The balance sheet reflects the success or failure of a company’s business strategy.
A successful business, in our view, is one that generates value, as defined by Alfred Marshall back in 1890;
‘Companies that generate a return on capital that exceeds the cost of that capital, create value.’
Modern accountants use a range of business performance measures which are designed to give a multi-layered view of the concern eg EBITDA, EBIT, Pre-tax etc.
Directors, investment professionals/analysts and the capital markets frequently focus on the performance of the organisation using such earnings-based metrics. Unfortunately, an earnings-driven perspective does not account for the overall cost of capital whereas the economic profit metric accounts for all costs attributable to the business including the cost of all capital used. To us, it is the most transparent mechanism and measure available to assess the health of a business.
So, it stands to reason that if businesses are using the wrong measures to judge performance, then it must follow that they are also making the wrong decisions and deploying the wrong strategies.
We have seen and continue to see plenty of examples in the world of football where clubs have misjudged their economic and financial performance which in turn has led to relegation, business downsizing and in some notable cases, severe financial difficulty.
In the UK energy supply market, the destruction of capital continues unchecked with the long-suffering consumer increasingly bearing the brunt of poor strategic management and an inability to curtail value destruction on an large scale.
In the UK supermarket sector, we have seen the fall of Tesco as a shining example of incorrect strategic direction based upon the wrong measurement of business performance.
Our latest work in the global pharmaceutical sector – which we aim to release in early 2019 – suggests that some companies are managing their businesses very well and creating significant returns for shareholders whilst others (including some very well-known names) are finding life increasingly difficult with poor strategic direction and consistent value destruction.
Our expertise lies in identifying the key value drivers in a business or market and benchmarking against peers. We then use this information to work on areas of improvement within the business using detailed economic profit and efficiency analyses that in turn will feed the necessary changes or amendments back into the business strategy and realign objectives towards a more robust balance sheet and value creation.
As the late Roberto Goizueta (former CEO of The Coca-Cola Company) said,
‘When you start charging people for their cost of capital, all sorts of good things happen’.
By deploying a value-driven strategy, Mr. Goizueta engineered a 7200% increase in the share price of Coca-Cola during his tenure as CEO.
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