Chapter One

Managing the Fundamentals

In turbulent times, an enterprise has to be managed both to withstand sudden blows and to avail itself of sudden unexpected opportunities. This means that in turbulent times the fundamentals have to be managed, and managed well.

In predictable times, such as we lived through in the twenty-five years between the Marshall Plan and the OPEC cartel, the fundamentals tend to be taken for granted. But the fundamentals deteriorate unless they are being managed carefully, consistently, conscientiously, and all the time. Indeed, the greatest danger to most enterprises todaybusinesses, non-businesses, and public service institutions alike-may not be public hostility to business, environmental constraints, over-zealous regulations, energy, or even inflation. It may be a hidden deterioration in the fundamentals. After a long period of relative tranquillity there is always the danger of unexpected and hidden weak spots in the areas everybody takes for granted, everybody considers boring routine.

Fundamentals do not change. But the specifies to manage them do change greatly with changes in internal and external conditions. Managing in turbulent times thus has to begin with a discussion of the new and different demands affecting the fundamentals of survival and success in the existing business. These are:

-liquidity,

-productivities, and

-the costs of the future.

To manage the present business is not enough; but it has to come first.

Adjusting for Inflation

Before one can manage successfully, it is necessary to know precisely what one is managing. But executives today-both in businesses and in non-business public service institutions-do not know the facts. What they think are facts are largely illusions and half-truths. The reality of their enterprise is hidden, distorted and deformed by inflation. Executives today have available to them many times the reports, information, and figures their predecessors had; they have become dependent on these figures and are thus endangered if the figures lie to them. During inflation, however, the figures lie. Money still tends to be considered the standard of value and to be a value in itself, but in inflation this is a delusion. Before the fundamentals can be managed, the facts about any business-its sales, its financial position, its assets and liabilities, and its earnings-must be adjusted for inflation.

In the Western countries and in Japan, business -after business these last ten years has announced "record profits" year after year. In fact, very few businesses (if any) in these countries can have made a profit at all. Making a profit is by definition impossible in an inflationary period, because inflation is the systematic destruction of wealth by government. The public, it should be said, senses this even though it does not understand it. This explains why the announcement of these "record profits" is being greeted with such skepticism by the stock exchange and with hostility by the public at large. But the illusion of "record profits" also leads to the wrong actions, the wrong decisions, the wrong analysis of the business. It leads to gross mismanagement.

All this is known to most executives. Yet few so far, have even tried to correct the misinformation inflation creates. We know what to do and it is not very difficult. We need to adjust sales, prices, inventory, receivables, fixed assets and their depreciation, and earnings to inflation-not with total precision but within a reasonable range of probability. Until this is done, even the most knowledgeable executive will remain the victim of the illusions inflation creates. He may know that the figures he gets are grossly misleading; but as long as these are the figures he has in front of him, he will act on them rather than on his own better knowledge. And he will act foolishly, wrongly, irresponsibly.

A second dangerous deception is the belief that "earnings shown because the enterprise still has the use of money obtained when costs of capital were lower (such as long-term debentures issued in pre-inflationary times and at preinflationary interest rates) are the true earnings of a business. Sooner or later (usually sooner) the money has to be replaced; and then the earnings must be adequate to cover the costs of capital at the time refinancing. In adjusting for inflation, money in the business has to be adjusted just the same way as any other fixed asset-and it is an axiom that interest rates will always equal the rate of inflation.

"Inventory profits" are never real profits. If inflation continues, the inventory will have to be replaced at tomorrow's higher prices. If inflation stops, inventory profits immediately turn into an inventory loss. In either case, the apparent "inventory profit" is more properly a contingency reserve.

One reason why executives in most countries and the great majority of companies do not adjust to inflation is the belief that inflation is a "transitory phenomenon." But this, after fifteen years of unremitting inflation, can hardly be considered rational. Another reason is that governments, with rare exceptions-Brazil is the most important one-resist the truth about inflation. Governments, especially under the twentieth-century system of progressive income taxes, are the main beneficiaries of inflation and have no incentive at all to reveal the true facts. In some countries, notably the United States, the tax system has given executives a powerful incentive for lying to themselves. The U.S. tax system greatly favors stock options and bonuses tied to reported earnings, making it very much to the executives' self-interest to report inflated earnings. But in countries where stock options or bonuses of this kind are unknown, such as Japan, executives resist just as strenuously attempts at any adjustment of their reported figures to inflation. The major reason is surely vanity: executives like to take credit for "record earnings" even when they know that the figures are mere delusion, and indeed dishonesty.

One often hears the argument, especially from accountants, that figures should not be adjusted since there is no accurate method known for doing so. But this is very much as if physicians unable to agree on the precise treatment for a very sick patient were to declare him totally fit, his raging fever mere illusion. In any case, most of the figures that accountants work out down to the last penny are, as every accountant knows, estimates within a fairly wide range of probability, such as the range of error plus or minus 20 percent that applies to the balance-sheet figure for fixed assets.