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This is a course to hone your financial intelligence. By the end, you will have a working understanding of most financial aspects of monitoring and managing a business. This is a course designed for entrepreneurs, non-financial executives and directors that serve on the boards of for-profit and not-for-profit organizations. This course is designed to allow you to participate in all financial conversations of any business. Some of you may even aspire to ascend to leadership positions or serve on the boards of publicly accountable enterprises. These are all situations where you must have a strong level of financial intelligence to contribute, participate, and fulfill your fiduciary obligations.
Does this picture scare you? Or at the very least mystify you? Accounting and finance are at the heart of every business. No matter how fantastic your business idea is, you aren’t going to stay in business for long if you aren’t making money or if you are in the non-profit world, balancing revenues and costs.
Understanding financial terminology, methodology and application is essential for any entrepreneur, executive or board member –no matter what your area of expertise. Financial intelligence is not rocket science and it is not our objective in this course to make you into a financial expert. But nor is it acceptable in this day and age to start up your own business, work at the highest levels of management, or serve on the board of directors without a strong level of financial intelligence.
Financial intelligence doesn’t mean you need to prepare financial information and analysis yourself. Financial intelligence does however mean that you understand the information presented to sufficiently evaluate its credibility, accuracy, and plausibility. Financial intelligence allows you to question those who prepare this information and those accountable for the results. In the absence of financial intelligence, you are blindly left to rely on the representations of those presenting the information. You 2 cannot exonerate yourself of this responsibility and claim ignorance.
Consider the quote from the late Bernie Ebbers, the former iconic CEO of Worldcom. Ebbers did not have a formal accounting background and attempted to use his ignorance of accounting principles as his primary defense when it was discovered his company had committed a massive accounting fraud. The court didn’t buy it and sentenced him to 25 years in prison.
I like to believe that a more compelling argument for building financial intelligence is the impact it will have on your executive presence -a key trait of any entrepreneur, executive or board director. When you talk dollars, you make sense. No matter what function or industry your expertise originate from, money is the common language every organization speaks. So when you articulate your plans, your tactics, and your performance in money-terms, your audience automatically understands the magnitude of your point. Are you ready to begin?
We are so glad you have decided to join us. Let us begin.Let’s begin by talking about users and their needs. Every accounting textbook starts here and for good reason. It is important to understand who is relying on financial information and for what purpose. While your role may be as an owner, executive or a director, understanding how other users make their decisions based on financial information is a necessary element of financial intelligence.As an owner, executive or director, you are likely using financial information to track performance, to manage or monitor spending, to evaluate a request for more resources, to set incentive compensation, or to make an investment or financing decision.
The key questions for you to ask are:
1.Do you have access to the right financial information?
2.Is that information credible?
3.And is that information timely enough to help you make decisions to manage and guide the business?
If they are not, you need to have a conversation with the right people to get what you need.
As an owner or a director appointed to act on behalf of the owners of the business, you are a key user of financial information. The financial side of the business is its lifeblood. In a for-profit company, owners of the business are the shareholders. Shareholder buy one or more shares of a business by contributing capital to get the business going. Some companies have one founding shareholder, others such as large public companies may have tens of thousands of shareholders. Shareholders don’t have a direct say in how a business is operated. Their interest in financial information is limited to the decision as to whether to buy, hold, or sell their shares. However, one of the few rights shareholders have is to appoint a slate of directors to the Board of Directors.
A director may be a shareholder. Sometimes senior managers are appointed directors, however, this tends to muddy the governance structure. Directors may be entirely independent of shareholders and management. Directors serve in an open-minded, impartial basis. The Board of Directors acts on behalf of all stakeholders, prime among them the shareholders who appoint them. But the directors also have a fiduciary responsibility to lenders and employees as well. As a director, you have full access to the financial statements of the business. However, financial statements do not always present the full picture of what is going on inside the organization. Those providing financial information may or may not provide a commentary to help you out in your understanding.
