Cash Flow Neglect: The Corporate Blindspot That's Killing Value

In the realm of business and finance, the timeless wisdom of Warren Buffett rings true: "The only reason for putting cash into any kind of an investment now is because you expect to take cash out."

It's a straightforward concept—cash flow (CF) is king. Yet, as evidenced by a recent study, many organizations seem to be veering off course from this fundamental principle.

Ernst & Young LLP's examination of the largest 200 US-listed companies reveals a startling disconnect between what should be core themes in business strategy—CF, growth, and return on capital (ROC)—and what is actually taking precedence.

The study uncovered that a significant portion of these companies are neglecting to emphasize CF and ROC in both executive compensation and analyst dialogues.

This misalignment is particularly concerning in today's climate, where investors are increasingly scrutinizing capital use for value creation.

The first eyebrow-raising finding from the study is the underweighted nature of CF and ROC in executive compensation.

Shockingly, 38% of companies in 2022 did not include these critical metrics to a meaningful degree in their compensation incentives. In essence, the majority of companies are failing to align their management's goals with the essential task of value creation.

This lack of emphasis on CF and ROC is not limited to compensation schemes; it also extends to the dialogue during quarterly earnings calls. Analysis of over 8,000 quarterly transcripts from the past decade revealed that executives discussed "cash" and "ROC" significantly less often than other financial metrics, such as "sales" and "sales growth."

So, why is this vital discussion about CF and ROC seemingly absent from the conversation? It's a mystery worthy of exploration. One potential culprit lies in the structure of executive compensation metrics.

Only 40% of companies are meaningfully incorporating CF into their short- or long-term compensation schemes, with a similar 36% including ROC to a meaningful degree.

This failure to incentivize executives based on these crucial metrics may be contributing to the disconnect between stated business principles and actual practice.

Additionally, the dialogue with investment analysts—a crucial avenue for communicating a company's strategy and financial health—also seems to miss the mark. Executives mention "cash" and "ROC" far less frequently than other metrics, even though these are essential drivers of value.

Analysts, in turn, have the opportunity to push for more meaningful discussions on these topics, holding companies accountable for their performance in these areas.

To address this issue, the solution starts at the top. Boards of directors and compensation committees must take responsibility for setting incentives that truly align with value creation.

Executives, in their dialogues with analysts, should continue to emphasize growth but also highlight the importance of improving ROC and optimizing the cost structure.

Analysts themselves can raise the bar by demanding more substantial discussions on CF and ROC, ensuring that companies are held accountable for all drivers of value.

Yet, the mystery of the missing metrics extends beyond compensation and investor dialogue. Inadequate reporting systems, misaligned incentives within functions, and a general lack of awareness and education on CF and ROC are all contributing factors.

As we delve deeper into this issue, one thing remains clear: the conversation needs to shift back to what truly drives value in a business. Cash flow and return on capital are not just buzzwords—they are the lifeblood of sustainable growth and value creation.

So, the question remains: In a world seemingly obsessed with the profit and loss statement, are we missing the forest for the trees?

Are we truly focusing on what matters most for long-term success?

What are your thoughts on the prioritization of cash flow and return on capital in today's business landscape?

How can companies better align their strategies with these fundamental principles?

https://hbr.org/sponsored/2024/02/companies-need-to-focus-more-on-cash-flow-and-return-on-capital