What the CEO wants you to know.
By Ram Charan
(how your company really works)
(Ram Charan is a highly sought adviser to CEOs (including GE, Ford, DuPont, EDS, Verizon). He got his DBA & MBA from Harvard and taught at Harvard.)
This is a small pocket book is on business acumen and a good example of the fact that only experts /guru’s can simplify complex subjects.
When it comes to running a business successfully, the street vendor and CEOs of the enterprise talk and think very much like. They speak a universal language of business. They practice a universal law of business.
I learned those business fundamentals as a child growing up in a small agricultural town in northern India. There I watched my father and uncle struggle to make living selling shoes from their small shop, a joint family enterprise. With no experience and no formal training, they competed head to head against others in the town who were also trying to eke out a living.
You may be a top-notch professional, but are you really a business person? Regardless of your job, dept., you need to develop your business acumen.
As you learn to see your company as a total business and make decisions that enhance its overall performance, you will help make meetings less bureaucratic, more focused on the business issues. Time will go quickly, as it does when discussions are constructive and energizing. You’ll get more excited about your job because you will see that your suggestions and decisions help the business grow and prosper. You will have a greater sense of purpose and your capacity will increase.
When you learn to speak the universal language of business, you can have meaningful discussion with anyone in the company, at any level. You will tear down the walls that separate you, from those well-dressed senior executives and MBAs who speak a language you may not understood. You will feel more connected to your company and your work. And the range of opportunities open to you will expand.
Street vendor’s skill:
How does a street vendor hawking fruits and vegetables in a small Indian town make a living? Someone with a MBA might say, “Anticipate demand”. But street vendor does not know the buzz words. He has to figure out what to buy that morning, - what quantity, quality, what assortment of fruits and vegetables – based on what he thinks he can sell that day (his sales ‘forecast’).
Then he has to figure out what prices to charge and be nimble enough to adjust prices as needed during the day. He does not want to carry the fruit home with him (the ‘inventory’). If it begins to decay, it will be of less value tomorrow. Another reason why the vendors does not want anything left over is that he needs the ‘cash’. All day long he has to weigh whether to cut prices, when to cut them, and by how much. If he is indecisive or makes a wrong trade-off, he may lose out.
It is no different in companies.
Each morning, the street vendors setup his cart. He puts the best-looking fruit in the front (retailers call this ‘merchandising’).He watches the competition – what they are selling and at what price. And the whole time, he’s thinking about not just today, but also tomorrow.
If he has trouble selling his produce, he might have to cut price (increase the value to the customer) or rearrange the display or yell louder (advertise) to attract attention to his stand. May be tomorrow he’ll find a better price at which to buy or he’ll change the assortment of fruits and vegetables (the ‘product mix’). If something does not work, he adjusts.
Whether the street vendor realizes it or not, his subconscious is pondering something deeper. How will he buy goods for the next day? He needs cash to stay in business. So do companies.
In India, when personal cash savings are hard to accumulate, the vendor may borrow cash to purchase fruit in order to make some more money. To make living, he has to make enough money to pay back what he borrowed, with some left over. Every time he sells a melon, he makes just a little bit of money. His profit, the difference between what he pays for the fruit and what he sells it for, is very low. His profit margin – the cash he gets to keep as a percentage of the toal cash he takes in. His profit (Some call it return on sales or operating margin)
Business acumen requires understanding the building blocks of money making. Money making business has 3 basic parts: cash generation, return on asset (combination of margin and velocity) and growth. True business people understand them and also its relationship between them. Add consumers to these 3 parts of money making and you have the core, or nucleus of any business.
The word velocity describes this idea of speed, turnover or movement. Think of raw materials moving through a factory and becoming finished products and think of those finished products moving off the shelf to the customer. That’s velocity.
Cash generation, margin, velocity, return on assets, growth & customers.
Cash generation is the difference between all the cash that flows in the business and all the cash that flows out of the business in a given period of time.
Regardless o the size or kind of business, you are using your own or someone’s money to grow. You borrow from a bank or use your savings. That money represents your investment or your investment capital.
