A version of this article appeared in the Autumn 2018 issue of strategy+business.
It is a truth universally acknowledged by business executives, Wall Street analysts, and investors the world over that cash is the lifeblood of an enterprise.
Free cash flow is a critical business performance metric. It’s how we measure successful investment and execution, how profit is distributed to shareholders, and how employees get paid. Without cash, a company folds. Irrespective of their size, shape, or footprint, businesses are on a continuous hunt for cash. At the same time, as the broader corporate goals are broken down into separate key performance indicators (KPIs), the primacy of optimizing organizational cash can get lost. In other words, the metrics provide no insight into how actions taken in one part of the business affect cash generated or held elsewhere. It prompts the question: If cash is king, why is it treated as a by-product rather than a focus?
I argue that the most important thing to look at in evaluating business performance is cash accessibility, or the ability of a company to use its free cash when and where it needs it. Businesses may have cash tied up in different places for a variety of reasons — often having to do with currency restrictions, banking regulations, and taxes — which can compromise cash accessibility. When money was cheap, there was usually a quick fix for this problem: Take on debt. But two things have changed. Interest rates are starting to rise globally, and tax regulations are shifting worldwide toward dramatically restricting the deductibility of interest expense.
Most companies do not have a handle on how accessible their cash is because their data collection and their reporting functions do not consider it a priority. The good news is that this can be fixed. The fix will require rethinking current performance measurements that optimize the wrong sorts of behaviors, and getting a better understanding of how to collect, analyze, and use data. Companies that are getting this right have a strategic edge because they have more accessible cash for their business. What they do with it, however, is another story.
The New Value Equation
Many companies are using an obsolete value equation. Thus, they have been unable to leverage performance management at the individual and team levels to drive sustainable firm-level success. Typically, current metrics look at the enterprise as the sum of its parts, totting up performance yields of individuals and teams in a way that loses track of their impact on cash accessibility. I propose a new value equation that maximizes accessible cash by optimizing internal and external relationships to focus on better targets. This requires leveraging purposeful data design and implementing performance management measures that incentivize behaviors aligned with strategy. Doing so will give an organization unprecedented insight into where the cash is and how company actions will affect its availability.
For a long time, the value equation for most companies looked like this:
Performance management + cost reduction = firm-level value
Value in this formula can take the form of profitability, return on assets, liquidity, stock price, earnings per share, Tobin’s Q (the ratio of the market value of a firm to the replacement costs of its assets), or any number of other (typically noncash) measures. The underlying assumption is that firm-level value is equal to the sum of the performance of the individuals in the organization and that this value can be maximized by eliminating waste in the supply chain. That makes a lot of sense, as long as you’re not particularly concerned with cash.
As is well known, it’s possible to have a great-looking income statement, but lack positive net cash flow. Businesses facing that scenario inevitably fail. I’ve seen senior executives become entranced by profitability, resource production, asset utilization, top-line revenue, and any one of a number of other measures. As a result, they take their eye off cash. The outcome is predictable: The income statement strengthens while the balance sheet weakens and, ultimately, the company falters because it can’t pay its bills.
Cash accessibility, in my view, is the most important thing to look at in evaluating business performance. Companies not only require net positive cash flow to operate sustainably, but they need that positive cash to be visible and as cheap and simple as possible to deploy. Cash accessibility isn’t the same thing as free cash flow (i.e., the difference between operating cash flow and capital expenditures), although free cash flow is certainly a component of it. In some situations, a company temporarily lacks liquidity or doesn’t have a significant amount of free cash to distribute because it has invested that cash in its business. In other instances, a company’s cash inflows outpace its outflows. However, that cash can end up in places where banking laws, export controls, and currency restrictions make it nearly impossible for the business to effectively deploy it. On paper, the company has the necessary liquidity. But in practice, it doesn’t. Water, water everywhere, but not a drop to drink.
Most companies do not have a handle on their cash accessibility because their data collection and their reporting functions do not consider it a priority.
Historically, companies have managed a lack of accessible cash mostly by borrowing from external sources. That wasn’t a bad strategy as long as the company had the capacity to service the debt. There has even been a tax incentive to take this route in the majority of countries, as the interest paid on debt from third parties was fully deductible for income tax purposes. Inspired by cheap money, companies took on record amounts of leverage and went to work growing the economy and rewarding shareholders. In a February 2018 report, Standard & Poor’s cited statistics showing that nonfinancial corporate debt as a percentage of GDP reached 96 percent globally in 2017, representing a 15 percentage point increase since 2011. This metric is important because it highlights just how much companies have binged on credit in recent years.
