Hysteresis in Financial Statements

“Hysteresis” Defined

The term “hysteresis” means that which comes later, being derived from the Greek verb meaning “to be behind.” In terms of cause and effect relationships, a hysteresis effect is one that remains after the initial cause is removed. To say it another way, the equilibrium state of any system is a product of that system’s prior conditioning.[1] In classical physics, magnetic hysteresis pertains to the various magnetic attributes of a material depending on the material’s voltage-current conditioning. In the engineering world, hysteresis effects are observed in the deformation of materials, thermal systems, and the design theory of control systems. Rechargeable batteries display hysteresis where the charging curve does not retrace under discharge, producing battery “memory effect” or permanent change to a battery’s properties when subjected to at least one charge-discharge cycle.

Macroeconomic hysteresis effects have been occasionally reported since the 1940s and broader application developed in the 1980s to describe the weak European economy where high unemployment went from temporary to chronic.[2] Last year, Ben Bernanke described the U.S. economy in a state of “hysteresis.”[3] The Fed Chief was referring to U.S. unemployment levels that, after being shocked by the U.S. recession, might not return to historical levels. Figure 1 depicts the recent U.S. unemployment history in a traditional manner with columns of data marching against time measured by years. While unemployment hovers between 4 and 6 percent over the first half of the decade, unemployment shot up to 8 and 10 percent over the past five years beginning with 2008. (The U.S. recession is said to have started in December 2007 and ended in the summer of 2009 but, barring the still-feared double dip, the assessment remains tentative.) However, describing the shift in unemployment levels as “hysteresis,” as possibly permanent, is not ascertainable from such a plot.

Figure 1. A customary depiction of U.S. unemployment, one with sharp jumps in 2008 and again in 2009.

Physicists would say this is not the way to understand hysteresis. A more revealing depiction of unemployment trends would be to plot unemployment, not as a function of time but as a function of some other economic variable, here GDP. Figure 2 presents a much more dramatic picture of the U.S. economy and the recession’s impact on unemployment. Clearly, the end of 2007 marks a shock to the U.S. economy sending unemployment levels soaring through 2009. The correlation between rising unemployment and the contracting economy is made strikingly conspicuous in Figure 2. Since the end of 2009, unemployment is seen to be steadily improving with indication that a return to historical levels may yet be achieved (albeit in 4 years time). The recession’s impact may not be permanent; Bernanke’s hysteresis is not present and the traditional pattern of U.S. economic growth at 5 percent unemployment levels may return.

Figure 2. A hysteresis depiction of U.S. unemployment for 12 years, ending in 2012, showing the correlation between contraction in U.S. economic output and unemployment levels. The U.S. recession is said to have started in December 2007 and ended in the summer of 2009 but, barring the still-feared double dip, the assessment remains tentative.

Going from macroeconomics to micro, can hysteresis effects be observed in company financial statements? Can the pre-recession growth followed by contraction of corporations be examined through the lens of hysteresis? Is the recession’s impact permanent or can the path of corporate growth be reclaimed? The recent U.S. recession provides many examples of company growth arrested by economic collapse, then retrenchment.[4] Company growth can be likened to a rechargeable battery where battery charge/discharge induces a change in the battery’s capacity to recharge, some times called “memory effect.” The battery’s physical structure is changed if not damaged. In what follows, hysteresis in corporate growth is revealed under the shock of the U.S. recession where some companies show resiliency while others show signs of lasting structural change. Two industries are taken as illustrative: Technical Services and Homebuilding.

Hysteresis in Corporate Financial Statements—The Professional Services Industry

Here we will examine company financial statements in a new way, teasing out hysteresis effects in the financial statements of the firm. Instead of plotting financial performance in a year-on-year manner, financial metrics will be analyzed in relation to some other company size metric. Further, to see hysteresis the metrics should be intrinsic, meaning the metrics apply equally to small and large firms. (In the physical world, hysteresis effects are independent of physical system size.) Such financial intrinsic measures include managerial accounting measures (e.g., a quick ratio of 1 has the same meaning in an entrepreneurial firm as it does in a multi-billion dollar company) and so-called critical success factors such as revenue per square foot in retailing.[5]

With the U.S. economy now about 80 percent services, the recession incurred many casualties in the service sector. Professional services firms like accountants, engineers, lawyers, financial managers and advisors, office manpower providers, and all services rendered via billable hours, are managed to at least one CSF, namely revenue per employee. Company professional services revenues must cover:

1. Fully burdened labor rates of billable hour employees;
2. Corporate overhead functions such as marketing, IT support, legal and accounting;
3. Allowance for nonbillable hours in the otherwise billable workforce (vacation, training and the like); and
4. Net profit.

The leaner the company overhead, the closer revenue per employee approximates fully burdened employee salary rates. As a result, the professional services provider becomes more efficient at generating revenue as it adds employees. Revenue per employee is a good holistic indicator of company vitality. Growth in a successful service provider should show concurrent growth in revenue per employee.

Let us see what happened to major professional services providers through the recession. The Boston Consulting Group’s revenue per employee grows steadily over an 8-year period spanning the recession with only a slight hiccup in 2008 when the firm hit recessionary headwinds, Figure 3.

