Return to Cardinal measures

Financial outcomes

  • Of the many financial measures available, only three qualify as the top financial cardinals – the alarm bells that will prompt action in good time
  • They’re total revenue, total costs and profitability
  • All three are top-of-the-tree financial measures – the performance of each one is determined by many component measures below them – the ‘drill-downers’
  • The three are ‘catch-all’ measures covering outputs, outcomes and inputs viz:
    • Total revenue covers not only all outputs sold but also all outcomes the customers took into account before making their purchases
    • Total costs covers the total mix of all input resources used
    • Profitability covers how well all input resources have been used – a ‘total productivity’ measure in effect
  • In the public sector, there’s only one financial cardinal – Total costs
  • At times, if something goes wrong lower down the tree, it may not show up at the financial cardinal level – good performances can be cancelled out by bad ones when all task and process results are aggregated
  • But, if something goes badly wrong ‘down below’, it should be noticed not only by the manager responsible but also other cardinal owners at all levels – transparency, honesty and quick action are key
  • Hence, financial cardinals must always be presented in good time
  • To quote Dr Devi Shetty, chairman of the Narayana Cardiac Hospital in India: “If you get the profit and loss at the end of the month, it’s a post mortem, the patient is dead – if you get the profit and loss daily, it’s a diagnosis and you can treat”
  • The three financial cardinals must also be measured and monitored together – otherwise managers might make themselves look good by boosting one at the expense of another
  • For instance, senior managers have been known to buy another company to boost their revenue and profits growth record – but their capital employed will also have increased, so profitability, not profits, may fall


Financial cardinals – A ‘true and fair’ picture?

  • All cardinal measures must be accurate, up-to-date and easily understandable
  • But there is justifiable cynicism from some investors when official auditors sign off a company’s financial accounts – for example, they ask why auditors of the big banks didn’t alert their investors to the dangers about to decimate share values in 2008
  • They point to the way some big organisations somehow disguised their official financial positions viz:
    • Dick Fuld’s Lehman Brothers, whose collapse apparently precipitated the whole ‘credit crunch’ – they were accused of balance sheet shenanigans, albeit legal ones
    • Bernie Ebbers’ WorldCom and Bernie Madoff’s Ponzi scheme – both were convicted of worse and landed in jail
  • They ask why no analyst spotted the problems at Jeff Skilling’s Enron – in fact, Enron is said to have disclosed all in its accounts but enshrouded them in such mind-numbing detail that nobody bothered to dig deep enough and unearth them – so they got away with their dangerous operating – at least until they didn’t
  • The fact is that good financial analysts need to be ahead of such games and their players, not trailing behind


Financial measures – For investors:

  • Investors look for places to invest their money so they can make more than they would, risk-free, on a government 10 year bond, say
  • The best returns, albeit with the highest risks, usually come from investing in shares in companies, particularly if the investor can find good companies valued well below what they’re worth which have great potential to do better
  • According to Joel Greenblatt of Gotham Capital, the top two financial measures that long term investors should use are:
    • RoCE – Return on Capital Employed:
      • Good companies usually have a higher RoCE than others in their sector
      • They have a special advantage – a new or better product, a well-known brand name or a strong competitive position say – which keeps competitors from destroying their ability to earn above average profits
      • This strength lets them keep investing in their business model and earning higher than average rates of return
    • EPS – Earnings per Share:
      • One can always buy some shares at bargain prices – ones which offer a high earnings yield or a low PER (< 5) – ones where you could expect to get a much higher return on your investment than if it were risk-free
      • Over a year, most companies shouldn’t change in value by much, yet Mr Market’s sentiment about them can change wildly – n.b. the big differences between annual high and low prices for every company in the FTSE 100
      • There are always ‘above average’ and ‘below average’ prices on offer over time – it’s just a matter of finding them
  • Longer term ‘value investors’ estimate a company’s value by the returns it has made and expects, and then buy low at a large discount to this value – what Ben Graham called a ‘margin of safety’:
    • They focus on financial fundamentals, customer outcomes, quality of management and staff, and the capacity for successful R&D, growth and constant improvement
    • In good times, they expect managers to focus on meeting customers’ needs well (leading to revenue and profits growth) plus debt access and EPS
    • In bad times, they expect the same focus on customers plus on cash balances, debt obligations, solvency (versus liquidity) and shoring up balance sheets
  • On the other hand, many hedge fund managers think short term only – they’re not concerned with underlying business fundamentals and prospects for companies they long or short – they seek quick returns, gamble on daily ‘noise’ movements in a share price which can be at odds with all business logic and rely on herds or ‘bigger fools’ to drive markets higher, or lower, regardless of what they think is justified
  • And many managers since the 80s have aimed to maximise short term profits by squeezing everything else – hence static wages, falling investment and low growth

Revenue – R

Sales revenue measures are only needed by senior and sales managers, although they’ll be of interest to others  Revenue per annum is the key measure of an organisation’s growth – its ‘top-line’ growth  Revenue can be broken down as follows  

Costs – C

Managers at all levels must try to ensure their total costs are minimised and, if they increase, at least grow at a slower rate than revenue  To do this, they must break down the costs of all their input resources, especially those which are significant and controllable – there’s no point fussing over one which …

Profitability – P

It’s profitability, not profits, that matters most Profitability determines whether you have a good business or not, and whether the return those profits make on the capital invested (RoCE) is good enough   Return on Capital Employed (or Net Assets) – RoCE:   = RoCE  (or RoNA)    =        Profits/ Sales    x   Sales/ CE  =  …