To understand business finance it is useful to have a diagram of how money flows round a business. Here is the business model:
Today we’re going to look at sources of money
The money used (or capital) in the business comes from stockholders (the owners) and lenders. Initially, the owners will pay for shares of stock and this money is invested in the business. As profits are earned, some of these profits are returned to the stockholders by way of dividends. If a company wishes to grow, it will retain profits within the business. These retained profits still belong to the stockholders but are being used to finance growth.
In the past, the term ‘stockholders’ funds’ was used to describe the amount of stockholders’ money invested in the business. The modern term is ‘equity’. Equity is therefore made up of the stockholders’ initial investment plus retained profits. The company owes this money to the stockholders but has no obligation to pay it back.
A company can borrow cash from a variety of sources. In a small business, the owners will often provide loans to the company – sometimes at a low rate of interest. The line of credit from the company’s bank is a popular form of financing since the company can access cash according to the needs of the business. However, lines of credit will usually carry a higher rate of interest than a long-term loan.
There is a wide range of other financial institutions seeking to lend to businesses. For the purposes of this book about basic finance, we will consider only the straightforward case where the loan is for a fixed term.
The implications of these two sources of money are different. In one sense, money from stockholders is cheaper. Return on the stockholders’ investment comes in the shape of dividends that are normally paid twice a year. In the early stages of a business the owners may very well drop the requirement for dividends and allow the managers to retain all the profits to allow them to grow the business. At that stage the money could be said to be free.
There is also no need for the managers to plan to have the cash to buy back the stock; in practical terms the money is in the company forever. The only downside in using stockholders’ funds to get a major business going is the cost of raising money in this way, since lawyers and accountants don’t come cheap. Another problem is that the business has to find someone willing to take the risk of putting money into an enterprise which, who knows, may fail. If the business does fail the owners lose all the money they have invested. It is this risk of failure which makes stockholders demand, in the long term, that their overall returns should be higher than the providers of loans. They get this return through the growth of dividends that the company pays out. In the long term, of course, if the company’s stock is traded on a stock market exchange the stockholders are hoping that the price of the shares will go up.
Loan finance (usually referred to as debt) is cheaper to arrange. Banks and financial institutions assess the risk of the company, make loans and charge an interest rate to reflect the perceived risk. It seems reasonable that they should tailor their interest charges to protect themselves against the risk of default; the problem is that a business in dire straits and in desperate need of cash has to pay more to get it – adding to the downward spiral.
Also, with debt, don’t forget, you have to plan how you’re going to repay the money within the agreed timescale.
Leverage is a term that accountants use to confuse people. It is used in a variety of situations but always has the same implication. The easiest way to explain leverage is to describe a familiar situation. Suppose I buy a house for $100,000 with a 90% interest-only mortgage. I have put in $10,000 of my own money and that is my ‘equity’ in the house. Consider what happens if the value of the property goes up by 10%.
|Original position||New position|
|Value of house||$100,000||$110,000|
The value of the property has gone up by 10% but my equity has gone up 100%. Excellent: easy money! The risk, of course, is that the price of the property may fall by 10%, in which case all of my equity is wiped out. If the value falls further, then I am into the position known as negative equity – note how financial terms are often used in everyday life.
The effect of leverage is to multiply my gains. In this case a 10% increase in the value of the house gave me a 100% increase in equity. Leverage is 10x (ten times). Notice that this multiplier can be applied to any percentage change in the value of the house. So, for example, a 25% increase in the value of the house in our example will give a 250% increase in equity.
In the next blog we’ll look at where the money is invested.
For many defenders of the English language this poor, unsuspecting word is the grandfather of nouns converted into verbs for the convenience of business. But should we allow it to continue to be pimped out to the dim and lazy or at least try to rehabilitate it as a noun?
Where did it come from?
