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Financial Analysis

The Management Pocketbooks Pocket Correspondence Course

Pocketblog has gone back to basics. This is part of an extended management course.


No manager worth their salt can get away with a trite ‘I don’t do numbers’ – numbers are an integral part of every aspect of business. And while every business has finance experts on hand to manipulate and interpret the money, every manager needs to be able to understand financial analysis, so they can contribute to decision-making.

The three basic financial tools are:

  1. The Balance Sheet
  2. The Income & Expenditure (or Profit & Loss) statement
  3. Cash flow Statement

As a manager, you may never need to prepare one of these, but you should certainly be able to read and interpret each of them. What may be less familiar to you are the various measures used in performance and investment analysis.

Performance Ratios

Return on Equity
How much we make from shareholders’ investment. Higher returns suggest a more valuable business. Calculate by dividing net income by total assets.

EBIT
Earnings Before Interest and Tax is a quick measure of the underlying profitability of the business.Some prefer…

EBITDA
Earnings Before Interest, Tax, Depreciation, and Amortisation

Gross Profit Margin
Tells us how much sales contribute to fixed costs. Calculate by dividing gross profit by sales revenue.

Net  Profit Margin
Calculates the total margin on sales revenue, after all costs. Calculate by dividing net income by sales revenue.

Operating profit margin
Excludes interest and taxation from the net profit margin calculation. Calculate by dividing EBIT by sales revenue – or use EBITDA.

Inventory turnover
Tells us how fast we sell and then replace inventory or, conversely, how badly we get stuck with inventory. Calculate by dividing the cost of all goods sold by the average value of your inventory over the same period. This fails to identify particular items of stagnant stock.

Investment Analysis

To understand the real value of an investment over a long-term, you need to create a discounted cash flow, where each receipt and payment is applied to the time slot in which it will occur, and then reduced by a discount factor (or Present Value factor) that represents the time value of money. So, a pound next year is worth less than a pound today, due to the impact of inflation.

The total of the present values of all of the payments and receipts is called the Net Present Value (NPV) and represents the value of the investment you would have to make in today’s money, to receive the total cash flows.

NPV calculations all depend on getting one crucial assumption right: the discount rate.  Higher inflation rates give higher discount factors. At the time of writing, the UK Treasury advises a discount rate of 3.5 per cent. The discount rate that a business would use is typically the rate they would pay to borrow money to fund the investment.

Discounted Cash Flow - Net Present Value

 

Click on the image to enlarge it

An alternative measure is the Internal Rate of Return (IRR). This is the discount rate that we would need to use to make the investment worthwhile. Higher IRRs are good and any IRR that is less than or just a little bigger than the the discount rate you would use (your cost of capital) will suggest that the investment will either be negative and lose money or, if just a little bigger, will be marginal and therefore very risky.

Discounted Cash Flow - Internal Rate of Return

Click on the image to enlarge it

Further Reading

From the Management Pocketbooks series:

  1. The Balance Sheet Pocketbook
  2. The Managing Cashflow Pocketbook
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A Tale of Two Budgets

The Management Pocketbooks Pocket Correspondence Course

Pocketblog has gone back to basics. This is part of an extended management course.


There was a time when the now traditional budgeting process did not exist. It emerged in the early twentieth century as a mechanism to exert central control on increasing large corporations with more and more regions and divisions. It put the power at the centre and constrained senior management in the regions and divisions to comply.

We looked some time ago at the triptych of mission, vision and values. Once these are agreed, senior managers can develop a strategy for the business and, from that, plans for the coming year. When costs and revenues are allocated to those plans, the costs can be divided among the regions, divisions and functional groups, to create a budget.

Budgeting is therefore a process that reinforces a static hierarchy, centralised control, and a fixed plan for the coming year. It happens in the overwhelming majority* of businesses; including Barnstaple Corp, a fictional US headquartered global manufacturer.

Barnstaple Corp

This results in Barnstaple having a high level of control over how and where it spends its investment money – able to channel cash to the regions and operating divisions where HQ analysis can see the great growth potential. Down on the ground, however, individual managers who are responsible for distinct product lines feel frustrated. They have very little true decision-making capacity and are forced to manage their business with no more resources than they are given.