A public company will release what is called a Management Discussion and Analysis or an MD&A. This reviews the financial results of the business through the eyes of management. This is important for you as an owner or a director to get this perspective.It’s important to note that if you are not provided with commentary or analysis that helps you understand the financial performance to your satisfaction, that you are not only within your rights, it’s your fiduciary responsibility to ask management to provide you with additional information to help you satisfy yourself that what has been represented in the financial statements, is accurate.The owners and the directors of any organization control the purse strings. They decide whether the business is to grow through reinvestment or acquisition or alternatively, when they lose faith, decide whether its time to sell or close the business. This is accomplished by the board approving decisions related to “capital allocation.”
Owners and directors fundamentally get to make or influence 10 types of decisions that concern how an organization sources cash and deploys it. Think of these as levers that owners and directors can pull at anytime. The challenge is knowing which of the ten levers to pull at any given point in time.
There are essentially five levers you can pull for sourcing cash.
1. Optimizing cash generated from operations by making any decisions that cut costs or alternatively grow revenues
2. Optimizing cash invested in working capital by changing credit terms with customer, reducing the amount of inventory you carry or by stretching payments to suppliers
3. Making a decision to sell of one or more parts of the business to raise cash
4. Raising cash from issuance of new debt from lenders
5. Raising cash from issuance of new equity from shareholders
There are generally five levers you can pull to deploy cash as well:
1. Re-invest in existing operations by buying new equipment or by opening up new locations or by investing in new technologies
2. Acquiring another business
3. Paying down debt
4. Paying a dividend to shareholders, if you are a for-profit enterprise
5. Repurchasing equity, again, if you are a for-profit enterprise
Managing the financial health of any organization boils down to these ten decisions and to make these decisions, you will need to understand how the organization is performing both operationally and financially. This evaluation and the decisions that ensue are the crux of your financial intelligence.
Let’s move on to talk about banks and lenders as our next group of users of financial information. As a non-finance executive, owner, or director, you typically won’t deal with the bankers and the lenders directly. This is often undertaken by your Chief Financial Officer or your Chief Executive Officer. However, many entrepreneurs find themselves unwittingly in front of bankers trying to raise capital to get their business launched. Banks and lenders make decisions on whether to extend you a loan or call existing loans they may have outstanding. Also, lenders make determinations about the terms of any loans.
The terms of a loan vary in size, in cost, in duration, in covenants, in oversight –10 among a whole host of factors.
Not every idea is fundable. So if you need capital, working with your finance team can help you identify the best sources of financing. There are many, many variations of lending agreements to consider.Short-term needs for financing can help you cover your expenses while you await collection of money owed to you by customers or inventory you need to have on hand to meet sales. These needs can be financed with short term sources of financing like a line of credit.
Long-term needs for financing might include the purchase of a building or equipment. These needs are often met using term loans, leases, and mortgages. Which is to say, just like the mortgage on your house, is a loan that gets paid off over a longer period of time.
Banks and lenders are interested in two things before they will provide you with a loan:
1. The organization must be able to repay the loan, so they will be looking at the cash flow that the business generates and ensuring there is a comfortable margin of safety to service the debt.
2. Banks and lenders will want to be secured. Security means that in the event the business does not repay, the lender can take the security and liquidate it to get their money back. Security is the hard assets of your business –in other words, those IOUs from customer, your inventory, your property, your equipment.
If you don’t have both #1 AND #2, getting money from banks is very difficult in which case, you will need to look to the owners to fund any cash requirements. In our next lesson, we are going to talk about where information comes from.10
Ok –collective yawn. Who possibly wants to know about systems and processes? As human beings we hate having people dictate to us that we need to do things a certain way. As human beings we cherish our freedom, our ingenuity, our creativity. So why talk about systems and processes at all and what does that have to do with our financial intelligence? Let’s be honest –as boring as these may seem, processes and systems bring integrity the very information upon which you will be making decisions. So you might think of this notion of bureaucracy as a “necessary evil.” However, in the absence of systems, controls, and processes, there would be chaos and fake information. In the long run, you want to advocate for systems and processes as they will make your life easier and it will help ensure assets are tracked and protected. When we safeguard an asset, we mean to protect it from someone walking away with it or it getting misplaced or lost.
