Treasury Cafe

Working Capital – Inventory Economic Order Quantity

2012-02-27T12:11:00.000-06:00

Today we explore a little more closely the analysis of inventory consistent with our Cash Conversion Cycle metrics and the particular nuances of inventory and its impact on our risk and cost of capital (discussed in last week’s “Working Capital – Finance and Inventory”post).

Economic Order Quantity

One of the first equations we run across when discussing inventory is the Economic Order Quantity. This calculation balances per batch costs with ongoing carrying costs of the inventory in order to determine when additional inventory should either be:

· Ordered, as the case in raw material for a production process, or a distributor or retail operator, or

Figure A

· Produced – in the case of scheduling production runs to satisfy customer demand for a product

The Economic Order Quantity formula is shown in Figure A.

Figure B shows the result of this calculation if we have a firm with a demand of 120,000 units per year (D), each with a value of ²100 (C), a carrying cost of 50% (k), and a per batch cost of ²1000 (S), then our optimal order quantity is about 693 units.

Figure B

One practice that separates a good analysis from a poor one is the process of finding ways to validate or “prove out” the results. I call this process triangulating, since we rely on more than one process to move us toward our objective.

Figure C

In this case, we can validate our result by simply calculating the costs under different order scenarios. Figure C shows the costs in the previous example under four different reorder scenarios near the 17.3. We note that the lowest total cost in this analysis is 17, followed by 18, with the others being higher. Since 17.3 is between 17 and 18 but closer to 17, this comparison is consistent with the results of our Figure B.

The Benefits of the Economic Order Quantity

The primary benefit of the Economic Order Quantity formula is its simplicity. The entire calculation and result obtained in Figure B took a total of 6 cells in a spreadsheet. It does not get much simpler than that!

While there are drawbacks to this formula (which we will discuss next), for many routine, low value items, it might not make any sense to go any further than this type of calculation. For instance, six cells in a spreadsheet might be a great way to order pencils or paperclips (though even that much analysis might be too much!).

The Drawbacks of the Economic Order Quantity

The underlying assumption in the Economic Order Quantity formula is that pace of the material is even throughout the year. In many cases, this is not realistic. A US retailer using this method will be substantially overstocked during the summer since a large part of retail sales is related to the Christmas holiday season.

In addition to pace, there is linearity in the formula which can also be problematic. Costs (both per batch and per unit) are fixed and do not vary. This is often not the case in real-life. At some point a new person needs to added to the warehouse staff if inventory levels get too high, so the cost function can be step-wise rather than linear. Or there will be economies of scale in some of the other costs, like insurance.

The Hidden Traps in Economic Order Quantity

In addition to the disadvantages, there are other “traps” which might be present in the calculation, primarily related to the difficulties that are sometimes present when attempting to make accounting information actionable from a finance perspective.

When we consider a concept such as carrying costs, the cost of the inventory infrastructure will be allocated to the inventory and included in any accounting perspective of carrying costs.

Yet, once our warehouse is built, this and the cost that go along with it is “sunk” from a continuing investment perspective, but it will not show up that way in a fully allocated accounting calculation.

For instance, if we have a warehouse that we heat and keep lighted at ²100 per year, we will spend this ²100 no matter whether there are 10 items in the facility or 100. Let’s say our per item cost of inventory is ²100. So if we carry 10 items on average per year our inventory costs ²1,000, and our carrying cost rate will be 10%. If we keep 100 units, it will be 1%.

Because this carrying cost charge is in the EOQ formula, it will impact the Q that ends up being calculated.

Yet, re-stating what was said at the beginning of the example, we will spend ²100 no matter what. As such, the optimal Q for our firm can only be calculated if we can remove that data.

In addition to carrying charge, often our inventory will include other sunk or immaterial-to-the-Q-calculation items in its cost, for reasons we have discussed in other posts – such as actual vs. standard costing, the breakdown of direct manufacturing vs. overhead, and the allocation of both thereof.

Key Takeaways

The Economic Order Quantity formula can serve, in certain circumstances, as an efficient means of ensuring that we invest the correct amount of funds into this working capital category. However, we need to be mindful of adjustments to the data we have on hand in order to ensure that the formula includes only economically relevant decision factors.

Questions

· What has your experience been with the Economic Order Quantity formula?

Add to the discussion with your thoughts, comments, questions and feedback! Please share Treasury Café with others. Thank you!

Working Capital – Finance and Inventory

2012-02-19T17:59:00.000-06:00

The most complicated of the “basic” working capital categories involved in the Cash Conversion Cycle is inventory. This is true for a number of reasons.

Inventory is often highly specific to its particular industry. Inventory can take several different forms. Inventory's valuation can vary. In addition, inventory is inextricably entwined with operations, sales and purchasing.

For all these reasons, a careful look at this investment is useful.

Stages

The different stages of the production process results in three separate types of inventory. The firm buys “raw materials” that it will use to convert into its products. During the production phase inventory is classified as “work in process”, or WIP. Finally, “finished goods” is the term used to denote inventory that is ready for sale, shipment and delivery.

Depending on the firm, the amount and proportion of inventory comprising these stages will vary. On one end, a firm whose production process requires very little time and its output can be delivered quickly might hold most of its inventory as raw materials.

For example, a bakery does not want to hold a lot of baked bread, which goes stale and moldy as a finished good, so it is far more optimal to keep flour, yeast, butter and the like in its original state until it can all be delivered early in the morning to its customers in just the right amounts.

A long production process, such as a brewery whose product requires fermentation for several weeks, will see a high amount of WIP, as most of its inventory will be in the fermentation vats.

A simple assembly operation, which assembles quickly but batches up units for high volume bulk sales, will hold a higher amount of finished goods.

Inventory and Cost of Capital

Just as we saw when we examined Accounts Receivable, our firm’s inventory policy will carry different implications for its cost of capital. In the case of Accounts Receivable, we could look to a replicating portfolio to arrive at this impact. Unfortunately, it is not as simple as that with inventory.

One factor that makes inventory more or less risky is the level of commoditization. The more inventory we hold in a commodity-like state lowers our risk level vs. the amount held in a non-commodity like state.

If we manufacture a specific part for a specific vehicle, for example, our finished goods are very specialized. We can sell them to only one customer, and then only so long as they continue selling the product for which ours is a part. In other words, our finished goods are not commodities at all.

On the other hand, if our raw material is ingots of iron, these can be sold to a large number of manufacturers making any number of different products in a multitude of industries.

Therefore, a business with a large amount of finished goods in relation to total inventory is more risky than one that holds a larger amount in raw materials.

Each firm must ascertain where in the process this occurs. It is not as simple as saying “raw materials are less risky than finished goods”.

What if we are the firm that receives the vehicle parts manufactured from iron ingots above? Our raw materials are very specific, say part of a car door for a specific model. If the manufacturing process were to shut down permanently, the only use for our raw material is scrap. On the other hand, as a finished good the car can at least be sold, even if it is not for the full list price.

So for the firm in the first example raw materials is the less risky category, while for the firm in the second example finished goods are.

Cost of Capital Worked Example

Let us say that Firm A generates ²1 per year forever, and its cost of capital for this industry is 10%. A perpetuity valuation method then places the value of this firm at ²10. Let’s further say that they paid for their production assets and infrastructure at just this amount, so their Net Present Value was ²0.

In addition, Firm A runs production continuously with a buffer stock of finished goods worth ²2. This is their working capital investment. Since the value of the finished goods in theory revolves around the state of Firm A’s industry, we can say that they should carry the same cost of capital, or 10%.

Just as we did in the last post, we use the Modigliani-Miller assumptions and determine that if we finance the firm with 50% debt at 7%, then our 50% equity is priced at 13%.

Figure A

Figure A shows Firm A in comparison to Firm B.

For Firm B, we assume all the above assumptions above hold, with the exception that Firm B keeps its inventory as raw material and produces to order only (like the car part manufacturer whose raw material is iron ingots).

In this case, the raw material inventory is more commodity-like. Commodity futures and forward contracts typically use short-term risk-free interest rates to discount their value vs. spot rates, and so for this reason we assign a lower cost of capital (i.e. risk) to this raw material investment, say 5%.

At our 50/50 capital structure, Firm B’s cost of equity is 11.3%, much lower than Firm A’s.

From this example we can see that our inventory and production policy, methods, and practices will have an impact on our firm’s value due to the cost of capital implications.

The Process Matters

As we just noted, the production process, the nature of the input materials and output materials all impact the working capital requirements of our inventory.

We can say, in general, our inventory practices are dependent on the following factors and questions, which need to be optimized for our firm:

· Supply variability – is the supply of raw materials highly variable in terms of either price or quantity?

· Batch supply costs – is there a high “up-front” cost to ordering, receiving, or storing needed raw materials?

· Per unit supply costs – are these costs different depending on the quantity level of the production run?

· Physical per unit inventory storage costs – we need space, insurance, and infrastructure to warehouse inventory in any form.

· Production rates – will manufacturing our product in different amounts affect our productivity?

· Production variability – are there factors that impact our ability to produce?

· Batch sales order costs – are there “up-front” costs on the part of our customers, or batching synergies on our part, to fulfilling sales orders?

· Per unit sales prices – is there variability in what our ultimate realized sales price will be?

· Demand variability – are there factors that can make our sales volumes dramatically different?

· Stock-out impact on sales – if we do not have product in stock, will our customers back-order or will we lose the sale entirely to competitors?

This entire process can be subjected to analytical treatment, which we will investigate in future Treasury Café posts.

Additional Issues With Multi-Product Firms

Our discussion of inventory to this point has been geared to a one-product / one-raw-material type of firm. This is somewhat simplistic. What if we manufacture 100 different items? And utilize 100 different raw materials?

Our analysis then involves the inter-relationship of each product, its manufacturing process, and its sales profile with all the other products in our “portfolio”.

As an example - simplifying the issue to a two product case - what is our optimal production process if product A has very small batch costs, while product B has large ones?

In this instance, we would want to optimize product B’s production schedule and “fill in the holes” with product A’s. Our solution would be entirely different if product A and product B had similar batch and unit costs but faced different variability in either raw material supply or finished good demand, along with different stock-out costs.

Key Takeaways

The inventory characteristics of our firm will impact our working capital level and the resulting risks undertaken, thereby impacting the cost of the capital required to be deployed.

Questions

What inventory peculiarities are present in your industry?

What is the optimal production process given the levels of risk in raw materials, WIP, and finished goods? Why?

Add to the discussion with your thoughts, comments, questions and feedback! Please share Treasury Café with others. Thank you!

Working Capital – Finance and Accounts Receivable

2012-02-13T08:18:00.003-06:00

In “Working Capital Primer: How is it that this Capital Works?”, we left with a promise to look a little more at the finance dynamics of working capital.

Back to Net Present Value – with a Twist

When we perform Net Present Value (NPV) calculation, we discount these cash flows at the appropriate cost of capital. Often we discount the net cash flow using a cost of capital that we have derived from the Capital Asset Pricing Model (CAPM) in one of its one-thousand plus manifestations.

While this is the usual practice, some theorists will tell us that we should discount each separate cash flow at its appropriate cost of capital, and build up to the result. This is very difficult to accomplish reliably and credibly.

When considering some of the components of working capital, however, we are not as constrained by such real-life practicalities.

Can We Re-Invent the Security?

Figure A

When preparing a valuation, we often use a “replicating portfolio” to confirm correct pricing. A replicating portfolio simply means a combination of other financial instruments that, when taken together, are identical to the original item.

The classic example is a forward contract, which has a payout profile shown in figure A:

Figure B

By combining a written put option, with a profile of that shown in Figure B, with a purchased call option, with a profile in figure C, we arrive at the same payout as the forward contract. In this case the options together are the “replicating portfolio” for the forward contract.

Figure C

The pricing of the put and the call need to be equivalent to the forward, otherwise an arbitrage opportunity occurs. Given that free money does not last forever, even when there is an arbitrage it is fleeting.

Why the Cost of Capital is Different

So let us assume that we have valued our firm’s cash flows at 10%, and this is based on a CAPM analysis using “cash-on-the-barrelhead” comparable companies. However, let’s assume that our firm is willing to extend 30-day payment terms to its customers. Is our firm’s cost of capital the same?

No, because for an investor to replicate our cash flow profile, they would need to both invest in a “cash-on-the-barrelhead” company and a 30-day debt obligation that matches the customer’s risk profile. Thus, the cost of capital of the two-firms is different.

