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When we have really big projects that cost hundreds of thousands or even millions of dollars, we turn more to the finance discipline than the financial or management accountants to analyze those types of decisions. Financial accounting is typically associated with reporting the past. Management accounting also reports the past, but analyzes cause and effect to support management decision making. Finance on the other hand is primarily associated with the future and making decisions about what to invest in and how to finance those investments. Finance as a discipline is about forecasting cash flows into the future using assumptions, which then allow for the determination of value. You already learned a little finance when you learned about how to value the equity of a company. Remember the whole discussion about the asset approach versus the income approach? That was finance because the going concern approach used that forecast of future cash flow to determine the multiple and the value of the business. In this lesson, we are going to prepare you to make all important decisions about what investment projects to approve or reject.
The value of a stream of cash flow underpins all of finance theory. That stream of cash flow is underpinned by assumptions about the future such as sales volumes, selling price, production costs, overhead costs etc.The one thing I can guarantee you coming out of this course is that every forecast of future cash flow you will ever see will be wrong. The question for you is to assess how wrong it could be before it will change your decision to approve or reject the investment decision. On top this idea of forecasting cash flows, you will layer what you have already learned about how we finance assets using debt and equity and the cost of capital. This lesson will tie together all that you learned in those earlier lessons. In the world of finance, we focus on cash flow, not earnings. Accountants calculate earnings and as you should recall from an earlier lesson, earnings do not equal cash flows. Earnings are a product of matching costs with revenues. Cash flows on the other hand, are not encumbered by this matching imperative.
You can collect all the cash up front and pay all the costs later. In a cash flow world, that would be revenue upfront with no costs, and costs later on with no revenues, and that is perfectly fine. GAAP has no say in the world of finance. Where debits and credits were the threshold concept of financial accounting, the time value of money is the threshold concept of finance. Time value of money recognizes that a dollar today is worth more than a dollar in the future. Why? Because today’s dollar can be invested to generate a return which a dollar in the future would not. Inflation is a very real economic phenomena that also erodes the value of a dollar received in the future.
So if you are confronted with making long-term investment decisions, say to acquire a business or build a new factory, that investment comes with an associated and expected long-term stream of cash flow. Recognize that the future cash flows are not worth as much to us as today’s cash. This requires us to think of a way of common size all of those cash flows into the future. The answer is a discounted cash flow methodology. Think of discounting cash flows as a way for penalizing or common sizing the future cash flows. Those cash flows nearest to today are the most probable and best understood and worth the most. Those cash flows years into the future are more uncertain, less understood, and we have to wait to get them. To discount cash flows, we need a discount rate.
A discount rate is often thought of as a hurdle rate. The higher this hurdle rate is, the more penalty that those cash flows in the future suffer. Lower discount rates have less impact on future cash flows. The discount rate represented the expected rate of return of your lenders and shareholders. We call this cost of capital or what we referred to earlier as the weighted average cost of capital or WACC. Yes, the WACC concept that we have discussed in earlier lessons shows itself again in this lesson. To discount a cash flow is to adjust the future cash flow amounts for the time value of money and then add up the resulting discounted cash flow amounts. If the sum of the discounted future cash flows is greater than the upfront investment required, then you’ve got a good project. If it’s less, that is a project you should reject.
Why does this work? This discount rate and the penalizing a future cash flow ensures that you generate a return to pay your investors (both shareholders and lenders in the proportion they invest in a project). If your project generates a higher amount of discounted cash flow than the initial investment, then there is a return for both the shareholders and the lenders with something left over. The leftover doesn’t go to the lenders, it creates value for the shareholders as holders of the residual interest. If the project doesn’t generate more discounted cash flow than the upfront investment, then who gets the short end of the stick? That’s right, the shareholder. So obviously, as an executive, owner, or director, making sound long-term investment decisions is critical to the long-term viability of the business.
To help you think about how long-term investment decisions in new acquisitions or major plant expansions should be considered and evaluated by management, let’s work through an example.
Let’s assume these amounts are in million of dollars.
