relyingonotherstomindthedetailsofactualwork
• “Financialdatadominatethediscourseinthemodernorganization,althoughoperationalperformanceisthedriveroffinancialresults.”
Source:“DeepChange:HowOperationalInnovationCanTransformYourCompany,”MichaelHammer,HarvardBusinessReview,Vol.82Issue4,April2004,pp.84-93.
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Answerthesequestionsforyourfirm
• WhatfinancialKPIsdoyouusetomeasuresupplychainperformance?
• Whatfinancialanalysisdoyouusetomakesupplychaindecisions?
TheLanguageofFinance
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Thelanguageoffinance
• FinancialStatements– BalanceSheet– IncomeStatement
• FinancialAnalysis– Ratios– Acronyms(ROA,ROIC,EVA,…)
BalanceSheet
• Snapshotofthefirm’svalue– Approximation:accountantsmeasuredvalueatthetimethetransactiontookplace– Bookvalueisthelowerofcostormarketvalue
• Assets(listedinorderofliquidity)– Current:cash,marketablesecurities,accountsreceivable,inventories– Fixed:property,plant,equipment(lessaccumulateddepreciation)– Intangible:patents,goodwill…“growthassets”
• Liabilities(listedinorderinwhichtheymustbepaid)– Current:accountspayable,notespayable,…– Long-term:notes,bonds,deferredincometaxes,…
• Shareholders’equity(a.k.a.networth)– Stock:preferred,common– Retainedearnings
Lasttobepaidifafirmisdissolved
consumedinthecurrentyear
consumedinthefuture
consumedtheoretically
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IncomeStatement
• Performancerecordbetweensnapshots• Explainswhyretainedearningshaschangedovertime
– Sales(netofmarkdowns)– Costofgoodssold– GROSSINCOME– Selling,general&administrative(SGA)expenses– OPERATINGINCOME– Depreciation&amortization– OPERATINGINCOME
– Interestexpense– Othernonoperatingexpenses/income
– Incometaxes– Extraordinaryitems– NETINCOME
EBITDA
EBIT
EIATBS
Financialstatements
“Financialstatementsarelikefineperfume;tobesniffedbutnotswallowed.”
− AbrahamBrilloff
Source:Higgins,R.AnalysisforFinancialManagement.10thed.McGraw-HillIrwin,2011.
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Financialanalysis
“accountantstrytomeasurethecurrentstandingandimmediatepastperformanceofafirm,whereasfinancialanalysisismuchmoreforwardlooking.”
− Aswath Damodaran,SternSchoolofBusiness
Source:http://pages.stern.nyu.edu/~adamodar/New_Home_Page/AccPrimer/accstate.htm
Financialanalysis
• Analogyaboutmanagingacompany’sfinancialperformance– stick,throttle,rudder
• “Weanalyzefinancialstatementsforthepurposeof– evaluatingperformanceand– understandingtheleversofmanagementcontrol.”
Source:Higgins,R.AnalysisforFinancialManagement.10thed.McGraw-HillIrwin,2011.
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Financialanalysis
• Higgins’threeleversofmanagementcontrol– Netmargin:Netincome/Sales– Assetturnover:Sales/Assets– Financialleverage:Assets/Shareholders’equity
• Studythe“tiesbetweenacompany’soperatingdecisions…anditsfinancialperformance.”– “Operatingdecisionsaretheleversbywhichmanagementcontrolsfinancialperformance.”
– Examplesgiven:howmanyunitstomakethismonth,howtopricethem
Source:Higgins,R.AnalysisforFinancialManagement.10thed.McGraw-HillIrwin,2011.
DuPontanalysis
• DuPontanalysisisbasedonareturn-on-investmentformuladevelopedin1914byaDuPontexplosivessalesmannamedDonaldsonBrownandusedbythecompany.Mr.BrownlateruseditasCFOatGeneralMotors,butitwasalreadyknownastheDuPontformula.
• Inessence,itisasimplecombinationoftworatiosSource:Flesher,D.L.,&Previts,G.J.(2013).DonaldsonBrown(1885-1965):thepowerofanindividualandhisideasovertime. TheAccountingHistoriansJournal,79-101.
