Jazy Thinking - Part 3

Today we will examine the last and final statement from Jazy regarding "Three Measures of your Company's Health": Cash Flow.

Jazy likes cash flow instead of basic P&L metrics because “all your other profit-and-loss numbers, like net income, have some art to them.. they’ve been messaged through the accounting process, which is filled with assumptions.”

It's certainly refreshing to see a top executive admit that most of today's modern accounting techniques are turning up to be ever more useless. As I said here:

'P&L' is an accounting concept, not an economic model. Many accounting tricks can be played to arrive at a predetermined profit target. Profit is therefore a temporary lagging indicator of an organization’s ability to manage its finances in such a way as to record the highest possible number for the quarter. Many organizations record profits but don’t return value above their cost of capital.

So cash flow is better than standard P&L metrics, but is it the best financial measure a company's health?

A company exists to return value to its investors. When a company has been in business a long time and is in a relatively static industry then cash flow is a good short-hand for the value they are creating. But fewer and fewer companies are in the enviable position of being valued for how much money they mint. Instead, companies are increasingly measured by whether they have some new concept or widget which will make a lot of cash in the future, but is doing nothing but costing money right now. Innovation is a process of taking something that is valuable today (time, money, natural resources, attention) and turning it into something that will be much more valuable tomorrow (products and services that can be replicated easily and sold at a profit to what it really cost to create them).

In those cases, cash flow is a lousy measure of your company's health. For instance, would you rather be a Microsoft shareholder today (a company that has great cash flow) or a Google shareholder six years ago (a company that, at that time, had almost no cash flow). A share of stock in Google six years ago is much more valuable than a share in Microsoft today, even though one company generates a lot of cash and the other didn't.

More and more companies (and analysts) are coming to realize that the P&L and cash flow statement suffer from the same basic problem: they don't tell you how much the company is really worth. Cash flow can tell you how healthy the company is right now, but that health can go away fast. A company with a really strong balance sheet, on the other hand, probably has a stronger position for the future.

The previous two posts in this series were focused on variations of a theme: human satisfaction (customers and employees). In each of those cases it seemed apparent that there were better methods for assessing a human emotional state than merely surveys and visits. Ironically, when we enter the world of numbers things become murky. How you evaluate the financial health of a company depends on the industry, stage of growth, innovation portfolio and risk tolerance. There is no one good financial measure.

The larger question will be the one that I wrote about in the "Prophet (Not Profit) Guys". The Chaisson brothers have some great work around the area of assessing the relative value of employee contribution. I strongly encourage you to keep track of what they are building over at the Prophet Group. I believe that they have the intellectual depth and investor experience to take a good run at solving for the "talent is more valuable than capital" equation.

And for those of you who are total finance junkies, I encourage you to check out the November 2005 Harvard Business Review article titled "You Have More Capital than you Think" by Robert Merton. While Merton is making a complex argument that equity capital is overused to cushion the inherent risk in a business, he has some brilliant points of illumination to which we should pay careful attention. Merton posits that we need to list a concept called "Value at Risk" in our balance sheets. Value at Risk (VAR) is "a dollar measure of a company's total riskiness."

Because Merton's VAR concept demands a careful accounting of the assets and liabilities associated with intangibles such as brand equity and knowledge-worker capital, it provides us an interesting financial framework for communicating to capital investors just how much our people are really worth. Or, conversely, what it would cost us to lose key people? Merton asks finance departments to consider these risks because he says that they can use credit instruments to hedge that risk and therefore put more of the company's equity capital into bolstering the position of the value added risks. I read that to mean "you can spend more capital rewarding value creation rather than stockpiling your money to hedge potential risks that you haven't even calculated effectively."

Is that the sound of crickets I hear? Perhaps this is too arcane to be interesting. I look forward to a day when I hear Wall Street start to consistently emphasize talent over money, and I think that people like John and Steve Chaisson and Robert Merton are starting to chart a intellectually and economically rigorous path that may get us there. (Once capital consistently flows to companies that attract, grow and utilize talent in the most effective manner corporate America will see that it is in their best interest to grow the overall talent pool, which means they will finally start demanding - and investing in - real change in the Western education system towards inspiring kids, fostering inherent creativity and fostering the kind of emotional intelligence that is needed to drive successful teams... but I digress.)

Tomorrow we will wrap all our Jazy thinking up in some concluding thoughts.