Some can see huge local opportunities, which they are unable to exploit due to lack of central funding. It is not that budgets cannot be adjusted mid-year; but the effort, bureaucracy and politicking required to negotiate this with HQ leaves many of them with a fatalistic attitude. They know that if they were given more autonomy, they could make more money for their bosses, but they feel as if nobody really cares about the profits of their one product line.

Idlas

Idlas works very differently. It is a fictional European headquartered retailer, that gives everyone of its employees in 24 countries a simple message: continually find and implement ways to serve our customers better. Anyone in the business can make a decision and primary levels of leadership are devolved to clusters of stores of no more than 50 to 60 branches. Headquarters serves as a resource pool for company-wide services, but individual senior managers at cluster level can opt out of those services if they can find alternatives that allow them to provide better service to their customers.

All decision-making at Idlas is governed by a few over-arching corporate values and promotions tend to be internal, locking those values into the company’s DNA. To support decision-making, HQ provides a constant stream of high quality information, that is openly available to any manager.

Similar and Different

Both Barnstaple and Idlas are highly admired companies making large profits for their shareholders. Both have very real equivalents in the world – each on both sides of the Atlantic, although the Idlas equivalents are far rarer than the Barnstaples. Both are extreme and idealised counterparts of their real-world equivalents – yet neither is very far from the reality of typical businesses of their type.

But both have a very different response to the VUCA** environment in which most large corporates are trading – and in which most small businesses trade too.

Barnstaple husbands its resources carefully, using centralised expert analysts to predict where they will be needed and a budgeting process that allocates them accordingly. Scrutiny of requests for budget variances happens centrally.

Idlas lets local managers read the local conditions and optimise as they go, drawing down on central resources, to invest what they judge necessary to maximise customer service and therefore profit.

Scrutiny takes place far more locally than at Barnstaple, among peers in the region.


* I am tempted to say 97.6 per cent of businesses, knowing that 98.3 percent of statistics are made up and that only 1.4 per cent of readers ever try to check a statistic and that only 21.2 per cent of them are ever persistent enough to get an answer. But I shan’t, for obvious reasons.

** VUCA: Volatile, Uncertain, Complex, Ambiguous

Further Reading

Barnstaple represents the archetype of command and control budgeting, whereas Idlas is emblematic of a devolved leadership model.

You can learn more about this from the Beyond Budgeting Institute.

You may also like The Managing Budgets Pocketbook.

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Lean Thinking

The Management Pocketbooks Pocket Correspondence Course

Pocketblog has gone back to basics. This is part of an extended management course.


Imagine that you were an Egyptian overseer, responsible for building a great pyramid for your Pharaoh. How would you want to organise things?

  • Would you want to start by knowing exactly what your Pharaoh wants?
  • Would you want to fully understand every part of the process?
  • Would you want to understand how stone moves from being part of the wall of a quarry to a perfectly fitting part of your Pharaoh’s pyramid?
  • Would you want to ensure that the giant blocks of stone arrived fast enough so the workers on the ramp always had a stone ready to move up?
  • Would you want to make sure stones got up to the top of the ramp fast enough to make sure that they were there as soon as the last stone was placed on the pyramid?
  • Would you want to avoid stones arriving too fast and causing a bottleneck?
  • Would you want to make sure every stone was perfect to avoid having to stop and find a replacement or re-dress the stone on site?

If your answer is yes to all of those questions, then congratulations: you are instinctively an ancient Lean Manager.

Lean thinking is not new: the ideas have been around for a very long time and accumulated in industry over the years. But there are a few names that are strongly associated with its emergence as a driving force in organisational effectiveness in the last years of the twentieth and early years of the twenty first century.

The thinking was done by the founder of Toyota, Sakichi Toyoda, his son, Kiichiro Toyoda, and their postWW2 production chief, Taiichi Ohno. The Toyodas set out how a production line could work best, avoiding the problems of Henry Ford’s original ‘don’t stop the flow of the line if anything goes wrong – sort it out at the end’ approach. When they could not make it work due to the flaws in their supply chain, it was Ohno who then solved the practical problems.

The message came out in a landmark study by researchers from The Massachusetts Institute of Technology (MIT). This was published in the 1991 book ‘The Machine that Changed the World’ which introduced the world to the term ‘Lean’. Two of its authors: James Womack and Daniel Jones, went on to write a series of influential books, spelling out how to apply the lean principles they had researched at Toyota, starting with ‘Lean Thinking’ and becoming even more practical, with ‘Lean Solutions’.

