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Business Readings
 Beyond the Numbers
Strategic financial decisions must be framed in the context of the whole business. BY PETER J. LEITNER, CMA, CFM Accounting and finance managers, on whom companies traditionally rely for financial analysis, now are expected to function as corporate strategists as well. In this role, controllers, treasurers, and CFOs must look beyond the usual monetary factors and examine their companies in light of six key elements: the core business, the market, competition, operations, past performance, and quality of management. Only when they understand the interrelationships at work can they make a meaningful financial analysis. To help financial managers in this endeavor, we developed a Business Assessment Model that should improve the quality of management decisions that depend on financial analyses. The model, which resembles a pyramid, frames financial decisions in the context of the entire business (see Figure 1).  It is segmented horizontally into three subsets that
increase in importance from the pyramid's base to its peak. The
foundation includes the core business, market, and competition, which
gauge a company's ability to generate revenue. The second tier
contains the operations and performance elements, which measure a
company's ability to create value for customers and stockholders,
respectively. Finally, the pyramid's peak is the management element,
which evaluates a company's leadership quality.
It is the interrelationships of the elements that strongly influence a business's overall prospects and particularly its resilience during turbulent periods. The model emphasizes the assessment of revenue because it is the least controllable item that an analyst evaluates. Hence, the reasons why the Business Assessment Model improves decision making become clear:
The Business Assessment Model intentionally de-emphasizes quantitative methods because most analysts, who already are steeped in data and formulas, need a framework for sifting and sorting through information, not another algorithm. Moreover, given that financial statements simply translate decisions and actions into accounting language, analysts must avoid the common pitfall of failing to see beyond the numbers. The Business Assessment Model should enhance the ability of the management accountant or financial analyst to interpret the results of a business assessment accurately. UNDERSTANDING THE PROCESS The analyst can gather the data required for the six elements by posing the questions found in Table 1 about a business that is under review.  CORE BUSINESS: "What is their business?" The answer to this question conveys the
essence of a company. Indeed, a company that exhibits such clarity of
purpose, which is part of a strong mission statement, tends to
consistently outperform its competitors because its resources are
concentrated on a relatively narrow area for maximum
effect.1
An often-used illustration involves a company whose business could be defined as either railroads or transportation. Although both are correct, the term transportation conveys what the company actually does, which is moving certain types of cargo from one place to another via steel rails for a particular type of customer. The company's expertise, therefore, is transportation. But this fact does not imply that it should diversify into building cargo ships, which is a different business altogether, nor does it suggest that the company limit itself to steel rails because innovation, like interstate highways and airplanes, eventually will erode too narrow a focus. The nuance here is subtle, but it communicates the focal point of management's attention. MARKET: "Who is the customer?" "What customer needs do they satisfy?" "What are the macro drivers of demand?" These questions help the analyst understand how a business generates revenue and from whom. Without this knowledge, any budgeting, financing, or strategic analysis will be of limited value because the analyst cannot be confident that sales will meet expectations. "Who is the customer?" addresses three issues. 1. Who, exactly, is purchasing a company's products or services? The answer to this question should be as specific as possible. Moreover, the analyst should differentiate between actual customers...those who are buying the products or services...and potential customers the company is targeting; they may not be one in the same. 2. What causes the customer to make a purchase? Typical variables to be considered include impulse purchases vs. those that are planned; luxury items vs. necessities; and whether or not the product or service is a complement to another that has a significant influence on demand. An analyst also should consider how price changes influence revenue (price elasticity of demand). Simply knowing that revenue is generated via direct sales, telemarketing, or advertising is insufficient. 3. Are there multiple customer levels to account for in a purchase decision? In other words, who really makes the purchase decision for a given product or service? Consider the average hospital, which has at least three "customers" who are parties to each transaction: the patient who receives the services, the physician who admits the patient and provides the medical care, and the HMO or insurance company that pays the bill. In order to generate revenue, hospitals must market themselves to everyone who participates in the decision to purchase hospital services. Asking "What customer needs do they satisfy?" is the analyst's attempt to specify the core benefit the product or service provides. The answer to this question gives the solution to the fundamental need that must be satisfied to create demand; as such, it must be broad enough to convey the essence of customers' needs. The management accountant or financial analyst must understand this issue because even subtle changes in customers' needs will affect revenue. To illustrate the foregoing, we could say that automobile manufacturers do not really sell cars but rather freedom and mobility. To test the validity of this benefit, consider what you don't have when your car's engine won't start. You don't have either freedom or mobility (assuming, of course, that adequate substitutes are unavailable). Therefore, you could conclude that future revenues for the automobile industry are contingent upon satisfying the need for freedom and mobility by producing reliable cars. Finally, "What are the macro demand drivers?" focuses on external forces that could have a material effect on revenue. Examples of such demand drivers include:
