When an IT manager finally takes on the CIO mantle, often the lucky soul is faced with a host of duties and arcane terminology having nothing to do with technology and everything to do with finance. After all, the key to making good investments in technology is understanding how they’ll boost the company’s fortunes and eventually add to the bottom line. n “Technical people who want to rise to middle and upper management need to, and usually do, pick up financial knowledge and skills,” says Robert Obee, vice president and CIO of Akron, Ohio-based Roadway Express. He came to Roadway 18 years ago prepared with multiple advanced business degrees and a strong financial grounding. “IT managers need to be equipped to deal with accounting and budgeting tools, and a strong understanding of the overall finances of the company in order to be effective.” n Plainly put, CIOs and their IT teams must understand financial ideas and terms. Think you’ve got it covered? We invite you to run through the following list of basic financial concepts. If you know the intricacies of all these terms, you’re either a former CPA or a natural stand-in for your CFO. If you’re familiar with only half or fewer, you may want to put a few new financial tricks in your bag.
P&L The profit and loss statement is the cornerstone of executive responsibility. Businesses generally maintain P&Ls for distinct business lines, as well as significant products. Responsibility for a P&L unit can make otherwise pleasant people very difficult and demanding.
Contribution Margins If you want to expand your profits by, say, 20 percent, how many people will you need to hire? To figure it out, calculate the contribution margin, which is the incremental revenue or profit each new employee (or product sale or customer) generates. Much of the art of predicting cash flows and operating income from a business initiative, or a P&L unit, lies in determining these margins. The CIO helps create the management information systems that best measure them. At Blue Bell, Pa.-based Unisys Corp., for example, “customer profitability is the Holy Grail,” says CIO John Carrow. “Because information systems need to build this measure from lots of different data, it’s important for the IT group here to have a solid understanding of the components from the bottom up.”
Expense Allocations This can go by various internal names, but the concept is the same: Each operating unit must pay part of the company’s general and administrative expenses, which include debt, real estate, secretaries and, yes, information systems. Deciding how much to allocate to a unit is one place where the rubber can hit the road in internal politics, as these charges can seriously affect a manager’s ability to meet his P&L goals. As a result, CIOs can face resistance to new technology initiatives because of the resulting increased allocations, unless the benefits are clear to all affected—or at least the right people: the board of directors.
Return on investment (ROI) The granddaddy of investment success measures, the return on investment, at its core, is an easy calculation: the amount of earnings taken in divided by the amount invested to generate the earnings. But estimating either number is a tricky business with many variables. Unfortunately, looking at the ROI by itself leaves out some critical elements of the cost of and the return on an investment.
Cost of Capital Most ROI measurements neglect this cost, which is the return investors expect on their money—in stock or debt. Sometimes it’s referred to as a “hurdle rate,” as it is the minimum rate of return required to earn back the cost of the invested capital; additional earnings are considered profit.
Net Present Value (NPV) and Internal Rate of Return (IRR) Used primarily at capital intensive and mature companies, NPV and IRR measures are more thorough than traditional ROI calculations, because they take into account the expected life of an investment, depreciation and the cost of capital. Complex approaches to quantifying these measures include accounting for varying discount rates with the changes in risk of an investment and the reinvestment of cash flow from an investment.
Real Options Theory Should your company launch a new product line, invest in a new sales channel or lay out for a new ERP system? Tough decision. One way to help make it is to apply the arcane Black-Scholes options pricing models (which were created to help price publicly traded options contracts by the eponymous finance professors) to corporate decisions and their associated assets and liabilities. This is a powerful tool for justifying new, risky investments and determining when to cut the company’s losses.
Seed and Angel Money In these VC-crazed times, these are almost household terms, but confusion abounds. Seed and angel financing refer to the very first investments made by private individuals, whether they be successful entrepreneurs putting their cash to work or a well-off college pal backing your big idea. This is distinct from first-round financing and subsequent rounds, as these later investors are typically institutional investors—that is, professionally managed venture capital funds and corporate strategic investors.
Options Employee stock option plans, more precisely, are “the most powerful recruitment and retention tool a company can have today,” says Bill Reichert, president of Garage.com, especially for startups that can’t offer a lot of cash up front. Companies set up these plans according to certain legal and financial guidelines, and they’re governed by rules and restrictions such as vesting schedules. They are different from employee stock ownership plans, which are a type of retirement benefit plan, and from exchange traded options, which are purchased contracts to buy or sell publicly traded stocks at set prices in the future.
Dilution and Antidilution The idea of dilution is simple enough: A company issues new shares to raise money or to finance an acquisition, and existing shareholders own less of the company as a result. Antidilution clauses, typically found in VC investment agreements and stock option programs, protect their holders’ investments from downward price pressure. An antidilution clause doesn’t guarantee, however, that its holder’s current percentage of ownership never changes.
Warrants and Warrant Coverage These agreements, like employee stock options, give their holder, usually an outside investor or vendor, the ability to purchase shares in the company at a set price. Many startups short on cash have found creative ways to use warrants early in their development to pay lawyers, landlords and equipment vendors. Lenders, too, get in on the act by lowering interest rates on loans and lease financing to the company in exchange for “warrant coverage,” which can range from 5 percent to 50 percent of the financed amount. So instead of paying 12 percent on a $1 million loan, a startup might instead pay 10 percent and grant $150,000 worth of warrants to the lender. Problems can arise, however, when warrants are used too loosely. “Warrants can end up as a very expensive way to pay for things if the company is even modestly successful,” says Lefteroff of PricewaterhouseCoopers.
