Operations Forensics: Business Performance Analysis Using Operations Measures and Tools

334 Pages·2013·21.37 MB·English

by  Richard Lai

business/finance
OperatiOns FOrensics O OperatiOns
Business Performance Analysis Using Operations Measures and Tools
richard Lai p
Investors and analysts often need to look into a firm’s operations more deeply than traditional finan- e
cial statements and models allow. This book describes newly developed tools for using operations
metrics to discern and influence the valuation of a firm. It is the first to present these techniques r
FOrensics
from a unified perspective: that of operations forensics, which looks at operations management not
from the traditional point of view of a manager but from that of an investor or shareholder. a
After a discussion of financial statements and the useful but incomplete insights they provide,
t
the book covers the three components of operations forensics: operational indicators, operations
details that can predict future performance; operational due diligence, methods for verifying com-
i
panies’ claims about operational excellence and valuing their operational assets; and operational
turnaround, an innovative approach to buyout and turnaround strategies. The text also offers brief O
reviews of operations management concepts, real-world examples of operations forensics, and a Business Performance Analysis Using
glossary. The mathematical material gradually increases in sophistication as the book progresses n
(but can be skipped without loss of continuity). Each chapter concludes with a “Takeaways and
Operations Measures and Tools
Toolkit” section, a brief summary of prior research, and suggestions for further reading.
Operations forensics offers powerful tools and frameworks for financial analysts, private equity s
firms, managers, and consultants. This book provides a valuable resource for MBA students and

practitioners. Downloadable supplementary material for instructors includes figures from the text
F
and 42 slides that can be used for class presentations.
richard Lai
O
Richard Lai works in a hedge fund. On the faculty of the Wharton School of the University of Penn-
sylvania from 2008 to 2011, he has also worked in banking, consulting, and wealth management. At
r
Wharton, he taught the popular “Operations Performance Analysis” MBA course.
“Richard Lai provides a seminal and practical operations-centric approach to (1) distill performance e
indicators, (2) assess the internal operations from an external investor’s perspective, and (3) im-
n
prove and turn around the operations from an internal management’s perspective. Anyone inter-
ested in linking operational and financial performance should master this text.”
—Jan Van Mieghem, Harold L. Stuart Distinguished Professor of Managerial Economics; Professor s
of Operations Management, Kellogg School of Management at Northwestern University
i
“When teaching operations to business school students, many of whom were headed to careers c
in the investment world, I argued that an understanding of operations ought to make them better
investors, but lacked a compelling way to show them how. Now Richard Lai has done that! This
s
powerful book should be a part of any business school curriculum.”
—Marshall Fisher, UPS Professor of Operations and Information Management, The Wharton School,
University of Pennsylvania

“Clear, concrete, and well-written, Operations Forensics is an invaluable text that endows opera-
tions managers with fresh insights and arms investment analysts with a powerful toolkit for predict-
ing and assessing the value of operational assets and turnaround opportunities.”
—Terence Lim, PhD, CFA, CPA, Founding Partner, Arwen Advisors
L
“Wow! An authoritative compilation of insights on how to ensure one understands true business a
performance. Every page has a useful tip on looking into a business’s operational guts and soul.
i
This will become the new textbook for investors seeking truth from their operational investments.
Masterful!”
—Sue Siegel, CEO, healthymagination, General Electric Company
Cover art: Bruno Budrovic © Images.com/Corbis
The MIT Press 978-0-262-01866-1
Massachusetts Institute of Technology
Cambridge, Massachusetts 02142
http://mitpress.mit.edu
Operations Forensics

Operations Forensics
Business Performance Analysis Using Operations Measures and Tools
Richard Lai
The MIT Press
Cambridge, Massachusetts
London, England
© 2013 Massachusetts Institute of Technology

All rights reserved. No part of this book may be reproduced in any form by any electronic or mechanical means
(including photocopying, recording, or information storage and retrieval) without permission in writing from the
publisher.

M IT Press books may be purchased at special quantity discounts for business or sales promotional use. For
information, please email [email protected] or write to Special Sales Department, The MIT Press,
55 Hayward Street, Cambridge, MA 02142.

T his book was set in Times New Roman by Toppan Best-set Premedia Limited, Hong Kong. Printed and bound
in the United States of America.

Library of Congress Cataloging-in-Publication Data
Lai, Richard, 1962 –
Operations forensics : business performance analysis using operations measures and tools / Richard Lai.
p. cm.
Includes bibliographical references and index.
ISBN 978-0-262-01866-1 (hardcover : alk. paper)
1. Production management. 2. Industrial management. 3. Performance. I. Title.
TS155.L244 2013
658.4 ′ 034 — dc23
2012027960

