Tools of Analysis How to Deploy Them
By Sujit Mundul
It is to be remembered that no way a car manufacturer can control assets to the extent that an advertising agency can.
Haig T. Boyadjian and James R. Warren in their famous book “Risks – Reading Corporate Signals” have given a grand introduction to the ‘Tools of Analysis’ and their utility. They have achieved wide popularity in analytical circles, particularly in the USA . The common theme behind them is that a few key numbers can be manipulated to unveil important trends in performance, as also insight into the likely success or failure of an enterprise. Fairly rudimentary forms of these tools are frequently used in practical analytical work and there is no doubt that in skilful hands they can be made to work splendidly. Our attempt will now be to consider as to whether they do or do not achieve what they are supposed to and also to point out their true advantages and shortcomings. In the journey, we will merely make some common-sense observations founded on elementary principles of business and accounting. One of them is known as “The Du Pont Formula”. The US chemical producer known as E.I. du Pont de Nemours pioneered in the 1950s a whole system of management control which has, for the most part, now disappeared into oblivion. Nevertheless, one calculation which was only a tiny part of the whole has become immortal:
What this implies is that the return on a company's assets is the product of the margin on sales and the rate of 'asset turnover'. Obviously, the sales figure cancels out in the equation and is in no way intrinsic to the calculation of the ROA (Return On Assets). Assume that ROA of a company has been increasing over a period of years. Some indication can be gained as to the reason for the change by plotting the movements in the margin and turnover ratios. ROA could be changing for one or both of two possible reasons. Either the company is more profitable than it was, or it has begun to operate on a smaller asset base relative to sales. Thus on the following figures:
The du Pont formula indicates that the improvement in the ROA over the years arose principally out of the better rate of assets turnover. This number has increased each year while for the first three years the margin remained fairly constant. In 1993, the margin leapt steeply and that breakthrough coupled with the further improved turnover virtually doubled the ROA.
An additional refinement can be made by multiplying the ROA with the leverage formula assets/equity to produce the return on equity (ROE), otherwise obtainable just by dividing income by the balance sheet equity. If the equity is now built into our example, we can examine the influence of leverage on ROE:
It is now clear that between 1990 and 1992 ROE was declining because the company was progressively less leveraged and more reliant on equity funding. This trend did continue in 1993 but the improvement in ROA was so significant that there was still a jump in ROE.
A series of ratios can probably be worked out if desired; the next stage perhaps being to multiply ROE by dividends/income, the dividend payout ratio, to calculate the dividend yield on book equity and so on.
Now let us see how valid this approach is. The first point to make is that this type of reasoning is very incisive and it is particularly valuable for illustrating the fundamental mechanics of different kinds of operations. Let us take an example of a supermarket chain. It inevitably operates on low margin and higher turnover with perhaps moderate usage of leverage. The critical factor in a supermarket's success is the rapid rate of sales without which ROE is bound to be depressed. On the other hand, a furniture retailer or a heavy manufacturing company will not be able to use turnover to drive ROE but must rely on higher margins. Community trade and financial institutions of all varieties have fine margins and substantial asset base, and for them leverage is essential if they are to achieve a respectable ROE.
The difficulty as so often lies in the validity of the numbers themselves which come straight from the company's annual reports. It may be mathematically accurate to account for the movements in ROE between 1990 and 1993 along the line already discussed, but the ratios are ultimately only as good as the numbers on which they are based.
Let us consider Net Income. Any unusual or extraordinary item included in income will obviously distort the figure and such distortion will carry on directly into ROA and ROE. Profit can also be manipulated in the short term with a number of factors and the concept of margin is in any case wide open to misinterpretation. In the above example, the improved 'margin' in 1993 is obviously real in one sense, since we are defining the margin as net income divided by sales. It might be an unwarranted assumption that the business had suddenly moved to a higher margin as the term is normally understood - if the change had come from an unusually high level of "other income" (perhaps interest) during that year. All that formula really tells us the mathematical truth that one component in the ROA or ROE is the quotient of income divided by sales. It does not tell us anything about what determines the relationship between income and sales.