It was Archimedes who said, ‘Give me a lever long enough and a fulcrum on which to place it, and I shall move the world.’ Archimedes was an ancient Greek mathematician, physicist, engineer and inventor credited with the explanation of the lever and the invention of a screw pump still used today – the Archimedes screw.
Clearly, he was a smart guy and he’d probably be spinning in his grave like a ceiling fan if he knew his wise observation had been corrupted by mediocre business executives intent on looking more competent than they really are.
When it made its way into business speak is unknown, and who we should blame for it is equally obscure.
But what does it mean?
Leverage is used to imply an assisted or additional advantage. In the same way that Archimedes could move something immovable with the help of a strategically positioned lever, business believes it can move profit upward by a strategically positioned ‘leveraged’ advantage. Or at least the executives in question believe a rousing speech on leveraging assets might help.
In many ways it’s a tautology like ‘added bonus’ or ‘free gift’. A bonus is by definition added or extra so the addition of added is meaningless. A gift is by definition free so the addition of free is unnecessary. Using leverage to explain the exploitation of a strategic or tactical advantage in business is also meaningless and unnecessary because by definition that’s what business is supposed to be doing in the first place. If a business has a nifty IT system, a patented design or particularly smart engineers surely it would be plain stupid not to take advantage of those things.
That said, leverage is also used as a specific finance term for any technique to multiply gains. Also known as gearing, it usually involves borrowing money to buy additional assets in the hope those assets will yield more profit than the cost of borrowing the money. Obviously this doesn’t always pan out so the losses rather than gains are often multiplied.
This dichotomy of meaning leads to the utterly ridiculous possibility of leveraging the leverage!
Where will I find leverage used?
This particular gem of business jargon is extremely versatile and can be found in meetings, reports and presentations across business, from finance (where it may actually be a meaningful term) to marketing, strategy and even shareholder meetings. It needs to be stamped out.
For example, when a CEO addresses a shareholder meeting and expresses his intention to, ‘leverage our significant investment in IT infrastructure across all the business units to drive profits and increase market share’, rather than nodding enthusiastically at this gibberish the shareholders should throw a few eggs and respond, ‘well I should hope so, otherwise why make the significant investment in the first place!’
How can I leverage my advantage?
The ‘beauty’ of the word leverage and the reason it is so popular in business is that it sounds good but means very little. It can be used to replace just about any activity verb. And, like so much of the worst business jargon it’s passive. It’s therefore easy to see why it’s wheeled out so often.
So if you have a report to write but you’ve not really done what you were supposed to do by the time you were supposed to have done it then ‘leverage’ is a fantastic little word that can get you off the hook. If you are ‘leveraging a project’, the reader has no way of knowing whether you’ve barely started it, almost finished it or palmed it off to someone else who is ignoring it! It’s particularly useful for speculative documents such as business plans and project proposals because it’s so vague. Plus it’s almost always accompanied by the unspecified ‘we’ not the specified ‘I’, thus enabling its user to abdicate all responsibility or accountability for the actual leveraging.
As a result of these special obfuscatory qualities the word leverage is incredibly useful for corporate minions eager to look good but do as little as humanly possible. It allows for non specific, passive inference of action occurring without saying what that action is, who is taking that action or when said action will be completed, and therefore implied value realised. In practical terms it allows subordinates to report on progress while still allowing the realities of a project to actually run the project. So much so that if you see a report, update or article that contains the word leverage you can pretty much guarantee that nothing is happening or that whatever is happening is happening a great deal slower than anyone could have thought possible.
Unless you are specifically talking about financial leverage or borrowing money to capitalise on an opportunity that could increase value then avoid the term. At the very least ‘leverage’ should remain a noun (as in ‘to apply leverage’) and not be pimped out as a passive pseudo-verb (as in ‘we are leveraging our infrastructure’). And whatever you do don’t do what one company did in 2001 when it made people redundant and told them the business was ‘leveraging their synergies’.
