Measuring What Matters There is an adage in business that says,?You get what you measure.??This suggests that we must introduce performance tracking metrics if we want to improve business

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JWI 531: Financial Management II

Week Three Lecture Notes

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MEASURING WHAT MATTERS What It Means With any business, there are countless sets of data that can be collected and analyzed. These data fall into every category imaginable, from marketing to operations to employee performance to, of course, finance. It is critical that financial leaders filter through the mounds of data to focus on the key metrics and ratios that matter most and use these Key Performance Indicators (KPIs) consistently to communicate results and drive improvements in the organization. Why It Matters

• If you don’t understand how performance metrics are changing over time and how you stack up to your competitors, you will be unable to develop, deploy, and refine effective strategies needed to win.

• You must use these metrics to communicate to your team members and business operators. It helps them identify patterns and look for positive and negative trends that impact performance and valuation.

• It’s all too easy to get caught up in “managing the wrong things.” Knowing what is most important

for the organization’s financial health empowers leaders to make better business decisions.

“Too often we measure everything and understand nothing.”

Jack Welch

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THE CHALLENGE AND OPPORTUNITY FOR MANAGERS

Understanding how a business operates can be complex and confusing. Many of us don’t want to admit this because we’re afraid it will make us look incompetent and unfit for leadership. But the reality is that even the smallest businesses have dozens of moving pieces impacting how work gets done and how money moves into and out of the organization. The challenge for financial leaders is not just to understand all the moving pieces, but to:

ü Cut through the noise to get at what really matters most to the organization’s financial health ü Communicate this to stakeholders in ways that can be understood ü Work with business leaders to drive activities that generate positive financial results

Every metric tells a story – the story of profit or loss. And, like any good story, it’s told in chapters or sections which must be assembled to understand the big picture. Each section tells you something different about the organization that will shed light on its financial health. For example, managers unfamiliar with key performance metrics often associate profitability or losses with parallel changes in the cash position of an organization, but this is not the case. Since cash flows are not used to define either revenues or expenses, the measurement of a profit or loss is disconnected from the cash position of the organization. An example of a key metric in the Income Statement is the Operating Margin, which is a measure of an organization’s efficiency in generating profits. Increasing your understanding of how revenues and expenses are incorporated into an organization’s financial records will make you a better and more effective manager. This week, we will explore specific ratios that will shed light on how to interpret profitability. As you learn how to interpret these key performance metrics, you can apply your knowledge within your own organization to improve operating performance. And last, but not least, if your company is public, it’s likely that most of your competitors are also public. This means you can look at how you compare to them in key areas, and you can start to ask questions about what can be done to improve your competitive strength.

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YOUR STARTING POINT

1. If someone asked you what the most important metrics are for your business, what would you

say? Could you explain which metrics gets reported for your business unit and why?

2. How efficient do you think your organization is at generating profits from your revenues? Has this changed over time? If so, why?

3. What performance metrics would have the biggest positive impact on your business if you could improve them?

4. How do you stack up against your competitors in key areas? Where are you strongest and where are you weakest?

5. Do you think your level of profitability has been satisfactory for the shareholders? How would you go about trying to determine that?

6. How can you better communicate key metrics to your team members?

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PERFORMANCE MANAGEMENT Staying Focused It’s not uncommon to see people’s eyes glaze over when they look at complex reports full of numbers and conclude that they are just obscure calculations that they will never be able to understand, but every number on every financial report is the result of real people doing real jobs every day. Your responsibility as a financial leader is to help the people who impact those numbers quantify what they do and connect it to the bigger picture of the financial health of the organization. Bragg offers the following guidance for CFOs, but this can be applied to any senior leader who is serious about using metrics to improve performance:

“The CFO should focus on a small number of key performance measurements over the long term, as well as a set of more specific measurements that are unique to the corporate strategy.”

The CFO Guidebook, p. 78 Examples of Key Performance Metrics The following metrics are of interest to financial managers and investors because they are effective tools that help to paint an accurate picture of how the organization is really performing. Bragg covers these in greater detail – including the relevant formulas – in chapter 5, but we summarize them here to demonstrate what a little digging can uncover.

• The Cash Conversion Cycle – The time period extending from the payment of cash to produce goods until the cash is received from the sale of those goods to customers. This is an important metric because it describes how long cash is invested in the business before it makes a return. Some factors that impact it include:

o Day Sales in Accounts Receivable – the number of days a customer has an invoice before it’s collected

o Day Sales in Inventory – the average amount of time it takes to convert inventory into sales

o Days Payable Outstanding – the number of days that a company takes to pay its suppliers

• Free Cash Flow – The net change in cash generated by the operations of a business during a reporting period, minus cash outlays for working capital, capital expenditures, and dividends during the same period. This is important because it is an indication of a business’s financial health, particularly of its ability to invest in new business opportunities.

