In finance, we’re constantly chasing various financial metrics such as Market Share, Revenue Growth, Operating Margin, Earnings (EPS) and numerous ratios such as ROI.
When it comes to presenting or explaining these figures, we routinely jump around from metric to metric, often telling a story or injecting our hypothesis as to why these individual metrics are so promising.
Yet in doing so, we often either fail to think about (or conveniently choose to omit) the consequence that arises from piecing together a handful of metrics.
The reality is, focusing on a narrow set of metrics often causes problems in other areas to literally bubble up.
For example, a Market Share growth strategy sounds great, but it often forces you to discount price or significantly increasing acquisition costs.
Increasing Revenue growth is top of mind for most companies, but it can force the business to take on excessive levels of inventory or significantly increase payment terms (Increasing Accounts Receivable).
As a result, the strategic outcome is often short-lived and can even result in decreased financial performance.
The reality is, far too many of the strategies we implement suffer from this same fate, yielding outcomes that fall short of our original targets.
Why is this? What can be done to prevent bad strategy and why are we so surprised each and every time we repeat these same strategic mistakes?
Operations Management 101
For anyone who has had the opportunity to take an Operations Management course, you’ll recall that the main focus of the class is about the study of an entire manufacturing system or plant.
For anyone new to Operations Management, just imagine a conveyor belt in your mind with a series of individual assemblies or steps along the way. It’s not hard to recognize that upgrading the performance of any one of these assembles doesn’t actually increase the overall performance of the system. Rather, it just creates an additional buildup of goods in the system. This buildup is wasteful and costly.
Just like the conveyor belt, your strategy is likely failing for the same reason.
Avoid Local Efficiencies
In Operations Management, the term “local efficiencies” is used to explain the phenomenon of focusing on one or two of the steps without taking a holistic or systematic focus on the entire system.
In Finance this is exactly what we’re doing when we concentrate on individual metrics such as Market Share, Revenue Growth, Operating Margin, Earnings or ROI.
We think that if we improve the efficiency of one metric that it will flow through the entire financial system and result in increased shareholder value. But this is rarely the case.
Invest in Bottlenecks
In Operations Management, the only way you can reduce waste in a system is to understand where the bottlenecks exist. Once you can identify them you need to remove them.
In Strategy, we rarely refer to the term bottleneck when setting a strategy, but we should.
A bottleneck in operations is your biggest constraint. Identifying and investing into these constraints is what will lead to the most performance benefit because it enables the system to flow without a buildup of waste.
In Strategy, not only do we need to know where our bottlenecks or constraints are, but we need to focus our effort on investing into these constraints upfront. Breaking down these barriers early not only leads to longer periods of performance (increase in DCF), but it also enables us to fail fast (in cases where eliminating the bottleneck or constraint proves too difficult). After all, breaking down existing market barriers is a risky proposition.
In most cases, the bottleneck is the secret to establishing a competitive advantage over your competitors.
Why Cash is King
So, what is the secret to building a well-run financial system? Well, the answer turns out to be pretty obvious. Start by recognizing that Cash is king.
Of course, this is a term that we are all familiar with. However, in practices, we often treat Cash as a second-class citizen. Why is this?
I often hear the excuse that Cash Flow is just too difficult to calculate compared to Revenue or Earnings for example. Sure, to some degree this is true. But not because it is a more complicated answer, but rather because it is a more complete answer. I think this is an important distinction because having a complete view of the world is always more valuable than having a limited or partial view.
EBITDA, Earnings or ROIs are not complete answers. Providing management with the entire story is critical regardless of whether you are setting a strategy or running a plant.
Identifying the Financial Assemblies
If Free Cash Flow per period is the output then the individual steps within the financial system are Revenue Growth, Operating Margin, Taxes, Changes in Working Capital, Incremental Fixed Capital Investment and Cost of Capital.
In order to establish a competitive advantage, your financial system must be more efficient than your competitors. That’s the key to a successful strategy.
Oftentimes we equate Operations and Strategy as opposites, often competing for limited resources. Yet the reality is that Operations and Strategy are more closely linked than most people think. Sure, they are two different areas of business, but they do not invalidate each other. Rather they actually work together to strengthen each other’s cause.
The article was first published in Unit 4 Prevero Blog