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DURING MY CAREER I have been involved in numerous businesses in various industries: some doing well and others in need of drastic attention. At an early stage in my career, I realized that many businesses could improve their performance if shown how. So I began to develop presentations addressing some of the aspects of creating value in a business. I then systematically presented my thoughts to the various management teams I was involved with. The outcome was dramatic in many cases. Performing businesses did better. Turnarounds became profitable. The first codification of this material was documented in a series of VHS tapes I did in 1990 titled “A Smile Is Not Enough,” which have been used as training material for several firms.

When I stepped down as executive chairman of Spectra Physics I was no longer responsible for any day-to-day operations. While I had many board opportunities to keep me busy I still had “time on my hands,” so to speak. Given this state of affairs I decided to write a book that addressed what I perceived to be a need to combine the essence of sound business practices with an analytical framework that managers and executives who don't have an MBA could use to make better decisions and advance their careers.

I would like to thank all of the organizations and people I have worked with who have made this work possible. In particular I must give credit to my dear friend and editor, Patrick Edsell. Pat is a very capable executive and was my business partner when he was CFO of Pharos AB and later CEO of Spectra Physics Inc. He devoted an enormous amount of time editing many revisions, including some of the earlier manuscripts (which must have been painful). In fact his contributions have made this a much better book than it would have been otherwise. Others who have played a significant role in the preparation of this book are: Yuanshun Li, PhD, Assistant Professor of Finance, Ryerson University, who did a detailed edit of a final manuscript; James Gabriel, retired CEO of the Harris Group Inc., who also edited a final version; Jason Spera, CEO of Aegis Software Inc., who tirelessly edited the sections on the Internet in Chapter 6; Dennis Pizzica, VP and Treasurer of Berwind Corporation, who made numerous helpful suggestions during his review of Chapter 9; and Steven Ritter, partner, KPMG LLP, who provided advice on accounting-related matters. Finally this book would not have been possible without the support of my family, who never complained about my periodic absences from events and preoccupation with the manuscript. In particular I must thank my wife, Deborah, who read numerous manuscripts, made many helpful suggestions, and who didn't have to ask what I was doing when passing my office for the past many years.

⧉ About This Book

While there is material in all chapters that is very readable, a level of comfort with algebra is required in order to appreciate much of what is presented. Conventional wisdom would suggest that value creation would include at least three business activities: operations, investment, and financing. Within these milieus, management is expected to find the optimum combination of debt and equity to minimize the firm's cost of capital and to provide adequate working capital. In addition, one of their prime objectives is to grow the organization's revenue and profit by identifying and making investments in Research and Development; Property, Plant, and Equipment; Operations; Marketing; Sales; Human Resources; Systems; Procurement; and Finance and Administration. This book addresses these issues by offering an analytical operations framework that management can use to optimize the impact of their investment decisions on operations and to create value through the growth of the firm.

Chapters 1 through 3 lay the groundwork for subsequent chapters.

Chapter 1 is dedicated to explaining the Income Statement, Balance Sheet, and Cash Flow Statement, how they interact, and the importance of a thorough understanding of these statements in decision making. The concept of measuring value is introduced early to give the reader an appreciation of what's involved. Also the notion of Required Revenue is defined and discussed to give the reader an appreciation of the role Revenue plays in covering all the expenses and taxes incurred by a company. The case study is built around a manager who has just returned from a training program and proceeds to use his new skills to analyze his company's financial statements.

Chapter 2 builds on the concepts developed in Chapter 1 and establishes the need for a model that enables management to make quick estimates of performance based on various assumptions about the business environment. To this end, the Envelope Equations that permit quick estimates of profit and cash flow are introduced. Their use is illustrated by various examples. The power of the way of thinking developed in the chapter is demonstrated in the case study where the chair of a corporation wrestles with an investment decision.

In Chapter 3, the issues associated with a company's cost of capital broadly known as the Weighted Average Cost of Capital are discussed. Beta is introduced, which leads into a discussion of the Capital Asset Pricing Model. The focus of the theory and examples is on investment decision making. For those who need a refresher, it includes an illustration of the concept of Present Value. The case study tells the story of a CEO of a successful company who, against the advice of his board of directors, makes a serious mistake but goes on to fix it and regains the confidence of his management team and directors.