We can evaluate this mathematically. Let us suppose that our “cash-on-the-barrelhead” firm has a 10% cost of capital, generates ²10 in cash inflows per year and ²9 in cash outflows per year, and we assume these will continue in perpetuity (to make the math really simple). The value of this firm is ²10, as shown in Figure D.

If we allow a 30-day payment period for our receivables, and the cost of obligations for similar rated entities as our customers is 5%, then our ²10 of cash inflows needs to be discounted by one month’s cost of capital at 5% in order for us to reflect the market’s valuation. The value of our firm is then ²9.59, as shown in Figure E.

We therefore lower our equity value by ²0.41 by allowing 30-day terms, due to the fact that we have taken on more risk.

Another way to look at this is from the balance sheet perspective. If both are financed at 50% debt, then the equity holder’s risk is lower for the cash-on-the-barrelhead firm than (13% vs. 13.8%).

Looking Closer – Pros and Cons

There are advantages and disadvantages to financing accounts receivable. In our just-completed valuation, it appears to be a disadvantage. However, if we generate additional sales because we grant customers credit, this disadvantage might be overcome.

Continuing with the previous example, what is the level of sales required (at 90% margin) to make our firm worth ²10? The answer to this is that if we generate enough sales to yield cash inflows of ²10.42292 per year, our firm will be valued at ²10, as in Figure F.

However, there are also additional operating costs associated with accounts receivable compared with a “cash-on-the-barrelhead” alternative. We need increased records management and accounting activity. We will incur collections expense. We will need to engage in a credit approval process. We are subject to invoice adjustments while the receivable remains outstanding. Inevitably, some customers will not pay.

Therefore, the decisions we make about accounts receivable policy become subject to a traditional cost/benefit analysis, where we include increase in sales, increased operating costs, and increased costs of additional risk.

Capital Structure Implications

Franco Modigliani and Merton Miller won a Nobel Prize for their insight that the financing of a firm does not matter in a world without taxes, bankruptcy costs, agency costs, asymmetric information, and efficient markets. In other words, not the real-world!

However, if we hold in abeyance this fact, we can explore the financing structure of our firm related to this accounts receivable issue.

If we obtain revolving type lines of credit, or debt with a collateral position in the more liquid assets, this can usually be obtained at lower rates, since the risk is lower because the assets are more liquid and more certain to be collected (there are laws that say if you got goods and services, you have to pay for them).

However, since this benefit was shared by the debtholders and equity holders in the Figure E capital structure, introducing a separate financing at lower rates merely pumps up the required rates of return of the remaining security holders. They are in a riskier position since they accepted lower rate financing, which is lower rate precisely for the fact that the lenders providing it have “first dibs”.

Reducing Days Sales Outstanding

If we want to lower our exposure to accounts receivable, or in other words reduce the Days Sales Outstanding, there are several actions we can consider:

Sell on shorter terms – payment in 15 days instead of 30.

Reminder and Collection Calls – make phone calls to those close to being overdue, or immediately upon becoming overdue, and then follow-up persistently.

Monitor Aging – look for companies that have balances in different aging “buckets”, and evaluate the feasibility of continuing business with them.

Subsequent Sales – do not make shipments to those overdue on bills.

Require Collateral – implement a collateral requirement with customers – they must keep an amount on deposit in order to purchase on credit terms, or they must have pre-paid the invoice prior to shipment occurring or service rendered.

Key Takeaways

Working Capital practices impact both the cost of capital and capital structure elements of our organization. We need to make decisions keeping the consequences in mind.

Questions

· What practices have you seen that have reduced Days Sales Outstanding?

· What consequences of Working Capital decisions have you witnessed?

Add to the discussion with your thoughts, comments, questions and feedback! Please share Treasury Café with others. Thank you!

Working Capital Primer: How is it that this Capital Works?

2012-02-07T03:52:00.000-06:00

In the last Treasury Café post, “Cash Conversion Cycle – A Good Measure?”, we discussed one potential metric to evaluate our organization’s working capital proficiency.

Taking a step back from that post, we can consider the fact that working capital is many things:

· Well understood

· Always accounted for

· Strategically assessed

…not being among them!

What exactly is working capital? What are the differences in how working capital can be evaluated? How can working capital be financed?

We touch on the answers to these questions here.

What Is Working Capital?

According to Investopedia, Working Capital is “the cash a business requires for day-to-day operations, or, more specifically, for financing the conversion of raw materials into finished goods, which the company sells for payment.“

According to Wikipedia, Working Capital is “a financial metric which represents operating liquidity available to a business, organization or other entity”

Cash generation and usage, liquidity, and financing of operations are at the heart of working capital.

Working Capital Example

In a small group meeting we can illustrate the definitions above as follows:

We have 4 people – Charlie, her parents, her customers, and her suppliers.

First Month

Charlie needs to buy raw materials to turn into widgets for her customers, and pay people to run the machines, and pay the landlord rent, and the equipment supplier their lease payment, and the investors their dividends and interest. All this costs her ²10 (for new readers, ² is the symbol for Treasury Café Monetary Units, or TCMU’s), and she needs to deliver this by the end of the month. We call these people, in aggregate, suppliers.

However, since she just started out, Charlie does not have this ²10, so she borrows it from her parents. At month end she pays the suppliers and delivers widgets to her customers. The cash pattern for this is depicted in the figure "First Month".

Recurring Month

The following month end, customers give Charlie ²10 for the widgets they got at the end of last month. Furthermore, Charlie in turn gives ²10 to her suppliers again for the current month’s activity. This pattern will repeat each month, as shown in the figure "Recurring Month".

Notice that Charlie’s parents do not ever get their funds back during this process. This is because the original ²10 is continually being re-cycled to fund the operations.

Let’s say after a period of time Charlie decides to close down. The final month’s cash flow will be depicted in the "Final Month" diagram.

Final Month

Charlie is finally able to pay back her parents!

Notice the critical nature of the working capital investment in this case - Charlie only has the funding to pay it off once the operations related to it are over.

This concept of “over” is important, and we will get back to it shortly.

Note that this example above can be conducted in small settings with real funds to illustrate the point with only the initial ²10. If you would like to do this, the only addition step you would need to do would be to move the ²10 between supplier and customer due to “all other economic activity” or something during the period. This is sometimes helpful for non-finance types to understand experientially what working capital is.

Working Capital Classification

Working Capital is often classified as “temporary” or “permanent”. This system comes about if we consider the organization’s assets by class over a period of time. The graph on the right depicts a cyclical firm with fixed assets and working capital assets (demarcated by the solid brown line). It then further divides the working capital assets (by way of the dotted red line) into permanent and temporary.

Permanent working capital assets are from the point of the fixed assets to the trough of the cycle. They are defined as such because they always exist no matter where we are in the cycle.

Temporary working capital assets are defined as those between trough and peak. They are defined as such because they disappear at a certain point in the cycle, and their value varies depending on where we are in time.

Often the distinction between the two can get confusing. This is where our concept of “over”, discussed earlier, can be helpful.

A business unit, eager to close the sale on a new deal, might argue that its capital cost should reflect short-term rates because the cash conversion cycle for this will be 40 days. However, we can ask “will the business with this customer be over then?” If we find that “No, we will be doing a new deal with them next month if this goes well, and every month thereafter” rather than “Yes, it is a one-shot deal” then the working capital looks to be more permanent and longer-lived (as Charlie’s parents have learned!).

Over time, a firm’s “permanent” and “temporary” working capital will vary. Looking at a graph of a firm growing over time can be illustrative. In this example, both the level of permanent working capital and temporary working capital grows along with the firm.

Financing Working Capital

Financing working capital assets is not an exact science. Some will tell you that the “permanent working capital” portion should be financed with long-term, “permanent” capital (i.e. long-term debt and equity), for the reason that it is permanent and therefore should be financed with something that matches the tenor.

This point of view can be explained by taking Charlie’s parents’ perspective of the situation. In our example above, they provide capital they do not get back until the firm closes its doors, as near a definition to permanent as any free-market enterprise can entertain! They therefore should expect a return commensurate with other long-term investment alternatives.

Alternatively, some would argue that working capital assets be financed at short-term capital rates. This argument relies in part on a different application of the matching principle – short-term assets should be financed by short-term liabilities.

If we consider a liquidation scenario where each investor gets a specific slice of the firm as collateral, then the working capital investors have less to worry about – customers pay their bills in full when due or face enforceable collection efforts, and any finished inventory can be sold for close to market prices provided it is not obsolete for some reason.

Investors with factory equipment, buildings and land face a lot more variability around the ultimate monetary realization and its’ timing. Thus, since the specific nature of the risk and the timing of its occurrence are different, that should lead us to conclude that the investments are different and require different treatment.

We can illustrate how funding can be short-term by modifying our original Charlie example slightly. If, once we collect from customer, add two additional steps to the process, 1) paying back her parents, and then 2) obtaining ²10 either by re-borrowing from her parents or from a new source, prior to her payment to the suppliers. Under this scenario, the provider of working capital funding gets to choose each month whether to continue it or not. Conversely, Charlie is at risk of not obtaining it each and every month as well.

Of course, any point between these two extremes can be chosen as well. We will look at this a little more in-depth in the next Treasury Café post.

Key Takeaways

Working Capital funding is an essential component of the firm’s financial strategy, and working capital requirements are an important factor to consider as the firm evaluates its opportunities and its needs.

Questions

· Does everyone in your organization have a solid understanding of Working Capital?

· Do you have a preference as to Working Capital financing? Why?

Add to the discussion with your thoughts, comments, questions and feedback! Please share Treasury Café with others. Thank you!

Cash Conversion Cycle – A Good Measure?

2012-02-02T08:43:00.000-06:00

If you google “Cash Conversion Cycle Calculation”, you will find many, many websites that provide the equations, give some simple examples, and send you forth with encouragement about using this fantastic tool in your work.

However, in real-life it is not really all that simple as it sometimes sounds. In this post we investigate some of the “potholes in the road” you may encounter as you attempt to employ the Cash Conversion Cycle calculation.

Cash Conversion Cycle – Intent and Calculation

The Cash Conversion Cycle (CCC) is one of the metrics that firms can use to track working capital efficiency in their operations. Once we come up with the Cash Conversion Cycle number and its components, we can compare the results against 1) accepted rules of thumb or standards, 2) industry averages, 3) our own prior period experiences as a trend or time series analysis.

The measure also helps us develop balance sheet elements in pro forma financial statements for valuation, growth investment scenarios, or merger and acquisition prospects.

Finally, another common usage is that of comparing the working capital efficiency of different firms with each other.

The Cash Conversion Cycle calculation equations are as follows:

As an example, let’s assume our firm has the following income statement and balance sheet:

From the above, the Cash Conversion Cycle calculation is as follows:

This is the point where reality intervenes.

The Cash Conversion Cycle, like all metrics, requires some thought as to the measure’s usage, appropriateness, and limitations. We must understand how the “black box” operates in order to determine whether we are achieving the objectives of the investigation.

Cash Conversion Cycle – Revenue Potholes

Each business has its unique sales and revenue profile. Difficulty with the Cash Conversion Cycle calculation can appear when different business lines are blended together.

For instance, if we calculate DSO for McDonald’s (see McDonalds financial statements if interested) , it is 17.9 days. When thinking about converting accounts receivable to cash, that is a great number!

However, I cannot remember the last time I got a Big Mac and told them to send me an invoice!

McDonalds operates company stores and franchises stores to others - two separate businesses (even though they both have to do with restaurants). The issue here is that the line of business related to the accounts receivable balances primarily pertains to the franchising activity, which involve rent, royalties, and percentage of sales payments. These will be periodic payments, giving rise to accounts receivable balances. Using only the franchise revenues as the figure in our DSO calculation, we arrive at 54.9 days.

What if we are performing an industry comparison instead?

If our comparison companies have 100% company-owned stores, then the 17.9 days we calculated will look high compared to theirs. Yet is it reasonable to conclude we are performing less than they? In theory, we should be about the same, because on a company-store only basis both firms will be “cash on the barrelhead” businesses.

What if the comparison companies are 100% franchise? Then our 17.9 days will look low, and we will pat ourselves on the back for doing a great job, even though this might not be the case on an apples-to-apples basis. Fortunately, in this case we have the information to get to the 54.9 day number.