Similarly, the relationship between sales and assets is an ill-defined one. It is supposed to be a measure of efficiency of how fast a company 'turns over' its assets into the sales figure; the faster the rate, the more efficient the company, though some types of business characteristically turn over assets faster than others. It is to be remembered that no way a car manufacturer can control assets to the extent that an advertising agency can.
The asset figure used in our example was the yearned book value of the assets and, unfortunately, there is a real danger in assuming that it represents the true value of the assets held by the company during the year. While it would be a refinement to use average assets calculated as the mean of the year's opening and closing balance sheet footings, that expedient does not get over the problem that the assets are not valued at anything approaching their real 'value' but are recorded at some derivative of historical cost. Book assets in larger part are mere unexpired costs and different accounting procedures would give different numbers for the same company.
When one compares performance over two successive years in the same company provided that the company has not undergone major structural alteration or unusual and extraordinary practices in the course of the year, the trend of the du Point numbers may be illustrative of the real trends.
(Mundul is CEO of Standard Chartered Bank Nepal Ltd.)
Managing the Impossible with Business Modeling
By Manohar Man Shrestha
Someone in Nepal is going to be listed in Fortune 500 soon, may be in the coming few decades. Then slowly, he will rise to the top 100. Inspired by this success, soon there will be many other Nepalis making it to the same list. Thenafter, it will be a common understanding that Nepalis have what it takes to command the riches of the world. This prophecy may seem far-fetched right now but with the correct business and life model, it can turn into a reality.
What is the model? It is a set of concepts that explains how certain things occur and predicts how the things will behave if certain factors are manipulated. If we get the model right, it means we could achieve miracles by manipulating certain parameters. If we operate under misguided models, all our efforts to get desired results will go in vain. Billionaires of this world discovered correct and accurate models and they exploited them to the fullest. And, like a good cow yielding plenty of milk, their model yielded plenty of cash. A good model can thus also be called a cash-cow.
The best illustration of business models can be made by a case study. Let’s take Bill Gates of Microsoft (Windows) Vs Steve Jobs of Apple (Ipod). Analysing these two entrepreneurs is like testing two genetically identical specimens under different situations (such as different diets or medications). Such scientific experimentations shed untainted insights into the objects under investigation. For example, we want to find out whether a meat diet is better than a cereal diet. You could make a person first have a meat diet and test his vital signs. Then you treat the same person with a cereal diet, and again test his vitals. But there is a problem with this method. Many things would have changed during the time of the experiment itself and it would take very long. The next best thing would be to give one person the meat diet and the other the cereal diet, and take tests. Almost good but these two persons are internally different so we could not say exactly which results are attributed to the diet and which ones to their varied genetics. So, to avoid all this, we use twins (that are genetically identical) in the experiment that involves a day-long marathon. The observation may be that the meat eaters start to pant earlier than the cereal eaters. The conclusion thus is that cereal diet is better than meat diet for physical strength.
In this case study of Gates Vs Jobs, we want to test two business models. History has completed this experiment for us, by the way. However to make it interesting we will unfold it as though we orchestrated it. One business model (A) is: “Hardware and software must be marketed by the same company. These two are inseparable. In this way we get income from both. The company will thus have a monopoly because everyone wanting our ‘great software’ will have to buy our hardware too.”
In the other business model (B) what we want to test is: “Software is a specialised business. You can’t be the best in both software as well as hardware. Everyone can make hardware. Only a few can make great software. The development of both must be separated for the sake of quality and the quantum growth of the computer or information technology industry. The software our company makes must be licensed to hardware companies. We want a monopoly only in software not in both hardware and software. It will be cheaper to buy software from our company than starting from scratch and developing it on one’s own. As a result, the same software will be used in America as well as in Angola .”
