Strategic Alignment of Information Technologies – Part 3

The Income Statement

A company’s income statement[1] is a financial report that tells us what transpired over a range of dates that led to either profit or loss for the organization. Just like we have laid out balance sheet numbers side-by-side for easy comparison, we can do the same thing with income statement figures, as well.
By looking at ABC Widgets Manufacturing’s Income Statements spreadsheet, one might immediately note that year 2004 was a very good year for the company. The firm made PBIT (profit before income taxes) of $126,000 on sales of $8.1 million. Revenues for 2004 were nearly $850,000 more than the average in years 2005 through 2008.
Of course, one cannot help but notice that NPAT (Net Profits after Taxes) declined dramatically between 2004 and 2007, where it reached its nadir of only $2,000. Things were not much better in 2008 where it rebounded to only $9,000 on more than $7 million in revenues.
Once again, these are interesting observations, but it is still hard to tell – at a glance – the management implications of some of these numbers. What might help us would be looking at some of the working relationships (ratios) between various numbers supplied to us from this historical data.

Ratio Analysis

Ratio analysis allows us to look at a set of calculated values – calculated from the underlying data we have just reviewed – in order to assess more quickly our organization’s positions and trends relative to

1. Solvency
2. Safety
3. Working Capital
4. Profitability
5. Asset Management

Solvency Ratios

Current Ratio = Current Assets / Current Liabilities  Interpretation: Higher is better

This ratio simply tells you, at a glance, how many dollars your organization has available in “current assets” to meet the demands of “current liabilities.” As we can see, in 2004, ABC Widgets had a little over $2 ($2.05) in current assets to satisfy every dollar in current liabilities. However, by 2008, that number had dwindled to only $1.35 to cover every dollar in current liabilities.

Quick Ratio or “Acid Test” Ratio = (Cash + AR + Marketable Securities[2]) / Current Liabilities  Interpretation: Higher is better

The Quick Ratio is referred to as the “acid test” of solvency because it looks only to the firm’s most liquid assets to meet the requirements of current liabilities. In 2004 our sample company had nearly 80 cents to satisfy every dollar in current liabilities. By 2005 that number had fallen to only about 50 cents for every dollar in current liabilities and has remained almost unchanged since.

Safety Ratio

Debt-Equity Ratio = Total Liabilities / Equity  Interpretation: Lower is better

The intent of this metric is to indicate the ability of the firm to withstand adversity (from a financial perspective only, of course). It may be understood as the “risk” metric, so the higher the value, the higher the risk. Over the five years we are considering here, this firm allowed its Debt-Equity (D-E) ratio to drift well above 1.30 at times, but has recovered to the present 1.37. The “1.37” means that the firm owes $1.37 for every dollar it has in equity. Therefore, in the midst of adversity, even if the company could not meet its obligations from current assets, the firm’s equity could likely step up to help meet the challenges.

Working Capital

Working Capital = Current Assets – Current Liabilities  Interpretation: Lower is better
Working Capital is the spread (in dollars) between current assets and current liabilities. It measures how many dollars the firm has tied up in its supply chain. In general, it is better to reduce this number. Organizations with higher cash velocities tend to have less cash tied up in their supply chain.[3]
Cash Conversion Cycle = Inventory Days + AR Avg. Days – AP Avg. Days  Interpretation: Lower is better
An organization’s Cash Conversion Cycle measures how long – how many days – cash is tied up in the supply chain on average. Again, fewer days in a firm’s Cash Conversion Cycle is better because it is indicative of one or more of the following:

• More rapid inventory turnover
• Improved AR average days-to-pay
• Faster payment of AP vendors[4]

[To be continued]
©2010 Richard D. Cushing

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[1] Sometimes referred to as a “Profit and Loss Statement”
[2] In our examples, the firms have no marketable securities.
[3] Some speed-demon companies even manage to have “negative” Working Capital through special supply chain arrangements.
[4] Only vendors that supply inventory or other product-related services should be included in calculating AP Average Days to Pay.

