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Executives don’t understand finance: Harvard professor

Kath Walters /

The best and most important business decisions are linked to finance outcomes, of course.

Or they should be. In fact that the executives in charge of most business decisions lack the financial training to evaluate those outcomes, says Harvard professor Benjamin Esty, the unit head of finance at Harvard Business School.

Esty has studied decision-making for 15 years, specifically how corporate finance specialists make very large investment decisions on complex projects such as bridges, high-speed rail or mines. “Ten years ago, I was asked to design a new leadership program for mid-to-senior executives. In teaching this, I quickly realised one of the biggest gaps people had was around the topic of finance,” he says.

It seems remarkable that leaders do not understand finance; but it’s not that simple. “You have the C-suite who know these things, but not at the next level or two – your plant manager, your legal officer, your human resources manager. These executives are all making operational decisions and they have to make them today, when the C-suite isn’t watching.”

Mid-level to senior executives may understand the principles of financial management, but they lack the confidence to join in financial debates. “They don’t have the terminology, so they lack the confidence to engage and feel good about engaging,” Esty says.

At the same time, responsibility is being devolved to executives further down the line. “Companies are becoming increasingly decentralised; you need every person to have the full financial ‘toolkit’,” Esty says.

What kind of financial information?

Profit is not the only thing that matters in business; it is the ability to generate cash flow together with profit that is the lifeblood of a company. “Without cash flow and profit, you wilt and die. This is not just a luxury,” says Esty.

When decision-makers are fluent in financial terms and ideas, they ask better questions. “They may have heard of terms like ‘discounted cash flow’ but they are not sure what they mean. It sounds like Greek. We don’t want to create a lot more chief financial officers, we want to create more decision-makers who are fluent in ‘Greek’, can speak with the ‘Greeks’ and sniff out if someone is trying to pull the wool over their eyes,” Esty says.

For example, decision-makers need the ability to quickly assess the financial performance and health of a prospective customer, supplier or joint venture partner from their financial statements. Or, when hiring people or investing in systems, to analyse the future stream of cash flow.

And then there is execution – analysing the financial impact of a strategy, such as growth. “People get seduced by growth,” he says. “Growth can be a good objective, but do you want to be the biggest cement producer or the most profitable? Sometimes those are the same things; you can grow into bankruptcy if you run out of cash. Executives need to look at when to grow, when to invest, and who to partner with.”

Why the Airbus didn’t take off

The delays in delivery of the A380 Airbus is a favourite case study for Esty.

“Step back in time,” he says. “Airbus said they would deliver close to 300 of the 380s by now, and they have delivered about 100. They said they would invest $13 billion and they have invested close to $20 billion. This is why I got interested. How does a company miss a cost forecast by $7 billion and a sales forecast by 60-70%? And Boeing’s 787 is the same thing – they have missed their launch, cost, and sales forecasts by wide margins, too.

Deciding to make the “biggest plane in the world” turned out to be a very costly financial decision, Esty says.

He says the same poor decision might apply in a shoe shop. Its vision is to fit the foot of every customer that comes in the door. “This might make sense in terms of the profit and loss, but operational managers are responsible for two other financial results: cash flow and the balance sheet. If you have an enormous inventory, it is costly to finance and store. Until you realise that inventory is costly, you cannot realise that you might be better off losing a customer or two.”

Another quiver in the bow

Esty is quick to explain that financial outcomes are just one measure of a decision. “We are trying to give another lens through which to look at decisions. You should never do a joint venture if you can’t stand your partner!

“I am not trying to say this should replace sound judgement, but it adds another arrow in the quiver – another tool to assess and think about how to make important management decisions.

“I think about the challenge of senior executives: of the hundreds of decisions that are made, can you pick the two, three or four to get right? One more tool turns out to be powerful.”

Fortunately, most senior executives learn very quickly – as if a door has opened and they simply walk through. A week is enough to get conversant with the basics. “We give enough of the language so that you can go talk to people. It is ‘conversational financials’. But it is lifelong learning; you go back and ask two more questions and read the analysis and it is a virtuous cycle. It is amazing how much people can take away from a week of training.”

Professor Esty will be visiting Australia in July this year. To catch up on more of his insights, contact the Harvard Club of Australia.

 

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