Introduction to Financial Intelligence for Supply Chain Managers: Understand the Link between Operations and Corporate Financial Performance
Earnings conference calls are a routine occurrence for executives of public companies. Each quarter, while we listen to the company’s CEO, president, CFO, and others recite their prepared remarks about earnings, we may be unfamiliar with the terminology that they use. Of course, we would expect executives to be comfortable speaking about financial information, but what about the rest of us? Shouldn’t we be comfortable too? Shouldn’t we understand how we affect our organization’s economic performance from the decisions and actions we carry out each day?
We can expect that people who work in finance and accounting, and those whose daily responsibilities include financial and accounting work, feel comfortable conversing in financial terms. As an example of this, on a third-quarter 2013 earnings conference call made by Dick’s Sporting Goods, Inc., we see common phrases used in most earnings conference calls.
- “Third-quarter earnings of $0.40 per diluted share”
- “We expect non-GAAP consolidated earnings per diluted share to be in the range of $2.62 to $2.65 per share”
- “Total sales for the third quarter of 2013 increased 6.7% to $1.4 billion”
- “Gross profit was $424.9 million or 30.34% of sales”
- “SG&A expenses in the third quarter of 2013 were $333.7 million or 23.83% of sales”
- “Net capital expenditures were $77 million”
- “Gross margins are expected to decline”
- “Operating margin is anticipated to decrease slightly”
These phrases can be overwhelming and somewhat confusing to a nonfinance person, but they don’t have to be. Terms and phrases such as earnings, earnings per share, net income, net profit, operating profit, gross profit, gross margins, operating margins, revenue, and sales are common and often are used interchangeably. Revenue, sales, and top line are a perfect example of this. These terms have the same meaning. Another common example of this is net earnings, net income, and bottom line; these mean the same thing. Understanding the meaning of these terminologies will assist supply chain and operations organizations to perform effectively.
For those of us in supply chain and operations management, the tasks we accomplish and the decisions we make every day affect our company’s financial performance. The questions are then, how exactly do we affect financial performance and why should we care? It should be our responsibility to know how we affect financial performance to make the best decisions possible. Much of the work we do involves making business cases and persuading executives to replace or add facilities, machinery, materials, and other resources. Obtaining approval depends, in large part, on financial returns. To facilitate these conversations, we ought to feel comfortable using financial terms with CFOs, creditors, owners, and other financial experts; the ability to speak fluently in financial terms makes us more effective. If we want to help our executive leadership demonstrate success during earnings calls, if we want our companies to be profitable, successful, and sustainable, or if we want to create value for our companies, we should know how we contribute to our organizations. If we have any inclination to earn greater responsibility in our companies or to take on executive leadership roles, we need to become knowledgeable in the finance and accounting aspects of organizations.
Financial standing affects our company’s ability to move forward in many ways, such as:
- Borrowing money for working capital
- Attracting investors and raising funds for growth
- Finding customers, paying dividends, and paying suppliers
- Purchasing inventory
- Contributing to retirement plans
- Providing employee growth opportunities
We aren’t just talking about reducing costs either; we are talking about implementing projects that add value to our companies, projects that drive revenue growth, deliver positive cash flow well into the future, and deliver satisfactory levels of return on invested capital (ROIC).
What Is Important to the CEO?
Before exploring what we can do in supply chain and operations to help create a profitable, competitive, and valuable company, we need to identify a company’s overarching purpose and what is important to CEOs. Primarily, the central purpose of a company is to increase shareholder value. Total return to shareholders (TRS) is frequently used to measure management and company performance. From a CEO’s perspective, there is pressure to show returns to shareholders that either meet or exceed shareholder expectations and achieve above-average earnings compared to competitors. If they don’t, share price is likely to fall due to unfavorable reviews from financial analysts. CEOs report to numerous audiences, such as:
- Board of directors
- Wall Street analysts
- Shareholders and investors
- Creditors and banks
Each audience has its own criteria for evaluating success. In addition, many other criteria and financial performance measures are reported and used to gauge company performance. Besides total return to shareholders, other common measures used to evaluate a company and its executive management team include:
- Earnings before interest taxes depreciation and amortization (EBITDA)
- Earnings per share (EPS)
- Earnings before interest and taxes (EBIT)
- Free cash flow (FCF)
- Gross margin, return on capital employed (ROCE)
- Return on investment (ROI)
- Return on invested capital (ROIC)
- Return on net assets (RONA)
- Sales growth
Why these? Quite simply, these measures are what are important to analysts, owners of company stock, and those who invest in or lend money to companies. If it is significant to external constituents, then it is important to the company executives. By no means is this an all-inclusive list. Several other performance measures are considered, but those listed are the most common. No single metric can tell the whole story; however, a core of key performance indicators can provide insight into the financial health of a company.
After exploring the performance measures that interest CEOs, we can ask ourselves how we can help our CEO report company performance in a positive light. In other words, what can we do to make all of the performance measures listed earlier stack up against our competitors and while meeting or exceeding the expectations of our board members, shareholders, analysts, investors, and bankers? Effective supply chain and operations management provides ample opportunity to add firm value and competitive advantage.