FROM THE OFFICE OF PUBLIC AFFAIRS

This conference could not be more timely.  The corporate fiascos of the past two years have created a once-in-a-generation opportunity to improve the performance of our capital markets and our economy.  This will be accomplished when we re-direct corporate behavior away from the game of managing quarterly earnings to focus on what really matters: cash flow – current and expected. 

To do this, we need to transform the practice of corporate disclosure, to invent a new set of best practices that will genuinely inform investors about the risk-reward prospects of the firms in which they invest.   This is not principally a job for government.  Government has a role in catalyzing change, perhaps in creating the incentives for action, but we need your help to show the private sector how they can put these ideas into practice.

We all know what needs to be done; we know in outline what corporate disclosures should look like. 

First, we need to explode the idea that the balance sheet remains a useful concept for measuring a firm’s assets and liabilities; we need to move beyond the false dichotomy between the balance sheet and the off-balance sheet.  When this happens, and investors have a picture of the real, economic leverage employed, attention will naturally turn to cash flow: to how management expects to pay down the leverage and still have some income left over for the shareholders.  This clarity will provide the incentive for firms to disclose the key indicators of business performance that management themselves use to judge expected cash flow.

In recent years, I have often heard it said that “There’s too much leverage in the system.”  My question is: how would anyone know? 

The balance sheet was a wonderful Italian invention that helped move us out of the dark ages and into the Renaissance.  But 500 years later, and after the last 50 years of innovation, we have learned a little bit more about finance.  We now know that the value of a firm is its future unencumbered cash flow.  The balance sheet and last quarter’s earning statement are of little help in divining that value. 

Investors need to know the real economic leverage being employed, whether through on- or off-balance sheet devices.  We need a measure of all the contractually-obligated liabilities, whether contingent or fixed, future or current.  We need a parallel measure of all the firm’s contractually obligated revenues. 

Tying them together will give the firm’s contractually-obligated net present value – a true indicator of the firm’s leverage.  This is not an untested or novel idea.  The concept of NPV appears everywhere in modern finance except in financial reporting.  This kind of disclosure is critical to the performance of our capital markets. 

Exposing true leverage is the only way that shareholders and creditors can judge true performance and can distinguish profit from business operations and from financial engineering.  Leverage is easy.  Value creation is not.

Contractually-obligated NPV will in most cases be negative.  That’s just another way of saying a firm has taken on risk, as almost all firms do.  But disclosing the true leverage will create the incentive for companies to disclose further how they plan to close the gap – how they plan to generate the cash flow needed to exceed net obligations. 

I have found that most corporate leaders have a very clear picture of their firm’s prospects.  They are proud of their companies’ data management systems, which can readily produce the handful of measures of business value and performance that reveal the most about their companies’ near-term prospects, such as customer loyalty data, their share of customer wallet, inventory turns, new assets gathered, or labor hours to finish a car.  Armed with the tools of the information revolution, CEOs expect to see these facts on their desks every morning.

Why don’t companies disclose these indicators of business performance to their shareholders?  While some do, too many do not.  I think their reluctance stems from a lack of sufficient incentive.  But I am optimistic that if companies did disclose their real, economic leverage, they would find a way to use these key business indictors to bring a little more substance to the Management Discussion and Analysis section of their periodic disclosures.

The challenge for you as policy thinkers and business leaders is to imagine how to prod and goad the private sector into making these disclosures.  Much of your discussion will center on government’s role.  In your discussions today, I urge you to bear in mind the limits of government action and to think about how the business community could put your ideas to practical use. 

I wish that government could accomplish these changes in business and investor behavior by fiat.  I don’t think it can.  The more important and interesting challenge for you today is to figure out how the business and investment communities can be induced to reorder their priorities and focus the capital markets on the importance of cash flow.   I wish you every success.

For further remarks on this subject, please see Under Secretary Fisher’s speech to the Securities Industry Association on November 8, 2002. http://www.treas.gov/press/releases/po3609.htm