How to secure a rock-steady profitability: A Scottish anecdote

Whisky is sunlight held together by water
(displayed on a board outside a pub in Edinburgh)

[you can find a French version of this article here]

Haut Brion, Petrus…

This summer, we got stranded on the Isle of Arran (Scotland) while we were heading to the Arran Distillery, and that proved to be an enlightening experience, not only for the picturesque situation, but also for the underlying concepts in finance that stemmed from those adventures – even though we had eventually to cancel the distillery tour.

Before we move to the anecdote per se, let us first recap some basic corporate finance (spiced with basic strategy). In most, if not all, of the businesses, the source of your revenues stems from your assets. And what is the definition of an asset? What are the characteristics for a thing to qualify as an “asset” to your company?

  • First, your asset must be generating revenues. Or, to put it the other way around, the generic definition of an economic asset is that it is something (it could be literally anything) that generates revenues to your company. In that sense, an apartment you own is an asset to you: you could rent it, or sell it, hence generating revenues. And as you can see with the apartment example, what we call revenues might even be extended to “saving on expenses”. Indeed, the mere fact that you own the apartment, and live in it, helps you not pay a rent. Therefore, in marginal analysis, your apartment generates a revenue (that is, a non-expense) to you.
  • A second characteristic of an economic asset is stability: it should generate a recurring revenue. As an illustration of revenue stability, we can imagine that your company owns a cask of whisky, and only one. If you offer regular tastings for a fee (e.g. 2 £ for a dram), we can talk about a recurring revenue… up until the cask is dry, and then your revenue is as gone as the angels’ share. Or, if you want to sell the whole cask, you will get a one-time revenue, and then nothing ever more. So the quality of an asset also pertains to the durability and/or the stability of the revenues it generates. A unique cask of whisky will generate temporary revenues, whereas a field of barley and a tractor, coupled with a spring source, a distillery and a warehouse, if properly managed, could generate revenues for centuries. In other words, one key aspect in finance (and strategy) is to make sure that your assets consistently deliver a stream of revenues, and one of your missions as a financial manager would be to capitalize on all the means to make sure that those revenues remain stable and recurring.
  • So, those are the qualities for an economic asset: the fact that it that generates a revenue to your company, and that this revenue is on a recurring basis. But there is one more characteristic if you want to record it in your balance sheet: the asset must be your property. In Europe, this goes as far as establishing your right of ownership on those assets (a bill for a machine, a trademark for a brand). If your company cannot exhibit a proof of ownership, those assets cannot be recorded in the balance sheet. For example, training of the employees might be considered an economic asset, in the sense that training them will either increase your company’s revenues (competent employees generate more sales) or it will diminish your costs (well-trained workers help save money). But since the company has no right of ownership on the employees, nor on their training, this economic asset does not qualify as an accounting asset that can be recorded in the corporate balance sheet. Still, it generates a recurring revenue, and providing that it is properly maintained (frequent investments in training), that revenue could last forever.

Now, let’s go back to my trip to the wild hills of the Isle of Arran. One Sunday morning, after a copious, hearty and delicious (in one word, Scottish) breakfast, I was driving on the unique road that circumvents the island, having booked a tour at the unique distillery at noon. But alas, all of a sudden, while I was leisurely telling my partner “hey, look, the sheep over there!”, there was a loud bang, and I burst a tyre. Please picture, if you can, a stopped car on the side of a desert road, a desolate academic and his partner surrounded by hills and cattle and clouds, a distillery whose promises vanish in the distance – a good 5 miles down the road, no mobile phone network, and buzzards already circling for the feast. Driving at a cautious 5mph, I finally managed to reach the distillery, where the people at the reception exhibited the Scottish hospitality in letting us use their landline phone to call for help at the four corners of this round island. And after 30 minutes, like an angel with greasy hands and a broad grin on his face came Angus and his truck (we will call the truck “Phantom 309”). Angus secured the car on the platform and we hopped in Phantom 309 to go to the garage. This is where the journey proved to be enlightening.

Driving with one hand, manoeuvring this big rig on that small road, Angus would delight us with local anecdotes or give us his opinion on the different types of whiskies that a palate can find in this blessed land of Scotland, mostly Highlands and islands. And then, all of sudden, he pointed at something on the side of the road: “here is your rock, I bet!” I checked the environment, and yes, it could have been there that we burst the tyre. Angus kept explaining: “this is a rock on which, I would say, there’s a burst tyre almost every week, sometimes more than that”. And as he drove south, he pointed other good rocks, and I complimented him on this business (as a matter of fact, Angus has the only business of towing and tyre repair on the whole island). Then it occurred to me that those rocks were probably qualifying as assets, in Angus’ business. Well, he did not own those rocks, but they were immovable, pretty hidden by the side of the road, but still very effective, and they surely represented a source of stable revenues for his company, probably until kingdom come, with no maintenance to perform.

So my final questions are: can we indeed consider that those rocks are assets for this type of business? Or, another way to ask the question: what could prevent us from classifying those rocks as assets? And finally, could we imagine other types of businesses that tap on such natural resources to secure their revenues?

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2 réponses à How to secure a rock-steady profitability: A Scottish anecdote

  1. Huan YU dit :

    Very interesting article professor, and questions in the last paragraph lead me to rethink about definition of assets. Apparently, those rocks should not be classified as assets on balance sheet of Angus, since he cannot really own these rocks, but they are stable and bring stable revenues for his business.
    Maybe this is just like a free lunch or luck, you don’t do anything, like investing, but you get paid in the end. Like operating a company successfully does not totally on how much you invest in fixed assets or right choice of strategies, but on other outside factors, which is not showed on financial reports.
    This also drives me to think about another question when we do financial analysis, is a company’s capital structure really that important when we want to analyze fixed assets effect on revenues? Or investment on fixed assets might not be the main driver or direct reason of revenues in some cases.

    • Docthib dit :

      Dear student, thank you very much for those comments. First, you are probably aware of the saying « there is no free lunch » in the world of finance. In fact, the situations where « you don’t do anything, like investing, but you get paid in the end » are very seldom, if ever existent. Someone offers you a free lunch, chances are you will have to repay, in one form or another, in the future. This could lead to another line of thought, which is « offering a free lunch to someone is in fact an investment that you are making », but let’s stick to the subject at hand.
      I completely agree with your view that financial reports do not capture some key elements of the company’s performance, e.g. effective R&D, employee morale, brand awareness… Now, what about your last question? Well, I might agree that looking at the asset structure might not be the *best* indicator to judge for the company’s potential to generate future revenues, but it is a handy measure that is always around, so let’s start with that. And then, you can include additional indicators such as the ones I mentioned, *providing that the company publishes them*, to refine you analysis.

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