A closer look at the dynamics of value creation
The fundamental question every entrepreneur needs to answer is: how do you make money in your business? This blog post first takes a closer look at the fundamental ingredients every company needs in order to create value, and how these ingredients combine to create a sustainable business. It then examines how you can track the financial success of your business.
This is the ninth post in a series of posts in which I discuss how to use prototype business models using system dynamics. To illustrate the process, we are building a simple, but complete model of a generic business – the generic business model prototype – as we go along. The objective of the generic business model prototype is twofold: to help you learn more about business AND to help you learn more about how to prototype a business using system dynamics. A list of all posts in the series can be accessed here, you can find an introduction to the business model prototype itself here.
My favourite approach to visualising the dynamics of how a company does business is to use causal loop diagrams. Today we will create such a diagram for a company’s value creation logic. In practice we mostly sketch such diagrams by hand on a flip-chart or whiteboard, in discussion with our clients. Later we transfer our sketches to an appropriate diagramming or modelling tool.
The main tool we use for system dynamics modelling is the iThink® modelling environment. The generic business model prototype was built using iThink®. On of iThink®’s great features is that it allows you to create causal loop diagrams that are linked to the detailed simulation model built using stocks and flows. This is good, because it means that the high-level causal loop diagram we develop today also defines the structure of the generic business model prototype: each element of the causal loop diagram is a module which hides the detailed stock and flow structure. In my next posts in this series I will then discuss each of these modules in detail.
The high-level causal loop diagram essentially consists of two parts, the value creation logic and the financial accounting logic:
- Value creation logic. A company’s value creation logic shows how the company uses resources and capabilities to create products, attract customers, sell products and thus generate revenue and cash. This cash is then used to buy more resources and build capabilities, leading to a self sustaining feedback loop that drives the company’s value creation.
- Financial accounting logic. The financial accounting logic contains all the elements needed to track the company’s finances in form of the cash flow statement, the income statement and the balance sheet.
The Value Creation Logic
The map of the value creation logic we will develop today is an extension of the causal loop diagram of the generic value creation logic blueprint I introduced in the third post of this series, the Generic Business Model Blueprint. Today I’d like to run through the logic behind this diagram in more detail.
To begin with, any company needs a good product (or even a product portfolio) to attract customers. The better the product portfolio, the more customers the company will attract. A product may be a good (such as a mobile phone or laptop) or a service (such as an online idea management platform). Some companies offer both goods and services.
But great product portfolio alone is not enough … in order to attract customers, the company will need some marketing capability. At the abstract level of the generic business model prototype, we model marketing as a capability. The better the company’s marketing capability is, the more customers it will attract.
The more customers a company has, the more products it will sell. How high the sales are will also depend on the company’s sales capability and on the quality and pricing of the product portfolio.
Product sales lead to revenue, revenue leads to cash (as soon as an invoice is paid by the customer). This cash is then used to buy new resources and build capabilities – both are needed to create (new) products.
The resulting diagram is already quite interesting – but if you examine the diagram in detail, you realise the picture cannot be complete: all the loops are positive, self-reenforcing loops, which means that all businesses would grow indefinitely and all entrepreneurs would be multi-millionaires. Unfortunately business is not that easy.
So what is missing in our model?
Well, there must be some balancing loops that constrain growth – no company can grow indefinitely. Typical constraints that companies experience in practice are:
- financial constraints, e.g. the cash that a company needs to finance its resources and capabilities
- resource constraints, e.g. shortages in resources the company needs to create product and build capabilities
- market constraints, e.g. a saturated market and/or heavy competition
Our generic business model prototype focusses on modelling business models, so our primary concern here are constraints due to lack of cash, lack of resources and lack of customers.
Cash shortages occur whenever the cost that a company incurs in building and maintaing capabilities and buying resources cannot be met by the cash that is available. Cash itself is either provided by revenue (or by financing, as we will see in the section on the financial accounting logic). Resource shortages occur whenever the demand for resources arising from building the product portfolio, maintaing customers, selling products and maintaing capabilities cannot be met by the resources that are available.
The last diagram is almost complete – it doesn’t just show the positive, reenforcing loops that help a company grow and thrive, it also shows the negative, balancing loops that can hold a company back. I’m an entrepreneur myself and believe me, I can physically feel the dynamic of each of these loops every day when running my business.
But there is still one important aspect missing from our diagram: smart companies learn from experience – they use customer feedback and their sales experience to improve their product portfolio and their capabilities.
Finally, we arrive at the following diagram of the generic value creation logic: The value creation logic shows how resources and capabilities are used to create products, attract customers, sell products and thus generate revenue and cash. This cash is then used to buy more resources and build capabilities, leading to a self sustaining feedback loop that drives the company’s value creation. Value creation is constrained by the cash available to the company, because buying resources and building and maintaining capabilities cost money.
