Harvard Business School Confidential
Page 16
Notes
1. David Mayer and Herbert M. Greenberg, “What Makes a Good Salesman,” Harvard Business Review 42, no. 4 (2006): 119–125.
2. Thomas Steenburgh, “Personal Selling and Sales Management” (Module note), (Boston: Harvard Business School Press, December 2006). Module notes are prepared for the purpose of aiding students in specific knowledge area.
3. Jeffrey Fox, How to Become a Rainmaker (New York: Hyperion, 2000).
4. Thomas Steenburgh, “Personal Selling and Sales Management” (Module note), (Boston: Harvard Business School Press, December 2006). Module notes are prepared for the purpose of aiding students in specific knowledge area.
5. Tom Peters, “Wherefore The Impact Of Superior Management Practice on Increased Human Welfare and the Pursuit of Happiness* and Excellence?” n.d., p. 22. Available online: www.tompeters.com/blogs/freestuff7uploads/TP_Purpose083107.pdf (access date: January 18, 2009).
6. Thomas Steenburgh, “Personal Selling and Sales Management” (Module note), (Boston: Harvard Business School Press, December 2006). Module notes are prepared for the purpose of aiding students in specific knowledge area.
7. Dianne Ledingham, Mark Kovac, and Heidi Locke Simon, “The New Science of Sales Force Productivity,” Harvard Business Review (September 2006): 124–133.
8. Ibid.
9. Ibid.
10
FINANCE
PROFIT IS NOT CASH
One of the most fundamental concepts in finance is “cash is king.” Most people find income statements intuitive. Sales minus cost equals profit; what could be simpler? Hence many people think about starting, investing in, or running a “profitable business” where profit (the bottom line) is attractive. However, few realize the difference between profit and cash, and often realization comes only when they are trapped in a cash crunch. (If you have experienced cash crunches before and can understand very well why it is critical to monitor and plan cash flow rather than profit, you can skip this chapter. You already know the key principles.)
If you are unsure why cash is key, take a look at the examples in Tables 10.1 and 10.2. It is an exaggerated example to illustrate the importance of looking at cash rather than profit.
The company had no sales last year because it was being set up, but the projection for the current year is 100 percent guaranteed. Would you buy Y at US$100,000? It looks like it cannot be that Table 10.1 shows how you can make your money back within the year!
But would it make a difference if you were to learn the following tidbits:
Instead of the normal 30- or 60-day credit terms, Y gives customers 13-month credit terms. This means US$1 million revenues will be collected next year, not the current year.
Table 10.1 Projected Profits
Company Y Annual Profit and Loss for the Current Year (US$)
Revenues 1,000,000
Costs of goods sold 400,000
Salary, rent, other expenses 300,000
Net Profit 300,000
Unfortunately, Y’s suppliers, employees, landlords, and other debtors are not as lenient. They all need to be paid 30 days after goods are delivered (suppliers), at the end of the month (employees), or even at the beginning of the month (rent).
Now what? All of a sudden, the financials are changed. Your cash flow projections for the year will look like Table 10.2.
So, you won’t just need US$100,000 to purchase the company, you also have to have US$700,000 cash to operate the business in the first year! You will then get the projected US$1 million in revenues after the first year. Therefore, as Harold Williams, the former chairman of the Securities and Exchange Commission, commented in Forbes, “If I had to make a forced choice between having earnings information and having cash flow information… I would take cash flow information.”1
Table 10.2 Projected Cash Flow
Company Y Cash Flow for the Current Year (US$)
Revenues collected 0
Costs of goods sold 400,000
Salary, rent, other expenses 300,000
Net Profit −700,000
Profit is an abstract entity. Profit is not tangible. You cannot touch or count profit. You cannot pay your bills with profit. Only cash is real. Your suppliers will gladly accept your cash—but not your profit. In one extreme case I saw, one of my clients sold his products to a company that subsequently went bankrupt. The company was profitable on paper. However, to push sales, the company’s management gave its customers a 24-month installment payment plan. To make it worse, no one at the company was following up with the customers to collect. Salespeople considered their jobs done once a sale was made. Also, since maintaining a good relationship with customers was important, salespeople did not see any benefit in pushing for on-time payment. On the other hand, finance department was mostly made up of clerks and bookkeepers. They were very diligent and accurate in recording payments when the payments arrived but they did not see getting the payments in the first place as their responsibility. Unfortunately the bank was not as “disorganized” as my client was. My client’s company was forced into bankruptcy after it defaulted on a few payments owed to the bank.
