Extract: Creating Financial Value4 min read . Updated: 12 Jun 2016, 03:52 PM IST
Author Malcolm Allitt on how 'additional value' such as specialization can ensure steady financial growth in a company
Most executives who reach a senior position get there because...they proved their expertise in sales, or marketing, or HR (human resource), or IT (information technology)—not because they were financial experts. Whether you like it or not, the higher you rise in a company, the closer you get to the ultimate responsibility: to see that the organization generates cash consistently.... And if there’s one area where your training and preparation might have been lacking, it’s likely to be in finance and how it works," writes Malcolm Allitt, a long-time associate at the UK’s Ashridge Business School, in his new book, Creating Financial Value—A Guide For Senior Executives With No Finance Background.
In simple, digestible terms, the book offers an introduction to finance topics that senior executives need to understand to be able to participate meaningfully in the formation of corporate development plans and develop sound business proposals. It also explains how a business creates financial value, and how a non-financial manager can confidently take an active role in the process.
In various sections of the chapter “Measures Of Success", Allitt, who is also a part-time faculty member at Coventry University, UK, focuses on how simply making profit is not enough for the growth of an organization, while explaining the importance of taking risk and adding new value to the existing business. Edited excerpts:
For most people, risk is something to be avoided. It implies that the likelihood and the consequences of something going wrong are more....
In the case of a business, “risky" usually means that profits vary quite sharply up and down from year to year dependent on trading conditions or market cyclicality. Some people actually like to invest in “volatile" businesses because they know that on average and over the long term (several years or longer), they are likely to earn more than by investing in low-risk businesses. In the short term, the share price is just as likely to plunge as to soar, and this uncertainty is what makes most of us fearful.
Where should business leaders focus their attention?
To say that this is all getting complicated is an understatement.
The man in the street might imagine that making a profit is a good enough outcome for a company. But...a business needs to do a little more than just “make a profit"—it has to create a reliable stream of cash into the future, and the “acceptable" size of this cash flow depends on the riskiness of the industry in which the company operates.
If we want our business to succeed, then we need to be clear about:
u The routes open to us for value creation and their relative merits;
u The relationship between risk and required return of the various options we might consider;
u How to measure success and create appropriate way-markers to assure us that we’re moving in the right direction.
Where does ‘new’ value come from?
In days gone by, companies could tick along perfectly happily just doing the same this year as they did last year. The cash and profits they generated from their routine activities were comfortably enough to keep their investors happy.
Nowadays, businesses work in a much more competitive environment. It’s often said that a company which isn’t growing is getting smaller—there’s really no such thing as standing still any more. In that case, leaders need to think about additional value to that which is already being created. Where might this come from?
I’d argue that new value can be created in companies through at least six different routes:
Route 1: by being more efficient
That is, do what you’re doing, but make ever-better returns from the assets and capabilities you control;
Route 2: through specialization
This might sound obvious, but patterns of market development and differing characteristics between industries create both opportunities and threats for value creation. Company leaders should be mindful of this;
Route 3: through opportunism
This involves a combination of optimizing the short-term price/volume curve to maximize profit and making the best use of scarce resources;
Route 4: by being more effective
This means more or less doing what you’re currently doing, but in new ways to help create sustainable competitive advantage—either by increasing revenue or reducing risk (or both);
Route 5: by doing new and different things
That is, undertaking projects and developments which exploit emerging opportunities.
Route 6: by financial management
Although this area is generally the preserve of the chief financial officer (CFO), it’s useful to know that different approaches to capital structure, dividend policy and other aspects of financial management can in themselves create value.
Broadly, and with the exception of Route 6, these options are in ascending order of risk. On the other hand, the riskier options also carry the higher potential for reward....
Corporate leaders have to strike the right balance between the safe and the bold and even within an industry it’s easy to see markedly different behaviours between different companies’ management: there is not a one-size-fits-all approach to financial value creation.