The Financial Accounting Logic
In the last section we built a model that shows the dynamics behind a company’s value creation logic. We’ve accounted for pretty much everything a company does (at a high level) by capturing the products it creates and sells and the resources and capabilities it needs to do this. We’ve also included the revenue we expect to generate and the cost we will incur in running our business. So we should also be able to track the companies finances using the the cash flow statement, the income statement and the balance sheet.
Let’s examine how to do this.
To me, the most important statement an entrepreneur or chief executive needs to run a company is the cash flow statement, because it shows how much cash the company has, how much cash it needs to pay its bills and where this cash comes from. Companies that do not have enough cash to pay their bills fail due to insolvency.
If you take a closer look at our value creation logic diagram, you will notice that currently there is only one source of cash, the company’s revenue. But initially, when starting up, most companies will not yet have a steady revenue stream. So the first question any entrepreneur needs to answer is: how will I finance my company?
Next to providing cash through revenue, there are two other options: debt financing (i.e. cash that is provided through banks and has to be repaid at some point) and equity financing (e.g. cash that is provided by the companies shareholders). I’ve added debt and equity financing to the diagram below.
Note that the amount of debts you need depend on the cash available to the company and on the current level of cost. I haven’t added a feedback loop for equity – how much equity a company is provided with is a question of the overall expected performance of the company – you may like to take a look at the initial equity needed to finance an internet startup in my last blog post for more on this.
We have now accounted for all possibilities of how cash can flow into a company. But have we accounted for all outflows? Not quite: let’s face it, nobody gives a company money just for fun. Customers provide revenue for great products and services, so banks earn interest on the money the company owes them (and they also need to pay the money back at some point), and the company’s shareholder’s want to be repaid for the risk they take in lending you money through dividends on the company’s earnings. Let’s add the cost of debt to our diagram, then we’ll figure out how to account for dividends.
The dividends a company pays depend on the company’s earnings. A company’s earnings are calculated by subtracting the cost from the revenue. The company is profitable if these earnings are positive (within a given period) in which case the company will also need to pay income tax.
At this high level we now have a complete picture of the company’s cash flow, which is simply the net inflow of cash into the company in a given time period.
We also have all the information we need for the income statement, which tracks a company’s earnings within a given time period (Earnings=Revenue-Cost-Tax).
All that is missing now is the companies balance sheet: The balance sheet shows which assets an enterprise owns, and how these assets are financed – through liabilities or through equity.
As an example to illustrate this: whenever a company purchases a new piece of equipment, it must account for this equipment as an asset, but it must also account for how the equipment was paid. It could be paid for via new debts, via an increase in equity, or from the company’s cash.
This system of accounting is known as double entry accounting. It ensures that the following equation always holds true:
When we come to the detailed stock and flow model we will see that all the elements of the balance sheet are modelled using stocks. At the high level of abstraction we have applied in our causal loop diagram of the value creation logic, the assets depend on the current value of my resources (e.g. equipment and inventories), the cash a company has, the revenue that has not been collected yet (the receivables) and any tax that may have been paid before it was due.
A company’s liabilities depend on the debt the company has, the tax it owes the state, and on the money a company owes its suppliers (i.e. the payables).
The company’s equity is equal to the initial shareholder’s stock, plus any provisions a company has made for tax, plus the earnings that have been retained and not paid to shareholders in the form of dividends.
We now have all information to check whether
Assets=Liabilities+Equity, i.e. the two sides of the balance sheet must always be equal.
The diagram below contains all the main stocks that are needed to create the balance sheet.
This completes our overview of the dynamics behind a company’s value creation and the elements needed to measure its financial success.
Today we spent some time in creating a generic model of a company’s value creation logic, the resulting model is illustrated in the next diagram.
At transentis, we use this model as a starting point for systematically analysing the value creation logic at our clients companies. It helps us to ask the right questions about their value creation logic and thus helps us to identify the concrete policies that drive our client’s business. In particular, we can identify areas where such policies are not defined, are unclear or are not having the desired effect. The model is thus useful in highlighting those areas where redesigned policies will have a positive effect on business development.
But don’t forget, this is just a generic model. Every time we use it, we find new aspects we hadn’t thought about before. Please do try to apply it to your business, I would love to hear how you get along!
In my next post on this topic I will take a detailed look at how to model a company’s finances using system dynamics. In particular, we will take a look at how to translate typical business activities into financial figures on our financial statements:
- Selling goods and services
- Collecting cash from invoices
- Purchasing goods and services
- Paying for bills
- Taking on and amortizing debt
- Determining tax and profits
- Accounting for and paying income tax
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