Consulting in financial management

14.1 Creating value

It is now almost universally recognized in business literature that the ultimate objective of all financial decisions – and indeed, of all strategic management decisions – is to create value. In the English-speaking countries this is explicitly seen as value for the common shareholders. In legal terms, this was never in doubt. The shareholders are the legal owners of the company. They provide its permanent capital funds. In a liquidation they have only a residual claim on assets, and they have a claim on the company’s earnings only after all other claimants have been satisfied.

Other providers of funds are lenders, who take a limited risk for a limited return. The shareholders take an unlimited risk and commit their funds without safeguards. In return they have the right to nominate a board of directors to supervise the company’s operation, and to ensure that it is managed in their interest. Dissenting voices are suggesting that equal weight should be given to the claims of other stakeholders – employees, suppliers, customers, lenders, the local community and even society at large. In practice, the two approaches can be harmonized. Paying due consideration to other stakeholders’ needs and interests is both a moral responsibility and good business sense and it is unlikely that value can be maximized in the long run if such considerations are ignored (see Chapter 23 for a detailed discussion of corporate social responsibility). But the shareholders are the ultimate claimants to the residual incremental value created after all the other claims have had due consideration, and maximization of shareholder value will be the underlying philosophy in this chapter.

Despite the clear ownership position of the common shareholders, it is only in recent years that shareholder value has come to be used as the basis for management decision-making. A first step in making the concept operational was to understand how value is created. In fact, three different concepts are in common use – though fortunately they lead to similar courses of action. One approach, pioneered and promoted by the consultants Stern, Stewart and Company, is market value added (MVA), which regards value as the difference between the market value and the book value of a company’s equity. Another view is the “free cash flow” approach, which takes the view that value is created only when the cash produced by a company’s operations exceeds the incremental investments required in fixed assets and working capital, and sees the value of a company as the present value of those future free cash flows. The simplest approach, however, and the one that will be used in this chapter, is that value is created only by making investments in which the return on invested capital (ROIC) exceeds the weighted average cost of capital (WACC).

The importance of a clear concept of value is that it provides the basis for developing a set of financial strategies and actions – value drivers – aimed at maximizing value. This is an area where finance and strategy come very close. Strategy is usually thought to be about developing a competitive advantage. The reason for a competitive advantage, though, is simply that it makes it possible

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– either because of premium pricing or through a cost advantage – to maximize the positive spread between the return on capital and its cost. On the assumption that the company is already using an optimal capital structure and accessing funds in each category as cheaply as possible, the focus will tend to be on finding the drivers that are the key to maximizing return on invested capital. This in turn leads to the identification of the key “drivers” in each area of operations. These will in the first instance take the form of financial ratios. The next step is to formulate a set of targets, guidelines and instructions on how performance in these key areas is to be improved.

It is also necessary to recognize that different operational drivers will need to be identified at different levels in the organization. At divisional level, gross margin may be a key driver. In an individual plant, capacity utilization may be seen as key. For the transport function within the plant, a driver may be as specific as access time per transaction. In every case, the drivers will have to be clearly explained to the people responsible. In the application of value-based management techniques a careful communication of the objectives of the approach to everybody involved is essential.

Shareholder value and executive compensation

Finance writers, analysts and consultants are increasingly aware that the interests of working directors and senior executives do not always coincide with those of the shareholders. The problem is usually discussed under the title “agency theory”, which postulates that the people appointed to act as agents in the interest of the shareholders may have conflicting motivations. A strategy of diversification of products or markets for risk reduction reasons, for example, may result from the fact that the professional managers are risk-averse. The shareholders, however, can easily manage risk for themselves by diversifying their shareholdings, and may prefer that the individual companies in which they invest stick to their core strategies. The problem is even more evident when the company receives a take-over offer: the price offered may well be a fair one for the shareholders, but the transaction may result in many of the directors and executives losing their jobs. The board may therefore advise the shareholders to refuse an offer which is actually in their interests.