𝑅 = 𝑇×𝑃where𝑅 = rateofreturnoncapitalinvested,𝑇 = rateofturnoverofinvestedcapital,and𝑃 = percentageofprofitonsales
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DuPontanalysis
assets TotalSalesoverAsset turn =
SalesincomeNet marginNet =
overAsset turn margin Net ROA ´=
Equityassets Totalleverage Financial =
leverage FinancialoverAsset turnmarginNet ROE ´´=
InventoryTurnover, anarrowerfocusthanAssetTurnover,isoftenametricforsupplychainprofessionals
GrossorOperatingMarginisamorecommonmetricforsupplychainprofessionalsthanNetMargin
DuPontanalysis
• TheDuPontformulais:
𝑁𝑒𝑡𝑀𝑎𝑟𝑔𝑖𝑛 = 𝑁𝑒𝑡𝐼𝑛𝑐𝑜𝑚𝑒
𝑆𝑎𝑙𝑒𝑠 𝐴𝑠𝑠𝑒𝑡𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = 𝑆𝑎𝑙𝑒𝑠
𝑇𝑜𝑡𝑎𝑙𝐴𝑠𝑠𝑒𝑡𝑠
𝑅𝑂𝐴 = 𝑁𝑒𝑡𝑀𝑎𝑟𝑔𝑖𝑛×𝐴𝑠𝑠𝑒𝑡𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟
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DuPontanalysis
• TheformulacommonlyusedtodayfocusesonROEandincorporatesfinancialleverage
𝑁𝑒𝑡𝑀𝑎𝑟𝑔𝑖𝑛 = 𝑁𝑒𝑡𝐼𝑛𝑐𝑜𝑚𝑒
𝑆𝑎𝑙𝑒𝑠
𝐴𝑠𝑠𝑒𝑡𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = 𝑆𝑎𝑙𝑒𝑠
𝑇𝑜𝑡𝑎𝑙𝐴𝑠𝑠𝑒𝑡𝑠
𝑅𝑂𝐸 = 𝑁𝑒𝑡𝑀𝑎𝑟𝑔𝑖𝑛×𝐴𝑠𝑠𝑒𝑡𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟×𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒
𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = 𝑇𝑜𝑡𝑎𝑙𝐴𝑠𝑠𝑒𝑡𝑠𝐸𝑞𝑢𝑖𝑡𝑦
GMROI
• GMROI=GrossMarginReturnOnInventoryInvestment
• NarrowerfocusthanDuPont• Usefulinevaluatinginventorydecisions,andtheirimpactonprofitability
𝐺𝑟𝑜𝑠𝑠𝑀𝑎𝑟𝑔𝑖𝑛 = 𝐺𝑟𝑜𝑠𝑠𝑃𝑟𝑜𝑓𝑖𝑡
𝑆𝑎𝑙𝑒𝑠𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟∗ =
𝑆𝑎𝑙𝑒𝑠𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
𝐺𝑀𝑅𝑂𝐼 = 𝐺𝑟𝑜𝑠𝑠𝑀𝑎𝑟𝑔𝑖𝑛×𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟
*𝑡ℎ𝑖𝑠𝑣𝑒𝑟𝑠𝑖𝑜𝑛𝑜𝑓𝑡ℎ𝑒𝑟𝑎𝑡𝑖𝑜𝑑𝑜𝑒𝑠𝑛𝑜𝑡𝑢𝑠𝑒𝐶𝑂𝐺𝑆𝑎𝑠𝑡ℎ𝑒𝑛𝑢𝑚𝑒𝑟𝑎𝑡𝑜𝑟
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Financeandsupplychainworktogethertocreatestockholdervalue
Div
iden
dInvestors
(Equity)
Firm
Investors
(Debt)
Operational Assets
Firm invests
Future cash flows: revenues, expenses, etc.
Operations/supplychain:usefundstogeneratereturns
Finance:acquirefunds
Finance:allocatefunds
Leversofperformancefor10diversecompanies,2010
Source:Higgins,R.AnalysisforFinancialManagement.10thed.McGraw-HillIrwin,2011.
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Overallmeasureoffinancialperformance• Isthereasinglemetricthatcanreflectthefirm’sfinancialperformanceforinvestors?
• forexecutives?
