Wednesday, March 5, 2008

Financial Metrics and the CFO

You think your CFO controls your company’s financial performance, think again.

Corporations are economic entities. Most commercial corporations exist with a single motive: to productively engage in economic activity and create wealth for their investors, and value for their customers, and employees. The financial metrics measure the success of these corporations. Conventionally the office of the CFO owns these metrics, and takes responsibility for maintaining healthy financial numbers. Take a deeper look and you will find that there are few of these numbers that the office of the CFO directly controls. And that is where you, me and everyone else comes in – while the CFOs own and report these numbers, it is really everyone who affects them and therefore directly controls them.

Conventionally, BI (Business Intelligence) has looked at metrics as Strategic, Tactical, and Operational. While this view provides a good classification it really is no good from the point of view of answering – “so what”?

Here is an innovative layering of the financial metrics that will help you go in the right direction by providing discrete actionable information.

Indicator (Windsock) Metrics:

The top layer is what I call the Indicator Metrics. These are the top level metrics that provide a quick overview of company’s financial health. They are composite in nature and are made up of other metrics. One key example from this layer is ROA (Return on Assets). ROA primarily measures the effectiveness with which a corporation uses its assets in generating the profits. Metrics similar to ROA in intent are Return to Equity, and Return on Capital, and Margins (gross, net, pre-tax, operating or any other hue of Margins).

Let us look at the ROA. It is typically a product of Margin and Asset Turnover. Margin is simply profit on sales, and directly measures the profitability of the business. Asset Turnover measures how many times the assets are used over to generate the sales – therefore measuring how effectively a corporation uses its assets.

If ROA is a concern comparing with industry averages you can tell whether asset utilization is an issue or profitability. In mature, competitive markets, profitability is less controllable due to external market factors that are hard to predict and control, but asset turnover efficiency can provide a corporation competitive edge.

These metrics generally tell the direction in which a corporation should look for efficiencies, hence the name Indicator Metrics, or Windsock Metrics. There are quite a few other metrics in this layer such as the various Ratios/Liquidity metrics, and some activity and leverage metrics.

Dashboard (Traffic Light) Metrics:

The second layer of metrics is also composite in nature. These metrics form the basis of the top level indicator metrics. However these metrics provide a good indicator of the operations that need review. Continuing from the ROA definition above, we had established Margin as one of the factors (that contributes towards ROA). Margin consists of profit over sales. The profit in this equation is generally NOPAT (net operating profit after taxes). Now NOPAT itself consists of Sales, COGS, SG&A, and Taxes. With the exception of Taxes (taxes also can be managed to an extent), others are directly controllable. Again comparisons to industry averages can quickly establish which of these (say between COGS, and SG&A) have the most potential for improvement.

Major components for COGS for a retail company will be merchandise (purchase) costs, distribution (supply chain) costs, labor (store and warehouse) costs, and other indirect costs (for example the advertising). All these numbers need to be controlled and watched closely to align to the projected/desired COGS target.

I call the metrics in this layer as the traffic light metrics as these metrics can be computed on a more frequent basis, and color coded (like a Dashboard) to be Red/Yellow/Green to drive the prevalent action bias in a corporation.

Actionable (Tuning Knob) Metrics:

Finally the last layer of metrics that touches directly upon the daily operations of the corporation, and therefore provides the “Tuning” ability to affect the higher levels above. Drilling down from our example above, cost of Merchandise is a large component in the COGS for retailers. This cost itself is direct cost of the merchandise, as well as the cost of generating POs, and managing their life-cycles, cost of handling customer returns, cost of wrong shipments (inbound and out), cost of bad quality, cost of measuring process efficiencies (supplier compliance, conformance), cost of settlement, etc. These are distinct costs that arise from distinct business processes. And hence they measure the efficiency (or inefficiency) of these processes, giving the culprits or potential processes to be improved.

These metrics provide the tuning knobs that affect the dash-board and indicator metrics; because these metrics directly point to a business processes that need improvement. For example, if the cost of managing purchase orders is high (compared to industry standards), then the process of creating and managing POs needs to be investigated. The higher costs may exist because of an inefficient PO management process/system, or (surprisingly) reveal a sound PO management; but an inefficient replenishment system that creates an unnecessarily high number of POs. Either way; these metrics provide a directly actionable result and therefore can help in tuning the higher level metrics that are more indicative in nature.

Operational (day-in-life) Metrics:

These metrics help a corporation run their daily business more effectively, like a list of orders to be expedited, or fulfilled. They may not directly point to the weaker processes but provide information for root cause analysis. We will skip these in favor of retaining the basic intent of this article. However we will cover these in a later discussion.

So Who Controls the Financials Then?
With the above context, think again about who really controls the financial performance of your company? The metrics that actually allow you to impact the financial performance are contained in business processes that a corporation adopts. These business processes range from everything in supply chain to merchandising to manufacturing planning and store operations. And none of these functions are planned, strategized, organized, or executed by the CFO’s office. Next time you see a poorly performing number try and dig deeper, you will find what you can do about it by looking at the underlying process(es) and have an impact on your company’s financials. Then of course a progressive CFO’s office can help too by actually supporting such analysis! Pray you have one!

No comments:

Post a Comment