The Value Chain

At the heart of Lean Thinking is an understanding of the value chain, which we discussed in an earlier post. Lean thinking starts by defining value from the point of view of the end customer for your products or services. When you do this, you usually find that only a small proportion of your activities directly contribute to that value (from the customer’s perspective). The rest – including some parts of what Michael Porter described as Primary Business Activities are only necessary as supporting this value creation.

Performance improvement comes first from eliminating steps and interactions that are not necessary for value creation and then, redesigning those that are to be as effective and efficient as possible. This means less wastage due to delays, re-work, duplication, scrapping below quality products, and oversupply.

The five principles of Lean Thinking are set out below.

The Five Principles of Lean Thinking

Waste

At various points, Lean Thinking decries wastage. The Toyota production chief set out seven sources of waste that destroy value.

  1. overproduction
  2. excessive inventory
  3. defects
  4. delays
  5. unnecessary transportation of goods
  6. unnecessary movement of materials
  7. unnecessary processing or materials

Where is there waste in your organisation?

Further Reading

In 1997, James Womack founded the Lean Enterprise Institute. Its website is a valuable source of resources for understanding more about Lean thinking.

In our Management Thinkers series, you may like Taiichi Ohno: Lean Production.

From the Management Pocketbooks series:

  1. Improving Efficiency Pocketbook
  2. Improving Profitability Pocketbook
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Synergy: Mutualism in the Human World

Synergy

SynergySynergy is a Big Idea that has been around… forever. Or as near as makes no difference on a human scale.

In the animal world, we call it mutualism, but you know how fundamental an idea is, when your mum expressed it to you in plain language when you were just a small child. ‘The whole is greater than the sum of the parts’. That’s what synergy means. So, why is it such a widely used word in business – so much so that it has pride of place on many-a buzzword bingo card?

And there’s another question we need to get to grips with… How real are the synergy benefits that leaders so often advocate for? The fact is that the whole being greater than the sum of its parts is a nice idea – but logically, it would seem to be flawed. So, when does the concept apply?

Continue reading Synergy: Mutualism in the Human World

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Product Manager: Strategist, Advocate, Keystone

Product Manager - Product Management

Product Manager - Product ManagementMovie stars, celebrities, and sportspeople have managers to take care of their business affairs. So, why shouldn’t a superstar product? And if every product can aim to be a superstar, then they will all need their own Product Manager.

And that’s what we’ll look at in this article; the role of a Product Manager:

  • Why we need them
  • What they do
  • The breadth of their role

So, let’s dive into the world of Product Management.

Continue reading Product Manager: Strategist, Advocate, Keystone

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Triple Constraint: Time, Cost, and Quality

Triple Constraint - Time Cost Quality

Triple Constraint - Time Cost QualityTime, cost, or quality. Choose one. They are the corners of the triple constraint. And this is the most basic, most important idea within Project Management.

Project Management itself is a Big Idea that we have already covered. But when you are leading a project, the triple constraint is your guiding compass. It gives you the bearing for every decision you need to make.

Continue reading Triple Constraint: Time, Cost, and Quality

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Outsourcing: Outsiders Working for You

Outsourcing

OutsourcingOutsourcing feels like it’s been around forever. And doubtless, as an adjunct to business operations, it has. But, as a widely-used business strategy, it really only dates to the 1980s.

Since then, outsourcing has become a vital option for large and small business, and for many public services too.

So, what is outsourcing, why do organisations use it as much as they do, and what are the risks?

Continue reading Outsourcing: Outsiders Working for You

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Value Engineering: The Same for Less

Value Engineering: The Same for Less

Value Engineering: The Same for LessHow do some products achieve astonishing quality and functionality at affordable prices? The answer is in the discipline of Value Engineering.

Value Engineering is often tarred with the same brush as ‘cost-cutting‘. Although it has a similar role, it plays to a wholly different business strategy. So, let’s look at what it is and why it matters.

Continue reading Value Engineering: The Same for Less

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Governance: Steering the Good Ship

Governance

GovernanceIn a world filled with temptations to take shortcuts, governance is our defence. It provides us with the direction and control that maintain the standards that serve the many against the carelessness or abuses of those with power.

It feels to this observer that never in my lifetime has the need for governance been as great as it is now.

Continue reading Governance: Steering the Good Ship

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