Chapter 4 provides an introduction to the valuation of Cash Flows. It begins by defining forecast and post-forecast cash flows, and then takes the reader through a series of models that, depending on the circumstances, can be arranged to suit a particular operating environment. The chapter concludes with several examples, including single and multi-stage cash flow business models, and a case study in which a young group of managers is given an opportunity to value the largest acquisition their company has ever contemplated.

Chapter 5 introduces the concept of Return on Capital Employed (ROCE), a widely used measure of the returns management generates relative to the capital employed in the business. This is followed by introducing the Income Statement and Balance Sheet accounts into the ROCE expression, and via these analytics the drivers of ROCE are identified. Several examples are cited and followed in a discussion of the practical aspects of managing ROCE. The case study tells the story of a management team that purchases a troubled company and then proceeds to fix it using a combination of the CEO's experience and the ROCE driver model.

Chapter 6 outlines strategies and best practices for managing ROCE and it is the most qualitative chapter in the book. Because it is largely qualitative this chapter is a prime example of the attribution problem referred to in the “Selected References” section of this book.

The chapter begins with a discussion of basic pricing-driven models that is followed by a dialogue that defines and characterizes the attributes of several value-added models. A detailed discussion of the factors that affect the cost of goods sold follows the business models that have been introduced with the objective of identifying what can be done to maximize Gross Margin. Operating Expenses are examined next in the context of viewing expenditures on Sales, Marketing, Human Resources, and so on as investments rather than expenses. Considerable space is devoted to the Internet and its impact on business and strategies. A model for estimating R&D expenses is illustrated by way of an example as are other concepts introduced in the chapter. A discussion and analysis of the strategies and best practices associated with balance sheet–related topics is included. It concludes with a case study in which a board of directors decides management's business model is broken and appoints an energetic, experienced director to develop and implement a plan to reinvent the business.

Chapter 7 is solely devoted to the measurement of Productivity and Operating Margin and the role they play in the long-term performance of a firm. A model that quantifies productivity is developed first. Then in order to make it a useful tool for estimating profitability, it is modified to incorporate the concept of operating margin, a predictor of future performance. The models are then explained in terms of manufacturing and service environments. Examples are used to illustrate the power of the concepts that have been introduced. The chapter concludes with a case study that portrays how a management team systematically developed productivity and operating margin improvement plans for an underperforming company.

Chapter 8 examines the question of maximizing profitability from another perspective. It is based on the premise that there is a relationship between what a customer is prepared to pay for a deliverable and how a company should be spending its money. It starts with a definition of the Expense Coverage Ratio (ExpCR) and then systematically goes through a process of creating alignment between the value a customer perceives in a deliverable and the money the company spends responding to the customers' needs. Examples that illustrate how the ratio can be used to predict future performance are included, as are strategies and best practices for managing the ExpCR. The concluding case study illustrates how a management team used the concepts embedded in the ExpCR to dramatically improve the company's performance.

Chapter 9 examines Leverage. It begins with a dialogue on debt and leverage and then proceeds to outline how interest rates for business loans are priced using something called the “London Inter-Bank Offered Rate” (LIBOR). A discussion of creditworthiness, security, covenants, financial performance, tenor, and priority is followed by an introduction to the various forms of debt financing. The import of creditworthiness in establishing the ultimate pricing of a security is addressed as is the role played by the various credit rating agencies. The concept of Return on Equity (ROE) is introduced, followed by the development of the ROE driver equation and various examples that illustrate the tradeoffs involved by various capital structures involving debt and equity. The chapter is all about capital structure. The case study illustrates how a management team went about financing future growth.

Chapter 10, the concluding chapter, is designed to bring together the concepts associated with understanding financial statements; how the management's day-to-day operational strategies (including financial and investment strategies) discussed throughout this book can influence value creation; and how all of this can be used to build or modify a business plan. It begins with a review of the key elements of financial performance and the financial statements. This is followed by a case study that portrays how a potential investor takes data that is presented to her in an investment prospectus, carefully reviews its contents, and then proceeds to modify the business plan based on her assumptions. She then builds a set of financial statements that reflect what she perceives to be a risk-adjusted view of the possible financial performance of the investment opportunity.

Lawrence C. Karlson

Palm Beach Gardens, Florida

February 2015