In the second of an ongoing series of explorations of key business ideas we investigate a much-abused and little understood term. Core competency is one of those over-used business phrases that often sneak out in high level meetings or when someone is trying to look a little more interesting than they really are. But is it useful or is it just stating the obvious?
Where did it come from?
The phrase core competency was coined by Coimbatore Krishnarao Prahalad, more commonly known as C. K. Prahalad (for obvious reasons) and Gary Hamel – both US based management ‘gurus’ and business authors. It was first referenced and described in a 1990 article they published in the Harvard Business Review called ‘The Core Competence of the Corporation.’
Both Hamel and Prahaled have been consistently regarded by major business publications such as Business Week, The Wall Street Journal and Fortune magazine as amongst the most influential business thinkers in the world.
But what does it mean?
According to Prahalad and Hamel core competency is a concept in management theory that relates to the specific attributes or factors that a business considers as central to the way it operates. A core competency is only a core competency when it meets three criteria:
- It’s not easily replicated by competitors.
- It can be widely used and re-deployed for many products and markets.
- It contributes to the customer’s experienced benefits and the value of the product or service.
Core competencies are particular strengths relative to the competition which provide added value in the eyes of the customer. They can relate to anything from technical expertise to processes and procedures to strong working relationships to innovation to customer loyalty. For example Apple’s user interface is a core competency. People who use Apple products love that they are intuitive and easy to use. So much so that people who are converted to Apple rarely leave Apple. Even though the products have their faults (such as low battery life) and are significantly more expensive than the competition their customers are passionate and loyal about Apple, something that’s not easy to replicate. Their intuitive operating system and user interface also translates across product categories and markets and definitely contribute to the customer’s experienced benefits and perceived value of the products.
Where will I find ‘core competency’ used?
Those who actually know what it means and understand Prahalad and Hamel’s definition use it to describe the ‘collective learning across the corporation’. This collective learning is only possible with outstanding cross-functional cooperation, and a willingness to coordinate and integrate diverse production skills and multiple technologies. Few companies are likely to create world leadership in more than five or six fundamental core competencies.
Those who don’t know what it means but like to throw the term around to impress people and look more knowledgeable than they are often simply use it to describe something a company is particularly good at. But being good at something does not necessarily mean that it’s a core competency. It’s only a core competency when it manifests into core products that serve as a link between the competency and the end user. For example 3M enjoy a core competency in the manufacture of substrates, coatings and adhesives that manifest as a product range that is being added to and developed all the time.
Basically core competency is just Darwin’s theory of evolution but applied to business. As a business grows and evolves it should get better at certain things that help it survive. Those evolutionary improvements that ensure the survival of the fittest should emerge from the collective efforts of the business not just from the individual strengths of the people in the business. That way, they are ‘baked into’ the business. The reality however is often very different: the core competencies within a business are, frequently, actually the core competencies of certain individuals within the business. When those individuals leave, so does the competency.
What’s my core competency?
Most businesses don’t operate around core competencies – they operate around business silos or a portfolio of independent businesses. As a result there is little incentive to share knowledge, experience and competency between the units. Prahalad and Hamel suggest this is an error and actively stops business from developing a significant competitive advantage.
Plus they argue that unless a business understands its core competency it is in danger of losing it without even realising what it’s lost until it’s too late. For example US manufacturers divested themselves of their TV manufacturing business in the 1970s because they believed the market was mature and low cost imports from Asia would render the sector obsolete. In doing so they lost their core competency in video which later handicapped them when everything went digital. Motorola divested itself of its semiconductor DRAM business at 256kb only later to realise they had divested a core competency in electronic data storage and were unable to get back in to the 1Mb market alone. Had they recognised their core competency and the time it took to develop and build it they would have made better strategic choices.
To identify what your core competencies are or could be you need to answer the following questions:
- Is there any part of your manufacture or delivery of your product or service that strongly influences your customer’s willingness to buy? If not it’s probably not a core competency.
- Is the value-adding competency difficult to imitate?
