I ran Tough Mudder Seattle back in September and one of my teammates made a comment about the 2008 Great Recession being explained in the movie The Big Short. I was aghast that false narrative had taken root. The Big Short gives the impression the 2008 financial crisis was the inevitable outcome of the last 30 years and not the result of one year (2007) of misguided government actions - actions that would've been modified with better financial understanding. Below I used what I thought were obvious references to what I saw happen when I compared great with suboptimal companies. This chapter picks up in the middle of a fictional story I used for illustration -- but the Enron and Lehman explanations actually happened. For more of the 'Functions' story refer to the full book. Enjoy . . .
16 Balance Sheet, Cash Flow & Taxes
We can see the impact of the P&L business model from the income statement in the Electronic Components Nogales and Outer Space Support rocket assembly building deals. We can also see how finance is used to drive four of Porter’s forces: competitor rivalry, buyer’s power, supplier’s power, and threat of substitutes. And we saw that great companies don’t compromise their business model for short term gain. The suboptimal do.
Maximum Overdrive and Illuminated Concepts, by chasing the short term, are in the change people, change programs, and cut costs to make money doom loop Jim Collins described in Good to Great. Many companies never recover from that doom loop.
As covered in Foundations of Excellence, customer first is not only a value but a prime directive of business. When the suboptimal companies compromise their business model by pursuing cost reductions to the exclusion of all else, they not only make less money; they fail in the customer first prime directive by providing substandard product. And that doom loop keeps rolling.
Compromising on the P&L business model also compromises on cash flow and the balance sheet. Below is a simple cash flow model. The numbers can be read as actual for a very small business or in 1,000s for a small cap company. The numbers in parentheses indicate cash payments or decreases in cash.
We can see a few things from this cash flow example. One is that cash is king. I thought I knew that but, as CEO of a small company, when wondering on a Monday if you have enough cash for payroll on Wednesday; you really know that cash is king. You can also see, in this example, that employees are the biggest category of cash paid out. Many finance guys reason, if we can cut employees in the short term and still hold onto the customer receipts, our cash flow immediately improves. That and costs on the P&L was why Steve saw critical employee cuts his first year at Illuminated Concepts.
Most of the time managers work the P&L but, as you can see, the cash flow statement is crucial. Companies use it to measure if their cash is covering their operations and if they have enough cash to buy the things they want, which could be other businesses. Companies have to make a certain amount of money on their P&L to grow their cash.
A couple other things are worth highlighting in this example. One, receiving payments from customers in a timely manner is important. A near universal measure of financial health of a company is how fast those payments happen. That metric is listed as DSO – days sales outstanding – which measures the average number of days it takes for a company to collect cash after a sale has been made. As you can imagine, happy customers pay more promptly than the unhappy. If customers are unhappy and delay payments so that $77,000 becomes say $50,000 in this example, the company would be bleeding cash even if it’s P&L is unchanged.
Another thing to notice is that the equipment upgrades, regardless of how their expensed, incur an immediate cash hit. This is why every industry from airlines to soda shops will delay equipment upgrades until needed. If the delay goes on too long, the short term cash preserved turns into a big long term problem. This is one reason why cash strapped companies struggle to improve.
Look at the loan section which covers debt management. This company is turning a significant amount of cash by taking loans and servicing those loans. Some finance groups take debt management to such a level that most of the cash churn is from this section rather than normal operations. Even when borrowing is inexpensive, it should be done in a careful manner. The reason I was tapped to become CEO wasn’t because the previous executives weren’t profitable; it was because their loan payments nearly drove cash to zero.
Startups, and companies that need to invest a significant amount of capital in things like a new plant or retooling, often use debt to raise capital. That debt is like credit card payments to a household budget. Debt can overwhelm a company’s income, even if it is profitable. The term bleed rate is used to measure how fast a company in this situation is losing cash. Investors will look closely at bleed rate to determine a new company’s future. One of the most famous examples of bleed rate was when investors began questioning Tesla in 2013 because of its losses. Tesla’s founder and owner Elon Musk famously invested $100 million of his own money to calm those fears.
Whereas the income statement and cash flow statement show changes in business over a defined period, usually a three month quarter; the balance sheet is a snapshot in time of the state of the business.