Strategic Alignment of Information Technologies – Part 2

Setting Strategic Goals

Leveraging Technologies for Sustained Competitive Advantage

What makes new technologies valuable to a business?

• Answer: In general, the ability of the technology to contribute to a sustained competitive advantage[1] is what makes it valuable to an enterprise.

What about a new technology allows it “to contribute to a sustained competitive advantage”?

• Answer: Scarcity – the less available it is to your competitors, the larger will be your advantage in leveraging it
• Answer: Innovation – the more innovatively your organization applies specific technologies, the less likely your competitors will be able to achieve the same results or benefits

Consider the example of steam engines. When steam engine technology became available, for those that had direct access (e.g., they could afford to buy steam powered equipment), steam engine technology gave them a significant advantage over competitors that could not pay the entry costs to gain access to that technology. Similarly, those that did not have or did not require direct access, but could benefit from indirect access (e.g., they could afford to ship goods faster on steam ships or by steam locomotive), also had a significant and sustained competitive advantage over their competitors that had no such access to the new technology.

Basic Information Technologies

Today, information technologies provide only the following basic services:

• Data capture
• Data storage
• Data processing
• Data retrieval
• Data transportation (communications)

Since none of these basic IT services is any longer scarce, simply applying the technology in a routine sort of way – as a “copy cat” – cannot provide any long term competitive advantage to your organization. In all likelihood, applying IT in typical fashion will provide no competitive advantage at all.
At best, applying non-scarce technologies in a way that simply matches your competition might help you take your firm from “failing” to “competing” (see accompanying diagram), but such an application of technologies could not, in itself, take your business from “failing” to “leading.”

Strategic Planning Begins with Understanding Where You are Today

Since most organizations begin planning their strategies based on where they have been and what they already know, they generally turn to their in-house history-keeping systems – that is, their accounting applications.[2] We, too, will begin our journey by looking at a sample company’s historical information and considering some of the implications of the data presented.

The Balance Sheet

As many of you already know, the Balance Sheet is a “snapshot” of a firm’s financial position with regard to three categories: 1) Assets – what the company owns, 2) Liabilities – what the company owes, and 3) Equity – the difference between the value of its assets and its liabilities or what it owes to its investors.

In preparing our strategies for fiscal year 2009, our company “ABC Widgets Manufacturing” is looking back over five years of history. The organization has a balance sheet with a little less than $3.7 million in assets, about $2.1 million in liabilities, and $1.55 million in equity. With a quick glance over the spreadsheet we’ve laid out, one might notice the following:

• While total assets have remained fairly steady over the last five years, cash has shrunk by about 15% (down from $102,000 to $85,000) and accounts receivable are also diminished slightly.
• The company has invested significantly in the following assets over the five years we’re reviewing:
  
  • $590,000 in land and buildings
  • $354,000 in equipment
  • $97,000 in furniture and fixtures
• Short-term bank notes payable have zoomed from $211,000 to $589,000, an increase of $378,000 or about $95,000 per year (average).
• Accounts payable have also increased about 34% between 2004 and 2008, moving from $558,000 in 2004 to $750,000 in 2008.

While these are interesting facts in themselves, they really tell us very little about what might be good or bad about operations in general. So, let us turn to the same company’s Income Statements between 2004 and 2008.

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[1] “Sustained competitive advantage” is a relative term. In some rapidly evolving industries an advantage of six months or a year may be enough. In other industries, perhaps “sustained” would be an advantage lasting a year, two years, or even longer.
[2] We call accounting systems “history-keeping systems” simply because that is what accounting really is – it is the fiscal record of your organization’s historical transactions. While the historical data may be used to produce forecasts and budgets of various kinds based on purely historical data or upon a combination of history and “forecasting parameters,” the accounting system is useless in actually connecting “forecasts” with the actions required to achieve those forecast results.