• ReturnonEquity
• ReturnonAssets 𝑅𝑂𝐴 = 𝑁𝑒𝑡𝐼𝑛𝑐𝑜𝑚𝑒𝑇𝑜𝑡𝑎𝑙𝐴𝑠𝑠𝑒𝑡𝑠
𝑅𝑂𝐸 = 𝑁𝑒𝑡𝐼𝑛𝑐𝑜𝑚𝑒𝐸𝑞𝑢𝑖𝑡𝑦
Specificmeasuresoffinancialperformance• Revenuegrowth
– Salesgrowth=(Salest/Salest-1)- 1– CompoundAnnualGrowthRate(CAGR)=(Salest/Salest-n)1/n- 1
• Operatingmargin– Grossmargin=GrossIncome/Sales– Operatingmargin=OperatingIncome/Sales– Netmargin=NetIncome/Sales
• Assetproductivity– Assetturnover=Sales/TotalAssets– Inventoryturnover=COGS/AverageInventory– Accountsreceivableturnover=CreditSales/AverageAccounts
Receivable– Accountspayableturnover=COGS/AverageAccountsPayable– Daysofinventoryoutstanding=AverageInventory/(COGS/365)
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Principalratiodefinitions(Higgins)*
Source:Higgins,R.AnalysisforFinancialManagement.10thed.McGraw-HillIrwin,2011.
*Excludingtheleverageandliquidityratios
Optiontoaddworkingcapital
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Ratiosdependontheindustry(upperquartile,median,lowerquartile)
Source:Higgins,R.AnalysisforFinancialManagement.10thed.McGraw-HillIrwin,2011.
Ratiosdependontheindustry(upperquartile,median,lowerquartile)
Source:Higgins,R.AnalysisforFinancialManagement.10thed.McGraw-HillIrwin,2011.
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Ratioanalysisadvice
• Therearenotany“correct”valuesforratios• Ratiovaluesneedtobeunderstoodincontext– Comparewithindustryaverages– Comparewithspecificcompetitors– Observetrendsovertime
• Developaframeworkofseveralratiostomonitor• Incombination,thesecluesmaytellaninterestingstory
Usingratioseffectively
• Ratiovaluesneedtobeunderstoodincontext• Usually,no“correct”valuesforratios• Relyonruleofthumbassessmenttechniques,comparisonwithindustryaveragesandspecificcompetitors,andlookingfortrends
Source:Higgins,R.AnalysisforFinancialManagement.10thed.McGraw-HillIrwin,2011.
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YouarenowreadytobeCEO
SunflowerNutraceutical(SNC)Simulation
SunflowerNutraceutical(SNC)
• HowdidyoulikebeingCEO?• Whatwasyourobjectiveinmakingdecisions(inrankorder)?
• Whatapproachesdidyouusetoevaluateoptions?
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SunflowerNutraceutical(SNC)results
TwogoalsoftheCEO
• ProvideShareholderValue• …andstayoutofjail
BernardJ."Bernie"Ebbersco-foundedthetelecommunicationscompanyWorldComandwastheCEO.In2005,hewassentencedto25yearsinprisonforhisroleinthe$11billionaccountingfraudthatbroughtdownthecompany.
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BalancedScorecard
• “Ultimately,causalpathsfromallthemeasuresonaScorecardshouldbelinkedtofinancialobjectives.”
• “Wehavefoundthatcompaniesusethreefinancialthemestoachievetheirbusinessstrategies:– RevenueGrowthandMix– CostReduction/ProductivityImprovement– AssetUtilization/InvestmentStrategy”
Source:Kaplan,R.S.,&Norton,D.P.(1996).Linkingthebalancedscorecardtostrategy. Californiamanagementreview, 39(1),53-79.
Source:Kaplan,R.S.,&Norton,D.P.(2001).Transformingthebalancedscorecardfromperformancemeasurementtostrategicmanagement:PartI. Accountinghorizons, 15(1),[email protected]
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[email protected]:http://www.maaw.info/ArticleSummaries/ArtSumKaplanNorton2001.htm
Source:website,TradeDynamics,LLC
19
Source:website,FinlisticsSolutions
DeloitteEnterpriseValueMap
Source:Lukac,E.G.,&Frazier,D.(2012).Linkingstrategytovalue. JournalofBusinessStrategy, 33(4),49-57.
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DeloitteEnterpriseValueMap
Downloadthefullmap:http://public.deloitte.com/media/0268/enterprise_value_map_2_0.pdf
GoaloftheCEO
• ProvideShareholderValue
• DriversofShareholderValue– RevenueGrowth– OperatingMargin– AssetProductivity
Supplychainprofessionalscanaffectallthree!
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Driversofshareholdervalue
RevenueGrowth
AssetProductivity
OperatingMargin
Risk
Leverage
Howdoessupplychainperformancemakeanimpactonfinancialresults?