10 9 8 7 6 5 4 3 2 1
Brief Table of Contents
Preface xvii
Guide for the Reader xix
Acknowledgments xxi
I INTRODUCTION 1
1 Operations Forensics 3
2 What Financial Statements May or May Not Reveal 17
II OPERATIONAL INDICATORS 39
3 Indicators of Accounting Performance 41
4 Indicators of Stock Market Performance 63
5 Indicators of Disruption 77
6 Indicators of Distress 85
III OPERATIONAL DUE DILIGENCE 93
7 The Many Facets of Due Diligence 95
8 Assessing the Customer Base 109
9 Assessing Lean Management 123
10 Assessing Risks 137
11 Assessing Options 161
IV OPERATIONAL TURNAROUNDS 181
12 Turning Around Purchasing 183
13 Turning Around Production 199
vi Brief Table of Contents
14 Turning Around Distribution 217
15 Sustaining the Turnaround 227
Appendix A Industry ROA Trees 259
Appendix B Resources 291
Appendix C Glossary 297
Notes 301
Index 305
Contents
Preface xvii
Guide for the Reader xix
Acknowledgments xxi
I INTRODUCTION 1
1 Operations Forensics 3
1.1 The Three Components of Operations Forensics 3
1.1.1 Operational Indicators 3
1.1.2 Operational Due Diligence 4
1.1.3 Operational Turnaround 4
1.2 Operations Forensics as a Perspective 5
1.3 Operations Forensics in the Field 6
1.3.1 Analysts 6
Goldman Sachs ’ s Retail Analyst Group 8
1.3.2 Private Equity Firms 12
KKR ’ s Capstone Group 13
Bain Capital 14
1.3.3 Managers and Consultants 15
1.4 Takeaways 15
1.5 Further Reading 15
2 What Financial Statements May or May Not Reveal 17
2.1 What Financial Statements Reveal 18
2.1.1 Inferring Business Model from Asset Intensity 18
Asset-Intensive Business Models 18
Asset-Light Business Models 19
2.1.2 Inferring Product Mix from Days of Inventory 21
2.1.3 Inferring Customer Type from Days of Receivables 22
viii Contents
2.1.4 Inferring the Cash Conversion Cycle from Receivables,
Payables, and Inventory 24
2.1.5 Inferring Margin from Inventory Turn and Vice Versa 25
2.1.6 Inferring the Business Mix 26
2.1.7 Exercise: From Financial Statements to Operations 27
2.2 What Financial Statements Do Not Reveal 29
2.2.1 Risks 29
2.2.2 Contingent Claims 29
2.2.3 Covenants and Rights 29
2.2.4 Reserves 29
2.2.5 Intangible Assets 30
2.2.6 Static and Backward-Looking View 30
2.3 When Might Financial Statements Be Less Accurate? 30
2.3.1 Opportunity 30
2.3.2 Means 32
2.3.3 Motive 33
2.4 Takeaways 35
2.5 Survey of Prior Research in One Paragraph 35
2.6 Further Reading 36
II OPERATIONAL INDICATORS 39
3 Indicators of Accounting Performance 41
3.1 Indicators of Current Performance: ROA Trees 41
3.1.1 Principles for Developing ROA Trees 42
Begin with Industry Language 43
Use as Many Decompositions for a Measure as Is Useful 43
Use a Driver for as Many Measures as Is Useful 43
Exploit Operational Principles in Decomposition 43
Use Different Trees for Different Roles 44
Make Explicit Both Current and Full Potential 44
Make Intangibles Explicit 44
3.1.2 ROA Tree for Airlines 45
Major Operational Indicators of ROA Performance 45
Case: Southwest Airlines 47
Non-US Airlines 49
3.2 Indicators of Future Performance 51
3.2.1 Advanced Topic: Predicting Sales, Earnings, and Margins
Using Inventory Information — the Bernard-Noel Model 52
3.2.2 Predicting Unit Costs Using the Experience Curve 56
Contents ix
3.2.3 Predicting Capital Effi ciency 58
Risk Pooling with the Square Root Rule 58
Scaling with the Square-Cube Rule 59
3.3 Takeaways and Toolkit 60
3.4 Survey of Prior Research in One Paragraph 61
3.5 Further Reading 61
4 Indicators of Stock Market Performance 63
4.1 A Perfect World 64
4.2 Opportunity Arising from Information Asymmetry 66
4.3 Means Arising from Managerial Decision Rights 66
4.4 Motives Arising from Valuation-Based Compensation and Short-termism 67
4.5 Implications for Inventory as Indicator for Valuation 68
4.6 Detecting Deviations 70
4.6.1 Statistical Process Control 71
4.6.2 Benford ’ s Law 71
4.6.3 The Beneish Model for Detecting Earnings Manipulation 72
4.7 Takeaways and Toolkit 74
4.8 Survey of Prior Research in One Paragraph 74
4.9 Further Reading 75
5 Indicators of Disruption 77
5.1 Types of Technological Innovations 77
5.1.1 Incremental Innovation 78
5.1.2 Radical Innovation 79
5.1.3 Modular Innovation 79
5.1.4 Architectural Innovation 79
5.2 Sustaining and Disruptive Innovations 80
5.3 Takeaways and Toolkit 83
5.4 Survey of Prior Research in One Paragraph 84
5.5 Further Reading 84
6 Indicators of Distress 85
6.1 A Short Note on Terminology and Defi nition 86
6.2 The Altman Z Score 86
6.2.1 Manufacturing Companies 86
6.2.2 Service and Distribution Companies 87
6.2.3 Private Companies 88
6.3 The “ Runway ” 89
6.4 Altman Z ’ s Marriage to the Runway 90
6.5 Takeaways and Toolkit 91