The balance sheet is described by the formula: Assets = Liability + Equity. Below is a simple balance sheet model. The balance sheet formula shows two equal numbers separated by an equals sign. The balance sheet itself always shows both of those equal numbers. This is called double entry bookkeeping and, in the West, traces its origin to Renaissance Italian cities of the 15th Century. The balance sheet is the centuries old T-Account ledger where debits are on the left and credits are on the right. A debit requires a corresponding equal valued credit with the same true in the reverse.
So what does the Balance Sheet tell us? If you tweak the formula to read: Equity = Assets – Liabilities; we can see the balance sheet shows the equity, the net worth, of a business in a snapshot of time. Equity simply means what your business is worth minus what it owes. In the example above, equity equals $12,000,000 or $17,160,000 minus $5,160,000. If someone owns a house worth $100,000 but owes $45,000; the house represents $55,000 of equity.
As net worth or equity is a prime stock price driver, there is mischief done on the balance sheet to maximize reported value. Enron is a good example of balance sheet mischief. After the TechWreck of April 2000, Enron crashed on what was called off book accounting. There were many other firms, like WorldCom, that crashed for the same reason but it’s worth looking at what Enron did to the simple balance sheet.
Enron was touted in 2000 in the Fortune 100 as one of the best companies to work for with 20,000 employees, extremely effective management, and some of the most stunning expensive facilities in the world. Enron was a Wall Street darling and, according to a Wall Street Journal columnist James Taranto, even had economics Nobel Prize winner Paul Krugman advising it. Enron typified the pinnacle of what clever financing could do.
But it was all a sham. Enron nested companies within companies and reported much of its balance sheet liabilities in those nested companies but not in its main entity. Why? Equity = Assets – Liabilities. By showing lower liabilities, Enron vastly inflated its reported net worth. That’s not all. Enron’s financial engineers not only contrived to lower liabilities, they used mark-to-market valuation to inflate the value of their assets.
Mark-to-market asset valuation is relatively new. Assets like land and buildings worth $10 million in 1970 would show on the balance sheet as being worth $10 million in 1975. Mark-to-market valuation says that if the land and buildings appreciated to $12 million then the value of the asset should be adjusted on the balance sheet. The assets now would be changed to what the market valued them. Going back to the formula: Equity = Assets – Liabilities; Enron was able to show massive increases in its equity, net worth, by taking liabilities off book and using mark-to-market asset value increases.
Mark-to-market asset valuation is volatile and it not only contributed to the 2001 recession, it was a key driver in the 2008-2009 Great Recession. Market valuation is too subjective. Who knows how the market values something? In Enron’s case, scores of financial engineers were brought in to estimate and model mark-to-market valuations.
Mark-to-market asset valuation enabled Enron’s financial engineers to attach value to a synthetic model on oil futures and again, vastly inflate the company’s value. All of it went up in smoke in 2001. The off book liabilities were discovered and the mark-to-market models were shown to be wrong. And Enron, Wall Street darling in 2000, ceases to exist. Arthur Andersen, a $9 billion accounting firm dating back to 1913, audited Enron’s books and was also pulled down.
After the jolts of 2000 – 2001 Congress decided to act and passed the Sarbanes-Oxley Act (SOX) to regulate and reign in fraud and provide stringent reporting requirements for mark-to-market valuations. I was Chief Operating Officer of a publically traded company when SOX was implemented and got to see the before and after regulatory results firsthand.
Before SOX implementation, in a quarterly board of director’s meeting, I was grilled by a board member on details of warranty costs as an indication of both quality and profit. That makes sense. The board members asked detailed questions about the simple financials to gauge the company’s management performance.
Fast forward five years to when SOX compliance was in full effect. We had in-house auditors, a costly expense that hindered R&D headcount, and a new CFO. I noticed a discrepancy in warranty costs and went to the CFO to ensure this was corrected in the board package. The CFO laughed and told me he’d once omitted a full page of a financial schedule and that the board of directors never noticed. The SOX-mandated third party audits convinced the board, most of which were the same people, that they didn’t need to personally question the financials. Unfortunately, I saw the same effect of quality regulation.
From my perspective, the added regulation didn’t help the situation. Simply better enforcing rules that companies like Enron violated would have been far more effective. Worse, the mandate of third party auditors provided cover for added complications. And the understanding of the financials across the organization and at board level went down. That enabled financial mischief that would have been caught at our company pre-SOX.
