assess your cloud adoption

8/10/2019 Assess Your Cloud Adoption

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G00248480

Assess Your Cloud Adoption Strategy's

Financial Statement ImpactPublished: 25 March 2013

Analyst(s): Biswajeet Mahapatra

Public cloud adoption can negatively affect working capital by increasing

current liabilities and reducing assets on the balance sheet. Some IT leaders

fine-tune their cloud adoption strategies to find a balance that avoids

negatively affecting the income statement or reducing corporate valuation.

Key Challenges Shifting capital expenditures (capex) to operational expenditures (opex) through cloud adoption

can negatively affect many companies. This is especially true when an enterprise is choosing

between the availability of working capital in terms of cash or cash equivalents and long-term

loans for capital investments.

Financial lease (see Note 1) could be a way out of this situation, but this has the impact of an

income statement and causes working capital pressures.

No silver bullet is available in terms of a perfect mixture of public cloud and in-house IT,

because each company's situation, environment, financial position and availability of capital is

different.

Recommendations Establish a capex-to-opex IT spending split. If it differs significantly from the industry average,

review it before embarking on a cloud adoption project.

Keep an eye on short-term borrowing rates to determine the allowable fluctuations in working

capital.

Benchmark the IT working capital/total IT assets ratio, and evaluate any changes to this ratio

when moving to the cloud.

Companies facing re-evaluation, merger or acquisition, as well as those looking to attract new

investment, should keep an eye on the assets side of the balance sheet; however, the capital

intensity ratio should also be kept in check.


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IntroductionIT leaders worldwide are being asked to cut costs and justify any investment decisions. To calculate

a proper ROI and show the business that the various IT investments are yielding results, IT leaders

need to know the different aspects of costs. They also need to know how to make a rational

decision that will help them provide the right solutions to business, as well as make financialdecisions that are in the best interests of the company. This will help them have fruitful discussions

with CFOs and enable them to show, in monetary terms, the value IT adds to business.

IT leaders often need to make decisions on whether to move to the cloud, and they need to

determine whether moving to cloud will help them reduce costs and add value to the business.

Moving to a public cloud adds pressure on the income statement in some specific vertical

industries, such as energy, utilities, telecommunication and healthcare. These industries are aware

of the benefits of cloud, but would want to have a healthy and comfortable mix of public cloud and

private cloud or similar in-house capabilities to balance pressures on the income statement and not

make the balance sheet asset-light.

Cash-rich companies have the ability to fund working capital requirements. Therefore, they aren't

forced to choose between public cloud or in-house IT (keeping all other factors, such as security,

availability of service providers and network connectivity constant). At the same time, companies in

capital-intensive sectors, such as large manufacturing plants, mining industry, oil and gas, are also

not worried about this situation, because, for them, the percentage of IT capital investment is low,

relative to the overall capital investment. Such large companies are not candidates for merger and

acquisition (M&A), so they can manage with a lot of in-house IT.

However small and midsize businesses (SMBs), such as textile units, marine products companies,

bakeries, retail shops, pharmaceutical manufacturers, cement mixing and constructing companies

and small nursing homes, would be interested in knowing the right combination of investment inhouse IT and software going for public cloud adoption, because they experience real-time

pressures on expenses and working capital, and, at the same time, they have to show they are

asset-heavy. Lower expenses and asset heaviness increase their valuation, and they can provide

higher earnings per share (EPS).

Analysis

Establish a Capex-to-Opex IT Spending Split

Across industries (see Figure 1), the average capex-to-opex (cash flow of IT spending) split hasremained almost steady since 2008.

Page 2 of 8 Gartner, Inc. | G00248480


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Figure 1. Cross-Industry IT Opex Versus Capex Spending

29

30

25

26

28

71

70

75

74

72

0 10 20 30 40 50 60 70 80 90 100

2008

2009

2010

2011

2012

Percent

Capital Operational

Source: Gartner (March 2013)

This split or division is expected to remain the same, and, except for a few aberrations, no industry

will be moving to a completely drastic model with 90% to 100% in any one kind of spending. The

actual composition may vary from industry to industry, but the range would remain approximately

the same. Figure 2 shows the pattern in the case of the utilities industry, which is more or less thesame. Figure 3 shows the pattern in case of transportation industry, which is also more or less the

same.

Gartner, Inc. | G00248480 Page 3 of 8


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Figure 2. Utilities: IT Opex Versus Capex Spending

31

35

29

31

35

69

65

71

69

65

0 10 20 30 40 50 60 70 80 90 100

2008

2009

2010

2011

2012

Percent

Capital Operational


Figure 3. Transportation: IT Opex Versus Capex Spending

30

26

27

28

27

70

74

73

72

73

0 10 20 30 40 50 60 70 80 90 100

2008

2009

2010

2011

2012

Percent

Capital Operational




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This capex-to-opex split will remain virtually the same, whether cloud services are used or not. If

you see that, in your IT organization, the composition is different from the industry average, and the

change is not in line with the financial plan, review your financial plan and the assumptions

supporting the plan. If your company is spending less than 5% of its capital investments, or the

overall opex spending is less than 5% of the overall opex spending, then it may not be an alarming

situation. However, it is still advisable to take a look at whether your working capital pressures are

high, and whether your debt component is increasing. If that is the case, reconsider the decision to

move to the public cloud. Maybe you can take steps to move some critical applications/

infrastructure back in-house or search less expensive options to move the absolutely noncritical

apps and infrastructure.