Financial statements are created by summarizing all the activities that happen in your organization over a period –usually a month, a quarter, or a year. So when you sell 12 products or pay employees or buy inventory –all of these activities have a home on a financial statements. The type of transaction dictates where it belongs. For example, when you sell things, you have revenue processes that capture this activity including receiving a sales order, filling it, billing it and collecting the money from a customer.
Accounting systems and processes organize these activities into similar buckets or what are called accounts. These accounts are summarized on the financial statement that you review.
That sales processes is just one of many processes in your organization. Everything that happens in your organization is part of a process. And many, if not most, of these processes have tie-ins to the financial reports. One process that many non-finance people may be less familiar with is the Financial Close Process. Think of this process as the tail end of almost every other process in the organization. This process “cleans up” all the sorts of transactions that weren’t dealt with by the system or the workaround processes in each of the functions.
The common sorts of things that get cleaned up in the close process include:
-Trade spending amounts incurred but not yet paid/received-Expense amounts incurred by not charged by the supplier.
-Shipments not yet delivered or invoiced to a customer.
-Payroll amounts that aren’t yet due but for which hours have been worked 13 during the period.
The output from the financial close process is the financial statements. Financial statements summarizes and reinforces the most important stories of the business, only translated into financial terms. Everything you hear from management about how the sales have gone, how operations has performed, how growth projects are progressing –will all be captured in the financial statements. Finance is the most integrated function in any organization and touches all departments. There are three primary statements that you will be presented with. Let’s review these quickly before we get into the details.
The income statement is often the most interesting statement for executives, owners, and directors. It’s also the statement which is both understood on the surface and misunderstood in the details. The income statement tabulates your revenues during a period. Revenues might also be called Sales. In Europe, most countries refer to revenue as “turnover.” Revenues are only recognized on the income statement when a product or service is delivered regardless of when cash changes hands. Expenses are expenditures incurred to earn the associated revenue. Most of these expenses are what you’d expect, you spend money and it becomes an expense. However, as you will learn, there is much more to it when it comes to how manufacturing costs and capital costs get expensed through the income statement. The key thing to remember with expenses is this idea that we want to capture and match all of the costs associated with revenue reported. You will use the income statement to evaluate management’s ability to manage the business, to achieve sales targets, to control spending, and to generate a bottom-line return.
Next, you have the balance sheet. The first thing you will notice about a balance sheet is that it “balances.” It balances the book value of assets against how these assets have been financed using liabilities and shareholders’ equity. An asset represent something that a business owns –customer IOUs, inventory, properties, equipment, and cash in the bank account are all assets. Those are the obvious types of “tangible assets.” However, there are also “intangible” assets such as patents, customer lists, trademarks, goodwill, prepaids and deferred taxes that may also show up as an asset. Tangible generally means to can see or touch the asset, whereas an intangible asset has economic benefit, but isn’t something you can walk away with.
Liabilities represent monies owed to others. This would include amounts owed to suppliers, amounts owed to the government, amounts owed to banks and amounts owed to other lenders. Sometimes, there are liabilities reported for amount that are not yet due, but have been incurred by virtue of what has already been reported on the income statement. For example, accrued liabilities are those that are reported as a liability for which there is no legal requirement to pay –say accrued payroll, or accrued invoices. You may also see contingent liabilities, which are included because there is a likely, but not certainty, amount that will have to be paid upon resolution of a particular matter.