Burn Rate This refers to the amount of startup capital a new company goes through each month or quarter as it tries to launch its product or come up with a salable discovery.
Earn-Ups and Earn-Outs Like incentive agreements made with employees during the sale of a company, earn-up and earn-out agreements give the selling company’s active managers a financial reason to stick around and meet performance targets set by the buyers. Earn-ups offer more ownership in the combined organization; earn-outs offer more cash, often paid out at set intervals as part of a planned exit for the seller of a business.
Earnings Multiple Also known as the price/earnings ratio, this is the main way stock values are compared. A company earning $5 a share with a multiple of 10 would be worth $50 per share. Its competitor may earn the same per share but have a multiple of 15, for a share price of $75. The magic of Wall Street sets the multiple—it’s a combined reflection of how investors and their advisers view a company’s steadiness of earnings, growth potential in revenues and earnings, market position and management quality.
Carve-outs and Spinoffs These refer to increasingly popular methods for turning a piece of a company into a separate division or wholly owned subsidiary. In a carve-out, the parent company establishes the division or subsidiary as a separate corporation, then offers new shares in the unit to public investors in an initial public offering. The cash from the IPO can go to either the new unit or the parent. In a spinoff, the parent distributes to its existing shareholders the new company’s shares on a tax-free basis, with or without a carve-out. Either way, IS executives at companies executing these transactions must establish completely separate IT capabilities at the parent and the new entity, or recommend alternatives.
Tracking Stock Different from the above techniques in that tracking stocks, or trackers, allow a company to create a separate class of stock backed by the financial results of a division without separating the division into a different corporate entity with its own board and balance sheet. This allows the parent company to retain operational control and financial ownership while allowing the market to price the new division differently from itself. Trackers have been used recently to separate high-growth, high-multiple businesses, such as dotcom and wireless divisions of parent corporations, with an eye to issuing employee stock options on the tracking stock as a recruitment tool. Trackers, however, often don’t perform as well as carve-outs and spinoffs.
Public Debt No, this isn’t the result of the federal government’s past deficits, at least not in the corporate context. It’s the arena of companies issuing bonds registered with the Securities and Exchange Commission (SEC) and sold to bond investors. Measured by invested capital, the debt market outweighs the U.S. public equity market with $11.1 trillion in bonds and $8.9 trillion in stocks. Tapping the public debt market can help a company lower its cost of capital, allowing it to make large asset investments more easily.
Debt Ratings Debt ratings are a measure of risk established by the debt rating agencies, the main ones being Moody’s Investor Service and Standard & Poor’s. A debt rating is based on the company’s cash flows, anticipated growth, industry stability and management talent, and it is somewhat subjective. The cost to a company of issuing debt is directly related to its rating, as investors demand more interest from riskier companies. This difference is typically measured in “basis points”—or hundredths of a percentage point—over the going rate for a U.S. Treasury bond, which is considered the “risk free” rate of return.
Depreciation and Amortization Different but similar. Depreciation is the reduction in the value of a company’s physical assets—buildings, plants, cars, computers—that must be applied against operating profit as a noncash expense as the goods are used. Amortization is a similar charge related to intangible assets, like patents and customer lists, as well as loans and capital leases, and their associated interest. Both are a burden to companies because they lower net earnings and earnings per share. Companies sometimes review tangible and intangible assets for impairment, hoping they are worth less than their current value on the balance sheet. They then “write down,” or devalue, those assets and recognize the reductions as a large charge against earnings.
Financial Accounting Standards Board (FASB) The FASB sets the rules accountants follow in tracking corporate performance and solvency, known as generally accepted accounting principles or GAAP. The FASB is a private, self-regulating body funded by corporations and the accounting profession, and it is given this power and overseen by the SEC. The FASB’s process is known to be glacially slow, yet it maintains enough independence to occasionally approve controversial changes.
Intangible Assets and goodwill These types of assets are typically obtained when a company buys another company, a particular product or a business line, and it shows up on the buyer’s balance sheet. Intangible assets comprise two groups: Identifiable intangible assets include all intellectual property, such as databases, customer lists, patents and brands. The second group, goodwill, includes everything else. Both are seen as a burden by most companies as they must be amortized over periods as short as two to three years for some intangibles and up to 40 years for goodwill. Instead of one company purchasing another, many companies try to merge in a “pooling of assets,” allowed under present accounting rules to avoid charges and boost net income. The FASB is in the process of changing these rules.
EBITDA Pronounced “ee-bit-da,” this alphabet soup is short for earnings before income taxes, depreciation and amortization, and it serves as a raw measure of operating earnings at a company. It is most important to capital-intensive companies, highly leveraged companies, and those with large amounts of intangible assets, as they have high depreciation and amortization amounts that are deducted from revenues in measuring net earnings. EBITDA is also called operating profit.
Materiality A financial event is considered material if it has a significant impact on revenues or profits. Significant can mean as little as 1 percent or 2 percent or as much as 5 percent. In a securities regulation context, public companies are required to disclose to shareholders any material events, such as a change of officers, tender offers or other activities that affect ownership or management of the company, as soon as they’re known. So if your website crashes for a few days and causes a slight dip in sales, you’d better hope your CFO determines the event was “immaterial for reporting purposes.”