But what if the comparable companies have a mix of company-owned and franchise operations as well, but in different ratios to each other, and they are not separated as on the McDonalds statements? Then we will not be able to make a truly valid comparison at all.

Thus, the objective of the analysis might determine what is better to use. Are we performing the Cash Conversion Cycle calculation in order to pinpoint opportunities to reduce it? Then we should focus on the 2^nd version of DSO, as that is likely where we might be able to make inroads.

Cash Conversion Cycle – Inventory and Cost of Goods Sold Potholes

Accounting rules allow us to use four different methods to value inventory – average cost, specific cost, first-in-first-out, and last-in-first-out.

This being the case, any DIO calculation will import these differences into the figure and render a comparison to another firm as apples-to-oranges. Sometimes, the financial statements might provide the data to get the figures comparable (such as a LIFO to FIFO reconciliation), but not always.

In a manufacturing setting, the value of the goods produced includes the raw material cost, direct labor, other direct costs, and allocated manufacturing overhead.

There are different methods a firm can use to allocate overhead. One might do it on the basis of labor time, another on machine time, another based on space occupied.

In addition, the method used to determine the amount to be allocated will also vary. One firm might use a “pool” using balances from one or more financial accounts in the books. Another firm might use a standard cost estimate that was established as part of a study.

Cash Conversion Cycle – Accounts Receivable Potholes

When companies report Accounts Receivable, this number needs to contain an estimate of uncollectible or bad debt expense within it. This amount of uncollectible can often be picked up in the footnotes of the financial statements, and sometimes it is identified on the balance sheet.

So long as we can find the number, we can compare this category with other firms if we are going to view the DSO measure on a grossed up basis.

However, if we are looking on a net basis we need to be careful. If you put the same receivable and sales data in front of five companies, you will get five different bad debt figures. One company will calculate it based on aging buckets, another percentage of sales, one will be aggressive, one will be conservative, etc.

Cash Conversion Cycle – Accounts Payable Potholes

Accounts Payable is a very active one on the balance sheet. Expenses for cost of goods sold are credited to this account.

Hmmm…but so are sales, general and administrative expenses. So are purchases related to capital projects.

The following example takes two companies, who have identical cost of goods sold and sold the same number of units. However, one company is making capital expenditures as part of a growth plan. With the payables portion of these cap ex payments mixed in with the other AP data, we arrive at a different DPO, even though by design we established that they had an identical Cash Conversion Cycle for the current product mix!

Sometimes we can overcome this. We can get a capital expenditure figure from the Statement of Cash Flows. We could make an assumption about the impact this has on payables (e.g. 30 days worth of capex is in AP). Or we could run a linear optimization program to calculate an equilibrium point where AP related to COGS and AP related to Cap Ex is the same number of days outstanding. We will have varying degrees of confidence as to the results this generates, however.

What is the Use?

With all these potholes in the road, we may reconsider the question as to whether we want to make this journey. It can be somewhat tempting to throw our hands up in the air and walk away – what’s the use?

That is certainly an option, but it is not the only one.

If we want to use the Cash Conversion Cycle to compare our own performance over-time, a lot of these potholes do not matter so much. If our methodology of calculating it is consistent from period to period, we will make an apples-to-apples comparison for our own case, using whatever level of detail is appropriate. This is also appropriate if we want to assign additional working capital requirements in a valuation pro forma.

If we want to use the Cash Conversion Cycle to set a benchmark to shoot for, we might use the basic formula, with all its problems, as a first pass, identify the top three or four firms, and do a deeper-dive calculation with just those three or four in order to set the bar for our objectives.

Finally, we can always use the basic Cash Conversion Cycle calculation, but exercise restraint in the conclusions we draw due to our awareness that many potholes are in the road. Do the companies all cluster within 10-15 days of each other? Or do they cluster at different parts of the range? Is the absolute value of the range very wide or close? This information tells us something, it just doesn’t do it to the precision of a soccer score, where we know with absolute certainty team A got one more goal than team B.

Few things in life are that certain anyways. Why should the Cash Conversion Cycle be any different?

Key Takeaways

Financial data gets to the financial statements in a myriad number of ways that can significantly impact the Cash Conversion Cycle calculation. For this reason, we need to temper our conclusions when viewing an analysis of results based on it. If we want a more definitive conclusion, we need to be willing to spend a good amount of time and effort in order to achieve it.

Questions

· What has been your experience with using the Cash Conversion Cycle calculation?

· Can you identify other factors in AP, AR, COGS, Sales, and Inventory that might make comparison of two organization’s numbers apples-to-oranges?

Add to the discussion with your thoughts, comments, questions and feedback! Please share Treasury Café with others. Thank you!

What I Learned on my Winter Vacation

2012-01-25T23:10:00.000-06:00

There are several indicators that I am a business and finance junkie. For example, one of the highlights of our honeymoon was touring a sugar and plantation. Another example: we own a classic VHS tape titled “From Tree to Cup” (which not surprisingly is all about coffee production) acquired as a vacation souvenir.

Consequently, as we wrap up a Disney World vacation, I can’t help but draw some impressions about our trip from the professional side of things.

Following are some lessons we can learn from Disney.

Think Big – And Long-Term

The Disney complex in Florida is 47 square miles. If we think about this for a moment, we realize that if all we planned on doing was to build a theme park and a couple of hotels there is no reason we would buy up so much land.

However, by this very large purchase, Disney obtained an option to develop a much larger resort destination, which over the course of the last 40 years or so it has done. If it had just bought for the current term, it could not have grown into what it has. In other words, Disney bought for the future.

The Disney property is virtually surrounded with the trappings of gaudy tourism - hotels, restaurants, t-shirt shops, miniature golf courses, etc. Without the land buffer from its initial purchase, developing a new theme park later would require guests to pass through this neon maze when going from one to the other. Not great when you are trying to get the guests into a magical bubble where “dreams come true”.

March Slowly (Collins would be Proud)

Much as we discussed in our last post, “Why You Can Always Be Great”, Disney is a “slow marcher”. The Magic Kingdom was developed in the early 1970’s, EPCOT in 1982, Hollywood Studios in 1989, Animal Kingdom in 1998.

While the greedy might have developed faster (and perhaps gaudier), Disney seems content to manage the pace of growth rather than immediately maximizing the property’s capacity.

Maximize Your Content’s Potential

There are a great many Disney brands. The thing I noticed during this trip was how they maximize the “content within their library”.

For example, upon entering the ticket area we heard the “Yo-Ho” pirate anthem. In the Magic Kingdom’s Adventure Land, we witnessed a street performance with characters from the Pirates of the Caribbean. As part of this performance, several children were pirate apprentices and learned some lessons related to this profession. Later, we went on the Pirates of the Caribbean ride.

Toy Story’s Woody character was seen in a parade in the Magic Kingdom, at a character greeting and on a poster hanging high in Hollywood Studios, in a parade in Hollywood Studios, in the Midway games ride, on signs marking a parking section in the Magic Kingdom, and in Andy’s room which is in the courtyard of the All-Star Movies resort.

Some might say that all this activity is about marketing and branding, and that is legitimate from one aspect, but it also has a content angle. Once the initial character and story was created, someone asked questions such as: How can this character or story line appear in other settings? Wouldn’t kids love to play at being pirates? Why not train them during a street show?

Details Matter

Part of what makes the theme park experience appealing is immersion in the ambiance that is created, and this cannot be accomplished without a lot of attention to detail.

In terms of design, if you are waiting in Space Mountain, there are space games people can play while they wait. There are videos to keep folks entertained in line. There are 8-Track tapes that cover the exits of the Pop Century resort’s 70’s buildings. The staff in Frontier Land dress differently than those on Main Street.

In terms of operations, details impact the guest experience to a great degree. For example, traffic and crowd control – someone can get out of a Disney park within minutes, contrasted with leaving a basketball or baseball game in Chicago, which can be an hour long ordeal. Cleanliness is another example - I had to look for three days to find any gum on the sidewalk.

Rejuvenate Often

Disney seems to consistently rejuvenate their parks and properties.

In the Magic Kingdom, one of the six major park areas and part of another are under redevelopment. Prior to this, a new roller coaster was added to Animal Kingdom, which previously lacked a signature thrill ride. Pirates of the Caribbean, Tiki-room, It’s a Small World, the Haunted House, all have been worked on over the past ten years.

New items are added to the mix in what might be characterized as “in-between” spaces. With area surrounding each park, they can expand incrementally, which Hollywood Studios has done. If there is a resort complex on one side of a lake, a second one can be created on the other.

Key Takeaways

Disney World, in addition to entertainment value, can provide us with examples of important management practices, such as bold long-term thinking, managed growth, maximizing content, attention to design and operational details, and rejuvenation.

Questions

· Do you have a management insight or two that is exemplified by Disney?

Add to the discussion with your thoughts, comments, questions and feedback! Please share Treasury Café with others. Thank you!

Why You Can Always Be Great

2012-01-20T04:14:00.002-06:00

There is always a book in my briefcase.

For the past week it has been “Great By Choice” by Collins and Hansen. I decided to read this due to its popularity, though I at all times keep in mind the doubts about the research methodology discussed by Rozenzweig in “The Halo Effect”.

However, things do not always have to be rigorously true in order for us to glean something useful from them, and with that spirit in mind I think there are some things in this book we can look at.

Today we will look at one of them.

The Tortoise and the Hare

According to Collins, one of the traits exhibited by “Great” companies is “Fanatic Discipline”. The practice of the “20 Mile March” is used as a symbol and metaphor for this characteristic.

The book introduces this metaphor through a comparison of 2 people walking from Los Angeles to Maine in the United States. Person A walks 20 miles every day consistently, be it rain, sleet, snow or hail (kind of like the mailman). Person B walks 40 miles on a good day, and hunkers down in bad weather, or to recuperate.

The outcome is somewhat reminiscent of the Tortoise and Hare fable. Person A, plodding along no matter what, arrives in Maine well before Person B.

Collins further illustrates this point by comparing the successful South Pole expedition of Amundsen with the failed one of Scott. Amundsen made it, and Scott died trying. Amundsen happened to move forward almost every day, even in the face of gale force antarctic winds, while Scott, who mixed all out pushes with intermittent breaks, did not.

Even when good weather would allow for a 24 hour push to complete the remaining 45 miles to the South Pole objective, the Amundsen party only traveled 17 that day.

Don’t Get Too Comfortable

According to Collins: “The 20 Mile march creates two types of self-imposed discomfort: (1) the discomfort of unwavering commitment to high performance in difficult conditions, and (2) the discomfort of holding back in good conditions.”

In other words, we keep going when we are down, and we do it despite a plethora of excuses we could use to justify not doing it. And we leave a lot on the table even when we could legitimately take it.

It is this dual natured fact that creates for us such a golden opportunity.

We’re Only Human

The behavioral field of psychology posits two main objectives for us humans – pursuit of pleasure and avoidance of pain. People are generally programmed for these two objectives (according to this theory).

So if we contrast the “Fanatic Discipline” of the great, we have the following:

Great Organizations		Human Nature
Undertake painful activities		Avoid painful activities
Leave good things on the table		Pursue pleasurable activities

Great organizations are in conflict with human nature. For this reason, few will be able to undertake them. Few will want to.

Even those that begin with the intention to become great are likely to be talked out of it by their reasonable sounding advisors, friends, families, stockholders, other stakeholders, and the press.

The result is that very, very, very few will even seek to achieve it. So we don’t have any real competition…

It’s New Years Day

…except ourselves. And this is the critical part. We will have continuous conflict within ourselves, because we are going against human nature to accomplish this.

Going to the fitness center is usually fairly easy, there is always a locker, and a stair-master, and a set of weights available to use…except for the first few weeks of January. That’s when the place is over-run by the New Year’s resolution folks, vowing to get in shape.

However, by the end of the month, the place is back to normal again. Why?

Because to maintain that New Year’s vow means to go against human nature, to willingly seek out discomfort (when I first heard the term “no pain no gain” it was in a weightlifting context), and to avoid pleasure. Fact is, most people cannot do it.

Some Steps You Can Take

Remind yourself everyday of the objective – a key theme in Shunry Suzuki’s “Zen Mind, Beginners Mind” is the dedicated practice of meditation, which you undertake for its own sake, without any idea of benefit, everyday, without fail. While you do not necessarily need to practice Zen meditation to achieve a great finance and treasury objective, you need to focus on it with just as much determination as a Zen practitioner approaches their mediation activity, and with a similar attitude.