In the same way, the more time you get before you actually have to pay your expenses, the better it is for your cash flow. It is well-known that the travel agency business in Hong Kong has very thin margins. I was told that in some cases an agent makes only US$2 to $3 on a US$300 air ticket! So why are there still so many travel agencies? One of the reasons is cash flow. Travel agencies get you to pay prior to your trip but they often do not pay the airlines, hotels, and restaurants (for package tours) until much later. In the years before the 1997 Asian financial crisis, many travel agency owners would use the cash flow to invest in real estate. All became very rich, though many lost a significant part of their wealth after the crisis.
LET BYGONES BE BYGONES
Cash is king but cash that has already been spent and is largely irretrievable probably should not be considered in future decisions. This is the all-important “sunk cost” concept. Here is a trap that is easy to fall into:
You invest in a stock and it is now making a loss. It isn’t clear when (or if) the stock will rebound. Instead of selling it and redeploying the capital to other, more attractive investments, the temptation is to hold onto the stock in the hope that its price will bounce back to above the purchase level.
Sunk cost does not always have to be about money. For example, suppose you’ve already spent days reading this book and you are almost finished. You have found it boring and have not learned anything from it. Looking at the table of contents, none of the remaining topics really interests you. But instead of putting the book away and reading another book that may be more interesting, you figure maybe you should finish reading this one since you “have read so much already… may as well finish it.”
Many people fail to apply sunk cost when they are making decisions.
There are a variety of reasons for this:
Lack of experience or training. As a result, they fail to quickly recognize what is sunk cost and what is not.
Loss aversion due to human psychology. Whether they are conscious of it or not, most people are naturally averse to loss. This could be due to the need to save face, or to the psychological difficulty of accepting that the earlier decisions were wrong and a loss has been incurred.
Loss aversion due to corporate pressures or misaligned incentives. Employees do not want to have to admit to their superiors that their decisions have led to waste. Management does not want to admit waste to shareholders. For public companies, admitting waste may mean whatever is sunk has to be taken off the current year profit (a write-off). This will also affect share price and possibly the careers of those involved.
Loss of objectivity. The examples presented thus far are deliberately straightforward to illustrate the concept. But in reality, some parameters are always estimates rather than definite numbers, making it tempting to hold out. For example, if you are deciding to hold or se
ll stock, you have to compare the future prospects of your stock with other investment options such as other stocks or properties. The different options may have different risks, growth prospects, and so on. Hence comparing these options will involve estimation and possibly some subjective judgment. Well-known experiments by psychologists have shown that people often become more optimistic about their investments once the investments are made (see sidebar). This means that in this example, even people who understand sunk cost may be overly optimistic about the option they have invested in compared to their other options.
Loss of Objectivity on Sunk Costs
A number of well-known experiments have been conducted to show that people often inflate probability estimations on the outcome of an investment once the investment is made. One of the best-known ones was conducted by R. E. Knox and J. A. Inkster in 1968.2 In the experiment, 141 horse bettors where studied: about half who had just finished placing a bet in the past 30 seconds and the other half just about to place a bet in the next 30 seconds. The bettors were asked to rate their expectation of their horse’s chances of winning on a seven-point scale—the higher the point, the higher the expectation of the horse winning. The result—3.48 average for the people before betting and 4.81 average for the people after betting. Subsequent experiments done by Knox and Inkster and a number of other psychologists produced similar findings.3
Hence, it is easy for even experienced businesspeople to fall into the sunk cost trap. Sometimes, decision makers have to be replaced so an organization can avoid the sunk cost trap. In the Harvard Business Review article “The Hidden Traps in Decision Making,” the authors cited a real-life example:
One of us helped a major U.S. bank discover that bankers responsible for originating the problem loans were far more likely to advance additional funds—repeatedly, in many cases—than were bankers who took over the accounts after the original loans were made.… had tried, consciously or unconsciously, to protect their earlier, flawed decisions. They have fallen victim to the sunk-cost bias. The bank finally solved the problem by instituting a policy requiring that a loan be immediately reassigned to another banker as soon as any problem arose.4
ASK, NICELY
For most companies, regular financial statements including the income statement, balance sheet, and cash flow statement are generated regularly by accounting staff using accounting software. Key measures can be read off or calculated from these statements based on definitions approved by authorities (accounting rules, tax laws, rating agency guidelines) and by management.
To explain the construction of financial statements and all the possible key measures that can be derived from the statements is beyond the scope of this book. They are not difficult, just full of details. (A slight digression here: I strongly advise that anyone interested in business should take at least a course in accounting. I had one course in accounting during my undergraduate days at Stanford. The key principles I learned there have served me well even to this day. A degree or an accreditation in accounting would have been even better, even for someone who does not want to be an accountant. Besides in-depth knowledge that is useful in management, such qualification can also open the path to a career as a CFO, which could be another way toward becoming a CEO. Without the academic qualification, such a career path is not even an option.) HBS does not teach details of how to prepare financial statements. Such data is usually already provided in the case studies. It is assumed that in real life, these statements would be prepared by qualified accounting personnel. Therefore, the focus at HBS is on mastering how to exploit the financial statements to get the data necessary to make critical decisions. The key is asking two questions— “why?” and “so what?”—and then answering them with data and logic.