This particular investment has an upfront cost of $40 million. It will require $4 million per year of sustaining capex. The start up cost for the project is $10 million this year, of which $7 million has already been spent. Another $5 million is expected in year 1.
The incremental revenues and expenses are based on incremental sales of $145 million growing at 2% per year for 3 years. The contribution margin is 35%. Fixed costs are $10 million.
By pursing this investment, the company will have to forgo $8 million in margin from other business lines.
The working capital investment is assumed to be $12 million for receivables and inventory. The tax rate is 25% and the cost of capital, or WACC, is 11%.With those assumptions, the question is whether the business should pursue the opportunity.
What is presented here is a called a net present value analysis and you should look for a net present value analysis anytime you are making a capital budgeting decision. A capital budgeting decision is a large dollar value, long-term project –particularly those projects that can make or break a company. At the top, you notice the forecast of future cash flows. Only incremental revenues and expenses are included in the analysis, i.e. those revenues and expenses that are relevant to the investment decision. This includes any one-time start up costs, but it excludes sunk costs, which are those costs you’ve already spent on the project. Accountants will track those sunk costs, but those in finance consider those cost irrelevant to the decision because they’ve already been spent.
Opportunity costs are tricky to understand, but think of it this way. If you invest in this project, you lose something else. So for instance, you are Intel and you release your latest semiconductor chip, those would generate the incremental sales and revenues. Your opportunity cost would be the lost sales from cannibalizing the sales of your existing chips, which are now inferior products on the market because you have released the next generation of chips. Income taxes are very real costs that should be considered unless the company has huge tax reserves to offset any income taxes payable.
Capital expenditures are the upfront investment that you are being asked to approve –notice that it happens at inception, i.e. as soon as you approve the disbursement of funds. No pressure. Make sure the analysis hasn’t forgotten the sustaining capex and working capital investment. These are often forgotten by management teams and as a result, they build the new plant and are ready to launch only to remember that they need to purchase raw materials and fill a distribution supply chain with inventory before they can begin operations. This takes cash to do! The discount factor in this case is 11%.
This is the cost of capital of the project. This includes the return expectation for shareholders and lenders in the assumed proportion and financial cost we looked at back in the equity module of this course. This is also called the hurdle rate.
At 11%, $1 is worth $0.90 after one year, $0.81 after a second year, and $0.73 after the third year. You can add up the discounted cash flows –$15, $17 and $25 million and subtract them from the upfront investment of $54 million leaving positive $3 million. This is your net present value of discounted cash flows. Because this is a positive number, both the lenders and the shareholder have gotten their expected rate of return and thus you can approve the project assuming you are comfortable with the assumptions made by management. The left over $3 million would accrue to the shareholders if management can live up to the assumptions included in the capital budget.
With this basic understanding of discounting cash flows, you can evaluate anything –a specific asset, a division, a company. Ask for a cash flow, discuss an appropriate discount factor, calculate the discounted future cash flows and add them up. The present value of discounted cash flows is the value of the thing that creates those cash flows. In this case, I’ve zeroed out the upfront investment and assumed this is an existing group of assets already owned by the business. The present value of those cash flows is $67 million. Thus, the value of that group of assets is $67 million.
Before we leave this topic of finance, let me tell you one more shortcut. I’ve worked in dozens of businesses of all sizes –from small entrepreneurial businesses right up to billion dollar electric and gas utilities. The larger a business gets, the more formal its capital budgeting process is. At the utilities, we would prepare very detailed capital budgets to support acquisition, construction of new power generating plants, or the investment in new smart meter technology.
At the other end of the spectrum, I’ve also worked with many entrepreneurs who do not prepare detailed discounted cash flow analysis to make investment decisions. The math they often use is often much simpler. They rationalize making an investment if they can get their money back quickly. This is called a “simple payback” analysis and it determines roughly how long it will take for the company to get its principal investment back from the cash flows invested. While it ignores discounting, entrepreneurs tend to take a shorter view of investment opportunities and may only make the investment if they are able to get their money back in 3-5 years. If you do the math, that rule of the thumb equates to using a discount factor of roughly 18%-25%. So it accomplishes the same thing.