Make the goal real now – create a vivid and compelling sense of the goal using all five of your senses – what will things look like if it is achieved? What will you hear, from yourself and others? What will you feel? Smell? Taste?

Access your resourceful and motivational states – the field of Neuro-Linguistic Programming tells us to find instances in our past where we were motivated and committed in order to replicate and re-create them. When in the past did you achieve a goal? What did you picture to yourself that kept you motivated? What did you tell yourself? What feelings did you generate? Codify these processes and repeat them for the current objective.

Focus on What You Can Control – the first I heard of the different “Zones of Control” was in Covey’s “Seven Habits of Highly Effective People” and it breaks down like this: there are areas you control, areas you influence, and areas where you can’t do anything about. Focus on what you control and increase that zone wherever possible. Minimize your focus on the other areas.

Key Takeaways

We can take our organizations to greatness, provided we are willing to not be too greedy during good times and not allow bad times to knock us off track.

Questions

· What activities do you practice that keeps you on track to meet your goals?

Add to the discussion with your thoughts, comments, questions and feedback! Please share Treasury Café with others. Thank you!

Death by 1,000 Cuts

2012-01-17T08:54:00.002-06:00

Assume we own an airline and our airplane is about to pull away from the gate. At this point, a lot of incurred costs have been set – aircraft, salaries, maintenance, gate fees, etc.

At the last moment a potential passenger shows up. The costs for this one additional passenger are minimal – a slight increase in fuel due to the extra weight, a couple of soft drinks, an additional snack, and that is about it.

If we determine that these additional costs related to this one passenger (the technical term is “variable costs”) are ²20 (the symbol ² representing Treasury Café monetary units), then in theory we should be willing to board that passenger so long as the fare exceeds that amount, i.e. something ²21 or greater.

This is due to the fact that there will be some contribution to fixed costs (at least ²1).

A Time and Place

This type of decision is called “marginal” or “incremental”, in that we are deciding based on one passenger at one particular point in time.

However, by its nature, the logic of marginal analysis is not well suited to extrapolation.

For example, if we price all of our airline tickets at ²21, then we would make ²1 per passenger on the airplane. If our airplane held 100 people, we would thus contribute ²100 towards our fixed costs.

This is all fine and dandy, unless it so happens that our fixed costs for this flight are ²500. If this were the case we would lose ²400 on the flight. This is not a recipe for long-term success.

Thus, we need to make sure we are not making decisions based on a marginal approach when the fact is we are making them for a longer term.

Marginal Practices Create Complexities

For our airplane, in order to cover fixed costs of ²500, then we need to make ²5 per passenger on average (assume returns of and on capital are included in the ²500 figure for simplicity).

So while in theory we are supposed to accept the fare from the one last passenger that contributes ²1, this raises several complications.

First, the price for all the other seats needs to be slightly higher to cover the ²4 we did not earn from the last person. Thus, if we know we are going to employ marginal economic thinking when the plane is pulling away from the gate, we need to price other seats accordingly in order to hit our ²5 average.

Second, once people know of this pricing pattern, we will likely have future flights with more of folks showing up for ²1 pricing versus our needed ²5. The “full-fare” prices then need to also adjust accordingly to account for this.

This simple example illustrates that analysis is not just a simple mathematical exercise. The decision today can affect many tomorrows, a characteristic known as “path-dependency”. Since we are going to set fare prices for future flights, our estimate of “full-fare” vs. “marginal-fare” passengers introduces probability and uncertainty into our pricing decision.

There are other situations where we might mistake long-term decisions for marginal ones.

Financing Mirages

Take lease vs. buy analysis. We perform this analysis assuming 100% debt financing. We do this for a good reason, because leases are debt-like financial obligations, and will be counted as debt for purposes of most financial covenants and ratings agency assessments. If we can lease the asset at a 5% rate and borrow at 6%, we should lease. If we can borrow at 4%, we should buy and finance ourselves.

However, either way we can’t just simply stop the analysis there. If we have possession of ²1,000 in assets, financed at 50/50 debt and equity, and through the lease vs. buy exercise we find leasing more attractive, so we then lease the next ²1,000, we now find ourselves at 75/25 debt and equity rather than 50/50. This change in our capital structure is going to impact our credit rating and our financial covenants. It certainly has impacted our risk position.

A series of seemingly “one-off” transactions has now snowballed into a major long-term impact.

Strategic Mirages

Another common place where incremental thinking can go awry is in strategic situations.

If we are a firm in a line of business where our required equity return (as determined using one of the thousand variations of the Capital Asset Pricing Model) is 12% and cost of debt is 6% at a 50/50 capital structure with a 50% tax rate, our weighted average after tax cost of capital is 7.5%.

We then purchase a line of business different than our current one. Let’s assume this is a riskier business, so the required equity return is 18% at a 50/50 capital structure. Assuming the same debt cost, our weighted average cost of capital is 10.5%.

Since at the outset, the cost of capital is 7.5%, and the new line of business is small, some will simply use the existing cost of capital to value the investment in this new line. As long as it is a very small piece of the whole pie, it is probably not terribly important.

But if the new line takes off, and becomes half of our company, then we find we have a weighted average cost of capital of 9%. Since the investments were all made to clear a hurdle of only 7.5%, our investors now find we are under earning by 1.5%.

This will not make them happy.

Wear Both Hats

In order to avoid the problems above, we need to analyze situations not only in their incremental form, but also as-if they are in long-term form as well. Even if they are not, we need to pretend that they are.

If we are going to invest in an asset via a lease, then we need to anticipate investing in a future asset via 100% equity. We need to make sure that the returns from the lease investment is such that it would be achievable as if it were financed at our target 50/50 capital structure.

If we do not do this, we may never make that all-equity investment, if only because the return hurdles are so much higher they might not be achievable.

For our strategic investment, while we might have access to 7.5% money, we still need to ensure that the new line of business will be economical as if it were financed by 10.5% money. Or, we need to make sure we realize and are confident that a less than 10.5% investment today will be made up for tomorrow with a greater than 10.5% investment.

Key Takeaways

When considering incremental or on-the-margin opportunities, we need to make sure we analyze them two ways, not only incrementally but as-if it is a long-term decision as well.

Questions

· Can you recall a time when incremental analysis was used inappropriately in your organization?

Add to the discussion with your thoughts, comments, questions and feedback! Please share Treasury Café with others. Thank you!

More Eyeballs for Dessert, Please!

2012-01-13T09:43:00.000-06:00

We have recently covered innovation in two separate posts.

In “More Eyeballs, Please!” we looked at the topic from the point of view of number of tasks we could take immediately with minimal organizational distraction.

In “May I Have a Framework for My Eyeballs, Please?” we examined innovation from the point of view of some major strategy consulting firms.

This third post in the trilogy looks at developing new ideas and innovation from a methodological perspective.

SCAMPER

This is an acronym for a series of questions designed to create new perspectives. It stands for:

· Substitute – can we substitute one thing for another? Bran flakes for corn flakes? Plastic for Steel?

· Combine – can we combine items? Raisins with cereal flakes? An iTunes store with a music device?

· Adapt – can we use something already in existence in a new way? Duct tape the rear-view mirror? Retail store model to sell our product?

· Modify (or Magnify, or Minify) – can we make something bigger or smaller? Can we make this phone’s touch screen bigger and call it a tablet?

· Put to Other Uses – can we put this to another use? Use the stapler as a hammer?

· Eliminate - is there something we can eliminate? Can we eliminate the game controller? Can we eliminate a separate keyboard?

· Rearrange (or Reverse) - what if things were in a different order?

Further Resources Links for SCAMPER:

http://litemind.com/scamper/

http://www.mindtools.com/pages/article/newCT_02.htm

http://creatingminds.org/tools/scamper.htm

Four More

If I were to cover all the other types in as much depth as SCAMPER, we would be here all day, so I am going to provide a brief description of some others along with a link to a further resource (usually the Asian Development Bank - great depth of articles in their Knowledge Center!) with more information and a listing of further resources:

Appreciative Inquiry – this process attempts to rely on theories such as positive thinking and the aspirational nature of people in order to bring more of these elements into the organization.

The Reframing Matrix – this term is used to describe looking at a question from different perspectives. A corporation might look at an issue from customers, employees, and shareholders point of view. Internally, one could look at a question from different functions viewpoints – what would marketing’s approach be? Operations? R&D? Sales? Finance? HR?

Thinking Hats – this technique uses different styles of thinking to generate different perspectives on a question or problem. Each style of thinking uses a color, so if we want to think about “just the facts” we would put on our White thinking hat.

Fishbones - the Fishbone diagram is a staple of Six Sigma methodologies. The focus for this tool generally centers around a process or event we wish to ascertain a root cause for, but there is nothing stopping us from using it for innovation rather than problem solving. The “bones” can be 6M’s, 5S’s, or 8P’s.

Get in the Spirit

Considering these different techniques can lead someone to get very confused and overwhelmed. What is the best method if we want to innovate a process? What about a new product? A service?

My belief is that any of these innovation methods will do a good job of identifying ideas (that’s why they are in this blog post and not on ‘the cutting room floor’).

What is more important is that a group of people who are motivated and interested in doing it are present.

I was once in a SCAMPER session that was part of a project where nobody was motivated to change from the status quo. There were maybe three ideas, and they were all lame.

I was in a Fishbone session once with a group and we had great fun with the technique and with each other, and came up with several ideas that could be put to use immediately or warranted further pursuit.

Key Takeaways

There are many models available that can assist a motivated team to innovate and create new ways of performing our work, the key word being “motivated team”.

Questions

· What has been your experience in using any of these idea generation techniques?

· Are you motivated to change your work processes and/or your organization’s products or services?

Add to the discussion with your thoughts, comments, questions and feedback! Please share Treasury Café with others. Thank you!

May I Have a Framework for My Eyeballs, Please?

2012-01-10T12:32:00.000-06:00

In last week’s “More Eyeballs, Please!” post it was suggested that we can’t seem to get enough of innovation. This may have been an understatement, since in less than one week’s time it has vaulted into the top 10 all-time Treasury Café posts!

Last week’s focus was on simple things we could do tomorrow – they did not involve a lot of organizational rigmarole, or require multiple layers of approval, or insist on senior management “buy-in”, or depend on a long involved business cases whose objective was wresting large amounts of budgetary dollars.

These are things that should almost always be avoided, so we will not focus on them this week either, though we will “turn the kaleidoscope” and look at innovation from some slightly different angles – those of the major consulting firms.

A Strategy, a Goal and a Culture

Booz & Co’s recent article “Why Culture is Key” summarizes key findings in their “Global 1000 Innovation study”.

Three strategies for innovation were outlined:

· Need Seekers – “shape new products and services based on superior end-user understanding”

· Market Readers – “focus largely on creating value through incremental innovations to their products and being ‘fast followers’ in the marketplace”

· Technology Drivers - seek to solve the unarticulated needs of their customers through leading edge new technology”

When we combine the objectives and cultural attributes of all three strategies, the two top innovation goals were:

· “Superior Product Performance”

· “Superior Product Quality”

And the two top cultural attributes were:

· “Strong identification with the customer and an overall orientation to the customer experience”

· “Passion for and pride in the products and services offered”

What strategy is best for a finance and treasury group will depend on the context of the situation. If the group is in a large, well-established firm than a Market Reader strategy will likely make the most sense, whereas in a small company a Need Seeker strategy could lead to really stellar long-term outcomes.

While the strategy may vary, the rest of it is fairly straightforward no matter who you are: shoot for superior products and services, do it with passion, and focus on your customer.

Apparently, despite its mystique, innovation is not rocket science.

Build a Network

In “Leadership and Innovation”, McKinsey & Company devotes a large portion of the article to innovation networks. Indeed, they state that “recent academic research finds that differences in individual creativity and intelligence matter far less for innovation than connections and networks”.

This is particularly intriguing since in the Wikifinance, Wikitreasury series we discussed tacit interactions in social networks to be the primary unit of work.

McKinsey outlines four critical steps in designing the “innovation network”:

· Connect - find pockets of people with the right mind-sets for innovation with a mix of approaches, seniority, and skills

· Engage – establish a framework around goals, objectives, time frames, levels of commitment

· Support – determine and provide sponsorship/leadership, technology and other support required and critical knowledge and information inputs

· Manage – recognition, performance management, assessment and tracking, membership transitions.