One way in which companies seek to overcome this problem is to make sure that the interests of the professional managers coincide with those of the shareholders, by giving them shares or, more commonly, stock (share) options. The practice is a sensible one, within limits, and has the further benefit of making it less likely that key executives will be seduced into leaving and perhaps going to work for competitors. But two reservations must be made. One is that if the awards are excessive the practice may lead to shareholder protests, particularly if the company has not been able to increase its dividend payments at a similar rate. It is important to ensure, therefore, that any such awards are related to performance rather than automatic. Secondly, the widespread use of such incentives has largely coincided with a lengthy period

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of increasing corporate profits and share prices. If the economy were to enter a period of recession and of bear markets these practices would lose their value, and might indeed lead to widespread demotivation of senior executives who believed that they had foregone salary increases in favour of such incentive payments.

14.2 The basic tools

It will be difficult for the consultant to assist a client in the finance area unless this client is financially literate, that is, possesses some basic understanding of accounting and financial terms and procedures, and is able to use them in a simple financial analysis. Bringing the client up to speed in financial appraisal is therefore a prerequisite for further consulting work in finance.

This book is not the place to set forth the basic principles of accounting or of financial analysis. We assume that a professional consultant has already mastered basic financial skills. It may still be in order, however, to offer some advice as to how he or she should go about educating clients who do not possess such skills. A wealth of instructional material on financial analysis and appraisal is now available. So much material is offered, in fact, that the consultant can play a useful role by reviewing as much of it as possible and selecting an appropriate combination for the client’s needs.

Whatever medium is selected to provide instruction for the client, there are certain essential elements that need to be covered, and that the consultant will need to bear in mind in putting together a training package.

Bookkeeping

The conventional approach to the teaching of accounting invariably started with bookkeeping. For managers this is time-consuming and, we believe, unnecessary. The concepts of “credits” and “debits” can also be dispensed with. The emphasis should be not upon how financial information is collected, but upon how it is used in managerial decisions.

Accounting principles

There are some basic accounting principles that clients must understand because financial statements will otherwise be meaningless. The essential items are:

–the concept of accrual, and the resulting differences between “accounting” and “cash-flow” figures;

–conservatism, and the “lower of cost or market” rule;

–the concept of non-cash charges (depreciation and amortization);

–the distinction between the company (corporation), as a legal entity, and its owners.

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Financial statements

Clearly, the client must be familiar with the basic components of a financial report. Understanding the balance sheet is important. Some trainers and consultants, however, give undue emphasis to the balance sheet and largely ignore the income statement. The consultant should seek out material that not only gives equal time to the analysis of the income statement, but that brings together information from both documents to produce an analysis of sources and uses of funds.

Ratio analysis

Virtually all financial analysis involves the calculation and use of ratios. The problem is that there are so many ratios, and so many variations on them, that the client is likely to become thoroughly confused. Fortunately, nobody needs to be familiar with scores of different ratios. It is much better to select a dozen or so, and then become completely proficient in their use. But while a few ratios will suffice, the shortlist must include representatives of four quite different areas. They are:

●Liquidity, or the ability of the company to pay its bills as they become due. The quick ratio, or acid test, is clearly the most important ratio in this respect. For companies making significant use of debt financing, the times interest earned or interest coverage ratio is equally important.

●Managerial efficiency, as expressed in turnover. The most important ratios here are accounts receivable expressed in average daily sales, and inventories expressed in average daily cost-of-goods sold.

●Capital structure: the relative proportions of debt and equity funds. The actual ratio used may be long-term debt to equity, total debt to equity, total debt to total capital, or one of many other possible formulations. It is important to choose one of these ratios and to use it consistently.

●Profitability, the most important area of all. Ratios include return on total assets, return on equity funds, and many possible variations on these. While all are acceptable, it is important to supplement them with the one ratio that removes the influence of existing financial structure on profitability: earnings before interest and taxes as a percentage return on total assets.

Equipped with these basic tools and concepts, the client will be better able to explain his or her requirements and to understand the consultant’s analysis and recommendations. There are, of course, instances in which the client will prefer the consultant to do the financial appraisal, or comment on the financial appraisal done by the client. Here again, the consultant should use these opportunities to develop the client’s competence in basic financial analysis.

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