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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Permalink Reply by JC Spender on April 25, 2011 at 12:34pm

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 - or rather, believes the firm's managers know something that the accountants won't admit to when they draw up the balance sheet.

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, their resources and their activities. 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.

As many posts imply, it would be useful to get a sense of the degree to which the firm's strategy is dependent on being able to leverage the market's valuation of the resources being consumed. This would lead to classifying firms as highly leveraged, or otherwise. Accountants are well used to thinking about leverage and debt/equity ratios. Rather than try and define IC, it might be more useful for us to develop non-market measures of 'knowledge' or 'use' leveraging. The implication is that those whose competitive advantage lies in leveraging freely available resources rather than in protecting and extending monopolistic positions should focus on puzzling out and managing the processes which generate the leveraging knowledge.

Penrose points to managing the 'management team's' learning, and that seems like a good start to developing an IC-based approach to management. Of course it has no real connection to that part of the IC discussion that is about making up for today's accounting deficiencies, accusing them of failing to account for the differences between book and market value.