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Back To Basics
by Bob Ferchat and Tony Carlson

 
   
 
   

The world, and our perception of it, is becoming increasingly complex. Our sense of being in control, of being master or mistress of our own destiny, erodes with each day's headlines.

In times of uncertainty and high stress, most people return to their basic beliefs. Think back to the days immediately following September 11th, to the traditional religious and patriotic fervor that swept the U.S. and its allies.

In business, there are no mid-morning terrorist attacks, no collapsing buildings. The world of the corporate boardroom is subtler, more sedate, its denizens trained to remain aloof from emotional reactions, to be more rational in making judgments. But uncertainty and high stress live here as well, particularly now as losses plague the financial statements of a rising number of enterprises. Only the most insensitive directors cannot imagine the consequences of the decisions they make or ratify in their decorum-filled sanctum.

If there is stress (and there is), if there is risk (and there is), if there is uncertainty (ditto), how does a board member - even the most dedicated and committed - fulfill his or her responsibilities in only a few hours a month? What does he or she use to monitor the effectiveness of the decisions, the unrolling of the investment and product strategies? Are the feelings of the CEO or the financial reports of what happened yesterday enough? Is there something even more basic that a director can bring to bear as a check and balance on behalf of the shareholders?

Without question, the answer is yes. This article explores a range of key questions, requests for information and analyses a corporate board member should consider bringing to bear on the company whose owners he or she represents.

But first, some context.

Three Realities

The art of business has at least three facets.

First is accounting, attested to as a reasonable representation of reality by auditors, although everyone recognizes that it is a product of many estimates and judgments. That said, accounting is essentially a rear-view mirror, looking back at what has happened. What's more, the view changes with each new accounting period.

Second is the economic reality, the view through the windshield at what's ahead. It includes intellectual property, creativity, know-how and the assembly of systems for production and distribution. Brands and trademarks provide icons for the economic reality, as symbols of the reputation of the company. The economic reality changes much more slowly than the accounting facet, being more dependent on the response of markets to new products and services or to any substantive changes - up or down - in corporate reputation.

The third reality is the perceived value of the company as expressed in its capitalized value based on the market price of its shares and debt. This final facet changes minute by minute with the fluctuations of share prices, interest rates and spreads. It is the reality of dashboard gauges - the speedometers and tachometers of the enterprise.

Management's attention typically darts between the rear-view mirror and the dashboard. It is most concerned with the accounting reality, though executives are frequently held accountable for the perceived value. Thus, they spend a disproportionate amount of time with the infamous analysts of Wall Street.

On the other hand, the board of directors should be most concerned with the forward view, the economic reality which is really a reflection of the future earning power of the corporation.

Put another way, management has as its priority the annual budgets and quarterly reports. Meanwhile the board's focus should be on longer-term trends and the risks of capital.

The board's primary focus on strategy is just as important for older industries as it is for the new economy organizations. Always has been. Think back to the industrial revolution which spawned the factories of mass production. Even while Bessemer was reinventing steel making, and Mr. Ford was revolutionizing the fledgling car industry, the dominant industry of the time - agriculture - was making exponential improvements in the technology of farming and distribution of foodstuffs. And that produced a happy symbiosis. As the productivity per farm worker and per acre of farmland skyrocketed, displaced agricultural workers upped stakes in droves to populate the new factory cities. Similarly today, as we evolve the services and information economy, the productivity of old-line industrial companies must increase as per capita farm output did a century ago.

Basic Tools

As companies experience the ravages of the current recession and the re-alignment of the so-called new economy, corporate directors should have new tools to ensure vigilant stewardship. The SEC, Institutional Investors and other professional bodies are just beginning to zero in on - and carefully spell out -- the responsibilities of corporate directors. That can only mean greater accountability. It will no longer be good enough to leave it to the glaring illumination of hindsight to expose signs that should have been noticed, evidence that could have been examined, trends that could have been detected.

There are basic sets of information that a corporate director can and in fact must receive to perform with diligent responsibility. For instance, no director in this century should serve on a board where there is no company policy on environmental protection, health and safety for its workers, anti-discrimination and even corporate governance. Any lawyer would quickly advise that these policies must exist and the board of directors should receive periodic reports on their operation and enforcement. A modern basic.

New Strategic Tools

But other tools must come into play given that the board of any company shares the responsibility for corporate strategy with the executive management. This is not show-and-tell sharing, or easy concurrence with whatever management puts in front of the board. Rather, it is an active discussion of the alternatives considered, the competitive strengths and weaknesses of the company and its competitors, and the critical consideration of competitive responses.

Strategy has to do with the future and the economic value of the enterprise. It will bear heavily on the market value. It therefore becomes important to add new metrics to assess progress against the strategic curve and determine the points of no return, since by the time the rear-view mirror comes into focus, by the time accounting values reflect the results of a strategy, it is normally too late to change.

These metrics are available if boards insist on obtaining them. After all, strategy deals with new products, price positioning, new distribution, new images and style along with new geographical coverages and other measurable variables. In industries where growth is product driven, it also pays to look carefully and thoroughly at the potential cannibalization effect of the new on the old, with guesstimates constantly weighed against actuals as results unfold.

