The impact of operational effectiveness
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…