Are you selecting the right strategic indicators? I

One of the key decisions of the CEOs and boards is to select the right key financial indicators to manage the company. Tipically, companies select EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization), EVA (Economic Value Added), Enterprise Value, among others. Although companies do not select just one indicator, they tend to use one as the cornerstone for the management focus (and their respective bonuses!).

As always, making a selection has its consequences (and of course, also its advantages...). Most of the companies I have worked for use EBITDA and they have a strong focus in this indicator.

Let´s start understanding how EBITDA is calculated:

EBITDA = Revenue – Expenses (excluding interest, taxes, depreciation and amortization)

As represented in the formula, it is a measure of the current profitability of the company, not taking in account the effects of interest (from loans for example), taxes, depreciation (the decrease of value in assets) and amortization (the payment of debts, for example). In the following table, you can see the main pros and cons of using EBITDA as the main financial indicator:

So, what can happen if we choose this indicator as the reason for living? There are several things that may happen:

- Reduction of the Return on Assets (ROA) or Return on Invested Capital (ROIC) -or getting inflated in assets and working capital. Due that the fact you are focused on profitability, you may decide to use more assets (for example, buy plants) to produce more revenues, or to have more inventory (in order to have more things to sell). However, at the end, a shareholder can complain that the money he invested is not having the right margin, compared with other financial instruments.

- Because you are not taking in account the effects of depreciation and amortization, you may have a distorted vision of the cash generated by the company. Tax and amortization can erode the cash generated.

- For the shareholders, it is not enough to use EBITDA to make his/her investments decisions. It does not take a vision of the use of the assets or working capital, it does not show the company valuation or show a trend of the future of the company, so it is difficult  for him/her to decide if it is a good place to put the money in.

As a conclusion, even though is a very common indicator and is used widely to compare companies, it should not be used in isolation to manage the destiny of the company.

If you are not segmenting, you are not thinking.

 

Actually,it is a phrase stolen from a conversation with a client, but it is completely true. The problems we try to solve in business are not as simple to attack with a one silver bullet. Let me illustrate with several situations:





- If you are dealing with a inventory rationalization problem, you should segment the products that you would like to attack using a segmentation like this:

 

In this case, you shall define different solution strategy for every segment of this problem. You solution will be different for "Non-Productive Stock" to the "Excesive Coverage".

 

- If you are priotizing initiatives that you want to implement, you can use a matrix with two main variables (complexity and benefits) to help you clasify them and establish a different strategy for each quadrant, as shown:

 

 

 

There are innumerable methodologies to this "divide and conquer" approach. Some of them are well known, others not so much:

 

- The Boston Matrix (for deciding in which business units to invest)

- The Ansoff Matrix (to understand the risk of different options)

- The Kepner-Tregoe Matrix (a decision making aide based in the classification and prioritization of information)

... and so forth.

 

You can take a look to different segmentations tools in "The Decision Book": http://www.amazon.com/The-Decision-Book-Strategic-Thinking/dp/0393079619/ref=sr_1_1?ie=UTF8&qid=1376097474&sr=8-1&keywords=The+Decision+Book

 

However, you can create your own "matrix", "segmentation" or even "hiper-cube" to solve your complex problem. I would recommend the following steps to create them:

 

- Frame the problem. To achieve this, formulate a powerful and specific question that you want to solve. Work hard in defining the right question.

 

- Select the criteria of segmentation. Be careful in defining them. The criteria should be "orthogonal", it means, a criteria can not dependent one from the another.

 

- Map your problem. Locate the different options in your matrix. Analize and classify them. Do the analytics to locate them.

 

- Define a differentiated strategy for the solution of each quadrant (or cube).

 

Using this approach, you will find that the problem can be separated in pieces, and you will feel confident in defining a better solution for each case.