Gates and Jobs are almost genetically identical in terms of business acumen, futuristic inclinations and ambition. ninty nine percent of the world still can’t figure out how to transform electrical inputs into a language that computers understand so that they can do our dirty work. These two fellows knew the language of 0 and 1 (binary codes), decades ago. It is said that Gates learnt his trade from Jobs.
In this experiment, like in the case of the twins above, Gates and Jobs are made to run Microsoft and Apple respectively. Jobs is given model A to use and Gates is given model B. At the beginning, having an Apple computer was hot. Nobody cared about Microsoft. Then Gates sold the license of his DOS (Disk Operating System) to IBM which was a giant in hardware. Soon, DOS became a rage. IBM rose and Gates got a free ride. According to his model, Gates sold the license of DOS to other competitors of IBM too. Jobs, on the other hand, following his model, refused to license out his Apple software to anyone else (it is true till date).
The results of this experiment are that Apple lost popularity owing to its expensiveness and lack of design variety. People wanted choice and variety when it came to hardware but as for software they wanted uniformity, one common language. Gates thus won the jackpot. He hit the market where it mattered.
The conclusion of Gates Vs Jobs case study is that model B is much better than model A. Of course, now Apple has come back with Ipod with a storm and the success of Ipod is still based on model A. Yet we can safely say that in the computer war, the concept that software development must be separated from hardware development showered Gates with billions in royalty.
What does it mean?
What this case study is trying to imply is that if one follows a correct business model then he will become rich. So, if you want to become the next tycoon of Nepal , it is high time that you start developing a super business model. It could be as easy as that. Again on the downside, if by chance like Jobs of Apple, you are confusing the incorrect model for the correct one, out of stubbornness, ignorance or plain attachment, you must jump off the boat before you sink with it.
Identifying Nepali tycoons’ business model
American business is well documented. The same cannot be said about Nepali businesses that work under a veil of mystery. How to explain the tremendous fortunes of Binod Chaudhary, late Mohan Gopal Khetan, late Mani Harsha Jyoti , late Hulas Chand Golchha , BK Shrestha (Chairman, Everest Bank) or those who have not come on the limelight as yet?
Was it accidental (being in the right place at the right time)? Was it destiny (fruits of good karma of the past life)? Was it shrewdness (ability to outwit the law and the competition)? Was it hard work (not shutting off their brains ever)? Was it connections (strong relationship with the movers and shakers of the country)? Was it proper timing (ability to take the number one position)? What was it?
But the problem doesn’t end in knowing what the cause was. What we want is to investigate the business models followed by these ultra-rich (in terms of Nepali context), understand them, modify them (i.e. keep what works and throw what doesn’t) to suit the present scenarios and new industries, and finally use them to become hyper-rich ourselves. Another approach would be to do a comparative analysis of their different business models, discover principles that are common, then use the same governing principles to develop new models.
All the above personalities have one thing in common. They started small. All of them started from trading (with Tibet or India ). Many of their contemporaries were in the same business. However, they were different and so became sucessful.
At that time, the business model of their friends, who never rose to even one hundredth of our tycoons’ height, must have been something like this: “Business is about buying cheap and selling at higher price. I am a trader and that is all. The profit is my income. I must save it for my children.”
On the other hand, the model of the people who got rich later must have been something in the line of: “Business is like a plant. The profits I make today will be the seeds for tomorrow. I must be able to sow my seeds in fertile new businesses. I must groom my children so that they will nurture the seeds I have sown. Now I am a trader, tomorrow I will get into an untapped market. I don’t save for my children; they must earn their living from the fruits of the forests of businesses which will grow from the seeds I plant now out of the profits I make.”
Do the statements given above truly reflect the models actually followed? Only the tycoons mentioned above or their mates will know the correct answer. But if we extrapolate the models into the future till half a century or more, they make logical sense–facts corroborate with theory. From simple traders, these people have now their hands into practically every business and industry of Nepal and their children are still taking care of their legacies.
