The Corporate Strategy, when isolated from the Financial Strategy, is incomplete
Stefan Alexander*
Companies have faced times of transition where the Corporate and Financial Strategy is constantly challenged.
At ACF, we are dedicated to implementing Corporate and Financial Strategies based on the analysis of the business model and its impacts on the capital structure.
It is common for this issue to come to the fore in times of transition, caused by changes in the economic or competitive landscape, a merger, or any other change in normalcy that directly affects capital structure. Situations in which financial management is a relevant part of the success and survival of the business.
Whenever we discuss this issue with shareholders and managers, the analogy with human health helps put everyone on the same page.
The analogy between business and human beings first appeared in literature when economist François Quesnay, who was also a physician, compared financial flows to blood flow in his ‘Tableau économique,’ in the 18th century.
Economics and its theories have evolved much since Quesnay, whose work was the foundation for physiocratic thought, but this approach remains relevant and useful in discussing the business model and its impacts on capital structure.
“Managers: let’s deal with the Business Strategy, then the CFO handles the financial details.”
In most cases, the first challenge we face is the current — and wrong — idea that financial issues are not an integral part of the strategic discussion and the business model. The financial area is often seen as “supporting activity,” and as a result, the financial strategy is not given due attention.
In non-financial corporations, many managers and shareholders do not understand that corporate strategy and business management are not complete unless they include the appropriate financial strategy and management. One thing does not exist without the other.
In comparing financial flows to the blood flow (as in Quesnay), it is possible to understand that the financial diagnosis is the first step to appreciate the effects of such transition period on the activities of the company. This diagnosis is meant to understand the impacts of the various activities on the company’s results, and is not limited to an assessment of financial activities only. It’s like a blood test, which we all do often. The purpose of a blood test is not to make discoveries about the blood itself, but to enable doctors to gather information to diagnose how the different organs of the body are working. The test’s warning signs often indicate additional measures or tests that are not even directly related to blood.
To make this analogy clearer, imagine a conversation between a doctor and a patient in which the former tells the latter that his blood test showed high cholesterol levels. The answer the patient would like to receive is, “Don’t worry, we will filter your blood and the problem will be solved.” Unfortunately, the prognosis is different: “I’ll give you a prescription, but you’ll have to change your lifestyle and eating habits, and start exercising!”
“CEO: My company is very leveraged!”
Managers and shareholders facing dramatic debt situations often do not have a clear understanding of the relationship between capital structure and operational activities. When a company reaches a higher level of debt than desired and does not prioritize the management of the financial activities in the business model, it is common to hear the question, “How do I solve this financial debt problem, so it does not get in the way of my business?” As if those two things were not directly related.
Such a reaction is understandable. When a child of ours has a high fever, we want a solution so that the temperature lowers. But is this the most relevant matter? In most cases, it’s not.
A company’s debt situation might be (and often is) only the consequence, rather than the cause. The diagnosis of the disease is, in most cases, more complex than just treating the symptom. “Where did this imbalance come from? What’s its origin?” If the disease is not treated, the fever returns after the antipyretic.
When a company does not strategically plan its capital structure and its level of indebtedness, the consequences can be dramatic. In practice, many companies use the credit market in a disorganized way, without any strategic planning, and, worse, they confuse the concepts of leverage and indebtedness.
From a conceptual point of view, the theoretical justification for the use of indebtedness as a source of funds would be the leverage of the shareholders’ return. In a simplistic way, up to a certain level of indebtedness, the higher the debt — with the increase in financial expenses resulting in a lower tax base — the greater shareholders’ return is.
However, this optimal leverage point is not easy to achieve in real life, and its planning ability depends largely on the predictability of the company’s results. The more volatile the company’s business is, the higher the likelihood that debt will be lower or higher than the optimal point. But the higher the indebtedness, the worse the creditworthiness of the company and, sooner or later, the higher the interest paid. Unfortunately, excess debt is not leverage — it’s just debt. Excessive debt reduces shareholders’ returns and, from a certain point on, it has far more serious consequences.
Within manageable intervals, this financial planning error has negative impacts only on shareholders’ returns but does not affect the sustainability of the company. They can be bypassed.
“Excess debt is not leverage — it’s just debt!”
However, when financial expenses and amortizations outperform operating cash generation, and the company is forced to contract debt to cope with this negative flow, the problem becomes much more serious.
From this point on, debt starts to grow by itself, in an uncontrolled way, like a cancer cell. Ultimately, there is metastasis.
In this case, the company’s “illness” is far more serious and the cure involves intensive treatment: If the company is not able to rebalance itself by increasing operating cash flow, selling assets, securing new loans or capitalizing itself, it will have to restructure its financial liabilities. In other words, the treatment is not simple and has serious side effects.
“Warning to Managers: There is no complete Corporate Strategy without a Financial Strategy.”
The analogies with human health have been useful to explain, in a simple way, the correlation between the financial strategy and the corporate strategy. Managers and shareholders need to understand that one thing does not exist without the other. However, problem prevention is almost a matter of common sense: A planned routine with healthy habits and cash generation has never hurt anyone.
*Partner of Alexander Corporate Finance (“ACF”), a consulting firm specialized in creating value during transition periods (www.alexandercf.com.br). Holder of a Master’s degree in Economics from PUC-Rio, former investment banker at BBA and Bank of America, and former CFO at Organizações Globo.