Equity is a balancing account that summarizes three things:
1. Capital contributed by owners.
2. Capital withdrawn by owners.
3. The cumulative amount of income earned by the business over its entire corporate history.
You will use the balance sheet to assess the financial strength of the organization. Financial strength means its ability to maintain operations or invest in new projects. You want to see availability of cash or access to raise cash. You don’t want to see too much debt. More on this, in a later lesson.
And finally, we have cash flow statement. This statement gives you a clearer picture of the flow of funds in and out of the company’s bank account. It’s broken into three sections.
Cash to/from operating activities summarizes how much cash the business has generated (or spent) during the period. You obviously want to see this as a positive number. Income reported on the income statement is not synonymous with cash generated with the business.
Cash to/from investing activities summarizes how the business has invested or divested in long-term assets –assets like investments, properties, and equipment.
Lastly, cash to/from financing activities summarizes how you funded the business through either debt issuances or equity contributions. Alternatively, if you are paying back loans or paying a dividend to your shareholders, those would show as negative cash outflows in this section.
The change in cash during the period and the absolute amount of cash at the end of the period is not as interesting as you might think. We will dive into this interpretation in a later lesson.
One last idea that you need to bear in mind as you read a set of financial statements –accrual accounting. To “close the books” and produce a set of financial statements, means to make an accurate cut off. When you are reviewing an income statement for a month, you want to ensure it only includes the activity of that month. Accountants call this accrual accounting which is another way of saying trying to match the activity, which includes the consumption and generation of assets to the period in which such activities happened.
Note that money coming into and out of the bank account may provide a different picture. Don’t worry about that, that is why you are also provided with a statement of cash flow, which is separate from a statement of income. A statement of income shows you how much accounting profit was earned in a period, whereas your cash flow statement shows you how much cash was collected or spent in that period.
But before we get there, we need to talk about the importance of internal control and the prevention of fraud. The topic of our next lesson.
I’d like to say I’m done with systems and processes, but not quite because I think it’s important for entrepreneurs, executives and directors to appreciate the importance of policies and procedures. Policies and procedures often feel bureaucratic and sometimes quite frankly, they are. However, they exist for a reason and that is to ensure integrity of the information and to safeguard the assets of the organization as we began talking about in our last lesson on accounting systems.
Internal controls include such things as:
-A requirement of managers to review and approve supplier invoices.
-A requirement of managers to review and approve employee expenses.
-Limited access of different people to various modules of IT system.
-Segregation of duties between the custody of assets and the record keeping.
There are, or there should be, dozens if not hundreds of little checks and balances in place in every organization. Everything from making sure access to the bank account is restricted to making sure the office is locked at the end of each day.
All of these little checks and balances exist to prevent and detect errors or fraud from happening. So, while some of these policies and procedures may seem annoying, they are important and exist for your own protection and that of your entire organization. When erroneous information is circulated or assets are stolen –the organization loses credibility and value. Executive management is responsible for the implementation and execution of a control framework. The Board of Directors is responsible for ensuring that the organization has a control framework in place. 21
The single most important thing for you to watch for is the “tone” of the organization. When there is a strong controls-oriented management team at the top, this tone is more likely to be adopted by middle management all the way down to the employee level. The opposite is also true unfortunately, a weak or, even worse, corrupt tone at the top, will often pollute levels below senior management.
It’s critically important to see senior management reinforcing the control environment by doing such things as:
-Following policy and procedure –if they don’t like the policy or the procedure then they should work with others to change it, but it’s unacceptable to have senior managers that ignore or override policies.
-Staff should also be expected to follow policies and procedures and when they aren’t, accountability is enforced.
-When mistakes are made, the root cause must be evaluated to determine 22 whether there is a gap in either the system, process or internal controls and appropriate actions taken.
If you see anything else to contrary, you should be questioning the leaders of the organization. Strong owners and directors will also assess the tone in the middle and the tone in the trenches.
There are a few way you can see for yourself, the strength of the internal control environment even if you don’t have direct access to these people:
-Do walk arounds and meet front line staff as part of a plant tour.
