Finance and Lending
Beyond measure: when metrics limit your bottom line
January 23, 2017 |
The C2FO Team
The Vasa warship set sail on its maiden voyage on August 10, 1698. Carrying 64 bronze canons, and decorated with nearly 500 sculptures, the ornate and towering wooden vessel was the most powerful military ship in the world at that time, a testament to the might of Sweden and the ambitions of its king, Gustav II Adolf.
Twenty minutes into the voyage, heavy winds struck the ship. It listed to the port side and sank into the cold Baltic Sea. Most of the ship’s crew and passengers were rescued, but thirty men were lost. The maiden voyage of this mighty vessel was less than a mile.
The cause of the sinking was debated for over 400 years until the ship was recovered and examined by marine archaeologists. Their first clue to the mystery occurred when they found four rulers onboard that had been used by the builders. Two rulers used Swedish feet, which had twelve inches per foot. The other two used Amsterdam feet, which had eleven inches in a foot.
Upon the discovery, the researchers measured the Vasa’s structure. They discovered that every board of the port side was thicker and heavier than the starboard side. The defect, when combined with its top-heavy two-deck support structure and cannons, caused the ship to list to port in a heavy wind. Apparently, the builders worked on each side of the ship without ever comparing measurements.
A 400-year mystery was solved. The mightiest ship in the world was sunk, in part, because of two different rulers.
The conflicting metrics in your business
While the consequences are less dire than a shipwreck, your business has metrics that conflict, preventing better return on your investments.
One of the metrics is the Cash Conversion Cycle (CCC). For non-finance majors, CCC is a unit of measure for how efficiently a company manages inventory, accounts receivable and accounts payable. Investors and analysts use this number to compare different companies within the same industry. Thus, efficient management of CCC is correlated to good stock returns.
Corporate treasurers manage to CCC by holding onto as much cash as possible, often by extending terms on accounts payable (AP). Not surprisingly, payment terms continue to increase globally, with average days payable outstanding (DPO) for large corporates (more than $1 billion in GAAP COGS) ranging from a low of 51 days in North America to a high of 75 days in Central and South America1.
As effective as extending payment terms is to minimize risk and protect cash, the strategy sinks other business metrics: those tied to your supply chain health.
Supply chain disruption results in an inability for the buying company to meet demand. Metrics that result from supply chain issues include reductions in revenue, return on investment, production and market share. Or, it can result in a higher cost of goods from suppliers. Like CCC, supply chain health impacts your status with investors and your cost of capital.
Supply chain health is harder to measure than CCC, but it impacts returns. Spend Matters2 analyzed data available on public companies, finding that in 17 of the 20 largest manufacturing industries, higher shareholder returns correlated with shorter payments to suppliers and a stronger supply chain.
A less recent, but still relevant, study3 reviewed data of more than 800 companies that experienced supply chain disruption in an eleven-year period. On average, these companies reported 33 to 40 percent lower stock returns. The impact of supply chain disruption had an enduring effect as well. The study estimated that the businesses would need two years or more to recover.
Lengthy recovery is in part due to the fixed nature of supplier contracts. Contract lengths vary depending on the business and the industry, but they’re usually longer than a year are often two, three or five years, making it hard to respond to supplier distress.
Given the conflict between Cash Conversion Cycle and supply chain health, which is the best measure?
The truest measure of your business is your bottom line
The short answer is that neither of these metrics is a universal for your business. The metric that matters most is your bottom line.
For treasurers, says Gil Villacarlos, a corporate finance consultant and former director of corporate treasury at a Fortune 50 company, this means shifting your strategy from extending payment terms and holding onto cash to a broader strategy that uses cash for a better return.
“For example, let’s assume your company generates $5B in cash per year but only needs $1B for operational cash, giving you an excess of $4B,” he continues.
“A conservative treasurer may take the cash not allocated for mergers and acquisitions or other strategic initiatives and invest it in money market funds, government bonds or treasury bills. Unfortunately, right now that would earn you .01% or maybe .02%.”
