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The Hot Topic in Finance

Yes, there are “hip” and “hot” topics in finance, including the key numbers to watch when assessing public companies. And there has been an interesting transformation over the years regarding what numbers were “hot.” In the late ’90s, 2000, and 2001, the key financial number everyone watched and talked about was EBITDA (earnings before interest, taxes, depreciation, and amortization). Wall Street looked for EBITDA to determine the health and potential of a company. Banks had EBITDA covenants in their corporate loan documents (some still do). EBITDA was even the hip topic of discussion at cocktail parties in the financial district.

But after the financial fraud of the late 1990s and 2000s, EBITDA is no longer the number to watch. The focus has shifted to numbers related to cash flow, with many public companies now reporting free cash flow, even though it is not a requirement to do so.

Why the change? First, Wall Street, bankers, and others realized that EBITDA was easy to manipulate. Companies that were monkeying with their books simply capitalized operating expenses (expenses that normally would be charged off in the current period were instead depreciated over several years). The move made companies' EBITDA number look better, thus getting more favorable attention. Obviously, much of this constituted the fraud we have read about, and WorldCom is the poster child for fraudulent expense capitalization. Lately, EBITDA lost its position as the key number on Wall Street because it could no longer be trusted.

Second, cash is also a lot harder to fabricate than profits. Cash is what is in your bank account. That is pretty easy to verify. Investors and bankers watching over these corporations felt a bit safer looking at cash.

And finally, and maybe most important, cash is really the key element in a healthy and growing business. Warren Buffett, possibly the most successful investor, focuses on cash; and in particular on the measure he calls owner earnings. His cash-based analysis has led to 40 years of successful investing, and now Wall Street and other investors are seeing the light.

For more information about free cash flow and owner earnings, check out these sites:

• http://www.investopedia.com/terms/f/freecashflow.asp
• http://www.investopedia.com/articles/fundamental/03/091703.asp
• http://www.investorwords.com/2084/free_cash_flow.html
• http://www.buffettsecrets.com/owner-earnings.htm

You can see that The Motley Fool commented on the fact that in 2002, analysts weren't looking at it as much as they should.

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Our Translation of Sarbanes-Oxley

If you step back for a moment from the specifics of Sarbanes-Oxley (fondly also known as Sarbox or just SOX) and look at the big picture, the goal of the law is financial transparency. Financial transparency is the exact opposite of what Enron, Worldcom and others did. They hid the actual performance of their company from the public. Financial transparency, on the other hand, means that a reasonable investor, shareholder, and employee can review the financial statements of a business and really know what is going on. A financially transparent company wants all those interested to understand their financial position because they believe that making things clear in the financial statements leads to a stronger business. And managers and leaders in today's organizations are on the front line of creating financial transparency. It supports good business decisions and it is good business practice.

But financial transparency isn't just about numbers. It is also about ethics and accountability, and about communication and education. Financial transparency helps to address these two key issues inside a company:

• Employees must trust that management is telling them the truth, and
• There must be a common language used throughout the organization to talk about the business.

Effective corporate financial transparency can help to transform an organization around these issues. When employees, managers, and leaders understand how the company makes money, how it measures financial success, and its current results and goals, trust increases and communication improves. Employees see that their work makes a difference, and managers and leaders have the opportunities to talk about the current situation and how their department or area of responsibility can make a difference in improving the results. Financial transparency, which consists of educating everyone about the numbers and then sharing the numbers on a regular basis, creates a trusting environment and a common language.

We believe that financial transparency truly does mean there is less likelihood of another Enron. It is interesting to note that virtually all of the corporate scandals were uncovered by an employee inside the company, someone who understood finance and accounting, saw that something was wrong, and spoke up.

Here is an example of a frontline employee understanding the policies of the company, and speaking up.

And here is just a little bit of background on the person who "blew the whistle" at Enron.

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A Case Study: A Business Literacy Transformation

Joe and I are owners of a consulting firm called the Business Literacy Institute. We work with mostly large companies, providing business literacy consulting and training products and services. All of our work is customized, so every program we deliver is different. The topics we teach, and the numbers we focus on, are based on the needs of the client. For some clients, we are in their catalog of courses, teaching Finance for Non-financial Managers once a quarter or so. For others, we develop programs for specific needs within an organization. In some cases, we help create a business literate workforce, creating programs for every level in the organization.

