Chapter 6: Introduction to the Operational Filter

THE NEXT TWO CHAPTERS (Chapter 7 and Chapter 8) will discuss the operational filter of the Step-Wise Approach to Value (SWAV). The purpose of this filter is to understand how a Strategic Alternative (SA) impacts the financial performance of a company. Many companies perform an analysis on a strategic alternative in isolation. That is, they look at the incremental increase in value that a SA would potentially generate. This type of analysis looks at cash flow improvements that are mostly generated in later years. What it fails to take into consideration is the short-term impacts on the financial performance of a company, as well as the potential destruction of value from interactive effects.

Short-term impacts on financial performance may include increases in costs (such as implementation costs) and/or productivity losses. Many business executives fail to see the short-term destruction of value from SAs. Companies that are looking to increase revenues and that are involved in merger and acquisition (M&A) activity may find that sales from the acquired company are going down and not up. This may be caused by cannibalization of revenue from other channels. What the merger has created is internal competition for revenue (as opposed to external competition) resulting in lower and not higher sales. Cannibalization may also occur when electronic sales channels are introduced. Many companies thought that launching websites would increase sales. What they discovered is that customers switched from traditional channels (like buying products in stores) to buying products over the Internet. In addition, cash flow may decrease if the acquiring company borrows excessively to make the acquisition. Many leveraged buyouts that were structured in the 1980s failed because the debt-laden acquisitions could not handle the excessive interest payments.

How does the operational filter detect short-term impacts and interactive effects? A number of financial tools are used to detect these erosive effects. The DuPont Model is a diagnostic tool that looks at the components of return on assets and return on equity to determine if changes in the income statement and/or the capital structure (the mix of debt and equity used to finance operations) are affecting financial performance. Activity-based management looks at the profit and cost structure of an organization based on the processes it performs.

Now that we tested the Strategic Alternative with the economic and strategic filters, we move to the operational aspect of the Step-Wise Approach to Value. We will discuss a number of tools used to analyze financial performance. We will show how to measure management performance (using the DuPont Model). We will look at what drives shareholder returns: profit margins, efficient utilization of assets, and leverage. We will show you how to assess your management of 1) the income statement to increase profit margins and 2) the balance sheet to increase asset turnover (utilization of assets). By understanding these tools you will be in a position to increase return on assets. We will also show how the use of leverage (change in the amount of debt used to finance corporate investments) can impact return to shareholders.

We will also describe the use of activity-based costing to obtain meaningful information for decision making. Most financial reporting systems and standard costing systems simply don't do the job, particularly in today's competitive environment. They look backward and are general ledger– and transaction orientated. Accordingly, we will focus on the application of ABC/ABM models to quantify resources consumed and the real cost of each activity. We will also look at the estimation of the true costs of production and the determination of real, measurable benefits.

Examination of operational drivers is key in addressing both short- and long-term impacts of Strategic Alternatives on shareholder value.