Reshaping business and the world by leveraging knowledge intangibles
IC Leverage Ratio
One of the simple ratios that financial consultants such as myself will use to increase the market value of a private company is to look at the IC Leverage Ratio. The IC Leverage Ratio relates directly to many small business owners who seem to be burning themselves out and not leveraging their own know-how to grow and expand their businesses.
Think about most small business owners in the United States. Most are very tactical and operational with their hands on the details and they are not using their knowledge and expertise to grow the business. They run around lost in details and they fail to touch customers and emerging markets, missing out on so many opportunities. This equates to a very low IC Leverage Ratio of 1 to 2.
Now contrast this with another small business owner who can spend three weeks out of the office in China building his next niche market while the folks back at headquarters have been so well coached by the owner, they can run the day to day operations of the company without any problems. The owner has leveraged himself by a factor of 5 to 1.
When a small business moves from an IC Leverage Ratio of say 1.5 to 3.5, it usually equates to a three-fold increase in sales and a two-fold increase in gross margin. This is pretty much the norm as documented over and over again by private capital firms in the United States.
It's unfortunate that so many small business owners are not leveraging their own personal IC to grow and expand opportunities. This is a significant factor behind the struggle of small businesses all across the United States.
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Replies to This Discussion
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Permalink Reply by Mary Adams on
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Matt- How do you calculate this ratio? By looking at the activities of the owner? Mary
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Permalink Reply by Matt Evans on -
The IC Leverage Ratio is not a simple quantifiable type metric. It tends to be much more qualitative in nature. However, in the world of finance it is not usual to find Investment Bankers and others who deal with value and intellectual capital to size up a company very quickly in terms of its IC Leverage Ratio.
For example, there is a big difference between a public accounting firm (which is heavily driven by IC) that needs 50 people to generate a benefit stream of $ 5 million vs another public accounting firm which requires only 10 people to generate this same benefit stream of $ 5 million. So you get a quick read on the IC Leverage Ratio by comparing companies in industries driven by IC by how well they use their people to generate the benefit stream. Also, benefit streams vary somewhat between industries. For many businesses, the benefit stream is Earnings Before Interest Taxes Depreciation (EBITDA). Keep in mind that the benefit stream is the basis behind assigning a value to a business and this is how people in finance think. You get evaluated ultimately on how much market value you create with the lowest investment cost; i.e. how well are you leveraging your people to generate that benefit stream that results in market value.
Let me give you another example that often happens with Investment Bankers. They will look at how much of your time is billed out over $ 500 per hour. Most businesses that are driven by IC tend to bill out their time and if you cannot bill out well over 50% of your time at greater then $ 500 per hour, then Investment Bankers will immediately think of your business as under-valued; i.e. you have a low IC Leverage Ratio (you are not leveraging your know how to maximize the benefit stream).
Having worked with Investment Bankers and others in finance, they almost have a "feel" about where your IC Leverage Ratio is when they start asking questions about the size of the company, the composition of your benefit stream, etc. So this is how most people seem to derive the IC Leverage Ratio.
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This is a great example of why IC is a holistic concept. The differences between two businesses and their benefits streams are not just a function of people or process or customer group or brand. It's a function of all three.
The interesting thing to me is how the role of structural capital is undervalued. In fact, the higher the level of the hourly rate and/or education of the people, the less they think that structural capital is important. It's a dangerous trap.
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Permalink Reply by Peter Spence on -
Matt,
The IC Leverage ratio you describe appears to lend itself well to explaining the concept of collaborative advantage in scaling up an organisation's capacity (from a smaller core HC base as you have mentioned) - how organisation's can perform big while remaining small - it also points to the importance of developing HC competencies to support collaboration - as IC levers. Other variables such as structural capital, that also scales up HC capacity, comes into the equation. I agree with you that benchmarking HC on a per capita nett revenue formula will provide an indicator of the IC leverage ratio - this will require further drilling down to establish the true levers of HC that contribute to this additional value and hence the IC measures of these levers - i.e. competencies and/or culture and/or structural capital etc.
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Permalink Reply by Matt Evans on
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It's kinda like Jim Collins points out in his book Good to Great - it ultimately boils down to your people; how well are you leveraging them. And yes I concur, collaboration is a skill set that everyone must have in this global connected world. A truly "educated" person is not so much someone who can analyze numbers or master technical skills, but master the softer skills such as communication, collaboration, leadership and critical thinking. So if I had to drill down and develop HC capacity, I would look to these as my critical underlying drivers.
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Permalink Reply by Rob Peters on -
There are 4 factors that are challenges for small business owners.
-In the U.S., there is a mindset among many business entrepreneurs that if you build it they will come. This seems to be more myth than fact. Selling is not respected so many owners are not performing the necessary working in strategy, execution, and measurement around acquiring new clients/customers.
-Also, if you are marketing & selling an intangible service or product, the complexities of articulating it's value proposition with a particular prospect's requirements goes up. Many small businesses are either selling to the wrong prospect or not articulating a meaningful ROI to the prospective client.
