Lawrence is the quintessential success story. He grew up in a small town in Canada and worked his way through Ryerson University, graduating from the engineering program. From there, he focused his energy, ambition, and talent on a career that, in a few short years, led to becoming President of Fisher and Porter's U.S. operations, while earning an MBA from Wharton along the way. Soon thereafter, Lawrence would join Bofors Electronics and hire me to work with him.
The thing that struck me immediately was that Lawrence had developed a comprehensive model for running businesses. With an MBA and a Master's in Economics, I had a pretty good education and a fair amount of experience when I joined Lawrence, but I had never put it all together into a model for running businesses as he had. His model made an incredible amount of sense and, more importantly, it worked. Lawrence used his model to manage the Bofors Electronics companies and subsequently the Pharos AB and Spectra-Physics AB companies. In every case, these companies produced exceptional returns for the owners and shareholders.
Lawrence's business acumen impressed a lot of other people as well. After selling one of our companies to Berwind Corporation, he was asked to join their Board. Subsequently, a number of other companies, including AmeriSource Inc., Campbell Soup Company, CDI Corporation, and H & E Equipment Services Inc., invited Lawrence to join their boards. All of these companies recognized the power and effectiveness of Lawrence's approach to business.
That brings us to this book. It started out in 1990 as a presentation he made to the key employees and leadership team of Spectra-Physics, a company we had recently acquired. Spectra-Physics was a major acquisition for our company, and it was critical that it be successful. We knew that for that to happen we would have to instill our management philosophy and culture quickly. So Lawrence created a presentation that he gave to several hundred key employees in the United States, Europe, and Asia over a couple of months. In his usual charismatic style, he explained his philosophy for creating value and articulated a business model for making it happen. That worldwide presentation was a catalyst for the success of the acquisition, not only because the overall concepts were understandable and appealing to his audience, but because Lawrence had the ability to make people believe that they, too, would be successful if his concepts were implemented.
Over the years, Lawrence has continued to refine his thoughts, with this book being the culmination of that effort. The reader should recognize three things. First, Lawrence supports his ideas rigorously through equations and mathematical models. While you don't need to understand the quantitative aspects of the book to extract value from it, if you do, you will have a better understanding of how everything fits together. Second, by working through the case studies and examples, you will get a thorough understanding of the business model that Lawrence used throughout his incredibly successful career. Finally, pay close attention to the takeaways at the beginning of every chapter. These represent the basic principles that underlie Lawrence's business model.
While many successful people write autobiographies, it's not often that an accomplished business leader takes the time and makes the effort to put his entire approach to business in writing. At times, Lawrence's ideas may seem unconventional, but I'm sure you will have many “Aha” moments as you read his detailed descriptions of what makes a business tick. Keep reading, and you'll soon understand what Lawrence taught me over the past 30 years.
CHAPTER ONE
Basic Concepts 1
• There are only two business reasons to own or invest in a company. One is because the company will grow its earnings and therefore value. The other is to receive dividends from the cash flow. In practice, it is often a combination of both.
• Management teams perform better if they are measured against some set of criteria. One of the criteria that is of interest to investors is the return provided by funds invested in the business. A measurement of this is Return on Capital Employed (ROCE).
• In a general sense, managers are tasked with two key objectives: (1) Find attractive investments, and (2) deliver attractive returns. Since ROCE compares what management delivers (Net Operating Profit after Tax) to what has been invested in the company (Capital Employed), it is a good measure of management's effectiveness.
• In some instances, a decline in cash flow can be avoided by cutting costs. In fact, management can increase cash flow by disinvesting in the business. However, in today's business climate, increasing cash flow by expense control doesn't work for very long. Eventually cost cutting is a dead end and the only remaining road to increasing shareholder value is growth. Growth opportunities don't just come along. A company has to be committed to investing for growth in order to get it and even then success is highly uncertain. Unlike sustaining investments, investments focused on growth inherently involve more risk. The upside is, of course, the possibility of a better return.
• Making a choice between sustaining or growth investments or investing for both is not simply a matter of money. In practice it (money) frequently turns out to be the least important resource. Investments directed at growth require ideas and sometimes new technologies. Furthermore, it's not very often that a management team that is outstanding when it comes to cost control and optimizing the productive level of sustaining investments is also good at managing a company for growth. While managing the process and resources associated with putting a company on a growth track can be learned, it takes time – often lots of time and many lessons learned. In practice, most companies make both sustaining and growth investments at the same time. Successful companies have learned that each category of investment has its own prerequisites and culture and therefore staff and manage accordingly.
• The key drivers of Cash Flow are Net Income, Investments, and Return on Capital Employed.
• Without Net Income, a company doesn't generate any cash from operations.
• The first thing that one should notice when examining a Cash Flow Statement is that “Cash” is missing. The reason for this is when it comes to the Cash Flow Statement the “Change in Cash” is what the statement determines.
• When considering the impact that Working Capital has on the Cash Flow Statement, it's the changes (Δ) in the various accounts that are important.
⧉ Introduction
The underlying assumption for the preparation of the material in this chapter is that the reader has limited comfort and experience with the financial statements and the language of business. The chapter begins the education process by creating a general expression for Net Income (NI), followed by a discussion of Earnings before Interest and Taxes (EBIT) and Earnings before Interest, Taxes and Depreciation (EBITDA).
Next the Balance Sheet is used to define Capital Employed (CE) and Return on Capital Employed (ROCE) and then to combine these expressions with the equation(s) developed for Net Income (NI). After a brief discussion of the kinds of Investments a company makes, the Cash Flow Statement is introduced to help define cash flow in terms of Cash Flow from Operating Activities (CFfOA), Cash Flow after Investing Activities (CFaIA), and Cash Generated/Used (CGU).2 Finally the Income Statement is worked backward, so to speak, where an expression is developed that describes the Required Revenue necessary to generate a given level of Net Income using the various components of the Income Statement.
⧉ Financial Statements
When one opens a financial report or a set of financial statements, the first statement encountered is usually the Income Statement, followed by a Balance Sheet and Cash Flow Statement. There isn't anything sacrosanct about this order of presentation. In fact they could be presented in any order. One of the reasons the presentation conventions have evolved in this manner is by doing so they present the financial affairs in a logical order. Stated simply, the Income Statement presents how a business has done during a period of time (usually the most recent period, i.e., month, quarter,