Don't Leave Finance to the Experts
Professor M.P. Narayanan demystifies finance for senior managers and executives transitioning into general management.
ANN ARBOR, Mich. — Corporate strategy no longer is a linear progression from point A to point B; it is now best viewed as a holistic, multidimensional process that seeks to create value in every facet of the organization. One of the most critical functions in any organization is finance, and it's a specialty where the non-financial senior executive often defers to the firm's CFO and financial staff. But M.P. Narayanan, the Robert Morrison Hoffer Professor of Business Administration, says finance is too important to be left to the experts. Top management drives strategy – and finance is nothing more than the economics of that strategy. As part of the monthlong Executive Program presented by Ross Executive Education, Narayanan seeks to demystify finance and bring a degree of comfort to the non-financial executive.
The Ross Executive Program is designed for senior leaders in need of an enterprise-wide perspective after spending much of their careers as functional experts. What do you find they want when it comes to a better understanding of finance, and how do you deliver it?
Narayanan: The bulk of the people in the program — not all of them, but most — are non-finance people who share a certain discomfort with finance. Some of them may have picked up some finance by osmosis, but even there we deal with a lot of misconceptions. Osmosis isn't the best way to learn. The way I teach finance is simply as a service function to corporate strategy. Strategy is about creating shareholder value, and finance and strategy are two sides of the same coin. You can't separate the two things. When you strategize, you have to think about the economics of the strategy. My challenge is to simplify finance, not complicate it, so that non-financial executives don't keep it at arm's length anymore. In one of my books, I write that finance is too important to be left to the experts. We recently presented a custom program for some top executives at the Tata Group in India. Participants cited some of the key takeaways as financial awareness, the importance of valuation, the impact of profitability, the cost of cash flow, and the cost of capital. That's the idea, to bring that to these non-financial managers.
One of your main areas of research is executive compensation. What are some things you can take from that field and bring to the Executive Program?
Narayanan: I like to get executives thinking about what constitutes performance. A company exists to create value for shareholders, which is another way of saying it exists to make money for its owners. So how do you measure performance in a way that is consistent with this goal? One might think it is obvious. For example, a lot of compensation schemes provide incentives based on profits or earnings produced. It's one of the most common metrics. On the surface, it seems logical. But the catch is that it's not, because if you use only profit, you're not considering how much capital you're using to produce the profit. In accounting terms, it is equivalent to saying he or she will use the income statement to measure how well a company is doing and totally ignore the balance sheet. It's incomplete. That's a big thing I bring to an audience of senior executives — showing them they not only have to consider profit, but how much capital they need to produce the profit. And you have to pay for capital. The people who give you capital are losing something when they give it to you, and they want something in return. So you have to consider that and decide whether or not you made money. Some companies do that but a significant number do not.
Can you give some examples of other, more complete ways companies use to determine executive pay?
Narayanan: Some companies compute what they call an economic profit. They take the accounting profit and do a reduction for capital costs. So if you made $20 in accounting profit and used $100 of capital at a rate of 10 percent, that's a $10 charge for the cost of capital. So you really made only $10 for the shareholders and not $20. Looking at only the $20 is incomplete. That's one way to do it. Some companies will try to measure return on invested capital (ROIC), a somewhat equivalent metric. So you make $20 accounting profit on $100 of capital, that's a 20-percent ROIC. But the people who provided the $100 could have made a 10-percent return themselves, so you gave them 10 percentage points more than they could have made. Therefore your value-add is 10 points, not 20 points. The problem with ROIC is it doesn't tell you the scale of the business. Take two possibilities: I could have made $20 of accounting profit with $100 of capital (20-percent ROIC), or I could have made $175 on $1,000 (17.5-percent ROIC). Given the two choices, shareholders would say take the $1,000 and make $175 for us. Even though it's a 17.5-percent rate of return instead of 20 percent, it's still more than the 10 percent they could have gotten on their own. But if you're only compensated on the percentage return, your incentive would be to choose the smaller investment of $100, because you're going to receive a bigger bonus on the 20-percent ROIC than the 17.5 percent. So the company's growth is stunted. As you grow, your rate of return diminishes. That's natural. Smart companies understand this and base executive pay not only on ROIC but also on some metric of growth. These are the subtleties I like to highlight as I interact with executives at the higher level.
What other financial considerations should executives consider as they move from an area of functional expertise to a more general management role?
Narayanan: For publicly held companies, there is the question of how to keep the stock price up, which is an entirely different equation. A stock price is a forward-looking item. It bakes the market's expectations of the future into it. The market bases these expectations on past and current performance. If you demonstrate a certain performance, the market adjusts its expectations based on that. Simply continuing the performance, even good performance, won't increase the stock returns. The stock price is all about the sizzle, not the steak. But the sizzle is based on the steak being prepared. They see the sizzle and they bake it into the stock price, if you don't mind me mixing metaphors. So to increase the stock returns, you have to surprise them positively. For public companies, it's not your performance that matters, but rather how you perform relative to expectations.
For more information, contact:
Terry Kosdrosky, (734) 936-2502, email@example.com