And four different “archetypes” of the innovation network’s members:

· Idea Generators – come up with ideas, ask questions, willing to take risks on high-profile experiments

· Researchers – mine data to find patterns, which they use as a source of new ideas

· Experts – value proficiency in a single domain and relish opportunities to get things done

· Producers – orchestrate the activities of the network, most likely to be making connections across teams and groups

Going back to the introduction for this post, we want to focus on keeping things simple. Even without a formal organizational effort, our treasury and finance groups can evaluate activities to execute the “innovation network” functions. For example, we can identify who in the organization has the innovation mind-sets and connect with them.

We can also get a sense of where our group’s strengths lay in terms of the archetypes – do we generate ideas? Are we really good at getting things done?

From McKinsey, we have learned that in order to innovate we need to work together and we need to include all kinds.

Key Takeaways

According to the consultants, innovation is not rocket science - all we need to do is get all kinds of people into a network together and focus on developing a superior product or service with passion, pride and a customer emphasis.

Questions

· How would you go about creating an innovation network in your organization?

· How do you focus on your customers and their needs?

· Which of the archetypes do you fit the best?

· If innovation is really this simple, why is it so hard?

Add to the discussion with your thoughts, comments, questions and feedback! Please share Treasury Café with others. Thank you!

More Eyeballs, Please!

2012-01-06T08:35:00.000-06:00

Innovation is one of those business topics that always seem to be on the front burner. We can’t seem to get enough of it. And for good reason!

Innovation is the way to create growth, keep a leg up on competitors, and achieve cost savings, among other things.

Innovation can often be spurred when someone unfamiliar with what we are doing encounters our work processes. Questions that were long-ago answered and then forgotten are asked again, requiring thoughtful and intelligent thought. Often, we find that they are answered differently than they were originally.

How can we get a “fresh set of eyes”?

Rotate for Fresh Viewpoints

It is when things are fresh and new that we usually ask questions about someone or something – why are we doing this? What is it for? How does this work? What do I have to do next? What choices do I have to make?

When two or more people hold a similar role, sometimes the work can be reorganized differently. If both people do tasks x and y, then we can reorganize it so that one person does all x and the other does all y.

We then rotate these people through the various roles periodically.

The benefit to this is as follows: if someone has been performing x for the last week, then at the time they move over to y they are doing something they haven’t done in a while, and they are going to be much more likely to ask questions about the process.

Swim Upstream and Down

Another mechanism to invite scrutiny from another perspective is to meet with our “upstream process suppliers”, or our “downstream process customers”.

We can do this in a meeting setting or a site-visit type of format. The objective with this is to show the other group what we do, how we do it, walking them through the process and its results.

Since this level of detail is new to others, they serve as our “fresh set of eyes”, and their questions as they seek to understand the information can lead to new ways of thinking about what we are doing.

For example, most payments are approved through an automated process, but there are various areas where specific exemptions to this are in place. The payment processor would need to refer to several tables and lookup screens to identify the appropriate exemption.

Once we realized this, we were able modify the process with a simple fix “upstream” that avoided almost all of the extra time and effort involved with the exceptions.

Roll Up Your Sleeves

One of my favorite techniques is to do my staff’s jobs from time to time. My own eyeballs become the fresh set.

One task someone on the team performed was to prepare a report using downloaded data from a system. As I performed this task, my understanding of VBA programming led me to the conclusion that we could likely program a large portion of the task.

We ended up creating a simple Excel routine that automated 80% of the task.

Use Your Bankers

Most banks have treasury personnel that are happy to tour our facilities, sit with our people, and witness how we accomplish our various tasks.

These folks have seen a lot of organizations, witnessed a lot of tasks being accomplished in a myriad set of ways. Their “fresh eyes” on our processes, combined with that background of knowledge, can often generate surprisingly easy improvements.

For instance, upon noticing an operation that required the person to refer to several documents back and forth in succession, they recommended we install dual screen monitors for those performing that function. This very simple recommendation saved over 20 minutes per day per person.

Schedule It

When I was in the asset based lending field, we would do an annual “Legal File Review”. This entailed sitting down with the five-inch thick set of documents with a lawyer, and laboriously plowing through each one.

As part of this process, a lot of questions were asked. According to x, we should be doing y, how are we going about that? These questions provoked a lot of re-examination about the loans.

When I moved over to the corporate side, we continued this tradition with the agreements that Treasury and Finance undertake. It forces us to put our eyeballs back onto things we might otherwise not, and it has driven changes and improvements, and it has certainly ensured compliance!

Set the Stage

There is resistance to opening up work processes to outside examination. We fear we will be criticized, or appear incompetent, or that we will likely need to change. All of these feelings work against the suggestions here.

As leaders, the more we are able to create an environment where mistakes are allowed, where growth is valued, where learning and trying new things out is encouraged, will make a difference in the effectiveness of these simple techniques.

It is a necessary prerequisite.

Key Takeaways

There are simple, homegrown and inexpensive ways to keep the work fresh in the eyes of our teams. Once we have created an environment that eases the fear of change, we can create a setting for innovation by:

· Rotating roles within the team

· Bringing in our process partners as observers

· Jumping into spots ourselves to perform the work involved

· Asking our banks for assistance

· Scheduling reviews and asking questions

Questions

· How do you keep the work fresh in a way that brings about new ideas that improve the process?

Add to the discussion with your thoughts, comments, questions and feedback! Please share Treasury Café with others. Thank you!

Rollin’ the DICEE – Another Take on the Treasury Vision

2012-01-03T08:52:00.000-06:00

Guy Kawasaki is one of those tech gurus that grew out of the early heyday of Apple and the whole Silicon Valley scene. He has written two books that I have read – “Reality Check” and “Enchantment” – and many more that I haven’t.

In both of those books, as well as his blog, he has discussed the acronym DICEE and how he uses that to evaluate great causes.

By exploring the question “how can Finance and Treasury be DICEE?” we can gain some insights into how best to direct our efforts and activities.

Deep

According to Mr. K - “A great product is deep. It doesn’t run out of features and functionality after a few weeks of use. Its creators have anticipated what you’ll need once you come up to speed. As your demands get more sophisticated, you discover that you don’t need a different product.”

Notice the future orientation contained in this characteristic – “anticipation”, “demands get more sophisticated”, and “moving up the power curve”. We need to be ahead of the organization’s game in order to provide a “deep” experience of Finance.

How do we do this?

Maintain strong relationships with the operating units - through information exchange (both formal and informal), conversations, and relationship development we will be in a better position to ascertain where these entities are headed, allowing us to ponder their needs once they get there.

Maintain strong relationships with our business partners - our banking partners, vendors, and other suppliers have a window into what others are doing and what might be important for us to consider.

Keep developing and expanding the skill set – we need to continuously improve our skills, abilities and experiences. Sure, we might not need the deep, “Big Data” analytic capability today, but if we have those skills we are in a position to lead towards a different kind of tomorrow.

Indulgent

From the blog, Mr. K states that “A great product is a luxury. It makes you feel special when you buy it. It’s not the least common denominator, cheapest solution in sight. It’s not necessarily flashy in a Ferrari kind of way, but deep down inside you know you’ve rewarded yourself when you buy a great product.”

Develop criteria – when we went through the process of developing the Treasury Vision, one relevant question was “how would we know if we obtained our objective?” Since being a Trusted Advisor presupposes a relationship with those whom we advise, a pertinent criteria would be our business partner’s reaction.

What does this look like? One example would be if a salesperson from our company is at a salesperson conference talking with other salespeople at other companies, and the topic of their respective Finance and Treasury groups comes up, our goal is to have our salesperson leave that conversation thinking “I am so happy I have the Finance and Treasury group that I have”.

It is not an easily quantifiable metric I know, but it is the outcome that we want.

Provide Unique Tools - another means of accomplishing this type of impact is to provide those in the firm with tools that are easy to use, tailored exclusively to the business, and are unique to the firm and the industry.

For example, anyone can put out a spreadsheet on the organization’s intranet that calculates Net Present Value. A lot of these are not very user-friendly – apart from some cells shaded to indicate input areas, they are not protected against inadvertent errors in the other places, the terminology is confusing, the equations in the cells are very complex, the format and layout are not well understood when they are viewed in printed form.

This is a great opportunity for the marriage of tech skills and finance skills we have discussed previously. If we sit down with the group, see what they do for a day, walk in their moccasins, go through step by step what the drivers are that they pay attention to when filling out those spreadsheets, we are in a position to customize an application especially for them, either in Excel, or a separate program in C++, Java, Visual Basic, iOS, etc., that works seamlessly with their other applications and is understandable by them.

Complete

“A complete cause provides a great experience that includes service, support, and a string of enhancements.” It is a “total user experience”.

Excelling in the completeness category needs to go beyond the basics if we are to succeed. Sure we need to answer phones and respond to emails in a timely manner, but there needs to be more.

In the context of the organization, one potential metric of our success in the completeness category is “mind-share”, a branding concept. Do others in the organization think of us immediately when a problem or situation comes up where we have developed an expertise? Are we the “go-to” group? Is our perspective sought out on items that are only remotely linked to us?

Educate the Customer – discussing with the different organizational entities the importance of various concepts we specialize in – Net Present Value, Cost of Capital, Strategic Leverage, etc. – enlists them as partners in the process. There is understanding of the rhyme and reason for things, and enables all to build off of a solid and commonly shared platform.

Be Supremely Flexible – this objective is challenging as it demands consistent creativity and innovation on our part in order to “roll with” others within the organization, delivering quality knowledge and insight in ways that fit easily within their already existent frameworks.

Empowering

“An empowering cause enables you to do old things better and to do new things you couldn’t do at all. It makes you smarter, stronger, and more skilled. It increases your confidence and your ability to control your life.”

Empowerment is a tricky organizational objective. Often corporate politics is about getting the bigger budgets, the higher allocation of employees, the corner offices in the prestigious locations. This is usually accomplished in part by being indispensible and vital.

If we empower our organizational customers, they end up with a greater degree of independence and are the source of their own success. They do not need us as much. They then begin to get the corner offices and the larger budgets.

Focus on what is important – keeping a focus on our critical mission, which is to be a trusted advisor and well-regarded teammate with valuable perspective, insight, and knowledge, we will more often than not err on the side of empowering our customers rather than getting caught up in the shallow political games.

Keep Turning the Kaleidoscope – part of the definition of empowering is to help customers “do new things” they couldn’t do before. This requires us to look at situations in new ways, in order to arrive at new or re-thought about ways of performing activities and achieving objectives.

Spend Time in the Trenches – just like a toddler delights us with a way of looking at things that we have “forgotten”, when we are able to participate with our customers in their activities the extra “set of eyeballs” can often bring a new perspective or way of thinking about things that is productive.

Elegant

Mr. K says: “An elegant cause means someone cared about the user interface and experience. An elegant cause works with people. An inelegant cause fights people.”

The interface terms belies his technological background, but in two words most who have dealt with a CFO organization can grasp the work-with or fight-with dynamic:

“Budget Process”

This is often used as an excuse for testiness or snarkiness – “I’m sorry about that last email, we are in the middle of the budget process you know” to which the response of “Ah, perfectly understandable” is then expected.

Indications that “someone cared” are found throughout the first four categories – going beyond the basics, anticipating future needs, customizing to the needs of the customer are all parts of the “user interface”.

Have a relationship manager with key constituencies – one means to maintain this elegance is to have someone “on point” with our critical customers to ensure that elegance is being constantly maintained, and identifying points where our business model is no longer DICEE.

One example is from the time I was responsible for development and maintenance of the 5-year plan for a business unit. We had preparation meetings, seeking to understand what the users of the information wanted to see, what aspects of the operation were critical value drivers, which activities made the big differences. We developed and tested in iterations. The outcome of this was a set of user templates that were in most cases 5 lines. The rest of the forecasting process we were able to accomplish on our own.

Key Takeaways

Using a framework such as DICEE when considering our operations and activities within the organization, Finance and Treasury can develop, initiate, and continue practices which will add value to its “customers” in many non-traditional and innovative ways.

Questions

· Do you have a situation where you participated in a Finance and Treasury operation that was Deep, Indulgent, Complete, Empowering and Elegant from its customers perspective?

· Do you have an experience where the opposite occurred? How might this be changed for better effect the next time around?

Add to the discussion with your thoughts, comments, questions and feedback! Please share Treasury Café with others. Thank you!

