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Finance ratios starve growth
How ratios reward outsourcing
A ratio has a numerator and a denominator, and it improves when either one moves. For return on net assets, profit is the numerator and assets are the denominator. Raising profit is hard, and outsourcing to get assets off the books is easier, so companies outsource more and more. Analysts adopted ratios in the mid-1980s, once the spreadsheet arrived, because fractions let them compare unlike companies such as Cisco and Sun Microsystems, while whole numbers like millions of dollars did not.
Why returns favor speed
Internal rate of return has profit on top and, underneath, how quickly the money comes back. Short-term projects improve it, so more companies invest only in projects that pay off fast. Efficiency innovations pay off in 6 months to 3 years with no risk, because the market is already there. Disruptive companies pay off in 5 to 10 years and put assets back on the balance sheet, so the ratios fall.
Where the cash goes
Each round of efficiency innovation throws off more free cash flow, and when analysts are asked again about disruptive investments, they come back with the same answer. The money goes into another round of efficiency innovations, which creates still more cash to place.
How did spreadsheets change corporate finance?
VisiCalc arrived in 1979 on the Apple II and was the first widely used spreadsheet program. Lotus 1-2-3 followed in 1983 on the IBM PC, and Microsoft Excel appeared in 1985. Before them, recalculating a financial model by hand could take days. Once a spreadsheet could recompute a whole model in seconds, analysts could build ratios for dozens of companies and compare them side by side.
Why do critics distrust internal rate of return?
Internal rate of return is the discount rate at which a project's net present value equals zero. It implicitly assumes that every cash payout is reinvested at that same rate, which is often unrealistic for a high-return project. A project with cash flows that switch between positive and negative can also produce more than one internal rate of return. Corporate finance textbooks often point to net present value as the more reliable measure for comparing projects of different sizes and lengths.
How does outsourcing show up in the numbers?
A company that outsources manufacturing no longer owns the factory, equipment, or inventory involved. Those items drop off its balance sheet, and any ratio with assets in the denominator rises. Apple, among many electronics firms, has relied heavily on contract manufacturers for its devices. Return on net assets for such a firm can look very strong without any rise in profit.
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