-Inquire of Human Resources around complaints, safety violations, employee turnover etc.
-Establish a whistle-blower hotline that gives employees and anonymous way to report misconduct. The importance of this internal control boils down to…Fraud!
While we are on this topic of internal controls, we must talk about fraud. It’s a topic few managers pay much attention to. It’s human nature to trust the people we’ve hired and worked with for years, but statistically speaking, this is an extremely naïve view of the world. So as leaders, we need to pull our heads out of the sand and face facts based on the data. Fraud happens. It’s not a matter of if it happens, but preventing and detecting how and when it happens.
And the data suggests this, experts estimate that 5% of your organization’s revenue is being lost to fraud each year. 5%! This is staggering amount of lost revenue for most organizations that most disbelieve, but this comes from an bi-annual study conducted by the Association of Certified Fraud Examiners.
To put the 5% into context, what the experts have found is that the average loss suffered by an organization, of the cases they have investigated, is $150,000. Now you may be thinking, there is no way anyone would not detect a $150,000 missing.Well, you need to bear in mind that the average duration of fraud happened over the course of 18 months –so less than $10,000 a month. That is a little harder for someone to pick up when it happens in small amounts over long periods of time.
When you think about fraud risk in your organization, you need to think broadly. There are more ways that fraud can be committed than you can possibly imagine. I don’t say this to scare you, but to ignore it is far worse. So let me give you a quick sense of what you need to watch for and challenge management to address. Experts categorize fraud into three buckets:
1. Asset misappropriation is the theft of assets. It’s by far the most frequent and is composed of dozens and dozens of schemes. Everything from padding of employee expense reports, to employees skimming revenues before they get recorded on the books, to theft of inventory. The losses are relatively less, but to one degree or another, most organizations have some sort of loss coming from asset misappropriation schemes.
2. Corruption –which includes bribes, illegal gratuities, and extortion. These are harder to detect because these schemes tend to happen outside of the organization between employees and customers and suppliers. Watch out for employees with wheeler-dealer attitudes and overly close relationships with customers/suppliers.
3. And finally we have reporting fraud, which is the least frequent, but most costly form of fraud. This happens when executives and/or finance people cook the books and misrepresent to you the true state of affairs. Why do they do it? Well, sometimes its to earn a bonus or add fuel to a stock price. Other times, it’s to keep a lender a bay.
Many organizations have auditors, who are an independent party who are brought into the business to look over the accounting records and the financial statements and express an opinion. But let’s clarify their role by first stating that their primary responsibility is to NOT detect fraud. In fact, relying on your external auditors to detect fraud is one of the least effective ways to detect fraud. So why do you have auditors in the first place is what many non-financial people wonder?An audit is performed to verify that the financial statements have integrity. Not that the financial statements are precisely accurate, rather that they are not “materially” misstated. Auditors talk about materiality in the context of a notional amount that the numbers would have to be wrong by before those users we talked about in our first lesson would change their financial decisions based on this information.
Auditors use a few rules of thumb to quantify this concept of materiality. An easy one for you to remember is 1% of revenue or 1% of total assets. So if you have $30 million in revenue that would suggest an materiality threshold of $300,000. In other words that your financial statements are accurate within +-$300,000. When compared to your average fraud of $150,000, that fraud would be “immaterial” to an auditor and within their tolerance level for misstatement.
You can jump up and down and get all excited about this with your auditors, but it will be to no avail. You don’t want auditors looking at every transaction that goes on in the business because audits are very expensive to conduct and your auditors are well paid. So, this is a trade off that you just need to accept. The auditor’s role is to express an independent opinion that the financial statements are fairly presented for the purposes of the decisions you must make in your role and those of the other financial stakeholder -namely banks and lenders.
With an understanding of the context of where financial information comes from and how you can rely on it, in the next lesson, we will drill into the financial information before you.
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