- Is the competency relevant and useful across different products and markets?
As a strategic exercise it is essential to identify and foster core competencies. Not only will this knowledge help direct resources and assist decision making but it will also help to avoid expensive strategic mistakes such as those experienced by the US manufacturers and Motorola.
A report by the British Heart Foundation has suggested that high intensity exercise can lead to an increased risk of heart rhythm disturbances. But before you kick off your running shoes and head for the sofa, remember that the benefits of regular exercise outweigh the risks. In fact, a healthy adult should aim to do 2.5 hours of moderate intensity aerobic activity per week. Perhaps you, or somebody you know, needs more convincing. So Kate Cook, author of The Corporate Wellness Bible, has compiled these five compelling reasons for ditching the onesie and donning those long-neglected jogging bottoms.
Why bother to exercise? Here are five compelling reasons
You may hate the idea of it, but taking exercise is life-changing and has real benefits if you’re aiming to lose weight. Once you get into the exercise habit, you won’t want to stop.
1. Exercise uses up calories. You will lose weight by cutting down on the calories you consume, but if you’re active too, your weight loss will be faster. I love food and working out means I can eat more. It also means that I don’t end up losing any weight, but just maintain the weight I am. When you exercise you build up muscle, which gives you shape; even thin people can use muscle tone. Muscle burns up more energy than fat tissue.
2. Exercise gives you a buzz. You’ve probably heard of the runner’s high, that happy, almost euphoric feeling during an exercise session. Experts put it down to a combination of factors – a release of endorphins, hormones that mask pain and produce a feeling of well-being; the secretion of neurotransmitters in the brain that control our mood and emotions and a plain old sense of achievement. Whatever gives you the high, there’s no doubting the feel-good glow it gives you.
3. Exercise boosts your confidence. Every time you work out or play a sport, you’re doing something positive for yourself, which is mood-enhancing in itself. When you start to see the results in the mirror, your self-esteem rockets. As soon as you see results, you will find it easier to stick to your weight loss plan, too.
4. Exercise reduces your appetite. As well as being a good distraction from the allure of the fridge, exercise slows the movement of food through your digestive system, so it takes longer for you to feel hungry.
5. Exercise helps you keep weight off. From a dietary perspective, the trouble with only tackling your weight loss is that it is usually quite hard to maintain your weight loss in the long term. Once you have reached your goal and are a little less strict with yourself, the weight can begin to come back. Studies have shown that people who have successfully lost weight by taking exercise as well as a sensible approach to food are better at keeping their weight stable longterm.
The key to incorporating exercise into your life is to find something you enjoy. I do believe there’s something for everyone. Some of us love swimming. For others, it’s running or tennis. These days gyms have a huge variety of classes on offer, ranging from the highly choreographed to gentle classes featuring very simple moves. There’s no excuse for at least not trying some of them out. If you really don’t like gyms, there is walking, which is a very good exercise indeed. It is easy to get into the habit of taking regular walks. Just one foot in front of the other, walk out of your door and keep going.
Unless you’ve been living under a rock for a few years you will have heard of Big Data. But is it all hype and hyperbole or will it really change the world?
Where did it come from?
The term Big Data was probably coined by John Mashey, chief scientist at Silicon Graphics. In the 90s if you were a Hollywood producer looking for cutting edge special effects or an intelligence agency looking for state of the art video surveillance you went to Silicon Graphics. The company was dealing with a huge amount of a new type of data and Mashey frequently gave talks on how this data would change the future, including one with the snappy title ‘Big Data and the Next Wave of Infrastress’.
Big Data gathered traction, especially in tech circles (i.e. people who actually knew what ‘infrastress’ meant). For the rest of us – it took a little longer. In 2012 Big Data burst out into the mainstream – it was a featured topic at the 2012 World Economic Forum in Davos, Switzerland. The US federal Government announced $200 million in funding for Big Data research programs and even the satirical cartoon Dilbert had something to say about Big Data.