[To be continued]

©2010 Richard D. Cushing

Strategic Alignment of Information Technologies – Part 1

The Changing Role of Information Technologies

Fewer than 50 years ago (in 1965), U.S. firms were investing less than five percent (5%) of their capital budgets in information technologies (IT). By the early 1980s, about 15% of capital expenditures in U.S. companies were going toward IT. A decade later (the 1990s), U.S. firms had doubled that number and were making capital investments in information technologies at a rate of about 30%. By 1999, in fear of significant failures due to the feared “Y2K problem,” U.S. firms were investing in IT at a rate approaching 50% of all capital expenditures. Even today, due to the challenges of competing in an unmistakably global economy, U.S. companies continue to invest huge dollars (about $2 trillion every year) in new information technologies.

By the mid-1980s, the increasing power of the (then) new Personal Computer (PC) was putting computing power within the reach of the pocketbook of even the smallest “mom-and-pop” operations. There seemed to be a growing consensus amongst managers of every ilk and in every trade and industry that, “If I could just get my computer systems to collect enough data about what my business is doing and how it’s doing it, I could manage flawlessly.” Some companies have been investing in information technologies, sometimes without much more thought about the investment than the underlying fear that if they did not invest in technology, they would somehow be left behind entirely.

Underlying Assumption

As the power and pervasive presence of information technologies have increased, many executives and managers have simply made the assumption that the strategic value of IT has increased right along with it. Some have made this assumption based more on what they see everyone else doing than upon any actual analysis within their own organization or upon any actual effort to align IT spending with strategic or tactical gains.

This willy-nilly approach to IT investment has been somewhat underwritten by the fact that many small businesses have no actual strategic planning mechanism in place anyway. The organization’s planning about the future or thoughts about how to attain certain future goals may still be contained wholly or in substantial part solely in the head of the owner (and maybe a handful of key managers).

Making the Leap from Entrepreneurial to Enterprise

One of the things that occurred in the late 1980s and through the 1990s was a relatively sustained period of economic growth in the United States. Fed directly or indirectly by the rapid opening of both domestic and global markets accessible via the Internet, there were thousands of new start-ups. Many of these new entrepreneurial organizations found rapid acceptance and grew at startling rates from miniscule one or two person operations to firms that employed hundreds or even thousands.

One of the challenges faced by owners and managers in organizations that find themselves forced to transition from entrepreneurial to enterprise is the discovery that what worked effectively when managing an organization with 15 or 20 employees in a single office may not be effective in an enterprise with 1,500 employees scattered geographically. Entrepreneurial managers were finding themselves forced to somehow capture the “tribal knowledge” resident in key personnel who still carried the vision that had led the organization to its initial success. Many times, the “tribal knowledge” was most easily captured and codified into “business rule” within new IT systems.

This series is intended to help executives and managers – whether or not your organization presently has a standard method for setting strategic goals – to establish some effective operational goals; to quantify the expected results as forecasts based on the goals; and in the final step, to offer some ideas about how budgets might be established and new technologies engaged to help achieve the firm’s goals.

[To be continued]

©2010 Richard D. Cushing

Safety Stock

Unfortunately, the calculation of the correct level of safety stock should be conditioned upon more than just lead time and average demand -- which are the limits of the standard approach to safety stock calculations. For example, what if the item is seasonal? What if the item has experienced unusual demand in the "average demand" calculation period? What if the item is subject to forecasts? The the accuracy of prior forecasts should be considered, as well. Yet another consideration is demand trends. Are sales at the facility increasing overall? Is the sales product line or purchase product line increasing or decreasing at a rate different than the overall trend at the facility.

Safety stock is specifically to cover variation in order to achieve specific levels of customer service; therefore, two goals should be held in mind and included in the calculation simultaneously: 1) achieving a specified level of customer service on the item and 2) minimizing inventory on-hand.

Good solutions for safety stock calculations should include replenishment factors that are dynamically maintained including:
1) Average lead time
2) Average daily demand based on working days (not calendar days or months)
3) Order cycle (for purchase product line)
4) Demand adjustments (for unusually high or low actual demand in "average demand" calculation look-back or look-forward periods)
5) Desired customer service level for item (SKU)
6) Trends

Few ERP software applications accomplish this task successfully.

Need help?  Contact me.