Baby...or Bathwater?

2011-12-29T18:28:00.000-06:00

Envision the followingscenario:

One of your riskprofessionals comes up to you and says “We should purchase this analytic systembecause it successfully predicted the downfall of the financial institutionsthat failed during 2008, it’s great!”

How should we respond?

To answer this question, weneed to take a small detour into thewonderful world of statistics.

Who is Null and Why Did He or She Have a Hypothesis?

Statistical comparisonsinvolve two sets of data, the “control”group and the “treatment” group.There are two possible relationshipsbetween these two groups - either there is not anything conclusive to show thatthey are really that different (the Null Hypothesis) or there is (theAlternative Hypothesis).

The person doing theinvestigating is usually looking toprovide evidence for the Alternative Hypothesis. Alternative Hypothesis’are based on questions such as: Does this drug work? Are guilty people sent tojail? Does this model adequately predict firms’ financial ruin?

The answer to this isdetermined using statistical techniques. Two outcomes are possible, 1) we “fail to reject the Null hypothesis”,meaning there is no evidence to support that the two groups are not the same,or 2) we “reject the Null hypothesis”,meaning the two groups are significantly different.

Poor Mr. or Ms. Null!

Imagine proposing to someonethat way – nice dinner, get down on your knee, bring out the ring box, and say“I fail to reject you as a spouse”! Pretty romantic, isn’t it?

Why the Funny Terminology?

I am sure some know thetechnical reason for this (if so, please leave a comment!), but the thing Ithink of (maybe because it is easier to remember) is Nassim Taleeb’s discussionin “The Black Swan”, which went something like the following:

Wecan count 10,000 swans, or as many as we have ever seen (if more), and they canall be white, but that does not prove“all swans are white”. It just means the ones we have observed are.

However,we can count 10 swans, or as few as 2, and if one of them is black, that does prove that “not all swans arewhite”.

One thing is provable, one isnot. Thus the funky terminology about “rejecting or failing to reject” the Nullhypothesis.

Enter Reality

So we have two statisticaloutcomes of the data based on the Null Hypothesis, and two sets of data in reallife that may or may not be different.

Any consultant knows thatthis should become a 2x2 matrix!This matrix will have one axis cover the statistical conclusions regarding thedata and the other axis describe the actual reality of the data.

In two of the four boxes,reality matches the conclusion, and in the other two it does not.

The Romance Continues - Adding Error to Rejection

Statisticians have come upwith some great terms for the other two boxes in this matrix. It is with greatpride that I present to you these two inspired terms:

· Type I error

· Type II error

We can all see why they awarePhD’s for this kind of stuff!

Our matrix is now complete,as follows:

We Now Conclude Our Detour and Return to Our Scenario

Going back to our originalscenario, we have been presented with this fantastic but costly software that isable to predict with 100% accuracy a firms’ financial failure.

The question that we need to ask is “what is the fullset of prediction data this model generated?”, and how does this compare to thealternative?

In the actual outcome of theabove, this financial model predicted that over 30 financial institutions weregoing to fail! In other words, it threw out the baby with the bathwater!

Key Takeaways

While we do not want to “throw out the baby with thebathwater”, nor do we want to “keep the bathwater with the baby!”

Questions

· What has beenyour experience with Type I and Type II error

· What has beenyour experience regarding the omission of one of the two?

Add to the discussion with your thoughts, comments, questions and feedback! Please share Treasury Café with others.Thank you!

Software as a Service or Installed?

2011-12-27T14:50:00.001-06:00

As discussed in prior posts, going with a Treasury Workstation involves a decision between utilizing the Software as a Service delivery model or the Installed model. Each has its strengths and weaknesses.

Googling this topic will get us zillions of hits. A lot of these are written by folks with an ulterior motive. One SaaS vendor had a pros and cons, and in the cons had a bullet that said installed software costs about 23% of the installed price in annual maintenance and licensing fees. I know from experience this is not always the case, at least in the projects I have been involved in.

Triangulating

As you know from prior posts, I am a fan of the process of “triangulation”, which in research mode means answering the question “what are the common and universal themes?” or “what topics show up more than once?” rather than taking any one document at its word.

In a sense it is creating a “best of…” set of information. Where there are many opinions, this process helps to identify what we might be able to really believe, as opposed to running into a “one off” opinion.

Links to six articles I reviewed are at the end of this post. In addition, there are links to several consultants who maintain archives on Treasury Workstation vendors and selection issues.

For the Treasury Workstation, there are two main factors that show up in almost every piece.

Financial Elements
The financial implications are obviously one of the primary drivers in this decision. There are a couple of different perspectives that need to be considered.

Payment Timing – for an installed system, there will be a large initial outlay of cash for the purchase of the license and the installation. The SaaS version has a much lower initial outlay.

Some organizations will appreciate the ability to capitalize and amortize a larger upfront payment, while others might consider an annual operating outlay to be more advantageous.

Ongoing – these costs are associated with annual maintenance and licensing fees. They can vary considerably. In theory, the installed system should be lower than the SaaS, since the installed vendor got an upfront payment, is not hosting anything on their system, and is not directly responsible for the continuing maintenance of the system.

In addition to payments to the software vendors, internal costs will also differ. The resource requirement is going to depend, no matter the choice, on how the system needs to integrate with others within the organization.

Deployment and Integration

The ability of the software to “play well” with the rest of the infrastructure is a primary factor in what the magnitude and scope of deployment and integration will entail.

If the installed route is chosen, it is often due to the fact that a deeper integration with the rest of the technology infrastructure is desired, which can take more internal resources to accomplish.

However, given that the SaaS systems cannot be customized to a great extent, it is also possible that the resources required to modify existing internal systems to work with the external will also be great.

Upgrades – since upgrades for the installed user are optional, a system delivering acceptable functionality can avoid costs associated with adding new or updating features, whereas a SaaS provider will pass those along.

To the extent that customization has occurred, upgrades pose the risk of making those customizations obsolete, so they need to be reconfigured with the upgrade.

Key Takeaways

Selection of an Installed or SaaS version of a Treasury Workstation requires a lot of thought and effort with respect to cash flow differences between the two products, and the organization’s implementation of its’ IT infrastructure strategy. Both forms of Treasury Workstation have their advantages and disadvantages, and it is up to the organization to decide what factors are to receive more merit in the decision than others.

Questions

· If you have recently implemented a Treasury Workstation solution, what were the primary factors that drove the decision between installed or SaaS versions?

Add to the discussion with your thoughts, comments, questions and feedback! Please share Treasury Café with others. Thank you!

Links for the Article

http://www.upsidesoft.com/Upside+Software/PDF/UpsideLive_ProductSheet-SaaS_vs_TradInst.pdf

http://blog.it-doneright.com/2011/01/03/new-year-part-2-saas-vs-locally-installed-software/

http://www.cabinetng.com/white-papers/internal_v_hosted.php

http://www.pragmaticmarketing.com/publications/magazine/6/5/the-economics-of-software-as-a-service-saas-vs-software-as-a-product

http://www.ama-assn.org/resources/doc/hit/asp-saas-client-compare.pdf

http://www.capterra.com/blog/finding-buying-software/top-3-advantages-and-disadvantages-of-installed-software-vs-saas

Consultant Links

http://www.treasurystrategies.com/rl/Treasury%20Technology

http://www.strategictreasurer.com/Links.php#tech

http://www.treasolution.com/ts_treasurylinks_treasury_technology.htm

No Way Back

2011-12-20T18:00:00.000-06:00

In our recent Treasury Café postwe discussed, at a very high level, fourdifferent options to handle the cash management needs of the organization –accounting system functionality, spreadsheets, bank provided systems, andTreasury workstations.

The decision to move from avariety of in-house processes to the more complete ERP or Treasury Workstationsolutions involves a very criticalstrategic (to Finance and Treasury) component we best not ignore.

A Business Case is Key

Most organizations, whenconsidering a technology investment, will require the development of a businesscase.

A business case can be thoughtof as a mini-business plan. It will contain an overview of the proposedproject, explain why that project is needed, detail how the project will beinitiated and managed, discuss the organizational impacts that will occur, anddemonstrate a financially compelling story, among other things.

The Initial Transition is Valuable…

Why is this business case processso critical?

In a nutshell – economics.

Look at any TreasuryWorkstation vendor, or any consulting firm who includes in its scope ofpractice (such as Treasury Strategies and their Treasury 3.0, a subject ofprior Treasury Café posts), and themajor economic selling point for adopting the technology is the benefit derivedby moving from spreadsheets and “off-line” processes to the more seamless,integrated, and accommodating functionality of the proposed technology product.

It is indisputable that thereare labor savings.

To give an example, if ourcash management staff was originally 10, with the workstation we might be ableto use 6, so the 4 FTE savings, because they are perpetual, can go a long waytowards paying for the system.

…but the Die is now Cast

So let’s assume that weembark on a project and that we realize all the benefits we had anticipated.This is great! It might go down as the best project in all of mankind!

What is wrong with thispicture?

After a period of time, whetherit be three years, or five, or ten, supposewe determine that a different system or technology infrastructure is moreadvantageous?

We might decide this for a number of reasons. Perhaps the vendor’s support for the current system hastransitioned from “continuous-improvement updates” to “maintenance-only”.Perhaps we want to move from installed base to SaaS due to our web utilizationpatterns. Perhaps we want to just stay “ahead of the curve” due to anorganizational philosophy.

Our problem is going to bethat, unlike the initial transition, movingfrom one system to another does not yield many tangible, identifiable benefits.

We went from 10 to 6 with ourlast project. This project might not yield any additional FTE savings, orperhaps at most 1.

In other words, we will incurexpense for the project, without any offsetting benefits to pay for it. Whenthe CEO or CFO then asks “what are we going to gain on next year’s P&L bydoing this?” the answer will be “none” or “not much”. Not a very persuasive argument, is it?

Given this, the system bywhich we take out the legacy inefficiencies will be the system we are likelygoing to continue to use (i.e. be stuck with) for many years to come.

Key Takeaways

Make sure your initial system selection is somethingyou will be able to live with for agood period of time. Moving from one system to another does not yield manydramatic economic benefits like the initial transition.

In other words, there’s nogoing back and there’s no do-over’s…and “building the bridge to the future” doesnot always make the most compelling tangible economic argument.

Questions

· Are you managingcash on spreadsheets or a technology product?

· How long have youbeen on your current technology product?

· Is there anymomentum for a “next generation” product in your organization? If so, how wasthis accomplished? If not, why was this plan not deemed appropriate?

Add to the discussion with your thoughts, comments, questions and feedback! Please share Treasury Café with others.Thank you!

How Long is 1,000 Man Years?

2011-12-18T18:00:00.000-06:00

In a recent post on Treasury technology options, I made clear a belief that Finance and Treasury should strive as much as possible to control its technology destiny.

The reason for this is that often when an IT change is desirable, the following reaction occurs amongst the IT folks when the possibility is broached with them:

· The eyes grow wide and bulge-out slightly

· Both hands are raised and begin flailing wildly back and forth in the air

· A variety of half-coherent ramblings are made, but always including the phrase “that will take 1,000 man-years to complete”

· Coherence returns along with the admonition that this request was not made three years ago, when the current year’s work was being planned

If we are to achieve the best we can, we need to somehow manage this fact of organizational life.

Focus on What You Can Control

My point with this is not to idly complain, because as we all know that does not do a lot of good. What will do a lot of good is if we take responsibility for fulfilling our organization’s needs in the best way we can so that we can achieve our objectives.

By doing this we focus on operating in the realm of things we can control rather than in the realm of things we cannot. Covey wrote about this in his “7 Habits of Highly Successful People” book.

Get Skilled

One very simple thing we can do is to accumulate a reservoir of technology talent, knowledge, and ability within our group. This is advantageous for several reasons.

First, with an understanding of how the technology works, the coding demands of different software elements, the system architecture and its design rationale, and an understanding of our needs, we are able to ask pointed, intelligent questions that help break down the “1,000-man years” perception into a series of component parts.

Projects become a lot less overwhelming when they are “chunked”. Having the ability to discourse intelligently and purposefully about the systems can often bring about a more mild reaction, and inspire “can do” thinking to replace the “can’t do” knee jerk reaction.

Second, technology is being incorporated into the fabric of everyday life in more and more ways.

Five years ago I knew nothing about routers, but now have a home network set-up like half of the others neighborhood. We can control our furnaces from smart phones. We get our grocery coupons on-line.