At the same time, though, companies produced record profits. In many cases a cycle has emerged wherein companies have become more and more dependent on easily accessible cash from banks and other external sources to generate the record profits needed to service their growing debt. That’s all well and good until interest rates go up while corporate debt matures and companies find themselves unable to keep up. Many companies are closer to this scenario than they may realize. A 2016 refinancing study by Standard & Poor’s indicated that more than US$4 trillion in corporate debt will come due through the year 2020, and central banks continue to indicate that additional rate hikes are on the horizon. In its report to Congress earlier in 2018, the Federal Reserve highlighted (pdf) the vulnerabilities in the U.S. financial system resulting from leverage in the nonfinancial business sector and the recent increase in the net issuance of risky debt.
Traditionally, interest rate increases haven’t been a particular concern in a robust economy. This is because high corporate returns generally covered any additional cost of borrowing and international tax laws often allowed for generous caps on interest expense deductions. But, as the result of actions by the Organisation for Economic Co-operation and Development (OECD) in recent years, as well as new tax legislation in major economies such as the U.S., interest expense deductibility limits are being significantly reduced.
Although cash accessibility should always have been on companies’ radar screens, rising interest rates and tax reform initiatives around the world are now forcing greater attention on the issue. But because the focus has traditionally been free cash flow, as opposed to accessible free cash flow, no standardized financial reports, ratios, or metrics exist to measure or assess it. Companies in general do not understand that the actions they think are right and accretive to the overall corporate strategy are actually hurting the business — because they are eroding cash. In my experience working with large enterprises, both domestic and multinational, the amount of cash that is potentially accessible is typically in the tens to hundreds of millions of dollars annually. Regardless of whether the market is bullish or bearish, that’s a compelling story.
The “Cash Grid”
Every business has places where cash is generated and places where it is consumed (to generate more cash). It’s the finance equivalent of the circle of life.
The way that cash moves in an organization is analogous to the transmission of electricity. To get the energy from where it is generated to customers, the power company relies on something known as a grid, a network that transmits electricity from one location to another. It’s important to note that the total energy delivered to customers via the grid will always be less than the amount generated at the plant. Why? Because it takes energy to move energy. That’s known as transmission cost.
If a grid is poorly maintained or spliced together from several different grids that no one ever really figured out how to rewire, it moves energy less efficiently, increasing transmission cost. Over time, less and less electricity gets to customers and the power company loses value literally into thin air. Eventually, the power generator may have to buy energy from other sources. Worst of all, the company may not even realize the full extent to which its inefficient grid is bleeding value because the grid itself is so complex that it offers no transparency into what’s really happening.
The same is true for cash. Most, if not all, financial reporting shows neither where cash is really available nor the true cost of getting it where it’s wanted.
The Role of Enterprise Financial Reporting
Broadly, companies have three distinct dimensions to their accounting: financial, management, and tax. Financial accounting (the “reporting” lens) is primarily concerned with the production of financial statements that provide external stakeholders such as investors and banks with insight into a business’s operations. Standards and rules for financial accounting are set by international and local bodies.
By contrast, management accounting (the “operational” lens) is not required to adhere to any particular set of conventions, standards, or rules. Its aim is to produce internal-use-only financial reports that give business leaders relevant information so they can make better decisions.
Finally, there’s tax accounting (the “legal entity” lens). Tax accounting is focused on producing financial reports that adhere to the statutory requirements for the jurisdictions in which a business must file and pay taxes. Revenue authorities set the rules.
Within each of these accounting disciplines, data exists to give us insights into cash accessibility. Unfortunately, that data is scattered throughout the organization, obscured, and often overlooked. Because of the ad hoc way in which each part of the organization has come to generate and use its data, it’s hard to get the full picture.
Let’s take a look at just why that is, using a hypothetical company, Obtuse Angle Enterprises, or OAE. OAE is a multinational enterprise that designs, manufactures, and sells an array of industrial products and is traded on a U.S. stock exchange. In total, OAE is made up of four business units (management reporting entities), matrixed across territorial organizations (legal entities) located in different countries. Each business unit has its own profit and loss statement based on OAE’s internal management accounting policies. These management reports play a significant role in determining compensation and promotion decisions for business leaders.