Strategies are also aimed at expanding market share or expanding the market itself. But we all know cases, unfortunately not rare, in which companies stayed with a strategy too long after it became clear that it was not working. As part of the board's strategic assessment, therefore, there should be a clear cut-off point agreed so that if the strategy does not achieve the expected results in a given time frame then it will be abandoned or changed. A "Go-No-Go" point.

Balance Sheet Focus

Almost all board meetings include financial reports on the profit and loss achieved by the company in the past financial period, usually a month or a quarter. The problem is, the danger for companies is usually not in monthly or even quarterly profits or losses. Rather, it rears its ugly head on the balance sheet. That is where under-utilized capital or insolvency shows up. Directors would do well to ask themselves and their colleagues how much time, relatively, is spent on balance sheet analysis versus the P&L at board meetings. In most cases, a little less P&L and lot more balance sheet is probably more prudent.

Companies get into financial difficulties because they have a shortage of cash to pay their bills or even to compete aggressively in tough times. Do board members spend enough time discussing the cash flows of the business and its plans? Probably not. Working capital can consume the economic vitality of a business unless it is managed and constantly reviewed for ways to reduce the assets involved relative to the revenues (i.e. increased turnover). The business models of the car companies -- with their scrupulous management of accounts receivable by factoring and "floor planning" dealer inventory --are wonderful examples of capital conservation. Inventories of raw materials and works-in-progress also turn very rapidly in the car producers. In a more 21st. century idiom, the financing of the growth demands of working capital at Dell Computer is Michael Dell's success formula. It is the envy of all his competitors. These two examples are basic and simple, but few competitors or sellers of other appliances are trying to copy them.

In that context, on a very pragmatic level, does your board even receive a trend chart on the aging of accounts receivable? How many proposals are examined to reduce the investment and improve the collection cycle or inventory turns cycles? Even a day or so in the collections or inventory cycles can mean a lot of capital conserved and decreased risk.

As companies struggle with a downturn in demand, many will increase the amount of inventory they carry. Intuitively, that is wrong. It increases risk. And that raises questions that should concern directors. For instance, what metrics and trend analysis is available to the board to scrutinize turnover of inventory into product revenue? Inventory is always composed of some fast moving items and some very slow moving stocks. Does the board see the trends for each class? Not complicated; just thorough.

Monthly or even quarterly data is of little use; longer term charting and analysis is much more appropriate. And it is management's responsibility to provide the information.

The management of the fixed assets of a company requires even more diligence than the purchase of items for inventory because not only do product parts and materials evolve but also the processes of manufacturing and assembly change. Companies can become wedded to an outdated process because they own the equipment, or they can change the process and shunt the equipment to the side, ignoring its lack of utility. Is there a regular review process in place to eliminate this locked-up capital and dispose of it? Does the board receive any information on the efficiency of the process? When equipment is purchased, is the alternative of buying used or slightly behind the technology curve examined? This is no trivial question. Just think how many very powerful and quite wonderful PCs are bought and then used for only a fraction of their potential as word processors and email devices.

The Supplier Cycle

A number of companies think it's smart business to stretch the payables and not settle with their suppliers when payment is due. Some "financial executives" see this as good practice, using suppliers to finance the inventory "free" of interest. But is it really?

Experience shows that companies that use fast payment as one of their negotiating tools are frequently given the better price, delivery and overall service. It only makes sense. The companies you buy from are frequently smaller than yours and cash is the most important thing to them. That's why they'll give the best price and service to the "fastest payer". It is always worth knowing, also, that if you pay the suppliers slowly, then your customers may act the same way and that is a losing equation. Not a magic bullet but a basic principle of wanting and getting the lowest cost.

Benchmarking

Benchmarking best practices is not just looking at costs or quality. It also should mean getting the maximum turnover of assets into revenues. Most business people would agree that return on investment (ROI) is vital for the ongoing financial health of a company. The ROI equation can be exploded to equal the product of return on sales (ROS) and Asset Turns (sales divided by assets). Profit/Sales X Sales/Assets= ROI. Therefore asset velocity is just as important to ROI as the percentage profit on revenues.

These are all detailed and basic, but surely diligence is a matter of making fewer mistakes. After all, professional sports teams most often win by making fewer mistakes than their opponents - and by taking advantage of the errors of the other team.

New P&L Perspectives

If the board must spend time on the P&L, then perhaps a different perspective is in order. Recognizing that the interest of the board is longer term and more economic than accounting, then one item in which the board member ought to be interested is change in the long-term trends of the company's break-even point. A rule of thumb: if that point is above 75% of the projected sales revenue, you might move forward in your seat a bit.

If administrative costs are paralleling upward revenue changes - or not following them downward -- then it's appropriate to inch forward a little more.

If your sales revenue is concentrated in a few customers or groups of customers, your vulnerability is increased and, suddenly, the quality and financing of large customers or groups is a primary focus for your evaluation of your risk. Just ask Nortel or Lucent if there are any doubts.

