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It is better
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John Sumser

is more
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John Gall


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Making Money II
(January 16, 2003) - 
After cash in pocket, revenue, cashflow and margin are the most important forms of money for a company on a day to day basis. Revenue is the result of a customer ordering a product or service. Cashflow is the business of managing the relationship between customer payments and the expenses of meeting the requirements of their order. Margin is the difference between the value of the order and the cost to deliver it.

The ideal business takes an order (revenue), processes it (cash flow) and turns out a product or service (and margin). The ideal business produces the same or more margin (as a percentage of revenue) on each identical product. Each of the three aspects of what we'll call "operating money" can be managed for improvement. Any real cost-saving will show as reduced cashflow and increased margin.

The more predictably a company can take a dollar in revenue (orders) and convert it into fifteen or twenty cents of margin (plus a product and a happy customer), the more the company is worth. Imagine a cash machine that takes other people's money and keeps 20%. A good business does that with increasing relaibility over the course of its existence.

Most straightforward valuations of a company simply equate the margin output to an investment. So, if the going investment rate is 10%, a company is worth 10 times its margin (or earnings). If the current rate is 5%, the company is worth 20 times its earnings. (Simply divide the current commercial bank loan rate into 1. This is how valuations are done in non-dot-com environments.) If there is something particularly special about the way the company produces its results (a special process, technique, trademark or brand), additional points can be added to the "multiple". 

It takes a number of years for a company to get good at growing while maintaining the rate at which it converts other people's money into margin. The reason that the stock market fluctuates is, in part, because even the most predictable and reliable firms have trouble keeping revenue growth, cashflow and margin in the required balance. Variations result in increases or decreases in the company's value and therefore the stock price. (If only it were really this simple.)

Most of a company's operating attention is focused on these three variables. Real organizational impact in the daily operating environment comes from increasing revenues (sales and marketing), decreasing or optimizing cash flow (collection rates) or improving profitability (margin). These are hard numbers that can be verified in the accounting system and against bank transactions. They involve real money.  

In another column, we'll lay out the next layer of the question, capital. Real wealth involves capital, not cash. As we pointed out simply in this article, the three operating variables are important because they individually and collectively drive the value of the company. One way of thinking about them is that they are nothing more than the symptoms of a company's underlying capital structure.

In the meantime, consider revenue, cashflow and margin again. The easiest way (although too much growth can cripple a company) to increase the value of a company is by increasing its revenues (more sales, higher perception of company quality). The next best way is by increasing its margin (better productivity, reduced real time in the execution process). Finally, collections and the timing of payments can be used to improve cashflow.

Each day, the CFO asks himself "How can I get my HR/HCM department to contribute to the solution of my real problems?" The CFO is thinking in terms of these variables. The question for HR is how do we start to contribute.

- John Sumser  

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Materials written by John Sumser © TwoColorHat. All Rights Reserved.
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