A final note on the effect of SOX mark-to-market regulation and the balance sheet. The U.S. by 2006 had the highest homeownership in history. At the end of 2006, the U.S. elected a large amount of new politicians. These new politicians wanted to allow even more to enjoy the benefit of home ownership. In 2007, these newly elected politicians pushed an agenda at odds with regulatory restraint. Those newly elected politicians bulldozed opposition and added an eye-watering trillion dollars of subprime mortgages in a single year. Subprime mortgages as a percent of the total increased from 4% to 8%.
Companies like Lehman Brothers had vastly increased their exposure to subprime mortgages in the real estate boom-times of the early 2000s. There was layering of risk in ridiculously leveraged multiples that a lot of folks want to point to as the cause of Lehman’s fall. But it was really the extra trillion dollars of subprime mortgages combined with the new mark-to-market asset valuations that did in Lehman. And it did in Lehman though its balance sheet. Lehman’s assets were once at a value far exceeding its liabilities. From the balance sheet, Equity = Assets – Liabilities perspective, it was a highly valued company.
In 2008, when people woke up to the fact that the value of a lot of subprime mortgages, which were assets on Lehman’s books, were overstated; the stringent SOX mandated mark-to-market asset valuation rules forced Lehman to report a crash in its value. Mark-to-market asset valuation was how Lehman lost 73% of its value in the first six months of 2008. They didn’t actually lose their assets, the assets were mandated to be valued less.
The Lehman collapse was the first domino that fell, leading to a global crash from which the world never fully recovered. It was not inevitable. It was bad political policy combined with bad financial understanding and management.
Financial principles apply to economies, big companies, and small companies. And you should know those principles. There are big and damaging consequences when employees and managers blindly trust their financial management.
There’s no need for blind trust. There’s nothing in the financials that defies logic and understanding. Push back on any finance person that tells you different. If you can see clear rules and business models then take the time to understand them. If you see close hold finance conversations and painful ad hoc judgment being made for deferrals or cost allocation; push back and demand an explanation. There is a reason profitability focus is a core value!
So it’s important that Dan, Beth, Cathy, and Steve pay attention to the financials of their companies. It’s even more important that we managers and executives at all levels own our numbers and not abdicate financial management responsibility to the finance group. It’s also important that we audit ourselves with much more focus than a regulatory agency. Regardless of your level, know and own your numbers.
What about taxes? Taxes come after initial financial performance assessment. The key measure I was held to in a private equity owned company was EBITDA which stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. I was judged on earnings before four other things were applied: interest, taxes, depreciation, and amortization.
We know what interest and depreciation are. As to amortization, think of amortization as a gradual reduction in a cost of value. Paying down a car loan is a good example. It is similar to depreciation which is a gradual reduction of value of tangible assets.
I was held, as CEO, to EBITDA, a measure that didn’t include either the gradual reductions or taxes. Most financial managers, and the government itself, will say to put a business plan together that makes sense as taxes won’t be a deciding factor. Taxes after all are just a cost of doing business and shouldn’t impact business decisions. But they do.
I opened an Asia manufacturing center as COO and was able to run a side by side comparison of the same product produced at both sites. It was as close to all things being equal as you could get in the real world. And, in a surprise, we were able to produce the product for 6% lower cost in Santa Clara, California, a place that at that time had a $600,000 average house price, than in our Asia site. And then taxes were applied.
For every $100 we made in profit in the U.S. on that product, $35 was owed in taxes. For every $100 we made in profit in Asia on that product, $5 was owed in taxes. The tax disparity was so large that it made no sense to continue to produce that product in the U.S. I had tears in my eyes when I realized the implications. To this day, there are dozens of workers in Asia doing what used to be done at that company in the U.S. due to misguided tax policy. Multiply that by thousands of companies and billions of salary dollars, add in other countries like Mexico, and you can see that taxation plays a huge role in how things are done. The U.S. corporate tax policies do untold damage. But that’s all the print I’m going to expend on taxes.
There are a few takeaways from this financial section. First, great companies have simple to understand and well communicated financials with long term goals. That allows great companies to better serve their customers and invest for the future. The suboptimal companies, by design, convolute their finances for short term reporting, use significant ‘at the moment’ judgments, and keep the understanding to a small group. This short term bias of poorly run, suboptimal companies often doesn’t even give them the short term results and, as we’ll see, does a disservice to their customers.