The im­pact of op­er­a­tional ef­fec­tive­ness

Finweek English Edition - - BUSINESS - By Gareth Ochse Feel free to con­tact me with any ques­tions or feed­back via fin­week@val­u­a­tionup.com.

There are three levers you can pull to i nf lu­ence t he f i nan­cial po­ten­tial and val­u­a­tion of your firm: (a) you can im­prove your strat­egy to achieve greater mar­ket share and higher rev­enues through price times vol­ume ef­fects, (b) you can im­prove your op­er­a­tional ef­fec­tive­ness – mak­ing sure that you don’t over­spend on any sup­plier or ex­pense and that you man­age your cash con­ver­sion cy­cle tightly, and (c) you can im­prove your cap­i­tal struc­ture so that you re­duce the over­all cost of cap­i­tal and thus im­prove your val­u­a­tion. Of th­ese, most SMEs tend to worry mostly about sales and strat­egy. Some worry about the cost of cap­i­tal but gen­er­ally only through try­ing to re­duce the in­ter­est they pay on debt (ver­sus em­ploy­ing the op­ti­mal amount of debt). The area that many en­trepreneurs ig­nore when they set strat­egy or ques­tion what they can do to im­prove, is op­er­a­tions.

Yet it’s the area I al­most al­ways ad­vise peo­ple to start; here is why:

Run­ning a tight ship by man­ag­ing your ac­counts re­ceiv­able, ac­counts payable and in­ven­tory lev­els frees up cash. When we use a dis­counted free cash f low model for val­u­a­tion, this ex­tra cash im­me­di­ately in­creases the value of the f irm. Thus a well-run firm is worth more than a poorly run firm. Sec­ond, when your op­er­a­tions are good, you can do more with less cash and you are less of a risk to your fun­ders, so you can ne­go­ti­ate a lower in­ter­est rate with them. In other words, your re­turn on cap­i­tal em­ployed goes up, which means that your cost of cap­i­tal can come down and your val­u­a­tion goes up. Of course the growth rate your firm can achieve with­out changes to div­i­dend pol­icy, cap­i­tal struc­ture or prof­itabil­ity also in­creases. This means that your in­creased op­er­a­tional ef­fec­tive­ness in­creases the po­ten­tial growth rate of the firm, in other words it en­ables you to pur­sue a more ag­gres­sive strat­egy with­out the need for ex­ter­nal fund­ing. Yet in so many com­pa­nies the op­er­a­tional stuff is seen as sec­ondary to the more pres­ti­gious tasks of strat­egy and sales.

There’s an­other great rea­son to fo­cus on op­er­a­tions first: the changes you’ll need to make are not com­plex and the re­sults will show quickly. You can make rad­i­cal im­prove­ments to your work­ing cash cy­cle within three to six months by man­ag­ing it care­fully. Sim­i­larly with your prof­itabil­ity: you can work through your in­come state­ment, look­ing for ways to re­duce costs of sales, mak­ing sure you don’t have sur­plus or un­pro­duc­tive staff, re­mov­ing ex­penses that aren’t busi­ness re­lated or shift­ing spend to items where re­turns are more cer­tain. The im­prove­ments you can make here don’t take long to do and their im­pact is felt al­most im­me­di­ately. The trick is to “peel back the lay­ers” and to ex­plore each item in enough de­tail to find the sav­ings. As a former strat­egy con­sul­tant I’ve seen this ex­act ap­proach work with as­tound­ing ef­fect in large banks, air­lines and man­u­fac­tur­ing com­pa­nies – the same can work for any SME and achieve sim­i­lar per­cent­age re­turns, just the num­bers are pro­por­tion­ately smaller.

To sum up th­ese changes, lets re­cap the last three ar­ti­cles, which looked at op­er­a­tional im­prove­ments, pos­si­bly by chang­ing ac­counts re­ceiv­able, ac­counts payable and in­ven­tory. Us­ing the com­bined ef­fects of im­prov­ing ac­counts re­ceiv­able, ac­counts payable, and in­ven­tory turnover, the busi­ness gen­er­ates an ex­tra R8 602 free cash in year 1 (a 2.75 times im­prove­ment in free cash f low) and in­creases val­u­a­tion from R30 700 to R41 145 (a 36% im­prove­ment in val­u­a­tion).

I’ve dis­cussed the ba­sics of how to achieve th­ese changes in pre­vi­ous ar­ti­cles. How­ever, the point to con­sider is how much eas­ier it is to achieve th­ese changes than the in­crease in sales re­quired to gen­er­ate the same change in val­u­a­tion. This will de­pend on the busi­ness, but for most SMEs, which find them­selves in an in­dus­try that’s “per­fectly com­pet­i­tive” (ie one where mak­ing ab­nor­mal re­turns is al­most im­pos­si­ble) the an­swer will be that it’s eas­ier to im­prove your val­u­a­tion through op­er­a­tional ef­fec­tive­ness than through strate­gic mea­sures. Since the art of strat­egy is really about al­lo­cat­ing re­sources most ef­fec­tively to achieve the growth of the value of the firm, for many busi­nesses the cor­rect strat­egy will be to chase down op­er­a­tional tar­gets rather than sales ones; es­pe­cially as get­ting op­er­a­tional ef­fi­cien­cies up in­creases the strate­gic and cap­i­tal struc­tur­ing po­ten­tial of the busi­ness. Food for thought…

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