In short, all dependencies need to be evaluated. Is this a subject that your board addresses?

Weeding & Feeding

The governing bodies of the securities regulators are constantly asking for more information on business segments, both lines of business and geographic. Generally management and the board provide only the bare minimum in annual reports or 10K filings. Yet for the board's purposes, it would seem obvious that knowing the assets involved and the contribution of each product or service line of business and geographic segment would be fundamental to exercising a strategic overview.

In fact one of the most famous practitioners of corporate management, Jack Welch of General Electric, contributed enormously to the generation of wealth at GE by a process of weed-and-feed which eliminated non-contributing lines of business within the GE portfolio. Getting the right information about product line and geographic contributions could materially help the company.

Boards almost always receive reports on the accounting results for the period just before the board meeting. Since the board is more concerned with the future than the past, does it not make sense to have an equally intense review of future periods? This should be augmented by a causal analysis of why the forecast varies from the plan and what actions are being put in place to ensure that the future is optimized, not to mention protected from risks as much as possible.

The building blocks for future results also need to be discussed in so far as how the strength of assets - particularly the largely intangible intellectual property, personnel and know-how -- are being strengthened. There should be discussion about changes to the business model that are being made to enhance future ROI, again recalling that velocity is as important as cost reduction in the classical productivity sense.

Mergers and Acquisitions

Although the pace slackened a bit in 2001, media headlines continue to herald mergers and acquisitions. Nowadays, the big swallowing the bigger seems to be the ambition of many companies as the billions of dollars rocket skyward. In the "good old days" - six to 24 months ago -- it was the big companies inhaling the infinitesimally small ones at prices that would make Croesus cringe.

But whichever party is the aggressor, the point is that companies who manage "small" dollars well seem to get intoxicated and regard the "big" dollars as somehow different and less relevant to husbanding. Some of the capital that flows is equal to the total investment in the base company since its very inception. A hundred years of business history and many thousands of jobs -- to say nothing of the billions of invested dollars -- are bet on a merger that has been studied for a few weeks or months.

The track record of success for these mergers would have to improve drastically even to reach the level of abysmal. Yet the dance goes on. Why are these dollars, which are just as valuable and which have untold risks attached, treated in such a cavalier fashion? Why are shares - whose issue dilutes ownership so significantly -- not treated with the same reverent respect that is accorded a dollar of cost or profit?

Board meetings that consider these actions are usually longer and more carefully attended than others. But most of the pre-meeting reading and face-to-face time are taken up by the lawyers and their documentation of the transaction. Much less is devoted to more germane issues such as discussing the plan of integration. Market surveys and focus groups are routinely used by marketers before they commit to the public launch of a new product. Do companies have a parallel process to test the reception of merged product or service offerings? Do we have a process to solicit the opinion of the owners of the shares? Shouldn't we? Blind trust may be becoming as obsolete as belief in the tooth fairy.

As anyone who has ever experienced or managed the process of integrating two companies will attest, the real work of a merger or acquisition occurs after all the papers are signed and the lawyers go on to the next adventure in economic poker. The principle of honest, straightforward and frequent communication to the interested parties is often forgotten in an oversimplified logic that mistakenly holds that the legal agreements pretty much cover the waterfront. In fact, any merger or acquisition will, by its nature, slow down the processes of both companies. The only open question is, what is the duration of the paralysis that results from the trauma. Planning for the detailed implementation helps. So does recognizing the potential dangers. But most important is acting, insisting on clear, consistent and continuous communication of the plans . . . and results. Rumor and speculation will still exist in such an environment, but with good planning and execution, they will not dominate the day and extend the recovery period.

Given the amount of money and the lives that will be affected by mergers and acquisitions, it is critical to apply a much more sophisticated and detailed process to minimize the risk of gross errors that will play out at great expense and human tragedy. Sounds like M&A 101, doesn't it. But those media headlines - and the stories behind them - tell us that a few people must have skipped that class.

Summary

The responsibilities of a corporate board of directors are different in many respects from those of executive management, particularly at this time as the expectations of outside scrutiny increase. The restructuring of the economy and the disappearance of erstwhile household names in the corporate world should also give us pause.

Faced with accelerating change in the environment, we cannot suddenly develop new wisdom and insight. But we can get our hands on more and different information, sliced and diced in new ways to provide us fresh analysis and an improved perspective of the risks and opportunities that face the companies on whose boards we serve.

With that information and analysis, the fundamental truths apply: encourage asset velocity; husband cash; plan in detail for post M&A execution.

Basic perhaps. But critical to survival.


     
   
     
   

The Authors

 

Bob Ferchat - former chief executive of companies such as Bell Mobility and Northern Telecom Canada - and Tony Carlson are principals of I-Magin-ation Inc., a Mississauga-based company that creates innovative content for the Internet. Their first book, Tangled Up In The Past is an analysis of why big companies miss technology opportunities that are staring them in the face.

     
   
     
   
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Copyright 2002 by Bob Ferchat and Tony Carlson. All rights reserved.

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