Get Operational

Technology knowledge helps us to be able to do more things for ourselves.

We can program routines using Treasury Workstation functionality. We can program Excel using Visual Basic for Applications in order to make information input simple while providing a seamless translation for upload into the workstation.

From our technical knowledge we are able to create systems and environments that interact with each other seamlessly, much as a great basketball team passes the ball around to move down the court for the open shot.

In addition to being in control of our daily life, there is one additional advantage. It earns the respect of the IT folks. They understand the work we have done, the investment of time and energy we have put in, and due to that we have earned the right to make some requests and expect them to be honored.

Get Graded

In the Steve Jobs biography by Isaacson, there is a passage that states something to the effect that A players seek the company of A players, while B players seek the company of C players.

By virtue of the work we have done by ourselves, on our own, to the best of our ability, pushing our knowledge to its limits and seeking to learn more, we prove we are A players. Due to this, we are more likely to attract the A players of IT.

The A players of IT are not the ones who go through the “1,000 man-year” dance. They are the ones who say – “Yeah, there’s a way we can do that!” Working with these folks is a joy and pleasure.

Key Takeaways

Our usage of technology will grow each and every year, as we have previously discussed in WikiFinance, WikiTreasury. In order to stay ahead of the trends, and work at our best with the rest of the organization, we need to:

· Continually learn new technologies, understand how they work and how to make them to interact

· Develop a level of technological sufficiency to perform tasks for ourselves (increasing the zone of control)

· Communicate intelligently with our IT specialists, creating a level playing field of mutual respect

· Create a compelling and challenging environment that attracts the A players

Questions

· What current technology learning opportunities are available in your current organization?

· What is the likely route of next generation technology that you need to “get up to speed” on?

· What is the status of your relationship with the IT folks? Is it respectful?

· What parts of the process can you perform in order to reduce the “1,000 man-years” reaction?

Add to the discussion with your thoughts, comments, questions and feedback! Please share Treasury Café with others. Thank you!

I’ve Been Workin' at the Station, All the Live Long Day

2011-12-15T04:23:00.000-06:00

Today I had the privilege to be the guest panelist for the Corporate Executive Board’s Treasury Leadership Roundtable Cash Management Cohort webinar on “Trendsin Treasury Technology”.

These kinds of events are alwaysfun for me because I can deliver some of Treasury Café’s insights to a newaudience in a different setting. As an added bonus, the folks at the TreasuryLeadership Roundtable do most of the “heavy lifting” - I just have to show up!

However, since my short-termmemory is notoriously fickle, I decided it best to cover that event now whilethings are still fresh in my mind.

Choices, Choices

For cash management andrelated roles, a company’s treasuryfunction will utilize either a) theorganization’s accounting systemfunctionality, b) traditional spreadsheets and othergeneric office tools, c) bank suppliedfunctionality, or d) specialized software systems referred to as Treasury Workstations (hence the titleof this blog post).

There are pros and cons to each alternative.

Option A – Jump In With the Accountants

The accounting systemfunctionality (and by accounting system I am referring to SAP, Oracle/Peoplesoft and others) is somewhat limitedcompared to the specialized alternatives. It is also more cumbersome. Itcan also be quite costly.

But the primary drawback inmy mind to this is that the Finance and Treasurygroup is beholden to the IT department. And the IT is much more interested in serving the accountants than the Finance and Treasury folks.

It all makes sense, though.It is difficult to see how it can be different. The accounting system istypically of primary concern to accountants, not finance folks (see Why You Need a Finance Person for some of the differences).

Accountantsin an organization outnumber financefolks by large orders of magnitude - 5 to 1, 10 to 1, 20 to 1.

CFO’s oforganizations usually emanate from theaccounting fold, which makes that group their favorite, and the source oftheir technical chops.

There are a lot of Sarbanes-Oxley (SOX) requirements foraccounting, and since CFO’s are on the line personally when certifying thevalidity of the accounting results, these issues get a lot of C-levelattention.

Let’s recap - the masses like it and the powerful elitelike it.

Now imagine being the ITperson assigned to the accounting system. You have two requests, one fromaccounting and one from finance. Whose requestdo you act on first, and whose doyou postpone until the tail-end of the three-year planning horizon?

Or when it is budget time,and you need to give up 5% of the planned spend to hit the stretch targets, do youtake it out of the accounting projects or the finance projects?

In other words, if theorganization is going with option “a”, Financeand Treasury will get the standard, delivered system functionality and nothingmore…ever!

They might not tell us thisoutright. What usually happens is that any request is met by a lot ofarm-waving and concerns that it will take 1,000 man-years to accomplish therequest.

Option B – Jump In With Bill Gates

Option “b” involves using standard office software to manage cash.This has the advantage of beingversatile and completely underFinance and Treasury’s control, thereby freeing us from IT’s 1,000man-years constraint.

For simple cash managementset-ups it can be the most viable alternative. The basic usage of these toolsare some of the more familiar to mostemployees, so they can all participate without any significant trainingperiods or change management efforts.

Most software vendors earntheir living by maligning use of spreadsheets due to the risk of error and the somewhat more manual nature of the processes to use them.

These disadvantages can be eliminated, but generally require programming solutions in Visual Basic forApplications. The software language skills might not be possessed by all ofthe Finance and Treasury staff.

Option C – Jump In With Your Bank

Option “c” – bank systems - Ido not have any personal familiarity with, but am told that these are useful for very basic functions butleave a lot to be desired as the needs of the organization become morecomplicated.

And if we have more than onebank, we end up using a lot of different systems to do the same thing, whichcan be inefficient as well.

In addition, there is a greatloss of flexibility, as usage of one bank or another becomes an organizationalprocess and procedure issue in addition to bank services.

Option D – Jump In With People Who Want to Do Business With You

Option “d” – Treasury Workstations– is the route that delivers to Financeand Treasury the most functionality in an efficient package, overcoming thedrawbacks to options “b” or “c”, and usually priced much more attractively thanoption “a”, even if we do not include the added benefit that IT is taken out ofthe picture for the most part.

Workstations these days comein two different flavors – installed software on the organization’sinfrastructure, and the Software as aService (SaaS) variety, where the software is hosted on the vendor’sservers and is accessed via web portals. Each of these approaches has theirpros and cons.

The installed model plays better with the organization’s infrastructureand is more “self-sufficient”. The software will still work the day after thevendor goes out of business. Interfaces between programs are internally constructedwhich also allows greater organizational control, though if we need IT toperform some of this function we run back into the 1,000 man-year problem. Itis also more costly.

The SaaS model is less expensive because it is subscription based asopposed to license based, and the vendor can leverage its scale to innovate andinclude features more effectively. For example, interfacing with Bank A’ssystem will be less costly for a SaaS provider because they can do it once, andspread the cost of this effort over the x number of subscribers to thesoftware. Under the installed option all the interface programming costs areborne by each individual company.

There is risk here, however. If the company shuts down its business overnight we are in amajor lurch. Years and years of datamight be lost forever. An emergency situation is created, which is likelyto occur at the most inopportune of times.

We Need WikiFinance, WikiTreasury skills!

The technology alternatives thatwe can use to manage cash and other Treasury functions is one of the primaryelements to the Wikifinance, WikiTreasuryenvironment we are moving towards.

For this reason, and others,it helps immensely to have a set of ITskills in the Finance and Treasury group. This was one of the slides in theTreasury Leadership Roundtable presentation, the ideal Treasury person as a mixof both finance knowledge and capabilities combined with technologicalknowledge of infrastructure, interfaces, and programming.

Let’s be clear - no software is ever going to provide 100%of the needed functionality. There is always going to be a certain amountof customization. This can take place within the Workstation software (if it isinstalled), the interface process, or through “off-line” activities.

To the extent that our owninternal people understand the processes, the architecture, and the interfaces,and have some modicum of programming capabilities, we are able to utilize theproduct to the best of our ability while simultaneously making it work withinour organization’s infrastructure with the minimum amount of added inefficiency.

And we can do it without relying on IT and the subsequent 1,000man-year problem.

Key Takeaways

There are several choices to be made whendetermining the technology directionof the Treasury and Finance area. Each choice has advantages and disadvantages.

In order to maximize theTreasury and Finance area’s impact, keytechnology capabilities, such as programming, architecture, and interface, need to be held within the group. Thiscannot be outsourced without critical loss of control!

Questions

· Which of theoptions are you currently using to manage your cash and treasury functions?

· What is thestatus of IT skills housed within the Treasury and Finance area?

· What steps can youtake today to enhance your capabilities?

· Do you have aroadmap for the future?

Add to the discussion with your thoughts, comments, questions and feedback! Please share Treasury Café with others.Thank you!

8 Steps to Monte-Carlo Insight

2011-12-08T20:22:00.001-06:00

I attended a day-long symposium several years back where a portion of the agenda was devoted to risk management. The primary speaker’s company had a policy of hedging 100% of their exposure to a raw material, and they executed this by locking in prices one year in advance.

How different is this to making spot purchases, only one year in advance? Is this really hedging? It seems like putting all the “year-ahead eggs in one basket” would produce similar volatility. Wouldn’t a dollar-cost average or roll-in strategy be better?

The great thing about today’s age is that we can answer these questions using the wonders of technology!

Can We Test It? Yes We Can!

In “Blogful of Thanks”, I mentioned Lee Crumbaugh and his focus on scenario analysis. “What is the weather going to be like today?”. “Hmm, that makes me think of scenario analysis” “What do you think of Sears threatening to move out of Illinois because the state is not going to provide tax breaks?” “Hmmm, my mind immediately jumps to scenario analysis”

I am really no different than Lee, except we need to replace “scenario analysis” with “Monte-Carlo analysis”. Let me tell you, a lot of things make me want to do a Monte-Carlo analysis!

If we think about it, the two are really not that different. A Monte-Carlo analysis is merely several thousand scenarios played out in rapid succession.

So let’s do a Monte-Carlo analysis!

Step 1 – Define the Model

For many interest rate, currency, and commodity products, prices tend to “mean revert”. This term is “statistical-ese” for the fact that when prices are too high, they tend to move lower, and when prices are too low, they tend to move higher. In other words, they are more likely to (but not guaranteed to) move towards the mean.

This can be described by the following simple mean reversion equation:

The alpha term (α) is the mean-reversion parameter. Mu (µ)is the long-run mean. Sigma (σ) is the standard deviation, and ϵ is the error term ( a random variable from a defined distribution).

Step 2 – Populate the Parameters

One of the features of many interest rate, currency, and commodity markets is that volatility decreases as we “move out the forward curve”. To see this, look at US corn at two different time periods:

The price for the “near” months is widely different, yet for the “out” months is pretty much the same. For some interest rate markets, the near month volatility can be twice that of the out months.

Often, determining the parameters of the model will involve statistical analysis of historic data (this can be a blog post onto itself, so I will not go into it here).

For the sake of this analysis, we are going to populate our corn price curves assuming that the long-run mean is $5.00.

We will set the alpha (i.e. the speed of mean reversion) parameter at .02 for the near months, and increase it gradually in .005 increments. This has the effect of making the out months’ center on the mean more quickly than the near months, consistent with the graph we have just seen.

We will set the standard deviation at .2 and gradually decrease it, again to capture the higher price movements of the near months vs. the out months phenomenon.

We will “draw” (i.e. simulate) our error term from a normal distribution with a 0 mean and 1 standard deviation.

Finally, since each month’s price for corn will to some extent reflect underlying fundamentals that affect every month’s price, we use a correlation matrix and establish correlations through our price curve using a Cholesky decomposition of the correlation matrix. Correlations for this model were .98 for neighbor months and decreasing by .02 for each month further.

These then are the assumptions through the 12 month forward curve:

Step 3 – Identify the Comparisons

In this step, we decide what we are going to model (now that we have a model!).

In this analysis, we are going to look at three different alternatives:

· No Hedge - 12 units purchased at the prompt month price

· Year-Ahead Hedge – 12 units purchased at the 12-month forward price

· Roll-In Hedge – one unit purchased each month for 12 months (i.e. one 12-month purchased 12 months ahead, one 11-month purchased 11 months ahead, etc.)

Step 4 – Push the Button!

Run the Monte Carlo! In this analysis we use 10,000 runs (determining how many runs to use is also a blog post in itself). I ran this in Excel and downloaded the results into R.