• Tradeoffsexist• [email protected]
AssetProductivityOperatingMargin
RevenueGrowth
Responsiveness(productavailability)Capability(newmarkets)
Leanness(reduceassets)Agility(adaptcapacities)
Leanness(reducecost)Segmentation(identifyopportunities)
22
SunflowerNutraceutical(SNC)analysis
SunflowerNutraceutical(SNC)analysis
23
SunflowerNutraceutical(SNC)analysis
SunflowerNutraceutical(SNC)analysis
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DuPontassessestheOperatingMargin–AssetProductivitytradeoffatahighlevel
“ProfitPath” “TurnoverPath”SameDestination:ROA
RevenueGrowth
AssetProductivity
OperatingMargin
DoyouseeanyextremeexamplesofProfitPathandTurnoverPath?
Source:Higgins,R.AnalysisforFinancialManagement.10thed.McGraw-HillIrwin,2011.
25
Leveragedrivesvalue+increasesriskRevenueGrowth
AssetProductivity
OperatingMargin
Risk
Leverage
Overallmeasureoffinancialperformance• ROA=NetIncome/TotalAssets• ROE=NetIncome/Equity• Bothmeasurescanbedistortedbyfinancialleverage,i.e.moredebt
CompanyD CompanyEEBIT $280 $280InterestExpense $180 $0EBT $100 $280IncomeTaxes(40%) $40 $112NetIncome $60 $168
TotalAssets $2,000 $2,000
LongTermDebt(10%) $1,800 $0TotalStockholder'sEquity $200 $2,000TotalLiabilities&Equity $2,000 $2,[email protected]
26
ROIC
• ROIC=ReturnonInvestedCapital– Returnsonallcapitalforinvestorsseekingareturn– Notonlyequity
• ROIC=NOPAT/InvestedCapital• NetOperatingProfitAfterTax(NOPAT)
– NOPAT=EBIT(1- Taxrate)– Earningsaftertaxasifitwereallequityfinanced(i.e.,not
consideringinterestexpenseortaxbooks)• InvestedCapital
– IC=Interest-bearingDebt+Equity– Sumofallsourcesofcashonwhichareturnmustbeearned
(i.e.,notincludingaccountspayable)– Youmaywanttosubtractexcesscash– PreferthebookvalueofInvestedCapital(i.e.thevalue
invested)[email protected]
ROIC
• ReturnonInvestedCapitala.k.a.RONA(ReturnonNetAssets)
• ROIC=EBIT(1-Taxrate)/(Interest-bearingdebt+Equity)
• Numerator:earningsaftertaxifitwereallequityfinanced(i.e.,notconsideringinterestexpenseortaxbooks)
• Denominator:sumofallsourcesofcashonwhichareturnmustbeearned
27
ROICisnotaffectedbyfinancingscheme
Source:Higgins,R.AnalysisforFinancialManagement.10thed.McGraw-HillIrwin,2011.
BalanceSheet
IncomeStatement
ROICisnotaffectedbyfinancialleverage
• ROICisagoodmeasureforsupplychainperformance– Itisnotconfoundedbyfinancingstrategies– Itshowsthefundamentalearningpowerofthefirm,i.e.,createdbyoperations
CompanyD CompanyEEBIT $280 $280InterestExpense $180 $0EBT $100 $280IncomeTaxes(40%) $40 $112NetIncome $60 $168
TotalAssets $2,000 $2,000
LongTermDebt(10%) $1,800 $0TotalStockholder'sEquity $200 $2,000TotalLiabilities&Equity $2,000 $2,000
CompanyD CompanyEROE 30.0% 8.4%ROA 3.0% 8.4%ROIC 8.4% 8.4%
28
EVA™
• EVA™=economicvalueadded=NOPAT– (IC*COC)
• where– IC=investedcapital– COC=costofcapital[i.e.WACC]– NOPAT=netoperatingprofitaftertaxes[i.e.EBIT*(1-TaxRate)]
• Transformaccountingprofitintoeconomicprofit– Convertaccrual-basedearningsintoacash-basedNOPAT– Converttotalassetstoinvestedcapital– Assessthequantityofcapitalusedtogeneratetheincome– ThecomplexityandefforttoadjustGAAPisaweaknessofEVA
[email protected]:EVA™isatrademarkedsymbolof Stern,Stewart&Co.
