Are You A Business Scientist?
A surprising number of business executives do not recognize that business is a science. Many do not comprehend the importance of scientific standards because too many do not understand the definition. Therefore, a good place to begin would be to describe the interface between business and physical sciences while defining the basic requirements associated with scientific measurement.
First, it is important to understand that science is not scientific without standards from which measurement is calibrated. Standards are a dependent constituent required to calibrate accuracy regardless of what is being measured; temperature is a good example of this. Reading a temperature requires a standard to have veritable value. Forty degrees means nothing by itself because forty degrees can be above or below zero. Zero is a required relative point necessary for a meaningful reading. Measurement from a single standard is often not enough to make an intelligent hypothesis. Forty degrees Fahrenheit, Celsius or Kelvins all have entirely different values when measured from a single point of relativity. A standard can be thought of as a known truth used to establish calibration from relative points. Standards bring clarity to business science; without standards, the science becomes conjecture. Business financials are not reliable without a sound system of measurement. A standard profit percentage can differ from one industry to the next. Residential remodeling businesses in cities with populations of more than one million should have gross profit percentages substantially higher than large commercial general contractors in the same demographic. A residential remodeling company would likely fail if it were to use the commercial contractor’s gross profit percentage as a standard to operate its business.
An understanding of normal values in a company’s income statement comparatives, with relation to the company’s industry, provides executives with relative points to measure where their businesses stand. This process transforms a comparative financial statement into a calibrated instrument from which to make intelligent decisions. A chemist standardizes a mass-spectrometer before running a chemical analysis for preciously the same reason. This process also indicates why comparative financials are essential to determine a company’s direction. Think of this process as a vehicle to understanding a company’s financial inertia in order to evaluate cause and effect.
Some of you are likely scratching your heads wondering how inertia, a law in physical science, applies to business — this is a fair question. The first step is to understand business as science. A business follows all the same rules; however, in science, rules are normally referred to as laws. Respecting these laws can prevent unnecessary heartache. Inertia is very apropos to business analysis when considering velocity of operations in conjunction with the direction and motion of financial trends. To better understand financial inertia, we should review Sir Isaac Newton’s First Law of Physics.
Newton’s First Law states, “Unless acted upon by an outside force, anything in motion stays in motion and anything at rest stays at rest.” This is why car passengers without seatbelts are thrown though windshields when involved in head-on collisions with stationary objects. Consider a car traveling 65 mph. Suddenly, the car is brought to a stop because the driver hits an outside force such as a tree. The passengers not wearing seat belts will continue moving at the speed of 65 mph until they encounter an energy absorbing force. The windshield and friction caused by gravel and gravity would be the energy absorbing outside force. The word used to describe this phenomenon is inertia. The same rules of physics apply to a stationary object you wish to put into motion. In order to get a missile weighing 100 thousand pounds to go from motionless to airborne requires a minimum of 100 thousand pounds of force. Force and energy are required to start motion; force and energy must be absorbed and dissipated to bring an object in motion to a state of rest.
Businesses follow rules evident in physical science. To take a business into a state of motion requires operational energy. Once a business is in motion, the owner should try and avoid the multitude of walls concealed from view in the road ahead. Hitting the “wall” can cause damaging effects similar to the car whose motion was catastrophically changed by the tree. If an original equipment manufacturing business, experiencing volumes growing at 30 percent annually, suddenly hits a wall, the company will experience devastating effects when faced with the abrupt protracting of its pace. This correlates with physical inertia. Energy has to be dissipated and absorbed when this velocity collides with an opposing force because the energy must go somewhere.
The faster a business is growing in an uncontrolled state, the more severe the consequences of a sudden change in direction and speed. The cumulative associated with Project Management, Research and Development, Through-Put, Cash Flow, Inventory, Sales and Marketing, and Human Resources has enormous operational energy. The energy has to be absorbed in order to slow or change direction. When a business in an uncontrolled accelerated state slams on the brakes, damage will ensue. Without safety belts, the occupants can be thrown out onto the street. Looking down the road to see obstructions and monitoring road conditions are prudently associated with safety. This same behavior in commerce is referred to as business planning— think of it as wall avoidance. It is important to understand that the laws of physics cannot be cheated.
