The Polyvalence of Knowledge: using financial ratios to inform system choice (Pt II) Reply

For too long the language of CIOs and CFOs has not been confluent.  CFOs want hard returns in the form of discounted cash flows and better return on equity (ROE).  CIOs speak of ‘intangible’ benefits, better working practices and compliance.  Despite its poor reputation, information management, however, does show up in the balance sheet.  Intuitively, it is easy to understand that if a business not only increases the speed and accuracy of decision making but also decreases the number of highly paid executives needed to do it, then the effect on the bottom line can be significant.

The first part of this blog looked at the structure of information management that shows up in the balance sheet.  This part looks at how to calculate some of those ratios.

Unfortunately, International Financial Regulation Standards (IFRS) are almost entirely geared towards the performance of capital as a measure of productive wealth.  As the information economy picks up speed, however, capital is neither the scarcest nor the more valuable resource a business can own.

The difficulty is in calculating the value of managerial decision making.  Without going in to the detailed calculations of Return-on-Management (ROM) I have outlined below two new financial ratios which allow businesses to determine a financial indicator of both information effectiveness and technology performance.

  1. Information Effectiveness.  This ratio measures the effectiveness of corporate decision making at increasing the financial value of the business.  This is defined as the decision making value minus the decision making costs.  As described in a previous blog The value of information is calculated through Information Value Added (IVA).  Information Value-Added = (Total Revenues + Intellectual Property + Intellectual Capital) – (operations value-added – capital value-added – all purchases of materials, energy and services).   This is to say that once all labour, expenses and capital (that is not part of an information system) is accounted for, the cost is subtracted from the total of gross revenues (plus IP).  In other words, it is the part of the profit which is not directly accounted for by operations or increased capital value.  It is profit which is attained purely through better managerial decision making.  This might be achieving better terms and conditions in the supply of a product or it might be in the reduction of insurance costs on a given contract.   The cost of information management is somewhat easier.  Ultimately, corporate decision making is accounted for as ‘overhead’ and therefore shows up in Sales, General & Administrative expenses (SG&A) on the balance sheet.  The sum total of managerial activity – which is ultimately what information management is for – can be accounted for within SG&A ledger.  The more operational aspects of SG&A, such as R&D costs should be removed first, however.
  2. Technology Performance.  The measurement of the ability of corporate information systems to increase company value.  Ultimately, this answers the question whether a firm’s technology is creating value, as opposed to being simply value for money.  More specifically, how much value are the company’s systems adding.  This is shown as the total value added by information support (IVA) less the total cost of technology and management, as a percentage of shareholder equity.  Note that shareholder equity is chosen above short term indicators such as EBT because many KM/management systems will take time to deliver longer term equity, as opposed to short term cash flow.  This metric assists in determining whether the cost of technology is worth the value it is creating.

Financial ratios have benefits over other performance indicators.  For instance, there is a tendency within the corporate environment to benchmark costs against firms in a similar segment.  This is excellent where small and medium sized enterprises have aggressive cost management programs.  However, in large companies with sprawling ICT environments benchmarked costs become less relevant for cost comparison and more relevant for contract management.  The benefit of financially driven information management is  that it allows a companies to benchmark against themselves.  In compiling quarterly or yearly indices firms can benchmark their own information management performance.  More importantly, these non-standard financial ratios provide not only a means for the CIO and CFO to communicate using a common language but also the ability to refine the exact nature of the solutions.

In summ, financial ratios will not tell a business what brands to buy but they will help executives refine their choice.

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