-Finally, the internet has changed everything. Small businesses and their solutions must be easily found through SEO and through Social Media platforms like LinkedIN, Twitter, and Facebook. Alot of time is wasted by small businesses in face to face networking groups that waste time and are not producing results.
-It has been difficult for small business owners to quantify the commitment of their on-line social networking partners, but that is changing. You, your business, and product/service's influence or relationship capital (RC) metric will play an important role going forward in creating awareness, differentiate you and your brand from competitors, and pull prospective clients to your product/service.
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Permalink Reply by Laurence Lock Lee on -
Wouldn't a simple revenue per employee work as an IC leverage ratio?
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I'm afraid that revenue per employee could be gamed too easily. If you outsource more work, then your ratio would go up but that wouldn't necessarily improve your use of IC.
It could be one of several data points that together paint a picture of IC leverage. The question is what are the other metrics that should round it out?
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Permalink Reply by Muhammad Khalique on -
No doubt the concept of IC is widely accepted and its applications also highly appreciated and acknowledged. The main issue is still unanswered how to measure the IC of organizations particularly SMEs. Many researchers in IC field recommended that BSC is more appropriate to measure the performance. I am also working on the same line, if any want to share his/her idea I will wellcome
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Permalink Reply by Muhammad Khalique on
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I agreed, and its need to do more research in SMEs field to create awareness in SMEs.
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Permalink Reply by Abhijit Talukdar on -
Matt, The concept of leveraging Intellectual Capital for business growth is not in doubt - however giving a quantitative shape to this idea has been found wanting. This subject in fact has been the focus of my studies for the past four years and I have been computing this leverage ratio - which I call Knowledge Basis - for the top Indian public listed firms for more than three years now. Take a look at http://bit.ly/gDkodB where you will find the Sensex firms (top 30 listed firms in India) along with their Knowledge Basis (K-basis) computed for the most recent quarter of available financial data. The K-basis is a ratio of the firm's Intellectual Capital to its Total Worth and therefore denotes the percentage of revenue that is being contributed by the knowledge assets of the firm. Further, if you inspect the detail page of any of these firms, you will also see a graph showing the trend in K-basis of the firm for the past three years! With this chart, we can now see whether the firm is making a conscious efforts to grow its knowledge assets over time, and therefore whether it is worthy of being a long term scrip in your portfolio.
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Permalink Reply by JC Spender on -
Matt's intuition about IC leverage alludes to Tobin's Q Ratio - as does Abhijit's post. Rather than getting to a definition of IC, the Nobel winner simply pointed to the divergence beween book and market values. The presumption is that the market 'knows' something the accountants don't admit to knowing even though the firm's managers know it.
Those interested in operationalizing the IC Leverage Ratio or Knowledge Basis might usefully consider what has happened to Tobin's idea.
Much of the debate within the IC field is around whether it is possible to define IC (and perhaps measure it). The discussion here around leverage helps illuminate the real nature of this question.
Surely any definition of the IC implied by these Q, LR or KB notions stands on the tangible assets being leveraged. IC is interesting ONLY because it seems to mysteriously increase the value of assets one can identify and measure.
Penrose's (1959) 'Theory of the Growth of the Firm' is the work most relevant to how IC might shape a firm's competitive advantage and growth.
The implication is that IC is 'knowledge' of a type which contrasts with any knowledge treated or equated with tangible assets. Ultimately IC is only interesting because it indicates the importance of what one does NOT know about the resources as conventionally measured.
We can illustrate this by noting how 'tools' are useful. I can spend my time at Home Depot looking at all the wonderful tools - but their real value, as opposed to their cost or 'book value', is contingent on my knowing how to use them. What I know, or do not know, is not available in the market as represented by the items on sale at Home Depot.
IC refers to what is not available except through one's own learning. Penrose points to the possibility of profit (and indeed survival in a competitive marketplace) as being the fruit of what the 'management team' is able to learn about how to make the resources being acquired in competitive markets MORE valuable. The management team's knowledge is about superior use of the resources and is not separable from what is known about them.
The intuition that IC is always about 'leveraging' what is known is right on. Measuring this IC is relatively simple - as Tobin showed. The firm itself is an instrument for measuring the IC it 'owns'.
But then a puzzle arises because we have no viable theory of the firm - an academic way of saying that we do not really know what firms are, thus the idea of using the firm itself as a measuring instrument is not too helpful. Consequently those interested in IC are often looking for some other measuring instrument.
Let's say we found one and were able to put a supplement into the annual accounts showing the firm's 'proper' valuation. Then what? We would either arrive back at the market's valuation - or else we would have the market disagreeing with our valuation and open up another kind of Q.
A more useful way of contributing might be to help any particular firms' managers get a sense of the nature of their IC and its dynamics - how it arises, what threatens it, and so on. Thinking about IC ultimately moves us towards a dynamic view of the firm - one that is sort of perpendicular to the image presented in the balance sheet.
I believe it is IC's inherent dynamism that makes it such a useful counter to our tendency to try and model, structure or measure firms and their activities. But against this, the attempt to measure IC so that it can be summed along with a firm's tangible assets is a retreat into the static.
© 2012 Created by Mary Adams.