• Working Capital Productivity – The comparison of sales to working capital. The intent is to measure whether a business has invested in enough working capital to support its sales.

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• Cash Reinvestment Measurements – There are several of these, but the key ones are: o Cash Reinvestment Ratio, which focuses on the proportion of cash flow that is reinvested

back into the business, specifically into the assets and working capital o Funds-Flow Adequacy Ratio, which is a forecasted measurement of cash flows to

determine if these will be sufficient for all projected company requirements

• Contribution Margin Ratio – The percentage of a firm’s contribution margin to its sales. This uses the product’s price minus its variable costs, resulting in the incremental profit earned for each unit sold.

• Core Earnings Ratio – This is a Standard & Poor’s ratio that strips away all non-operational earnings from a company’s reported results.

• Quality of Earnings Ratio – Companies can manipulate a lot of data in different ways in an income statement, but if you take the net profits, subtract the cash from operations, and divide this by average assets, you end up with a very useful metric that cuts through a lot of clutter.

• Breakeven Point – The sales volume at which a business earns exactly no money. It can also be used to model the point at which various mixes of product sales and fixed costs will trigger a loss.

• Margin of Safety – The reduction in sales that can occur before the breakeven point of a business is reached. This is great for highlighting risk factors associated with sales.

• Return on Equity (ROE) – The amount of return earned from equity invested in the business. This is a critical metric for investors and for calculating bonuses for senior managers.

• Return on Assets (ROA) – The return on the assets owned by the company and paid for by investors. The generic ROA formula is Net Income divided by Total Assets.

• Affordable Growth Rate – A great measure for developing a stable growth strategy. This can be estimated by assuming that a certain proportion of assets must be maintained in order to fund future growth.

Putting It to Work What gets measured gets improved. If you can’t measure it, you can’t tell if it’s getting better or worse. Study the key metrics that most investors look at and determine what’s critical for your business. You must explain to others on your team how these same metrics translate down to the operation of the business. You can use the examples covered by Bragg as starting points to get you thinking, but be selective. Otherwise, you will likely overwhelm your team. Work with your finance leaders and your operators to get the discussions started to: (1) identify what really matters and why, and (2) communicate the changes in as clear a way as possible to track performance, identify problems, and set goals.

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SUCCEEDING BEYOND THE COURSE

As you read the materials and participate in class activities, stay focused on the key learning outcomes for the week and how they can be applied to your job.

• Identify the most important financial metrics and ratios used to track performance Keep a list of the metrics and ratios financial analysts look at most frequently. Why do they focus on these? Go back to the 10-K reports for companies you are interested in and review their key metrics and ratios. What story do they tell? Pay attention to differences among competitors in the same sector. This is the best way to pinpoint relative strengths and weakness.

• Analyze key operating measures to assess efficiency and return Identify the Key Operating Metrics your team or company is most focused on. How are these tracked? Do you understand what each item means? Make a note of anything you don’t understand and ask for clarification. Remember, it’s important to look at how the numbers and ratios change over time (this could be weekly, quarter-to-quarter, or year-to-year) in order to shed light on whether business is looking better or worse. Without understanding how these variances are trending, you are dealing with a static picture of performance that does not provide your team with enough information to make well-informed business decisions. Get the whole team focused on asking good questions, such as: Are key indicators improving or declining? Is the organization becoming more or less efficient at generating profitability from revenue or assets? Are accounts receivable collections slowing down? Is inventory piling up?

• Communicate financial data to stakeholders to improve performance Analysis alone is useless. As a financial leader, your job is to take what you find and communicate it to stakeholders so they can act on it. Work with your financial leaders and your frontline operators to confirm the key metrics currently used are the right ones. Don’t just assume that what has always been tracked are the only performance indicators. Additional indicators that have not been tracked or shared may be far better at shedding light on opportunities for improvement. Bring these to your next team meeting and discuss them. Get the team talking about which metrics are moving in the right direction and which are moving in the wrong direction. What’s causing this, and what would need to happen to improve?

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ACTION PLAN To apply what I have learned this week in my course to my job, I will…

Action Item(s) Resources and Tools Needed (from this course and in my workplace) Timeline and Milestones Success Metrics