“A better return on that cash is hiding in plain sight: your supply chain. If there are no other strategic investments in the pipeline, programs like C2FO allow you to use your cash to pay down AP and get a discount that could be 3-5% versus earning .01%,” says Villacarlos.
Dynamic markets like C2FO also let you respond to market changes. You can take advantage of real-time opportunities to make cash available when suppliers need it most or when you need to improve your bottom line. You also have the flexibility to choose when you want to take advantage of supply chain management or when you prefer to leverage other ways to use your cash.
Focusing on outcomes instead of metrics increases returns and strengthens your supply chain
Supply chain management through treasury solves the conflict between supply chain health and Cash Conversion Cycle. By focusing on increasing returns instead of increasing payment terms, everyone wins including suppliers.
Small suppliers swim, not sink, with access to cash. By giving a discount in exchange for early payment they access working capital at a much lower rate than their financing cost.
“For large suppliers, shorter payment terms offer a way to increase their revenue,” adds Villacarlos.
“Corporate cost of capital is a common benchmark, but it’s often in flux. If a company’s bond credit rating gets downgraded from A to BBB, their cost of capital immediately increases. Changes in interest rates or foreign currency exposures for global companies also affect the cost of capital. For an average BBB-rated company, the cost of capital is generally about 15-17%, so the quicker a company can convert that cash, the more it will earn in annualized investments.”
Preventing metrics from ruling your business strategy
It’s a bit hard to fathom how the Vasa could have been hand built by a single crew of builders and yet each side of the vessel —every board — was measured to a separate ruler. There were other flaws in the ship and in the process to build it. Many of these occurred because the king continually changed the requirements for the Vasa from the armament she would carry, to adding a second deck, to the length of the vessel itself.
Late in the process, the captain and vice admiral overseeing the Vasa’s construction discovered the top-heavy design issue during a stability test. However, the team continued working under direct royal pressure and amidst continually shifting requirements. They made only minimal adjustments possible to address the ship’s instability.
In the wake of the accident, the king initially blamed the crew for negligence. In the inquest that followed, builders and crew blamed one another. In the end, the original shipwright, Henrik Hybertsson — who drafted the original plan that was continually revised by the king during construction — was faulted. He died before the Vasa was complete.
After the inquest, the project’s leaders, who knowingly completed an unstable ship, and the vice admiral, who ignored concerns for fear of the king’s repercussions, were all promoted. Because the inquest was more focused on assigning blame than understanding the cause, no one ever questioned the shifting requirements during construction and the measurements used.
Questioning an entrenched standard like the Cash Conversion Cycle is hard. Investors and analysts use it to value your company, and company leadership often uses it to evaluate treasury’s performance. But managing to a single metric instead of an outcome limits your strategy — and your opportunity.
The economist Charles Goodhart first observed this pitfall. Goodhart’s Law states that when a given economic measure becomes a standard, it ceases to become a good metric. In other words, the value of that metric becomes the target instead of the larger outcome.
As with the team building the Vasa, sometimes you should question the measurements to succeed — especially under pressure of continual change.
A broader set of strategies helps your business navigate change
Had the Vasa proved seaworthy, the captain and crew would have faced many more challenges. Unpredictable storms, shifting winds. The rise and fall of tides. And war. The Vasa crew would have to outgun — and outsmart — smaller the vessels the large warship could not outmaneuver.
Fortunately, any cannon balls to our broadside are metaphorical in business. But the lessons from the Vasa‘s story are still relevant 400 years later in the age of Big Data and rapid change. Perhaps even more so now that we are flooded with metrics and it’s easier to get caught up in numbers and lose sight of the overall outcome.
We need to adapt our strategy in changing conditions. To question the metrics. And be willing to set a new course if it means a better outcome.
1 Rudd Bosman, The New Supply Chain Challenge: Risk Management in a Global Economy, FM Global, 2006
2 Kevin B. Hendricks and Vinod R. Singhal, An Empirical Analysis of the Effect of Supply Chain Disruptions on Long- run Stock Price Performance and Equity Risk of the Firm, November 2003, Production and Operations Management Journal, vol. 14, no. 1, pp. 35-52, 2009.
3 Solving the liquidity paradox: Opening the floodgates of liquidity to grow business