For utility companies, the discount factor is very small –more like 5%. In this situation, payback doesn’t happen as fast, the investment dollars are significantly larger, and thus, it’s these types of business that spend more time on the financial analysis that support the approval of the capital expenditure.
In this final lesson of building your financial intelligence, let’s talk about the role of finance in the organization. In this course we did not delve into financial reporting, management accounting or finance to any great degree, and intentionally so. The objective of this course was to allow you to understand, monitor and challenge the financial information of any business and do it well.
Every organization-small or large, regardless of sector -needs a strong finance function. The finance function is accountable for aggregating data with integrity, summarizing and reporting the results with accuracy, and very importantly adding value to information that facilitates your understanding. This is no small undertaking and finance functions are buried in details and data. But those finance functions that do it well, are often highly influential advisors and strategic partners inside the business.
Modern finance functions are not just the back office any more. The days of proverbial “bean counting” have passed. Data has exploded and the need for timely information has erupted. Entrepreneurs, executives and directors should expect and demand timely, transparent, accurate financial information of management. Not all finance functions are capable of fulfilling this expectation. At Executive Finance, Blair and I define finance functional maturity into 3 different levels.
After I review these three levels, you should be able to quickly assess the capabilities of the finance function in your business. Let’s review the characteristics of each of the three levels.
Level 1 finance functions are what we label “compliance driven.” These are finance functions that are buried in detail and struggling to keep up. A level 1 finance function’s primary focus is to comply: to provide statutory financial reporting, to keep up with remittances, and to report the past, deposit the receipts and pay the vendors. A Level 1 finance function lacks in resources or may have one or two resources completely overwhelmed with what is going on, after all, the finance mandate is broad and touches every corner of the organization. An organization with a level 1 finance function makes decisions without much financial analysis. You will also notice a lot of questioning of the numbers themselves -where owners, executives, or directors ask questions about what is included in the numbers. The finance people may not have good answers or will undertake to get back to you.
Telltale sign of Level 1 finance. Level 1 finance functions arise from poor functional leadership, a misconception around the value proposition of finance, and/or high turnover. When the leaders of the company perceive the finance function as a necessary and expensive evil, they often exclude finance from the business and focus on hiring bean counters to do all the stuff that has to be done. In these organizations, the finance function lags the rest of the organization. If the organization is analogous to a train, the finance function would be the caboose. You will never get value from your finance function if this is your perception of finance and as a result, this will hold the business back. So the first takeaway for you is to recognize if you have a level 1 finance function.
Levels 2 and 3 will give you a sense of what a finance function should be delivering to the organization.
Hopefully, I’ve convinced you that level 1 is not a happy place for you or your business. Let’s talk about level 2.Level 2 is what we call the center of excellence. There is a huge difference between level 1 and level 2. Going back to my train analogy, finance goes from being a caboose to being a passenger on the train. Finance goes from being a back office to a partner in business, working cooperatively across all the functions of the business.
At level 2, you have a well balanced team of financial professionals so that everything is covered off. A level 2 finance function moves beyond financial reporting and embraces management accounting so that you have good analysis into what is going on today. A level 2 finance function also has strong budgeting and forecasting abilities. This allows the organization to plan and execute strategy. This operational focus allows the rest of the organization to make better decisions and provide managers with better control to adjust course as necessary.
Level 2 finance functions are very sustainable. When done well, level 2 finance function can ride first class in the passenger car. So what could possibly be left for a third level of maturity?
Level 3 is what we have labelled as World Class Finance. This is the highest level of maturity and as the title suggests it’s a very audacious representation of the finance function. World class finance functions are highly adaptable and are often required when a business is growing rapidly in terms of: number of geographical jurisdictions, through different channels, using different technologies, integrating and structuring mergers and acquisitions, etc.