Basically Big Data is the term used for the collection of very large, often very complex data sets that can now be analysed in non-traditional ways to provide insights that were unheard of a decade ago.
To give you an idea of just how big, Big Data is … if you take all the data that was created in the world from the dawn of civilization until the year 2010, the same amount of data will soon be generated every minute.
This explosion of data has come from advances in technology. The smart phone in your pocket is now more powerful than your desktop computer was just a few years ago and is capturing data all the time, including where you are (via GPS sensors). Whenever you are connected to the internet, via your phone, tablet or computer, data is being gathered about what are you doing – playing an app, listening to music, using the internet or social media. Every time you share a photo, tweet, update your Facebook page, shop online, walk past CCTV, call a recorded customer service line, send an email, use an e-reader, watch Netflix or upload video you’re adding to Big Data. There are 30 billion pieces of content uploaded to Facebook and eight years of video uploaded to YouTube every day! In fact there are now nearly as many bits of information in the digital universe as there are stars in the actual universe.
But it’s not the volume of data that is the potential game changer – it’s our ability to store, combine and analyze it.
Where will I find Big Data being used?
Big Data is everywhere and its impact can be witnessed in everything from sport to health and fitness to medicine to entertainment to crime prevention and business.
There are now smart TVs that remember your viewing preferences and use face recognition to ensure children can’t access age inappropriate material. Book e-readers are gathering data about your reading habits. There are wearable devices that track your activity, calorie intake and heart rate to help keep you healthy. You can get smart carpet which can raise the alarm if your elderly mother doesn’t make her usual morning cuppa. You can even get a smart nappy which will send a tweet when the nappy needs changing! Obviously a swift sniff of the offending backside would do just as well but there are sensors in the nappy which can check the contents for signs of infection. Sensors in a baby’s mattress which measure breathing and heart rate could herald the end of cot death.
Not only are we gathering information and data that we simply didn’t have access to before but vastly improved computer processing power and complex analytics is allowing us to combine large, messy and previously unconnected data sets to find out everything from the bizarre to the life saving. For example the US retailer Wal-Mart combined in-house sales data with external weather data and discovered that the sale of Pop-Tarts jumped as soon as there was a hurricane warning! No one knows why but the beauty of Big Data is that you don’t need to know why because the data does the talking. Now Wal-Mart move the Pop-Tart display to the front of the shop when a storm is approaching and Pop-Tart sales skyrocket. The FBI has also combined data from social media, CCTV cameras, phone calls and texts to track down criminals and predict the next terrorist attack. There are apps that alert police to gunfire in real time. It’s also now possible, based on their twitter posts, to predict which mothers will suffer from postnatal depression. Professional sport is using big data analytics to find talent and improve performance and politicians are using it to figure out where they need to campaign to win elections.
Can I use Big Data?
It is easy to be overwhelmed by Big Data especially when you consider that most businesses don’t even use the small data they currently have access to never mind harnessing the potential of Big Data.
There is already a backlash as people increasingly question just how useful it’s really going to be. It’s certainly true that most businesses will never be able to compete with the Big Data giants like Amazon, Facebook and Google. Luckily they don’t need to.
The trick for turning the hype into practical business savvy insights is to be really clear on your strategy, work out what questions you need to answer in order to deliver that strategy and focus on collecting and analysing only that data. Unless you’re an analytic powerhouse, collecting too much data is as useless as collecting too little.
Plus you don’t need to have Big Data to benefit from Big Data. It’s now possible to source external data to cross reference with your own internal data. For example many retailers are combining their own sales or loyalty card information with weather data or GPS data to send out targeted promotions.
Like most innovations Big Data has potential but only if you don’t allow yourself to get bamboozled by the media furore and wacky stories of futuristic ‘smart living’. Find out what you need to know in order to be better and establish what combination of traditional data and Big Data will help you to deliver that outcome.