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October 13, 2008

Financial Crisis' Flawed Metrics

Partha Mohanram
Philip H. Geier, Jr., Associate Professor of Business
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While everyone is looking for reasons why this nation is in a financial mess, let me toss another one into the ring. We’re in this situation because we’ve focused almost exclusively on the income statement and ignored the balance sheet.

An income statement indicates how revenues are transformed into net income, or profits after taking expenses into account. The balance sheet lays out the assets deployed in the operations to generate the revenues that drive profits. The critical factor for any firm’s success is its profitability, i.e., how much profit is the firm making relative to the amount of assets that have been deployed. Almost no one looks at profitability — we focus on raw profits instead, to our detriment.

Who’s “we”?

It’s the manager chasing growth in sales and earnings, without worrying about the resources used to obtain the growth.

It’s the financial analyst who incessantly focuses on Earnings Per Share (EPS) targets without any concern for whether the targets were met by organic growth or by value-diminishing acquisitions.

It’s the investment banker who spends most of his attention on whether a transaction is going to be "accretive" or "dilutive" to EPS, not on whether the transaction is going to improve asset productivity.

It’s the business media, which focus on these flawed metrics and increase the pressure on managers to meet rising earnings expectations, even at the cost of declining profitability.

It’s investors who focus all their attention on whether the firms meet analysts' estimates, harshly penalizing firms that miss by a few cents.

It’s the board of directors who compensate managers based on earnings targets instead of profitability targets.

It’s the regulators who have permitted firms to park many of their toxic assets off the balance sheet.

And it’s all of us in business academia for not properly explaining to our students that profit growth and profitability growth are not the same; in fact they are often opposites.

What happens when one ignores the balance sheet? First, one ignores the quantum of assets deployed for the generation of income. Consider Lehman Brothers and other firms that increased their profits quite dramatically until last year through investments in mortgage-backed and similar assets. Their profit growth was dramatic, as was their stock price performance, almost doubling from $44 at the start of 2005 to around $80 in June of 2007. However, if one considers the growth in the amount of assets on their balance sheet, the trend in profitability is much more modest.

Second, one ignores the quality of assets on the balance sheet. If one had paid attention to the rising profits from these risky investments with one eye on the balance sheet, one might have had a better appreciation for the nature of the risk involved. Of course, regulators made this worse by allowing firms to place many of their assets (such as Variable Interest Entities (VIEs), which are at the heart of the subprime mess) off the balance sheets. When people ignore what’s on the balance sheet, what are the odds that they’re reading the footnotes to see what’s left off it?

What does paying more attention to the balance sheet imply? Managers should care as much about what any new transaction brings to their balance sheet as what it brings to their income statements. Analysts should stop focusing exclusively on EPS targets and also forecast profitability targets. Investment bankers should abandon the charade of “accretion-dilution” analysis and focus on whether an M&A transaction really adds economic value (historically, most do not, and my guess is this is partially driven by ignoring the balance sheet).

The business press should stop facilitating the negative cycle caused by an emphasis on profits and growth without regard to the assets used to derive them. Boards of directors should reward managers for growth in profitability, not profit, by incorporating measures such as residual income (earnings less a charge for capital employed) in deciding executive compensation. Regulators should clamp down on off-balance sheet items, a lesson that apparently wasn't learned from the Enron debacle. Finally, business academics must train the next generation of managers, financial analysts and investment bankers to understand the critical difference between profit and profitability.

With any crisis, there is always a period of increased scrutiny, followed by business as usual. In this case, I hope all the “we’s” listed above continue to pay greater attention to the balance sheet once this crisis has been resolved.

This column originally appeared on Forbes.com on Oct. 5, 2008.

Photo credit: Dan Foy

Comments

by Mikeson | October 14, 2008 at 1:08 AM

To echo with Partha's comment, practically speaking, should ROE or ROC, linking income and balance together, become one of metrics to measure manager's performance, rather than just sales and earnings? I think some company is implementing that.

by Filippo Scognamiglio | October 14, 2008 at 11:39 AM

Some companies, with varying degrees of effectiveness, are employing similar concepts such as EVA (I know for one that Siemens is, at a divisional level and also for setting individual managers' targets). I would agree that using any indicator showing what Prof. Mohanram calls "profitability" as a ratio which also includes capital charges in its denominator is a great improvement over traditional indicators such as EPS. Extending this idea to wishful thinking and linking to Prof. Mohanram's own comment on "riskiness of assets", it would certainly be great to add a further item that allows us to correct the above ratio in terms of how much risk the company took to generate said profitability, in order to be able to evaluate if the actual rewards compensate us for the risk. Given the difficulties, however, in calculating operational risk, I don't know how such a globally accepted indicator of this kind could ever be developed.

by nick | October 17, 2008 at 4:02 PM

Specifically with the financials, like Lehman, I think you absolutely need to pay attention to the balance sheet. To build on that point (or possibly take it in another direction), I'd say there is just not enough public disclosure right now to even come close to being able to asses the quality of assets. One example: firms report generic categories like Prime, Alt-A or Subprime mortgage exposure. Leaving aside the fact that the reported figures are net of hedges, which may or may not be correlated with the underlying assets, you would need a lot more information in order to be able to judge the value. Even if a firm disclosed detail down to the level of a '2007 AAA rated Alt-A security', this could be a bond that would ultimately take a 50% loss or get a full recovery. That doesn't provide that much information. I would think you would need almost a line-item detail of loans and portfolios to be confident in valuation of financial firms.

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