World class finance functions come equipped with scalable systems, automated processes, and real time reporting. The finance function provides the rest of the organization with a clear lens through which the future can be seen and long-term investment decisions made, bringing in a strong finance discipline. The perception of a world class finance function grows beyond being a partner in business to one of becoming the trusted advisor for the CEO and the Board of Directors -an advisor that is integrally important to the growth strategy of the organization. World class finance functions will pay for themselves many times over by providing you with information to make better long-term strategic decisions, raising the cheapest sources of capital available, and helping you in structuring your corporate development initiatives.
This is a very exciting mandate for you to task your finance function with achieving. Included with this course is an assessment template that you can provide to your finance leader to help them determine for themselves their level of functional maturity.
Most finance functions have elements of all three levels so there are no bright lines that say specifically you are one level or another, but after sharing the description of the three levels, most executives and owners familiar with their finance functions can assess maturity level quite easily. We have done this poll with thousands of participants over the years and remarkably the results are very consistent.
Without fail, we see over half of the finance functions out there in the world today performing at a level 1 compliance driven or lower level. Typically, we see about a third of the finance functions out there in the world today perform at a level 2 maturity level. Only roughly 10% of finance functions in the world today perform at a level 3 maturity level.
Which means there is a tonne of room for improvement for most finance functions and huge opportunities for the finance function to add more value. As an owner, executive, or director, the question for you to ask yourself is quite simple –do you desire a Level 2 or a Level 3 finance function?
Level 1 should not be an option. If it is, question yourself and your own perception of why an organization has a finance and accounting function in the first place. So the decision is whether it’s Level 2 or Level 3. Here is how you think about that decision.
Level 2 finance functions are predicated on supporting a relatively stable business. You can achieve level 2 with a good team of finance people. Big investments in technology can be avoided by employing smart and highly competent people who implement good processes and internal controls.
Level 3 finance functions are predicated on supporting high growth businesses. Not only do you need highly competent and highly diversified skills sets in finance, you often need world class systems as well. If you notice or believe your business has a level 1 finance function, achieving level 2 or level 3 isn’t as simple as snapping your fingers.
First, hire a good strong finance leader who understands the three levels and provide them with the resources and freedom to build a team around them. Transforming a finance function to higher levels of maturity can take a couple of years, so patience is required. If it were that easy, you wouldn’t see so many finance functions mired at level 1. But once you have a strong level 2 or level 3 finance function, I promise your role as an owner, executive or a director will become much more strategic than it is without one. Mark our words.
Which brings us to the end of this course. Financial professionals will go to school for 4-8 years to learn the technical aspects of accounting and finance. Our intention was never to make you a financial expert. Our goal for this course is to make you a better leader, a better fiduciary, and a more financially literate skeptic. First and foremost, we have given you enough information to drill into the numbers and ask questions about the financial aspects of any business. You can now demand better information that will help you in making the strategic decisions confronting you.
By understanding financial reporting, management accounting, and finance –we hope you engage in deeper conversations about the number presented. Financial reporting, while precise, still has sway in the numbers –recall the concept of materiality.
Management accounting has soft areas as well in terms of cost allocation between different products and lines of business. Finance? Don’t get me started on finance because as a finance junkie myself, I’ll be the first to admit that sometimes the discipline of finance is more art than it is science. The forecast of future cash flow based on a set of assumptions is inherently risky and uncertain. Choosing the right discount rate requires judgement.
Don’t let all the precision of spreadsheets and formulas fool you. Our goal has been to arm you with enough understanding to engage with the finance and accounting people to have these types conversations. I promise that everything you learn from the numbers will help you become a better owner, executive or director in all facets of your involvement with the business.
Along the way, we’ve given you the “cool” vernacular to talk like a finance pro. You can now use “burn rate” “EBITDA” “Capex” at your next conference or cocktail party. Maybe you’ll even negotiate the framework for your next deal using these concepts.
And lastly, we hope you feel a little more confident around the financials of the business. Financial intelligence is one of the most critical elements of your executive presence. Good luck and thank you for joining for this course.
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