In looking at these variables, the analyst considers the external factors that create uncertainty in the revenue line as well as how the company can hedge against these risks, if at all. COMPETITION: "What are the key opportunities and risks?"The model also allows the analyst to expose the strengths and vulnerabilities of a company and its competitors. It is not enough to rank competing firms by sales dollars, market share, geographic coverage, or some other measure. So the model integrates the opportunities and risks of a given competitive environment into a matrix that presents the company vis-à-vis its major competitors in terms of the factors that influence purchase decisions. By identifying the nature of each factor for each company and then arranging the information in the matrix, the analyst can evaluate each one individually and in relation to its peer group. In the process of completing the matrix, the analyst should gain two critical insights. First, the company's vulnerabilities become quite obvious (and are, incidentally, synonymous with advantages for the competition). Second, each competitor's weaknesses also become evident, which provides opportunities for the company under review to exploit as competitive advantages. The following hypothetical example illustrates this point. An automobile manufacturer, ACME Motors, is considering building a new plant that would be funded by cash reserves and the issuance of 30-year bonds. The capital investment analysis indicates that it should proceed, but how confident would you be in the revenue forecast? Demand for automobiles probably will continue, but it is uncertain from whom they will be purchased. To address this problem, measure ACME's prospects in relation to those of its three primary competitors. Assume that all companies produce only one model. The answer is shown in Table 2, a competitor matrix that highlights ACME's areas of opportunity and risk. Variables that drive consumer decisions in automobile purchases are shown in column 1 and are based on a marketing mix2 that isolates them.  The information in the matrix suggests several things about ACME's revenue prospects. First, market research indicates that the decision to buy a new car is influenced strongly by four factors: reliability, relative price, access to dealerships, and advertising on network television. Second, of ACME's three competitors:
To be confident that the revenue and cash flows will materialize to sustain the new plant, ACME needs to verify that it can attain and sustain sufficient market share. Initiatives that offer such confidence include commitments from management to improve product reliability, maintain or reduce prices, increase the number of dealerships, and maintain media spending on network TV advertising. If management doesn't commit to these initiatives, the long-term revenue forecast, from which net present value and internal rate of return analyses are derived to justify the new plant, should be reconsidered. OPERATIONS: "How do they make money?" With this question, the analyst is identifying where in the company's operating cycle value is actually created by delivering to the customer a core benefit or solution to a fundamental need. In this context, value is defined from the customer's perspective. In addition, the analyst can understand any business operation as a system in which resources, such as cash, raw material, information and other assets, are converted and transformed from inputs to outputs.3 The operations element of the model is important for two reasons: 1. Knowing exactly where value is created (what the customer really pays for) is like knowing which goose, among all others, lays the golden eggs. With this information, it becomes possible to set priorities regarding the allocation of capital and other scarce resources. 2. The vibrancy of the value-creating area indicates a company's future prospects. For example, a high rework rate in a manufacturer or a high turnover rate of creative personnel in an advertising agency may indicate major problems for those companies in the near future. But classifying each part of a business as either "value added" or "support" does not suggest that support functions (or the people in them) are superfluous. To the contrary, they permit the value-added functions to operate smoothly and efficiently. Here's one approach to determining where in its operating cycle a company creates value:
Let's use an advertising agency, the classic example of a service firm that relies on "intellectual capital" to create value for its clients, as an illustration. After determining the customer needs that the agency satisfies (defined here as enhancing demand for the client's products or services), we could assemble the information in Table 3. 
From this analysis, it is clear that the greatest value added for the client is in developing advertising ideas, such as writing a memorable phrase or developing a powerful visual image. Among all of the agency functions, it is what the client pays for. This fact also is reflected in the remuneration paid to senior creative directors, who usually are the best-paid employees in an advertising agency. Therefore, an agency's greatest source of value is in this department. PERFORMANCE: "What is the revenue growth rate?" "What is the contribution (or gross) margin?" "What is the return on capital?" When addressing these questions, the analyst finally has a need to sharpen his or her pencil. But this element of the model is limited to three measures: growth in sales, contribution (or gross) margin, and return on capital. I'm not denying the importance of other ratios and financial measures, especially cash flow analysis, but I'm emphasizing three measures that:
A caveat: All financial ratios have limitations, especially the ease of manipulation and the reliability of the financial statements on which they are based. Sales growth: The sales growth ratio is the clearest measure of the demand for a company's products or services, especially over a period of years and in comparison to competing firms. Sales growth is calculated as:
Adjustments the analyst will find useful include comparing the growth of unit sales to that of dollar sales and factoring out the effects of acquisitions and divestitures on sales. Red flags that warrant closer inspection include:
Contribution or gross margin: The contribution or gross margin indicates the franchise power, or brand equity, of a given enterprise. A margin in excess of 50% often suggests the presence of proprietary advantages (such as valuable patents, trademarks, or an extraordinary consumer preference for the goods or services the firm sells). Such advantages usually can support a premium pricing strategy. The formulas for these ratios are:
