Video transcript:

I call the governance ratios those parameters that help let me know whether or not the organization is in fact using lean appropriately. These governance ratios are seven specific ratios. It really revolves around three major things: the cash conversion cycle, which is days of accounts receivable; days of accounts payable; and days of inventory. And what you're saying, how long does it take you to convert your cash to pay? There are systems related to accounts payable. There are systems related to accounts receivable. And there are systems related to inventory. All of which you want to be lean and Six Sigma.

The next category is called the DuPont formula. The return on equity, which is three more ratios. The net income divided by sales, which is an indication of profit margin. Is the business profitable? And asset turnover: it means, is it properly sized?  That's sales divided by total assets. So, in other words, do you have the right-sized facility for what you're doing? And the last one is leverage. How much leverage do you have in a strictly return-on-equity model?  When you look at it, it's a wonderful aspect.

The final aspect is the economic value added, which is the net income minus the cost of equity capital times shareholders' equity. And why that's important: it's saying, "Am I doing well for the risk I'm taking? Am I earning the appropriate rate of return?" I find a lot of companies don't do that.

The airline industry, steel industry, railroad industry, any number of industries where there's been turmoil in the industries. They lost sight of that it's not how well you're doing vis-à-vis the competitor. It's how well you're doing for the risk you're undertaking. And that's why EVA is so important. These governance ratios are really designed to give you that simple benchmark that you can use to help you have a better perspective of, "Am I doing okay?"


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