When a rock rolls downhill unobstructed, it will continue to move downward until it hits “rock-bottom.” Stand in front of a Mack truck in motion; the truck wins every time. Wishing otherwise will have devastating consequences, yet this is what many business owners do. Watching your profits decline period after period also defines a direction. Remember the Mack truck and do more than wish—navigate. Businesses experiencing a continuous decline in profits or cash flow are witnessing fiscal inertia traveling downhill. Wishing will not change the direction (unless you believe in telekinesis). If you want to reverse the direction of a rock rolling downhill, a few things must happen. First, initiating change will require honest recognition of the direction and velocity of movement. Second, you need to understand the physics involved. It will take an equal force to stop the downturn and an even greater force to change a downturn into an upturn.
Experienced business analysts learn that financials tend to move in different directions. Upturns and downturns define trends, but only when evaluated against standards within a large enough sample. This is why comparative financial statements are essential to understanding where a company was, currently is, and is headed. Consider this case story—a business owner’s approach to cash flow was purely reactive and the company was functioning in a progressively worsening crisis. Part of the business analysis required the investigation of historical data from the company’s Days Working Capital Reserve. In the previous four quarters, Q1 had 41 days reserve, Q2 had 26 days reserve, Q3 had five days reserve and Q4 had negative 14 days reserve.
In physical science, this is the equivalent of a boulder rolling down a hill. Once the boulder is put into motion, it will continue a downward unobstructed journey unless another opposing force offsets its inertia. Initiating the opposing force is recognition of the problem. Retooling behaviors, instituting cash flow management, along with other operational changes, are, in essence, the opposing forces required to change direction.
Consider another case story—a large commercial contractor had a continuous drop in gross profit percentages for three consecutive year-ends. The same trend was evident in the business owner’s most current year-to-date statement. The gross profit percentage was annually declining in a range of one to five percentage points. In spite of this, the company remained marginally profitable when the total return to ownership income was considered. Actual bottom line profitability remained static between one to twotenths of a percent at each year’s end. Ironically, the same income statement revealed a steady growth in gross sales volume increasing approximately 10 percentage points annually. There are three different dynamics to consider: gross profit slowly rolling downhill, gross sales volume moving steadily in an upward direction and a stationary negligible return to ownership profit.
Remember, Newton’s First Law states that stationary objects want to stay stationary; in business we call this “stale.” In lieu of not having a better plan, the contractor cannibalized profitability by continuously underbidding his competition. This was done in order to maintain 10 percent growth while locked in a feeble race with fixed costs. The underbidding behavior significantly impacts direct cost of goods as percentages to gross revenues. This was why the company experienced a continued spiraling downturn in gross profit percentage. This resulted in management having to work harder and harder to feed a looming cash flow problem with no gain to operating profit percent. The company was forced to increase sales at a minimum of 10 percent in order to perpetuate this pattern. To maintain growth, the company’s management was forced to underbid repeatedly.
The last case history demonstrates cyclical inertia. The cyclic motion is as evident as a squirrel running on a treadmill, working hard to go nowhere. Remember, Newton said that anything in motion wants to stay in motion. To recognition of the company’s problems and the directions these problems continued to lead management was the first step to offset the futility of the treadmill. Recognition of direction is almost always the first step to apply an offsetting force to change a business’ course.
It is considerably easier to recognize the course and speed a car is traveling than a business. This is because cars travel in plain sight. Traveling in plain sight does not exempt anyone from having calibrated speedometers to maintain legally enforced limits and judge stopping distances. It is more difficult to accurately determine the speed and direction a business is headed because its motion has an appreciably intangible nature. This is why comparative financial statements were designed to include indicators similar to those found in most vehicles. Income statements possess speedometers, compasses and fuel gauges. The use of financial indicators is similar to that of a car’s gauges in that we have to know where to look for them and how to interpret what they read.
Navigation of any vehicle without observing its instruments is a recipe for bad science. Would you drive your car without monitoring your speedometer or gas gauge? Operating a business is no different. Challenge yourself, upon completion of this article, to close your office door and take out your financial statements. Ask yourself, “What kind of business scientist have I been?” Finally, determine what kind of business scientist you would like to be and remember that nothing changes if nothing changes.