Making your own business model
Coming into the 21 st century, stung by the lure of riches flaunted on the many channels by the cable TV, bombarded with multitudes of newly created desires, with egos bloated with better education and longer life, impressed by stories of yesterday’s ‘nobodies’ rising to great heights now, electrified with passion, ambition and enhanced brainpower, we Nepalis want to become tycoons too.
Of course, it takes more than correct business and life model to make it big. But it starts once you grow an intense desire in your heart.
The fundamental block (figure 1) of wealth is a system that has an input, an output and a by-product. For example, take a furniture factory. Many people have got rich from this system. The input is wood or timber and capital (for the machinery). The output is furniture. The by-product is the profit. Take school as another example. The input is students and capital (for the infrastructure). The output is educated students who pass the exams. The by-product is profits. Take a restaurant. The input is the supplies and capital (for the layout). The output is satisfied customers (whose stomach and minds are satisfied). The by-product is profits. Every time in order to increase the profits, you must increase the rate of conversion from input to output by the system.
Such a system consists of four sides (figure 2). The first pair is the suppliers and the clients. In the case of a bank, depositors are the suppliers and the creditors are the clients. For a movie theatre, film producers are the suppliers and the moviegoers are the clients. The second pair is the leader and the followers. Every business in the beginning was nothing more than an idea. Without followers the idea can't grow into a business. Without idea (leader) there can't be a business. Inside the rectangle of this system are the employees, machines, technology, and knowledge.
Now that the business basics are clear, it is time to focus on your strengths, weaknesses, interests, inclinations and aversions. There are many roads to fortune. David Beckham got there by playing football and posing on ads. Shahrukh Khan got there by acting and posing in ads. Michael Jackson got there by singing and buying the copyright to The Beatles songs. Richard Branson of Virgin got there by investing in soft drinks to airlines and resorts. Donald Trump got there by buying and building real estates in New York . Sidney Sheldon got there by writing best-sellers. Andrew Carnegie got there by operating steel factories. Warren Buffet got there by buying stocks. Napoleon Hill got there by studying how rich people got rich and revealing the secrets to the world.
Once you know what you want and what your limitations are, you are ready to make a business model. It must answer at least the following questions:
1. What is the input and output?
2. How you are going to utilise the by-product (profit)?
3. Who are your suppliers?
4. Who are your clients?
5. Are you a leader or a follower?
6. What will be the roles of your followers?
7. What types of employees are needed?
8. What machines and technology are needed?
9. Where to find the knowledge required?
10. How will this system grow?
If you asked Bill Gates these questions he would probably answer as follows:
"In my model, the input is creativity and the output is software. The suppliers are those who provide the CDs and packaging units to store and sell our software. Our clients are hardware manufacturers although users are individuals. We use our profits by re-investing them in research and development to prepare for the next technological leap like we did with the Internet, although critics say we were late. I am the leader and my follower's role is to keep up with my pace and vision. I need nerds (people with high Intelligent Quotient and low Emotional Quotient) as employees. I need the best computers and packaging units. The knowledge that will keep me in number one position is in devoted staff that is why I like to pamper them. My business will grow by taking free-rides (that is licensing software to hardware companies)."
If you asked a would-be Nepali tycoon this is how he may respond:
"In my model, the inputs are raw materials and products from overseas and the output is finished products and value-added products. The suppliers are manufacturers inside Nepal and abroad. Our clients are locals and foreign parties. We use our profits to invest in any emerging businesses that may be a luxury item today but will become a basic need tomorrow. I am a leader and my follower's role is to take care of the operations while I keep a strategic and big picture view of the business. I need hardworking and result-oriented employees. I need affordable machineries and technology, just for the basics. The knowledge to keep abreast of competition is in the developed nation: I must copy their successful models, modify and implement them here in Nepal before anybody else does so. My business will grow by becoming the brand of choice and through my reputation as most reliable and promising partner."
Never say, ‘Never’. You could be the next Nepali billionaire in the Fortune 500 list. Why not?
(Shrestha is Senior Trainer & Advisor of Standard Icon Pvt. Ltd.)