Figure 3. The Boston Consulting Group’s revenue per employee grows progressively with company size, showing little impact from the U.S. recession.[6]

Deloitte Touch, another business consultant, shows much stronger reaction to the recessionary headwinds of 2008, Figure 4. The company’s revenue per employee sharply decreases as revenues also decrease. The path of retreat does not retrace the previous path of growth and, as indicated by the clockwise turn toward contraction, Deloitte Touche sheds revenues faster than it can shed employees. The company corrected its one-year fall in 2009, recovering nicely to pre-recessionary form through 2012.

Figure 4. A second consulting firm shows sharp reaction to the recessionary headwinds of 2008.

Showing that these plots aren’t peculiar to one industry, engineering and construction firm Bechtel shows very similar behavior, experiencing growth reversal in 2008 and, this time, recovery beginning in 2010, Figure 5.

Figure 5. Engineering firm Becthel’s revenue per employee undergoes a two-year retreat, then recovers in 2011.

Finally, PricewaterhouseCoopers, shows a little different behavior, Figure 6. Here, the company’s revenue per employee contracts in 2008 but unlike the other curves, in 2009, revenue per employee has rejoined PricewaterhouseCoopers’ pre-2008 growth trajectory.

Figure 6. PricewaterhouseCoopers suffers the reversals of 2008’s recessionary headwinds but the company completely recovers by 2010, rejoining its pre-2007 growth trajectory.

The hysteresis effects revealed in these plots can be interpreted through the phenomenon of hysteresis as seen from the physical world. Drawing on analogy to the physics of materials science, growing a company by staffing up is elastic (reversible stress) while shedding staff is inelastic, or plastic, due to residual strain left in the organization from being overstaffed while workload declines. Deloitte Touche and Bechtel exhibit plastic deformation, or hysteresis, as both organization’s revenue per employee may someday recover to pre-recession levels, but the companies will need much larger staffs and revenues to support pre-recession organizational efficiencies. PricewaterhouseCoopers is a more classical hysteresis behavior first seen in classical physics’ magnetization and demagnetization of ferrous materials. Here, the hysteresis loop closes and, even though there is slight plastic deformation, the company appears to completely recover its pre-recession growth trajectory and the prior organizational efficiency necessary to achieve it. We now turn to a company where hysteresis effects are beyond plastic, of a more permanent nature.

Jacobs Engineering revenue per employee plot (Figure 4) shows reasonably healthy growth in revenue per employee through 2008 when growth is intercepted by the recession. The curve turns (clockwise) and retreats and Jacobs, like other professional services firms, sheds revenue faster than it sheds employees. By 2010, contraction stops and revenues start growing again, but the turn in the plot is not to close the hysteresis loop but to turn counter-clockwise, a reflection that renewed growth comes from adding too many employees in 2011 compared to pre-2008 revenue per employee levels. Worse, 2012 shows more revenue growth, growth fed by ever increasing employee additions. Clearly this downward trend cannot be sustained. In any event the organization has suffered some sort of longer-term damage, and is so far unable to reclaim its historical growth pattern and trajectory.

Figure 7. Jacobs’ revenue per employee is still searching for its historical ascent following the U.S. recession. The company’s plastic deformation may be of a more permanent nature as recovery to pre-recession revenue-per-employee levels appear to be a long way off.

When Will Home Building Recover, if at All?

The recession’s impact on new home construction is severe. Demand for new homes came to a hard stop in early 2008 and homebuilders were left with inventories of undesired homes. Inventory turnover rate is a CSF in homebuilding as the carrying costs of home inventory are enormous compared to other consumer product inventory costs. Hardest hit may have been Standard Pacific homes.

The effect of the recession on inventory turnover is dramatically illustrated by the hysteresis plot for Standard Pacific Homes (Figure 8).[7] From 2001 on, inventory turnover rate was reasonably steady at 1.4, meaning newly constructed homes sat in inventory about 8 months before being sold. The onslaught of the housing recession in 2005 is dramatic with inventory turnover dropping to nearly 18 months in one year. From that point revenues started a long multiyear decline and Standard Pacific, like most homebuilders facing an economic downturn, cut overhead expense (including marketing) and sold off inventory while, at the same time, attempted to maintain operations, which counterproductively only added to unsold inventory.

Figure 8. A dramatic depiction of the U.S. recession’s impact on home builder Standard Pacific.

The effect is nearly disastrous for the entire homebuilding industry, as home builders find themselves trapped in a deep hole of long inventory turns that gets only deeper as builders add to inventory (Figure 9-1 and 9-2). Hysteresis is chronic, if not calcified, and recent reports of nascent homebuilding recovery notwithstanding, these homebuilders’ capacity to grow has been seriously damaged, perhaps beyond repair while hysteresis indicates the recession lives on.[8]

Figure 9-1. (See Figure 9-2.)

Figure 9-2. Other leading homebuilders with similar hysteresis trajectories. Although some improvement in inventory turnover rate occurred in 2010, homebuilders renewed their downward spiral into what looks like a black hole from which none can escape.

Concluding Note

The few examples given here are just the beginning application of the concept of hysteresis to ascertaining company financial performance as well as capacity for turnaround and recapture of historical growth trajectories. Here, we see how analyzing company financial performance through the lens of hysteresis can be diagnostic—Jacobs’ inability to adjust workforce to meet declining work load inflicted long-term damage on the company—and prognostic—the home building industry will require many years to return to normal. There are many more industries and many more company financial statements to which the concept of financial hysteresis can be applied. Hysteresis trajectories through the recent recession provide track records of management in tough economic times, insight that will be useful in the next economic downturn, if indeed, the present one is behind us.