The business units buy and sell goods and services internally, buy from external vendors, and sell to external customers; each business unit conducts business in multiple countries.
When a product moves from a U.S. factory to a Canadian sales office in the same business unit, leadership isn’t concerned about the price charged between the two because it’s a wash when it comes to the income statement. However, OAE has a distinct legal entity in the U.S. and another one in Canada, and the transaction has immediate cash impacts for both of them, involving currency exchange, income tax, customs duties, sales tax, and other factors. In the tax accounting dimension, the price matters greatly. In contrast, when two business units in the U.S. transact business, the price of the goods sold may be of interest to the leaders of those two units, and it thus makes a big difference in management accounting. But it is less relevant from a tax accounting standpoint because the entire transaction takes place within a single legal entity.
It gets even more complicated. For example, let’s say that a business unit based in Denver has historically purchased all its repair parts from another business unit’s factory in Tulsa, Okla., at a price established by OAE for management accounting purposes when the company was first set up more than 25 years ago. Over time the prices charged between third parties in the market drift farther and farther away from the price set for OAE’s internal transactions. Incentivized to maximize the business unit’s income, the Denver leaders stop buying the repair parts from Tulsa, after finding that they can purchase the same products at half the price from an online retailer in China.
The next year, Denver’s financial results improve, thanks to materially reduced cost. The Tulsa unit’s results stay close to the same because repair parts are immaterial to its overall business. Yet OAE’s bottom-line profitability and cash flow shrink. OAE’s management is puzzled. If the business units do the same as or better than before, how can the company overall end up in a worse position? None of management’s current KPIs shed any light on the situation. We know that an increase in inventory carrying costs along with a slew of unintended tax and currency consequences related to the purchases from the external vendor in China are to blame, but that’s only because we can see what management can’t: Relationships and behaviors in the business, driven by well-intentioned but poorly designed incentives, are maximizing individual results to the detriment of the overall company.
In many companies today, the corporate tax and treasury departments are working to identify and mitigate the consequences of the behaviors and relationships that negatively impact cash. However, it isn’t enough to manage the outcomes on the back end. To create and sustain shareholder value over the long term, companies must be able to see, intelligently evaluate, and drive strategically accretive behaviors and relationships within and between the layers that directly contribute to positive free cash accessibility. For that to work, companies need to reimagine not only their approach to reporting, but also their approach to performance management and data design.
Rethinking Performance Management
At its most rudimentary level, performance management is concerned with the measurement, improvement, and enhancement of individual knowledge, skills, and abilities. The discipline is predicated on the belief that managing these factors will result in greater success for the organization. Both human resource scholars and practitioners have long hewed to the generally accepted principle that maximizing individual performance leads to maximum organizational performance. However, little empirical research directly links the performance improvement of individuals to improved firm-level performance.
The key assumption in the existing value equation is that individual performance is accretive overall. From this perspective, a company is analogous to a bowling team, in which the individual bowlers’ scores are added together and the team with the highest score wins. But in many companies, such as OAE, the scores don’t always add up that way. It is possible for one or all individuals or units to maximize their own results, and still produce an outcome that is detrimental to the whole.
And that brings us to the new value equation, one that maximizes accessible cash as a means of creating sustainably increased shareholder value. It looks like this:
Sustainably increased shareholder value = maximum accessible cash = internal and external relationships optimized to focus on cash + purposeful data design and insightful reporting + performance management measures that incentivize behaviors aligned with strategy
To make this new value equation a reality, companies need to master the “subtle science and exact art” — as J.K. Rowling’s Severus Snape might put it — of aligning the seen and unseen business relationships in the three reporting lenses. This entails coordinating relationships that create value and drive profit as seen through the management lens with the resulting transactions in which cash can be put at risk in the legal entity lens (and obscured in the reporting lens). It’s time to adopt a better approach, one in which the same transaction can easily be tracked, with its implications for management, reporting, and the legal entity visible to all.
- Liz Sweigart specializes in advising multinationals on structuring, pricing, and executing inter- and intra-company transactions. Based in Houston, she is a principal with PwC US.