Simplebottomline
Ifeconomicvalueaddedispositiveinagivenyear,thefirmhasearnedmorethan
theamountrequiredtocompensatedebtholdersandshareholders
29
EconomicValueAdded
SALES
COGS
GROSSMARGIN
TOTALEXPENSES
NETPROFIT(EBIT)
TAXES
NOPAT
CAPITALCHARGE
TOTALCAPITAL
COSTOFCAPITAL(%)
CURRENTASSETS
FIXEDASSETS
OTHERCURRENTASSETS
INVENTORY
EVA
−
−
−
+
+
X
−
OTHER+
Source:“Supplychainmetrics,”DouglasM.LambertandTerranceL.Pohlen.InternationalJournalofLogisticsManagement,Vol.12No.1,2001,pp.1-19.
30
Source:“Supplychainmetrics,”DouglasM.LambertandTerranceL.Pohlen.InternationalJournalofLogisticsManagement,Vol.12No.1,2001,pp.1-19.
Example:supplychaintradeoff
New Proposal
100,000$
86,500$ 11,500$ 75,000$
13,500$ 5,130$ 8,370$
60,000$ 44,000$ 16,000$
6,000$ 4,400$ 1,600$
2,370$ 103.0%
Base
Revenues 100,000$
Operating Costs - 85,000$ SC 10,000$ Non-SC 75,000$
EBIT = 15,000$ Taxes 38% - 5,700$ NOPAT = 9,300$
Capital 70,000$ SC 54,000$ Non-SC 16,000$
Cost of Capital 10%Capital Charge - 7,000$
SC 5,400$ Non-SC 1,600$
EVA = 2,300$
Base
Revenues 100,000$
Operating Costs - 85,000$ SC 10,000$ Non-SC 75,000$
EBIT = 15,000$ Taxes 38% - 5,700$ NOPAT = 9,300$
Capital 70,000$ SC 54,000$ Non-SC 16,000$
Cost of Capital 10%Capital Charge - 7,000$
SC 5,400$ Non-SC 1,600$
EVA = 2,300$
New Proposal
100,000$
86,500$ 11,500$ 75,000$
13,500$ 5,130$ 8,370$
60,000$ 44,000$ 16,000$
6,000$ 4,400$ 1,600$
2,370$ 103.0%
31
Example:supplychainimprovement
Ops better 10%
100,000$
84,000$ 9,000$
75,000$
16,000$ 6,080$ 9,920$
70,000$ 54,000$ 16,000$
7,000$ 5,400$ 1,600$
2,920$ 127.0%
Base
Revenues 100,000$
Operating Costs - 85,000$ SC 10,000$ Non-SC 75,000$
EBIT = 15,000$ Taxes 38% - 5,700$ NOPAT = 9,300$
Capital 70,000$ SC 54,000$ Non-SC 16,000$
Cost of Capital 10%Capital Charge - 7,000$
SC 5,400$ Non-SC 1,600$
EVA = 2,300$
Cap better 10%
100,000$
85,000$ 10,000$ 75,000$
15,000$ 5,700$ 9,300$
64,600$ 48,600$ 16,000$
6,460$ 4,860$ 1,600$
2,840$ 123.5%
EVAisalignedwithNPV
ThepresentvalueofEVAsfromagivenprojectismathematicallyequivalenttotheNPVoftheproject
32
EVAisnotnew,sowhyisitpopular?
• Consultantsaregoodatrepackagingoldideas– BasicideausedbyGeneralMotorsin1920s– LabeledbyGeneralElectricin1950sas“residualincome”– TrademarkedbySternStewartin1990sasEVA™(withfurthernewterminologysuchasNOPAT)
• Uniformity:itcanbeusedforthreecrucialmanagementfunctions– Investmentanalysis(insteadofNPV,IRR,BCR)– Businessunitperformanceappraisal(insteadofROE,ROA)– Compensationincentive(turnmiddlemanagersinto“owners”)
• ItismorestreamlinedthanrelyingonahostofmeasuressuchasNPV,IRR,BCR,ROE,ROIC,EPS,etc.
Source:Higgins,R.AnalysisforFinancialManagement.10thed.McGraw-HillIrwin,2011
“EVApromisestocompletethetransformationofvaluecreationfromameresloganintoapowerfulmanagementtool,onethatmayatlastmove
modernfinanceoutoftheclassroomandintotheboardroom– andperhapsevenontotheshopfloor.”
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