Strategy-Driven Finance

                In the last 2 months, I followed a training on ‘director effectiveness’, to better understand the role of the board, versus the CEO, versus the management. One of the sessions was on board finance, and as I was reviewing the outline on accounting basics in preparation of it, I was struck by an insight, that I will call “Strategy-Driven Finance”.

                The accounting basics introduces the profit and loss, the balance sheet, the cashflow statement and profitability metrics, like the Return On Equity. The outline shows a value tree, like the one show below, modeled like the famous Dupont model that does the same for Return On Assets.

                The text continues that to drive value, we should analyze and optimize each of the value drivers. Can we increase prices? Can we reduce operational costs? Can we optimize taxes? Can we increase Net PPE turns? Can we reduce receivables and increase inventory turns? The motto, except for sales, is that less is more.

                The approach of breaking down a value metric, in its underlying drivers, and then driving value, by trying to improve those drivers, is so common that, for long, I was blinded for the fact that this approach is failed, and even dangerous. What if fails to recognize, is the connection between the metrics.

                The basics of the supply chain triangle and how it links to the Return On Capital Employed, as illustrated below, tells us that it is OK to have a bit more inventory as long as it is compensated by a higher margin.

                The basics of the strategy-driven supply chain, introduced in my book “The Strategy Driven Supply Chain” and an earlier LinkedIn article, learns us, that inventories and other buffers are driven by complexity and variability, and that these are in turn driven by our strategy. Product leaders have more product complexity which will drive higher upstream inventories. That is OK as we are typically able to drive a premium from our customers, resulting in a 50-60% gross margin. Lowest price players won’t have those gross margins but will compensate by being more efficient in their working capital and fixed asset turns. So inventory and Net PPE turns go together with gross margin. The essence of the strategy-driven supply chain is shown below.

                So, we cannot optimize the metrics in isolation. That is dangerous. Without realizing, we may put the inventory targets of the lowest price player in the market, on us as a product leader or a total solution player. That basically undermines our strategic positioning. So the strategy connects the different financial metrics and when we realize that, we can define what I call “Strategy-Driven Finance”.

                We summarize strategy-driven finance in the figure below. You see that we have flipped the value tree, now starting with the value drivers on the left. The strategy will define the targets for all operational metrics in an integrated way, instead of individually. We still like to roll them up into the Return On Capital Employed (ROCE) as we find it very useful as a value metric for supply chain and operations, looking at EBIT and the Capital Employed, both very tangible things. If we add the leverage, we can get back to the Return On Equity (ROE). Strategy is driving the ROCE, finance is driving the leverage, the interest and the tax optimization.

                So the conclusion is the strategy-driven approach doesn’t work for supply chain only, it functions equally well for finance. Whenever I see a value tree or someone talking about reducing inventories, I’ll flip the value tree, and start asking about the strategic positioning and what ratio of gross margin versus inventory would seem fair. Once you realize, it sounds obvious. But it apparently took me 5 years, since the publication of my first book, and a finance basics course, to fully realize it.