Clayton M. Christensen: The New Church of Finance: Deeply held belief systems and complex codes must be changed

In early Christian history, Christianity merged and consolidated with other belief systems in the Mediterranean. Emperor Constantine urged the leaders of the Christian church to get together and hammer out the orthodox beliefs. Similarly, the leaders of the New Church of Finance have formalized their orthodox beliefs regarding profit. And it turns out that their definitions of profitability are mostly denominated in ratios. You have such concepts as Return on Net Assets (RONA), Economic Value Added (EVA), Internal Rate of Return (IRR), Earnings Per Share (EPS) and Gross Margin Percentage. They are all ratios.

What is measured is managed

By standardizing the definition of profitability, corporations lined up to optimize these profitability ratios. RONA provides a good example. A company could improve its RONA by generating more revenue and put that in the numerator.

But the other way to improve this ratio is to reduce the denominator by a company getting rid of assets. Reducing assets is much easier than increasing revenue. So if a CEO is rewarded for a good RONA ratio, the incentive is to outsource aggressively. When there are no assets on a balance sheet, then this rate of return is infinite, and according to this definition, it might seems like such a company is doing better and better.

The story of McDonnell Douglas, however, provides a cautionary tale. The DC3 was its warrior. McDonnell Douglas made everything in the DC3. But its return on assets was low. So with each of the subsequent airplane models they outsourced more, until the company outsourced everything with the DC10.

McDonnell Douglas stopped making things, but instead became an assembler of sub-systems. RONA increased to about 60 percent. The company reduced its assets because it no longer made components. But when customers needed spare parts, they went to the suppliers of McDonnell Douglas rather than McDonnell Douglas itself. Although "profitable" by one definition, once the company had sold the DC10 there was no ongoing cash flow sufficient to do a DC11.

Internal Rate of Return (IRR) is another finance ratio that discourages empowering innovation. Empowering innovations tend to emerge 5 to 10 years after the investment. But IRR encourages investors to get in and out of a company fast. IRR disappears for something that will take five years to pay off. It effectively prevents investors, private equity players, and venture capitalist from investing in the long term. Sustaining innovations and efficiency innovations, on the other hand, have a quick turnaround.

A better measure?

I went to Taiwan and China to seek answers to this puzzle. The semiconductor industry is instructive. Intel is the only company that still makes its own chips domestically. Everyone else outsources it. If you become a semiconductor manufacturer without any factories, the New Church of Finance gives you high marks for profitability because your RONA is wonderful.

But when I talked to Morris Chang, chairman of TSMC in Taiwan, he asked why Americans are so eager to get assets off their balance sheets. He was quite happy to put assets onto his balance sheet, even though it costs about $10 billion to build a new factory.

Although he did so kindly, Chang essentially explained why our focus on ratios is senseless. Chang noted that banks don't accept deposits denominated in ratios. In doing so he reminded me that there is a simpler way to account for finances: in whole dollars. After all, that is what banks accept ?— dollars. Consequently, Chang suggested what is probably a better measure of profitability: tons of money. His dictum is that more tons of money is better than less tons of money.

The focus on carefully calculated ratios might make sense when capital is scarce because every dollar needs to be used optimally. But today capital is not scarce. Corporate balance sheets are flush with cash and sovereign funds in places like Abu Dhabi have money in the trillions of dollars.

American capitalists, enthralled by the doctrines of finance, have put their income statements in service of the balance sheet. But under that model, cash won't be invested in new growth businesses because of the way the "priesthood" of finance defines profitability.

Remember the bottom line