How to secure a rock-steady profitability: A Scottish anecdote

P1010340French version here

Whisky is sunlight held together by water
(displayed on a board outside a pub in Edinburgh)

This summer, I got stranded on the Isle of Arran (Scotland) while I was heading to the Arran Distillery, and that proved to be an enlightening experience, not only for the picturesque situation, but also for the underlying concepts in finance that stemmed from those adventures – even though I eventually had to cancel the distillery tour.

Before we move to the anecdote per se, let us first recap some basic corporate finance (spiced with basic strategy). In most, if not all, of the businesses, the source of your revenues stems from your assets. And what is the definition of an asset? What are the characteristics for a thing to qualify as an “asset” to your company?

  • First, your asset must be generating revenues. Or, to put it the other way around, the generic definition of an economic asset is that it is something (it could be literally anything) that generates revenues to your company. In that sense, an apartment you own is an asset to you: you could rent it, or sell it, hence generating revenues. And as you can see with the apartment example, what we call revenues might even be extended to “saving on expenses”. Indeed, the mere fact that you own the apartment, and live in it, helps you not pay a rent. Therefore, in marginal analysis, your apartment generates a revenue (that is, a non-expense) to you.
  • A second characteristic of an economic asset is stability: it should generate a recurring revenue. As an illustration of revenue stability, we can imagine that your company owns a cask of whisky, and only one. If you offer regular tastings for a fee (e.g. 2 £ for a dram), we can talk about a recurring revenue… up until the cask is dry, and then your revenue is as gone as the angels’ share. Or, if you want to sell the whole cask, you will get a one-time revenue, and then nothing ever more. So the quality of an asset also pertains to the durability and/or the stability of the revenues it generates. A unique cask of whisky will generate temporary revenues, whereas a field of barley and a tractor, coupled with a spring source, a distillery and a warehouse, if properly managed, could generate revenues for centuries. In other words, one key aspect in finance (and strategy) is to make sure that your assets consistently deliver a stream of revenues, and one of your missions as a financial manager would be to capitalize on all the means to make sure that those revenues remain stable and recurring.
  • So, those are the qualities for an economic asset: the fact that it that generates a revenue to your company, and that this revenue is on a recurring basis. But there is one more characteristic if you want to record it in your balance sheet: the asset must be your property. In Europe, this goes as far as establishing your right of ownership on those assets (a bill for a machine, a trademark for a brand). If your company cannot exhibit a proof of ownership, those assets cannot be recorded in the balance sheet. For example, training of the employees might be considered an economic asset, in the sense that training them will either increase your company’s revenues (competent employees generate more sales) or it will diminish your costs (well-trained workers help save money). But since the company has no right of ownership on the employees, nor on their training, this economic asset does not qualify as an accounting asset that can be recorded in the corporate balance sheet. Still, it generates a recurring revenue, and providing that it is properly maintained (frequent investments in training), that revenue could last forever.

Now, let’s go back to my trip to the wild hills of the Isle of Arran. One Sunday morning, after a copious, hearty and delicious (in one word, Scottish) breakfast, I was driving on the unique road that circumvents the island, having booked a tour at the unique distillery at noon. But alas, all of a sudden, while I was leisurely telling my partner “hey, look, the sheep over there!”, there was a loud bang, and I burst a tyre. Please picture, if you can, a stopped car on the side of a desert road, a desolate academic and his partner surrounded by hills and cattle and clouds, a distillery whose promises vanish in the distance – a good 5 miles down the road, no mobile phone network, and buzzards already circling for the feast. Driving at a cautious 5mph, I finally managed to reach the distillery, where the people at the reception exhibited the Scottish hospitality in letting us use their landline phone to call for help at the four corners of this round island. And after 30 minutes, like an angel with greasy hands and a broad grin on his face came Angus and his truck (we will call the truck “Phantom 309”). Angus secured the car on the platform and we hopped in Phantom 309 to go to the garage. This is where the journey proved to be enlightening.

Driving with one hand, manoeuvring this big rig on that small road, Angus would delight us with local anecdotes or give us his opinion on the different types of whiskies that a palate can find in this blessed land of Scotland, mostly Highlands and islands. And then, all of sudden, he pointed at something on the side of the road: “here is your rock, I bet!” I checked the environment, and yes, it could have been there that we burst the tyre. Angus kept explaining: “this is a rock on which, I would say, there’s a burst tyre almost every week, sometimes more than that”. And as he drove south, he pointed other good rocks, and I complimented him on this business (as a matter of fact, Angus has the only business of towing and tyre repair on the whole island). Then it occurred to me that those rocks were probably qualifying as assets, in Angus’ business. Well, he did not own those rocks, but they were immovable, pretty hidden by the side of the road, but still very effective, and they surely represented a source of stable revenues for his company, probably until kingdom come, with no maintenance to perform. So my final questions are: can we indeed consider that those rocks are assets for this type of business? Or, another way to ask the question: what could prevent us from classifying those rocks as assets? And finally, could we imagine other types of businesses that tap on such natural resources to secure their revenues?

April 20th : Isaac Newton made a +100% profit on this day, almost 300 years ago

Dear readers and finance enthusiasts,

on this day (April 20th), but in 1720, Sir Isaac Newton decided he could no longer bear the frenzy of the markets around the South Sea Company shares (first IPO in England), and decided to sell them, thus making a whopping +100% profit in the operation! Alas, and this is a reminder that past performance is not a guide for future performance, Sir Isaac Newton would then enter the game again, and lose much much more in the end… More info here, and on Wikipedia and thanks to Jason Zweig (WSJ) for bringing this to our attention today.

Launch of the web site “Breaking the financial ice”

Dear visitor,
Here is the first blog post announcing the launch of this website breakingthefinancialice.com, while we are eagerly waiting for the release of the eponymous book (A Practical Guide to Corporate Finance – Breaking the Financial Ice, due in October 2015). This site will be under construction over the next weeks and messages like this one will be posted on additions.
Feel free to comment on these announcements or suggest modifications and we will do our best to answer your queries.
Sincerely,
CT