Why
Asking why forces the discipline of identifying root causes. In finance, causes are often called drivers: revenue drivers, cost drivers, growth drivers. By identifying and managing the drivers, management can use them to push revenues up and costs down, and to accelerate growth.
So What
“So what” questions should be tirelessly asked until it drives you and everybody a little crazy. This includes asking:
“So what?”
“So what does this mean?”
“So what are the action items?”
If you are getting financial data that won’t allow any of these questions to be answered, then the question becomes “so what are we doing collecting and looking at this data?” I have seen many long financial (or operational) reports filled with detailed data. But much of that data was never really read or used by anyone. Such data collection becomes a routine and no value is created.
I have included a real-life example of using “why” and “so what” in Appendix A. These two questions are powerful in helping to identify root causes and critical actions. But care must be taken not to alienate people. While some people (maybe your boss) will be impressed by your active and strategic thinking, many others (especially your equals) may react negatively for a variety of reasons:
It can sound very arrogant if someone else produced the data and you keep asking “why?” or “so what?”
People may feel intimidated or resentful when asked questions they cannot or are not prepared enough to answer, especially when you are asking them about what they are supposed to be expert in.
It might cause jealousy. People may perceive you as flaunting your own alleged insight rather than genuinely trying to solve the problem.
If people are alienated, they will not support your brainstorming wholeheartedly. Worse, they may become your political enemies and try to sabotage your effort behind your back. As a result, think carefully about how and when you ask these questions. Some possibilities of making the whys and so-whats less alienating:
“I am not an expert; Mr. X will know better. Could the reason be … ?”
“I was talking to Mr. X the other day and he mentioned one of the reasons was .… What do you think?”
“If this is the data, could it mean ….”
“I wonder what this means….”
“I think Mr. X has already implemented some initiatives to deal with this. Maybe the data is indicating we should support him in expanding his effort .…”
In short, unless you are with a group of people totally open-minded on brainstorming, it would be advisable to plan and ask the questions in a politically sensitive manner.
An interesting illustration of the need for caution with questions is from the media—I saw the Nicolas Cage movie National Treasure a while ago. In the movie, Cage’s wife drives him crazy and almost to a divorce because she keeps asking him, “So?” Cage misunderstands her intentions and feels she is constantly pressuring and questioning him. They only manage to reconcile after they rebuild their mutual trust by undergoing a major adventure together and beginning to communicate properly.
IPO: THE HOLY GRAIL?
The initial public offering (IPO) is when shares of a company are first sold to the public and subsequently traded on a public stock exchange. Newspapers are filled with stories about entrepreneurs such as the founders and initial staff of Google, eBay, or Alibaba who became billionaires overnight because of their IPOs. As a result, many aspiring entrepreneurs constantly talk about an IPO as their only end goal. It is worth noting that while IPOs can definitely be good things, they have their downsides. Often, there are other options besides IPO that should not be ignored.
IPOs can be glamorous and lucrative. This is because:
An IPO is (mostly) for companies that have achieved certain milestones and have an attractive growth potential.
Capital from an IPO can fund a company’s growth.
Before the IPO, entrepreneurs and other shareholders cannot easily cash out of their investment. The IPO provides liquidity for shares owned by entrepreneurs and pre-IPO investors. This means shares turn from “paper money” to real money.
An IPO is usually accompanied by significant press covera
ge and PR effort. Entrepreneurs who started significant companies, like the founders of Google or Amazon, often attract much media coverage and become well-known and prominent public figures.
However, an IPO comes with certain downsides, too:
IPO itself is a time-consuming and expensive process involving lawyers, bankers, PR agencies, and many others.
Confidential information such as company strategy and financials have to be disclosed to the public, competitors, and potential competitors.
Share price and effort to maintain share price may distract management or, worse, lead management to make certain decisions that are focused on the short-term rather than the long-term.
In countries like the United States, disgruntled shareholders often sue a company and key management when profits are lower than forecast.
An IPO is important because it is one of the most common ways to exit (or “cash out”) of a new company. Exit is often necessary for a very practical reason. Many investment funds are not set up to own businesses in perpetuity. They have a defined, finite time horizon and they need to return the invested capital (hopefully, plus a profit) to the fund investors by the end of the agreed period. An IPO is only one way to exit or cash out. Another option is acquisition by another company. While it’s less glamorous, acquisition can often be even more attractive than an IPO:
An IPO requires that a company has reached a certain size. Acquisition does not.
The acquisition negotiation and due-diligence process, while lengthy, is simpler and less expensive than the IPO process.