The things you are invested in are assts (plant, office, etc.) Some of these assets are big items that are not expected to be sold are sometimes called fixed assets (e.g. building). What kind of money is being returned to you through tier use? In short, what is your return on assets (ROA).
Some people would rather talk about return on investment or return on equity (equity is the money shareholders have invested in the business). How much money are you making with your investments or with the money shareholders invested in the company?
Some people use the term inventory turns to describe inventory velocity. Whatever the assets, figuring out asset velocity requires some simple arithmetic: your total sales for say, a year divided by total assets. Inventory velocity = divide total sales by total inventories. The faster the velocity, the higher the return. In fact return on assets is nothing more than profit margin multiplied by asset velocity.
Return = Margin x Velocity or R=M x V The result R is stated as percentage, a single number that can be used for comparison.
Throughout the book, the term ‘margin’ to refer to net profit margin after taxes. That is the money the company earns, after paying, all its expenses, interest payments, and taxes.
Gross margin from which net margin is derived, is calculated by taking the total sales and subtracting the costs ‘directly’ associated with making or buying the product or service.
For ROA. Multiply margin by velocity of assets (velocity of assets is sales divided by assets). E.g. a company has a 5% profit margin, $10K in sales and $2K in assets.
ROA = 5 % x (10k/2k) = 25%
For ROI, multiply profit margin by velocity of investment (velocity of investment is sales divided by investment). E.g. same company where $5k in total investment.
ROI = 5% x (10/5) = 10%
For ROE, multiply profit margin by velocity of equity (velocity of equity is sales divided by equity). E.g. same example, with $1K in shareholder’s equity (this excludes money the company may have borrowed from a bank).
R= 5% x (10/1) = 50%
Many people focus on profit margin, but successful CEOs think about both margin and velocity. This dual focus is the masterpiece of business acumen. As you hone your business skills, think hard about return on assets and its basic ingredients of velocity and profit margin.
One truth about business is that the return on assets has to be greater than the cost of using your own and other people’s money (bankers & shareholders) – the cost of capital.
Some of the questions, to gauge the health of the company.
1. What were the company’s sales during the last year?
2. Is the company growing?
3. What is the company’s profit margin? Is it growing?
4. How does your margin compare with your competitors?
5. How does it compare with those of other industries?
6. Do you know the company’s inventory velocity?
7. What is the company’s return on assets?
8. Is the company’s cash generation increasing?
9. Is the company gaining against competition (market share)
The main task for the CEO of a publically traded company goes beyond money making and is linked to price-earnings multiple – also called P-E ration. P is the price of an individual stock and E is the earning per share – how much profit the company made for each share of stock. P-E of 7 means, for every dollar of earnings per share, the stock is worth 7 times. Higher the P-e ration, the more wealth is created.
Security analysts have the job of deciding what they think is an appropriate P-E ration for the companies they track. If their assessment shows that the company deserves a higher P-E ration than the market reflects, their firms tend to buy the company’s stock. The opposite is also true.
A common comparison is to look at the P-E ration of an individual company against the average P-E ratio of Standard & Poor’s 500 – a collection of 500 companies that are widely held and represent the broad economy of the nation.
These calculations are not correctly reflecting dot.com companies and investors are still learning how to deal with it.
Think about the broader context your company operates in. What are the external realities of your particular business.
1. Is there excess capacity in the industry
2. Is the industry consolidating
3. Do you face stiff pricing competition
4. Might your business be affected by currency fluctuation or changes in interest rates?
5. Are you facing new competitors?
6. What is happening in e-commerce?
Consider the individuals who report to you and others you interact with in your everyday work life.
1. What are the 2 or 3 non-negotiable requirements of the job now and 2 years out?
2. What are the 2 or 3 things you would call the individual’s natural talents and drive?
3. What is the one major blind side of person that might prevent him or her from growing further?
4. How can you help coach this person?
Be a leader of the business. With the command and urgency of a street vendor, pick the 3 or 4 items you and those reporting to you should focus on. Don’t try to cover the waterfront, don’t keep changing your mind and don’t back away from the challenge. Make the priorities known by repeating them often.
What are you going to do help your company’s money making in the next 60 to 90 days? Be a part of it. Let the excitement begin.