Margins that either remain constant or increase (especially when compared in relation to a competitor's) are favorable signs. Moreover, for safety, high contribution or gross margins also can be a quantifiable competitive advantage. Of these two measures, preference should be given to the contribution margin because it highlights the company's ability to cover fixed charges, which becomes particularly important in turnarounds, start-ups, and highly-leveraged firms. When variable cost information is not readily available, however, or when a company has few variable costs (as is often the case in information technology enterprises), the gross margin ratio is an excellent substitute. Red flags indicating a need for further analysis include:
Return on capital: Return on capital (ROC) conveys a company's overall financial well-being by indicating how efficiently the company uses all of the capital with which management is entrusted to generate a profit, regardless of whether the capital is obtained from stockholders or lenders. Furthermore, as stated in the seminal book, Graham & Dodd's Security Analysis, "The most comprehensive gauge of success of an enterprise is the percentage earned on invested capital."4 It becomes clear that a company must earn an acceptable return on capital, or its prospects will dim quickly. The formula for this ratio is:
Note: Short-term debt, such as commercial paper, should be included in LTD if used to finance long-term assets; any mezzanine securities should also be included in LTD. Generally speaking, a high ROC minimizes a company's dependence on external capital sources, giving it more financial flexibility. It is essential, however, to compare a company's ROC with that of its competitors in the industry, as well as the industry average ROC with that of other industries, to assess performance fully.  The maturity of both the company and its industry, as well as the capital-intensive nature of the industry, are relevant. Of greatest importance for our purposes, however, is that the ROC ratio permits the analyst to determine the real return on capital, or whether or not the company is creating or destroying corporate value. By comparing the firm's ROC with the weighted average cost of capital (WACC), which includes the cost of equity as well as the interest costs of debt, the universal goal of creating shareholder value can be measured unequivocally. This relationship is expressed as: If ROC > WACC, then value is created. If ROC < WACC, then value is destroyed. To quantify the amount of value a company creates or destroys in a given year in dollar terms, consider the financial information about a hypothetical company shown in Table 4. If the ROC had been 4.6% lower than the WACC, then $4,600,000 of value would have been destroyed. A company that consistently earns less than its cost of capital is on a slippery slope that only becomes more so with the passage of time because it cannot sustain such an imbalance indefinitely. At some point, the capital markets, both public and private, will become less than enthusiastic about investing additional funds. Also, customers will gravitate toward competitors and, if the company is publicly owned, hostile suitors will emerge. If not rejuvenated soon, the company is likely to complete its slide into insolvency. MANAGEMENT: "Are they up to the task at hand?" Evaluating management is the least precise and most difficult element of any business assessment, yet it is the most critical. Professional investors, particularly those who focus on illiquid, high-risk venture capital and leveraged buyout transactions, often agree that management quality is the best predictor of business success or failure. The quality of management and leadership is important because business is fraught with risk. Markets change direction quickly, and these changes often are fueled by new technology and fierce foreign and domestic competition. As such, a company's prospects often are dependent on management's ability to navigate through turbulent and tumultuous times. To the extent that individual businesses are unique in terms of industry, scale, maturity, historical performance, and specific challenges and opportunities, so, too, are managerial requirements. The skills, abilities, and personalities of the management team must complement the business. True excellence in leadership often can be found in the corporate culture, especially in the manner in which young talent is selected and developed and in the ways management's successors are groomed. Here are four areas that should be stressed, given the importance of evaluating management.
A deficiency in even one of these areas, however minor it may seem, must be considered serious. Although no one is perfect, analysts who discount these particular issues do so at their company's peril. In making these judgments, the analyst must rely on less formal sources of information, especially casual interviews and observations. Above all, he or she should listen carefully to his or her intuition, for often therein lies the answer. DEVELOPING STRATEGY Management accountants and financial analysts can use the Business Assessment Model to enhance the value of their work, particularly when they are involved in business combinations, debt or equity funding, capital investments, and new corporate ventures. The model synthesizes data on the core business, the market, competition, operations, historical performance, and management to provide a holistic assessment of a business, regardless of its type, industry, or economic sector. Although analysts' contributions traditionally have been limited to accounting and financial issues, it is imprudent to use financial information in a vacuum, particularly in an increasingly competitive business environment. Understanding the elements that drive financial information is crucial. Further, as accounting and finance managers increasingly are called upon to develop and execute corporate strategy, they must go beyond accounting and finance to ensure that strategic business decisions are optimized. Peter Leitner, CMA, CFM, is president of Waterford Advisors, Inc., a New York City-based investment bank that serves healthcare and information technology companies. Mr. Leitner holds a B.S. degree in healthcare management from Ithaca College and an MBA degree in accounting and finance from Lehigh University. An IMA member-at-large, he can be reached at (212) 755-1344 or peterleitner@sprintmail.com. 1 James B. Hobbs, Corporate Staying Power, D.C. Heath & Co., 1987, p. 22. 2 Robert D. Hisrich and Michael P. Peters, Marketing Decisions for New and Mature Products: Planning, Development, and Control, Charles E. Merrill Publishing Co., 1984, p. 77. 3 Roger G. Schroeder, Operations Management: Decision Making in the Operations Function, third edition, McGraw-Hill, Inc., 1989, p. 195. 4 Sydney Cottle, Roger F. Murray, and Frank E. Block, Graham & Dodd's Security Analysis, fifth edition, McGraw-Hill, Inc., 1988, p. 351.
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