The work we did for one particular client was especially interesting because it resulted in an organizational transformation. The name of the company has been changed.

In the early 1990s a new regional vice president arrived on the west coast for ODS, Inc. She had worked in smaller regions and assumed that the work she did there would apply to this larger region. She quickly learned, however, that she couldn't connect with each individual, there were just too many. And then came the biggest shock of all—a union attempt. Although the union was not voted in, the vice president took it as a message from employees that they felt disenfranchised. Yet she knew that their teamwork and commitment were keys to long-term success. She came across the idea of business literacy, which fit with her philosophy that employees should be partners in success, and fit with ODS Inc.'s philosophy that employees are a competitive advantage. ODS Inc. already offered a strong salary and benefits package (including profit sharing). However she knew that creating a company of business people meant more than pay and benefits.

The first step at ODS Inc. was to conduct an assessment to determine employees' current level of understanding of the business. The assessment revealed, among other things, that:

• Employees didn't understand the information already being shared, although management assumed they did.
• Employees believed that their work had little impact on the success of the company.
• Middle management couldn't identify or define the organization's key numbers.

These and other findings informed the development of a business literacy program entitled "You Are the Difference," consisting of a classroom training program, Money Maps®, and a communication and reinforcement process. Everyone in the organization attended a 1⁄2-day training session that included ODS Inc.'s philosophy, strategy, income statement, and key measures. After the training, managers began holding weekly meetings, setting short-term "line of sight" team goals, and posting and discussing financial results.

Today, ODS Inc. is a different organization. The word "employee" is no longer used. Everyone is a business partner. (At one branch the employees took it upon themselves to order new parking signs so that the word "employee" effectively disappeared from the facility.) Customers send e-mails to managers, using the phrase "business partner" as they describe the high level of customer service and professionalism. Profitability has risen without an increase in sales. EVA (economic value added) results have jumped to new levels. Vehicle and worker compensation costs are down. Profit sharing is at its highest ever. And, just as important, trust has increased, turnover decreased, and morale improved.

Additional Recommended Finance Reading

We believe, of course, that every manager should read Financial Intelligence. However, as we said in the book, a good manager shouldn't just look at the numbers to understand his or her business. So, here are a few books we recommend to round out your reading list:

• A Stake in the Outcome—What can go right and what can wrong in small, closely held businesses when equity is shared broadly.
• First, Break All the Rules—One perspective on what people really look for in a workplace and what makes a company great to work for.
• Good to Great—What it takes to be successful in the long term. We especially love the hedge hog concept.
• Small Giants—A look at successful entrepreneurs who care more about success and lifestyle than revenue and growth.
• The Discipline of Market Leaders—An understanding of the strategy behind some of the biggest and most successful companies in the last 30 years.
• The Goal—Introduces revolutionary concepts related to managing a manufacturing company. Goldratt’s project management finance philosophy mirrors our own.

If you want to read more about finance, then try the books listed below. We've included a few about a concept called open book management, an approach to managing a company that has to do with the numbers, as well as with communication and education, and is in alignment with our philosophy.

• Great Game of Business—The philosophy and elements of teaching everyone about the numbers, sharing them on a regular basis, and sharing equity. Some would say this is true financial transparency.
• Maverick—An even more radical approach to opening the books, including salary information and performance reviews. Not for everyone, but the employee manual at the end of the book is worth the read.
• Open Book Management—Great insights and stories about successful companies that opened the books.
• Relevance Lost—An explanation of why managerial accounting has gone in the wrong direction in the last 50 years.
• The Interpretation of Financial Statements—A look at how great investment thinkers of our time looked at financials. Buffett looked to Graham as his financial mentor.
• The Warren Buffett Portfolio—Lots of financial analysis, so it isn’t for everyone. But great insight into how Buffett thinks and invests.

Finally, if you want a good financial analysis text (if you really want to get in depth into the subject of finance), we recommend the book below. However, there are many more good ones out there.

• Corporate Finance by Ross and Westerfield

Thanks

It has been great sharing our thoughts with you today. Feel free to contact either one of us through our websites, either www.financialintelligencebook.com or www.business-literacy.com.

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