Step 5 – Assess the Results

The results of this analysis are as follows:

The lowest average price was the “Year-Ahead Hedge”, followed by the “Roll-In Hedge”. Spot was the highest average price, as well as the highest standard deviation. Graphically (brown is "No-Hedge", red is "Roll-In", and orange is "Year-Ahead"):

Based on this, the symposium presenter was correct in using a “Year-Ahead Hedge” strategy, if (and that’s a big if) prices move as modeled.

Step 6 – Interpret the Results

This result disappointed me because I thought the “Roll-In Hedge” strategy would be better, since it averages in different prices as opposed to the an “all eggs in one basket” strategy. So does it make sense that the opposite would be the case? Why?

The reason I propose is that the “Year-Ahead Hedge”, because it transacts at the highest point of the curve in terms of mean-reversion, and the lowest point of the curve in terms of volatility, is able to overcome the averaging benefit of the “Roll-In Hedge”.

Step 7 – Question the Results

If this is indeed the reason, we should be able to “question the data” or “question the model” to refute or confirm our conclusions.

If the rate of mean reversion and volatility made a difference, we should be able to eliminate the hedge effectiveness by making both of these factors constant across all 12 forward month periods.

This has the following results:

As we can see, there is not a difference in any of the hedges.

If rate of mean reversion and volatility make a difference, then we should also be able to put them in a different place and by doing so generate different results.

To do this, we put the highest mean reversion rate and the lowest volatility at month 6, and then increased gradually on both sides of the forward curve (i.e. towards month 1 and month 12). If we looked at a graph of these we would see a big “U”.

Under this scenario, the “Roll-In Hedge” does better than either alternative:

The “Roll-In Hedge” does better under this because it is the only hedge scenario which takes advantage of the low volatility / high mean reverting period 6 (and to a slightly lesser extent periods 7 and 8, 6 and 9, etc.). The other two strategies are at the high end of volatility and low end of mean reversion.

These results enhance our initial conclusion, and allow us to generalize, “it is better to concentrate hedging activity in low volatility months and/or higher mean-reverting time periods”.

Step 8 – Identify Further Areas of Research

From Step 7 we have decided that concentrating hedge instruments in low volatility / high mean reverting periods produces the most optimal results.

One area of interest might be to conduct a break even analysis of the parameters. This would address questions such as “By how much does volatility need to be increased at the tail end for hedge improvement to significantly disappear?” or “What mean-reversion level accomplishes a similar effect?”

Another set of questions might surround hedging volumes – “how different are the results of purchases are seasonal rather than constant throughout the year?” or “What level of base load capacity do we need vs. contingent capacity to make this strategy likely to be effective?”

Key Takeaways

A Monte-Carlo analysis of major risks can provide valuable insights into your risk management strategies and processes. In addition, it can provide indicators as to the true value drivers of your organization’s risk and allows you to make adjustments in real-time.

A Monte-Carlo analysis can also provide questions that either allows you to feel more confident in your results, or point to areas where further research is warranted.

Questions

· Have you performed a Monte-Carlo analysis in the past month?

· What insights were learned through this analysis?

· What strategies were undertaken?

· What critical value drivers are you paying attention to as a result?

· What are the unanswered questions to pursue in the next round of studies?

Add to the discussion with your thoughts, comments, questions and feedback! Please share Treasury Café with others. Thank you!

NPV in the Tree

2011-12-02T04:14:00.001-06:00

In a recent Inc. Magazine post, an investment Red Frog Events made to build a tree-house in the middle of their office space was discussed. In my experience this is not very common.

Given that we are fresh off evaluating Net Present Value, or NPV, this is a great opportunity to explore utilizing this method in a break-even analysis framework on something very tangible.

“Tree Up” the Factors

For this exercise we will assume that we have used the Capital Asset Pricing Model, or similar mechanism, and through that analysis determined that our required rate of return is 20% reflecting a Weighted Average Cost of Capital at a 40% tax rate. We will assume that a tree-house in an office will have a five-year asset life, with no salvage value at the end, and that it is eligible for three year accelerated depreciation for tax purposes. We also assume that tax losses may be taken in the year they occur. Finally, we assume that the benefits do not grow or decline during this period of time.

Given these assumptions, we can use the Reverse Method to generate the Earnings Before Interest, Taxes, Depreciation, and Amortization, or EBITDA, required to “break-even” on the investment. In other words, earn our required rate of return exactly, so the project, inclusive of the investment outflow, has a Net Present Value of $0.

For this case, the investment needs to generate an EBITDA of $39,024 annually (for the rest of this post rounded to $40,000), calculated as shown:

Investment Benefits

Red Frog identified five areas of benefit: recruitment, happiness, creativity, appreciation, and attention.

Four of these benefits relate to employees, so the next step is to get some information to go into the “number cruncher”.

The Baseline Scenario

Red Frog is in the event planning industry. I googled “how much is the average event planner salary” and got numbers ranging from $40,000 to $60,000. So let’s use $50,000 as the average employee salary. Red Frog has 115 of them.

The Recruiting Benefit – In Full Glory

The tree house is used as an icon of Red Frog’s “creative work environment”, and they receive over 2,000 resumes every month.

What is unknown is how many more resumes they receive due to the tree house symbolism than they otherwise would have, and whether there is a material difference between the two populations (received normally, received because of tree-house) with respect to talent level (i.e. are more talented people inspired by the tree house to apply when they normally would not have? And are they the ones more likely to be hired?).

Note that resolving these unknowns would be a great Big Data exercise for the treasury and analytics group! And then we could calculate our NPV on that basis.

The Recruiting Benefit – Simplified

However, in order to simplify the focus on NPV (this is a blog, not a whitepaper!), we will go instead with the following assumption, that normal recruiting costs are typically 150% of the salary of the position, so in this case would be $75,000 ($50,000 x 150%).

At 115 employees, assuming a turnover rate of 5% (higher than some industries and lower than others), they need to fill about 5 positions per year. Dividing our need to generate $40,000 by 5 is $8,000 per position filled.

Subtracting this from the $75,000 average yields $67,000. This represents about 11% savings.

Feasibility Assessment

Is this a feasible amount to be generated from the tree-house investment? At an average of $50,000 per year, an employee makes $25 per hour (assuming a 40-hour workweek). To reach $8,000, we need to save 320 hours of time (assuming all are paid the same).

Recruitment costs include the following items: lower productivity due to short-staff situations, advertising, time and expense of interviewing, time spent evaluating and deciding, time spent negotiating, and then time and materials related to on-boarding (any HR readers reading this, feel free to add more items in the comments).

Is the spot filled a month earlier? This is 160 hours towards the 320 right there. If we interview either in a series or as a panel, say four are involved for two hours, then each interview saved is 8 hours. Therefore, if we interview 5 less individuals that’s another 40 hours saved.

Pause…Are You Aware That…

…we are discussing the amount of hours required to perform tasks. In most companies labor is a major cost driver. So in the above example we are evaluating the investment in terms of a something big and important to profitability and survivability. Something anyone running the business knows a lot about.

Compare that to combing through the accounting records to figure out what our NPV was. What would be discussed then? Items like how much overhead is allocated to what labor categories? Fixed items that need to be backed out of the variable costs, such as cubicle space, computer terminals, pencils and paperclips in the supply closet, etc. What costs were put into O&M versus capitalized?

Notice the difference? Major, important cost drivers every business manager understands vs. minor allocation and classification issues. Things an operator is not going to intuitively understand very well. Things only an accountant can love (nothing against accountants, only that they are not the ones running the business).

Now Back to the Show

So far, we have calculated 200 hours towards a 320 hour hurdle. The second benefit identified is happiness, which leads to higher productivity.

If the 115 employees are each more productive for 1 hour per year, we have come within 5 hours of meeting our hurdle, with three remaining benefits still to be evaluated.

Based on this (and the boatload of assumptions that went into it), we can say that this appears to be a worthwhile investment.

We might want to do some sensitivity testing or scenario analysis around this investment. What if there is a recession and we don’t hire for 2 years? How much more productive do the employees need to be in order to make this investment pay off? Three hours each. A business unit operator would be able to make a judgment as to whether that was feasible or not.

Key Takeaways

We, as finance, analysis, and treasury professionals, can fulfill our Trusted Advisor role to the business by:

1. Discussing important value drivers with operations folks

2. Discuss these items in language they understand and items that are important enough for them to control

3. Avoid burdening the operations folks with things only an accountant could love, and

4. Hire an inventory firm to count the number of pencils and paperclips in the office!

Questions

· Do you routinely discuss the business in terms of major value drivers?

· Do you focus a large percentage of your time assessing scenarios and sensitivities impacting major value drivers?

· Do you end up spending too much time with “pencils and paperclips” exercises?

Add to the discussion with your thoughts, comments, questions and feedback! Please share Treasury Café with others. Thank you!

Reverse Engineering NPV - Part Two

2011-11-28T13:22:00.001-06:00

In the last Treasury Café post we discussed approaching the NPV valuation from a different perspective and some of the benefits it holds.

Now we are going to transition from concept-level to demonstration.

The Transformed NPV Equation

By algebra, we can transform the NPV equation in its most familiar form:

To the following:

Notes to this equation are as follows:

a) EBITDA is equal to cash flow available to investors before tax. This should in theory be equal to pre-tax CF in the first equation. In cases where EBITDA contains a lot of “clutter” with respect to cash, then substitute Cash Flow Available to Investors in the above equation.

b) Investment is the capital provided by investors

c) tax_rate is the applicable income tax rate, expressed as a percentage. It is assumed to not change during the investment horizon

d) dep_rate _i is the tax depreciation rate for the investment in year i, expressed as a percentage

e) discount_factor _i is the result of dividing 1 by (1+r)ⁱ , where i is the year and r is the required rate of return (calculated using the Capital Asset Pricing Model or other method, see earlier Treasury Café posts)

f) growth_factor _i is the growth (or decline) in EBITDA in year i, expressed as a ratio. For example, if growth is 0%, growth factor would be 1. If growth is 1%, then year 1 would be 1, year 2 would be 1.01, year 3 would be 1.0201, etc.

The Transformed NPV Equation in Action – Case A

Let’s say we have ²10 TCMU’s (² stands for Treasury Café Monetary Units) to invest, and we want to invest in a project that earns 10%. Any returns due to capital structure, interest deductibility for tax purposes, etc. have been factored into this return requirement (i.e. it is the Weighted Average Cost of Capital). We face a 40% tax rate. The assets are expected to last five years, but for tax purposes are allowed to be depreciated over four. We expect the assets to produce a steady income, neither growing nor declining.

This produces an EBITDA requirement of about ²3.003 per year:

What is the less burdensome series of questions for the operating business units:

1) Tell us what you will invest this coming year? How much will you make on this investment? What is the resulting rate of return?

2) If you have ²10 to invest, can you make ²3 per year?

Questions in series 1 involve a number of “pencils and paperclips” exercises on the part of the business unit.

The question in series 2, simple and direct, focuses on the part of the financial statements that the business units most control and with which they are most familiar – revenue, cost of goods sold, and direct overhead.

The Transformed NPV Equation in Action – Now For Some Strategic Fun!

If we imagine the example above as a box, and we have two boxes, we can stack them either vertically or horizontally, as follows:

In the first case, vertical combination, we can examine various investment strategies regarding combinations of business units.

For example, if we have two business units, one that declines 5% per year, and one that increases 5% per year. What do we look like in 5 years if we invest ²10 in each one?

In five years, while EBITDA has remained relatively flat, the composition of the company has gravitated from 50-50 to 60-40. With all respects to the efficient market hypothesis, investors are likely to view our business somewhat differently than before.

In the horizontal case, we can evaluate different investment scenarios for the business unit over time, such as a “Cash Cow” strategy vs. a “Star Performer” if we are using Boston Consulting Group’s famous classification. By assessing each of these, we can draw conclusions and insights as to what is possible and under what conditions, providing a roadmap to strategic flexibility as the future unfolds.

Key Takeaways

Analyzing pro forma requirements for EBITDA allows us to assess strategic alternatives in a manner that “speaks the language” of primary decision makers, allowing us to gather their input more effectively. This analysis can be performed without the inefficiencies of full-scale “pencils and paperclips” organizational efforts.

Questions

· How efficient is your budgeting and forecasting process?

Your thoughts, comments, questions and/or feedback are all welcome! Please share Treasury Café with others. Your support is sincerely and gratefully appreciated.