The Hidden Devil in those Financial Numbers

Executives searching for actionable information in the financial statements of their companies find few clues to understand how they can manage their organizations to improve their present or future performance. One study by the Harvard Business School found that 66% of companies, with over $500M in revenue, set targets that exceeded 9% real growth. The results were starkly unsatisfactory with less than one company in ten achieving their goals. In fact, only 13% were able to achieve 5.5% compound annual growth rates while providing shareholder returns in excess of their cost of capital.

Companies achieve their performance goals by first defining their objectives and the means they will use to achieve them. They need to galvanize their workforce and communicate the strategy in concrete terms. Typically, companies make decisions in uncertain environments with insufficient knowledge of the business climate in which they operate. Consequently, companies iteratively learn from their experience in implementing their strategies to progressively improve their tactics to achieve their goals. Measurement of results by metrics is the means companies use to assess their achievements and reevaluate their strategies.

Companies define their goals in terms of market share gains, margins, customer satisfaction, quality ratings, brand image, etc. that will help them achieve their financial goals. Financial measures, such as NPV, IRR, and Rate of return on capital employed, etc., offer, at best, one measure of their achievements. In any case, companies need to know how they can increase their cash flows and lower their discount rates in order to improve their rate of return numbers.

The growing importance of the knowledge economy, consequently intangibles, is barely reflected in the financial numbers of companies. When assets like goodwill, intellectual property or reputation are valued, the numbers are far too controversial, due to the limitations of GAAP rules, to be useful for operating purposes. Intangibles such as customer loyalty or the customer life cycle values can have a critical impact on the future earnings of companies but barely receive a mention in most financial statements. Similarly, the reputation or the brand image of a company can influence a company's ability to raise funds from capital markets and to sustain the interest of customers over an extended period of time. The confidence of capital markets and customers in the company ensures that it is able to raise money at relatively low cost of capital.

Financial statements can mislead because the traditional methods of classification of items are not applicable to knowledge based industries. Expenses in services such as marketing consulting are an investment in the business model of the company which can help a company seize new business opportunities. The traditional financial measures, on the other hand, see such expenses as costs and don’t even begin to measure the performance of investments in intangibles or as variables in the determination of the financial results achieved by the company.

What's more, current accounting measures overlook several quantitative measures such as time of delivery, productivity, and quality and customer acquisition. When companies do have these numbers, they are often not detailed enough to indicate customers acquired for individual regions, product categories and by the time of the year. Companies need to compare the details of their performance with the best practices in the industry to be able to tell whether they have room for improvement.

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