Keep an Eye on Short-Term Borrowing Rates

External funds available for a period of one year or less are called short-term finance. In some

countries, short-term funds are used to finance working capital. Trade credit and bank borrowing

are the only options available to finance working capital. Trade credit is not the normal route used

by IT organizations to finance working capital requirements. Short-term borrowing is the method

normally practiced by IT organizations to finance working capital requirements. Working capital

loans, cash credit and overdraft are the normal methods used by IT managers to fund working

capital requirements. All of these charge an interest rate that's higher than normal long-term loans;

hence, you should keep an eye on short-term borrowing rates, and, while determining the total cost

of ownership (TCO) of cloud adoption, cost of capital should also be considered.

In most cases, the IT department is funded by corporate and does not have access to external

loans. Hence, the impact of any major changes in working capital requirements on any function has

an impact at the corporate level. This is why CFOs scrutinize such requirements carefully. IT leaders

need to work with the IT finance teams and CFOs to ensure that there are no major working capital

fluctuations, especially in organizations that normally have high working capital requirements, suchas media, real estate, food and beverages, airlines, hospitality (i.e., hotels) and utilities. Additional

working capital burdens in such industries can become difficult to manage, especially if the cost of

borrowing is high. This is applicable more in countries with high inflation and interest rates.

However, many cloud adoptions happen in a decentralized manner at the individual or business unit

level, and neither the IT department nor the CFO is involved in such decisions. Hence, all

organizations should develop a process in which all IT purchases (including services and the cloud)

need to be reported for financial impact calculation purposes.

Benchmark an IT Working Capital/Total IT Assets Ratio

The ratio of net IT working capital to total IT assets is computed by dividing the net IT working

capital (current assets minus current liabilities) by total IT assets.

A higher ratio indicates higher working capital compared to total IT assets. Higher working capital

means the current assets situation is healthy. This ratio is also important for companies planning a

revaluation or expecting new funds, because a positive or higher ratio indicates more liquidity in the

company, which can be attractive to new or angel investors. When the total IT assets increase, the



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ratio will decrease. This isn't an issue for concern, because some companies would like to keep this

ratio at an optimum level. It is often seen as an increase in total assets funded by short-term

borrowing (especially in IT investments), and this decreases the working capital further. Hence, the

overall ratio may not fluctuate much.

Moving to a public cloud will surely increase current liabilities and reduce working capital; however,a public cloud adoption will also lead to a reduction in assets. Hence, the overall ratio may still

remain the same. So the crux is how is the capital expenditure funded and whether it is putting

undue pressure on expense statements. If not, then there is no cause for worry.

Keep an Eye on the Assets Side of the Balance Sheet and the Capital Intensity Ratio

Capital intensity is total assets divided by revenue. In cases where chargeback is already

implemented, or where IT is a shared service, this is the ratio of total IT assets to IT revenue. Most

of the time when it is an internal captive IT organization, the price of services is at par with cost

(which means no markup). In such scenarios, the ratio would be less, but it still shows the utilization

level of assets compared with the goods (IT services) sold.

However, if the capital intensity ratio is high, then the organization has invested heavily in assets

relative to the revenue that those assets are generating. The same assets would be depreciated in

three to five years, so the depreciation charges would also be high, and the company might have

taken higher loans to fund those assets. This means higher liabilities and more pressure on working

capital.

Hence, companies up for investment or M&A, or companies that want to show a heavier assets

column in the balance sheet, should not go all out to increase their IT assets, because it has a

bearing on working capital too. Many companies have spoken to us and cited one of the major

reasons for moving away from the cloud and investing in their own assets is to make their balancesheets look better and reduce pressures on working capital. An important caution is in order:

Funding assets through short-term borrowing will have a negative impact on working capital. If

companies want to invest in IT assets and avoid working capital pressures, they should do it on

long-term borrowing only. In some cases, it may be difficult to get long-term borrowing only for IT

assets.

Recommended ReadingSome documents may not be available as part of your current Gartner subscription.

"Field Research Summary: Public Cloud Adoption"

"The Impact of Public Cloud Adoption on Working Capital"

"CFO Advisory: Cloud Computing; Finance and Economics"

"IT Asset Management, Applications Strategy and Cloud to Be Impacted by Accounting Changes"



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Evidence

http://financialratioss.com/other-financial-ratios/working-capital-to-total-assets-ratio-definition

http://in.advfn.com/Help/net-working-capital-to-total-assets-303.html

Note 1 Financial Lease

As per IAS171, a lease is classified as a financial lease when all risks and reward of ownership are

transferred substantially.

http://in.advfn.com/Help/net-working-capital-to-total-assets-303.htmlhttp://financialratioss.com/other-financial-ratios/working-capital-to-total-assets-ratio-definition


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