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Businesses face real challenges in creating and sustaining profit. Notwithstanding the achievement of personal and family goals and the personal enjoyment of working in the business, management focus should be on increasing owner value. Owner value can be measured in several ways, the most common of which is in financial performance such as increased cash flow, increased equity, better utilization of capital and optimized profit to name a few.
Who doesn’t want to report better financial results? What’s often missed is the connection between financial performance as presented in the year-end financial statements and business strategy. Very clearly financial performance can be, and should be, used in developing, implementing and modifying business strategy.
There are several reasons why, often, no connection exists between business strategy and financial statements. First, strategy is about where the business is going while financial statements report on where the business has been. That is, what happened last year or in the last couple of years. Second, most businesses need to focus attention on the urgency of managing cashflow. Third, profit margins are often small and there is a tendency, and sometimes urgency, to try to better manage operations to achieve improved profit. Depending on your operational cycle, this can be a relatively short term activity. What should be looked at is what can be done strategically and longer term that would provide the results you want.
What needs to happen is to have business owners actually discuss, develop and agree on longer term strategy. That is, where do you want your business to be in five years and what do you have to do to get there.
The connection between financial performance and strategy development is two fold. Businesses should use financial performance indicators in developing strategy and once developed, they should use financial information to test what progress toward achieving the strategy is being made.
The following statement is an example of how a business can use financial performance in setting and monitoring strategy.
The owners of Smith Nurseries and Greenhouses will accept a minimum annual return on equity of minus 4% on combined operations and believe that the business should be able to provide a target return of 16%. It is expected that owner equity increases by at least 6% per year, maintaining an average leverage of 1/1.
Let’s take a look at the statement. What it is saying is that owners accept that once in a while, something will happen in the business, or in the industry in general, that results in a loss for the year. It is goes on to state that they believe that the business should be able to achieve a good return, if everything goes as planned. However, things happen in business, targets are often not achieved and they accept that as well. But, they expect that the business at least reports a certain return.
Businesses can make decisions that will increase the likelihood of achieving certain financial goals. Usually there is a risk associated with these decisions. Theoretically, the greater the risk, the greater the return. Often, the decision involves borrowing money. Businesses can actually report better financial performance by using more borrowed money. This is called leverage. So, the last sentence in the statement puts a parameter around risk associated with leverage. In this way, the business owner cannot simply borrow more money in an attempt to improve financial performance as expressed by return to equity because that would result in greater leverage and more risk.
The question then, is how does this translate into strategy? There should be discussion and agreement, between owners, on the indicators as described in the statement above. This activity is simply one of the things that owners must do in setting strategy.
It is generally somewhat easier to set the desired return, 16% in the example. Equity in your business is the difference between the value of all assets (all things you own in the business, including cash, land and buildings and equipment) and all liabilities (money you owe). Return on equity is the relationship between the equity in your business and your profit. If your equity (the difference between assets and liabilities) is $500,000 and your profit is $50,000, you have a 10% return on equity. Everyone would love to get a great return on equity, but this indicator should be set realistically. Can the business actually ever achieve this target? If not, then as the business proceeds, owners can find themselves disheartened by never achieving the target and this can be counter-productive.
It is far more difficult to set the minimum target. As noted, most businesses accept they will lose money sometime due to circumstances. The question is, how much. And in a business with multiple owners, there is very likely disagreement on what is acceptable here. Just how much money are you prepared to lose? If your answer is none, then what must be done/what strategy must be used to ensure this does not happen?
There is a follow-on point to make here. And that is, if you are prepared to lose 4% in a year, how many times will you accept this until you decide to do something differently in the business so that the chance of a loss is reduced? Again, what must be done/what strategy must be used? This is a difficult exercise to work through as most business owners are natural optimists and would rather think of all the positive things that will happen in the business than the negative ones.
The most difficult aspect is the expected return because this is the financial performance that, year in/year out, will be achieved given the normal operational variability that exists in the business; in this case 6%. Further, this decision should be made in the context of the opportunity cost associated with getting a return on the equity you have invested in the business.
In other words, assume your equity in the business is $500,000. If someone were to give you $500,000 cash and you were going to invest it, what return (expressed as the interest rate in money markets) would you require before investing? Having $500,000 in cash or $500,000 in equity is really no different; at least from the perspective of what return you want. Theoretically, if the business cannot achieve a 6% return, what must be done/what strategy must be used? Often when faced with this decision, business owners try to improve operations and/or expand. This often simply perpetuates and/or magnifies the problem. Sometimes significant strategies are used, such as diversification, to increase margins or even exiting the business.
Building owner value is vitally important and requires that businesses develop and implement strategies that are designed to achieve it. Financial performance can provide very useful information when determining which strategies to use and how they are measured. Clearly, financial performance should be much more than looking at the business ‘from the rear view mirror’!
By Terry Betker, Director, Agriculture - Industry & Government. For more information, please contact your local MNP advisor or Terry at 1.877.500.0795.
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