Financial depletion?

Integrated reporting jigsawAs the saying goes “…we live in interesting times!” Stock markets are testing historic highs in the US supported by price to earnings ratios that are also becoming the highest on record[1]. Yet if one reads various financial articles[2] we can see that many businesses are sitting on “hoards of cash;” cash that is being used is often assigned to buying back stock[3] – and not small amounts. What is happening? Is business running out of ideas for the future? It is even rumoured, in talking to people in business that capital investments that are being made are often looking for a one-year payback or less. Strategically that would not appear to make any sense if you want to be in business for the long term.

Maybe this activity is telling us something else? Could it be that those in leadership positions are confused about the future and are having a tough time assessing the risks that exist in the market place? If this is true, in an era of sustained profitability and solid EPS (Earnings per Share), then it might be a bit worrying. It could indicate that leadership is wringing out every last cent of profitability from the core business and hoping that the future will gradually become clearer. Once the US election is over; once the oil crisis stabilizes; once terrorism has been wrestled to the ground; once Brexit and the future of the EU has stabilized or at least become clearer? Often efforts to reduce cost on the core business can lead to enhanced short term profits, but can cause serious damage to the underlying ability to compete in the long term. Downsizing done poorly[4] can cause negative attitudes and reduce morale in the very workforce that is being expected to innovate and be creative.

For investors this might be a sure sign that that risks are increasing – especially since the world economy is moving through a new industrial revolution[5]; this is typically how many decision makers respond in facing the unknown – “focus on what we do know and maximize results based on that.” The risk of doing this is especially high when compensation often focuses on short term returns.

We also know that the global investment community was surprised when the “dot com” bubble burst but what it really demonstrated was that investors find it almost impossible to effectively understand and value many technology based organizations. Relying on past results is a challenge as projections of future earnings are based on assumptions and many of the assumptions are just opinions; sometimes only loosely based on facts. What this all may indicate is that investors need to be asking different questions. The problem is that when a “sea change” takes place in the environment within which we operate we are in uncharted territory.  Some talk about “big data” as being the salvation with effective ‘mining’ offering leaders the insight they need. Unfortunately, however big the data, it is still based on either history or assumptions.

For business, now is the time for clear visions of the future.  When IBM “bet on the computer” market it is rumoured that their research told them that the market for main-frame computers was probably about five.[6]  Bill Gates suggested that his vision was a “…computer on every desk”.  Lee Iacocca supported development of the mini-van before people realized what a great idea it would be. When Google acquired Keyhole, which was the foundation for Google Earth, the board, based on their trust in the judgement of Sergey  Brin one of the co-founders, allowed the idea to proceed with no concept of how they would make money out of it. There is a VERY narrow line between risk taking and irresponsibility but financial analysis alone, especially during paradigm shifting times, cannot indicate a right or wrong decision.  Rather, you just change the assumptions that change the numbers then roll the dice!

The greater the impacts of change the more important it is to have a broad based set of “sensors” available that can help indicate – as early as possible, if things are on track or veering off. While financial management and control are key, because running out of cash signals “the end”, it is the ability to assign cash resources to activities that generate value outcomes for the customer (reducing costs and assuring quality) that ultimately determines the success of any organization, by driving growth and revenues. Therefore any organization must pay close attention to the development of its human capacity while managing financial performance. Financial resources are used to pay people (in many cases the largest portion of expenditures) but people create value which drives business success and therefore should be thought of less as a “cost” and more as an “investment.” The competitive advantage of many organizations in the 4th Industrial will be their ability to optimize the creativity and innovation of its workforce. Thus the greatest risk for shareholders is allowing this to be sub-optimized by poor management. The challenge today is that many shareholders have no real idea whether management is enhancing the value and potential of its workforce or depleting it.

Several developments are happening that offer help in governance to progressive organizations; first is the growing emphasis on greater shareholder accountability in corporate governance.  For example, the recent paper by the UK based FRC (Financial Reporting Council) illustrates that culture is a key aspect of effective governance and should be addressed at board level (although it doesn’t actually say “how”). Second, the global shift in corporate reporting, towards a model based on the addition of 5 other “capitals” that has been developed by the IIRC as integrated reporting (<IR>). This model builds on the last thirty years of shifts from just financial reporting, to the triple bottom line, through corporate social responsibility and several other initiatives (such as CDR – Carbon Disclosure Reporting initiated by the investor community to gain greater insight into carbon risk).

Third, the development of tools to try and better understand how to identify and monitor non-financial assets that comprise an increasingly large proportion of financial value; and are in fact made up of the value that buyers are willing to pay to invest in the non-financial assets of an organization. Accounting calls this “goodwill”, which is crystallized in organizations accounts only when a buy/sell transaction, such as a merger or acquisition takes place.  However, even when such a transaction has not yet taken place, that “goodwill value” still exists and supports the value of an organization (roughly reflected in its share value and its market to book price). Given that this amount on average can now be up to 80% of an organizations value, then surely a board should be interested in what management is doing “behind the scenes” to enhance this value or, where it occurs, depleting value? The problem in relying solely on financial information is that the damage of non-financial asset depletion is often only realised when revenues fall, profits decline and market share is lost. At that point it’s often too late.

Given that human capital is probably the most important of the “new capitals” requiring attention, then boards should seek insight into the effect this has on other, value drivers. As an example, human capital, as the driver of innovation and creativity, generates most of intellectual capital, manufactured capital (such as systems) and a lot of social capital in areas such as customer and value chain relationships. The work of the Maturity Institute in developing a holistic assessment tool that can be used to determine, to what degree, organizations really do believe that “people are our most important asset” is a powerful step in the direction of helping understand and assess the current position and create a basis for moving forward. Using a tool such as this, boards can start to gain insight into the degree to which financial resources are being used to build a foundation for a successful 4th generation business of being used to “pay people” as part of the cost of doing business. This approach can be embraced within the new integrated reporting, <IR>, framework as an indicator of the development of human capital.  Shareholders will then be able to link management decisions to optimize profits through making judicious investments in building a people based culture: the crucible of future growth and success. Organizations can then finally move away from measuring the effectiveness of HR through “how many hours of training is being delivered” into something that has meaning in terms of linkage to the strategic goals of the business. Shareholders in turn will be able to better assess the risk of both short term earnings as well as long term viability and sustainability.

Nick A Shepherd, FCPA, FCGA, FCMC, FCCA

[1] A P/E ratio of 18.3 X as of August 3rd 2016

[2] http://www.nytimes.com/2016/01/24/magazine/why-are-corporations-hoarding-trillions.html?_r=0

[3] http://awealthofcommonsense.com/2016/04/what-do-share-buybacks-really-tell-us-about-the-stock-market/

[4] http://www.imanet.org/resources-publications/thought-leadership-new/new-strategic-cost-management/behavioral-aspects-of-cost-management

[5]https://www.weforum.org/agenda/2016/01/the-fourth-industrial-revolution-what-it-means-and-how-to-respond/

[6] Although this attribution is questioned by many – even though it has been used in several books and articles as attributed to Tom Watson, CEO of IBM

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