5 Valuable Tips For Proper Financial Reviews

JAN
15
2020
JAN 15, 2020

Ensuring Great Board Director Financial Governance

(Originally appeared in the January 15th, 2020 'Across the Board' publication, a Board Director, Board Advisor, C-Level, and Business Newsletter reaching 26,000+ exceptional business leaders in over 70 countries with articles focused on leadership, strategy, and governance topics - sign up here)

Throughout the history of companies having Boards of Directors, a disproportionate number of Board Members were selected in large part (or solely) based on their financial knowledge, background, and expertise in the financial industry. Finance, after all, is a major component and focus area for true governance, especially when it comes to public company Directors' responsibility to regulatory agencies as well as profit-hungry shareholders. This led to a heavy concentration of Boards with members solely from the finance industry, with the effect of Board meetings sounding more like accounting meetings or investor forums. We have witnessed in more recent times, however, a much welcomed balance on Boards as it pertains to diversity of background, expertise, and industry experience. I like to think that my global work and international speaking in the space of proper 'Board architecture,' along with my book on the topic, have played a role in this paradigm shift.

All of this said, every Board Member, regardless of expertise area or industry vertical, should have the ability to constructively and accurately know what to look for when reviewing the financial health of the company they serve. I have seen many a Board Director without a formal finance background become an invaluable set of eyes when it comes to reviewing the company's financial statements. Why is this? Typically it is because nothing listed within the financial statements is taken for granted. Everything deserves a look. Everything deserves a logical explanation, able to be understood in layperson's terms. Everything is open for questioning.

Interestingly, the topic of proper financial review acumen, and the following steps within this article, are not solely an outline for new or aspiring Board Directors, but a reminder and refresher for existing and career Board Directors, too. I frequently ask Directors the question, "...what financial indicators do you monitor in the organizations you serve to get a view of the company's health?" - needless to say, I am more often than not disappointed with the answer received. Consider utilizing the following 5 areas as your guide to structure and test your approach as it pertains to your own robust financial review process.

When performing your financial review duties as a Board Member, always ensure that you have the most recent and up-to-date a) income statement, b) balance sheet, and c) statement of cash flows. These will all be needed to get the answers to questions you want to know about - and, quite frankly, are responsible for:

1) Evaluating Profit Performance:

As we all know, a business generates profits by ensuring expenses are less than sales revenue. The further apart these numbers, the better the profits. This simple and obvious comparison is the starting point for a Board Director to get their bearings within the period of time being reviewed. Your evaluations relating to profit performance should always answer the following questions:

  • First, is the top line (sales revenue) what was forecasted? 
  • Is the bottom line (net profit) what was forecasted?
  • What is the actual profit performance of the company and how does this compare to the forecast?
  • How does the profit performance compare with previous years and with previous corresponding periods?
  • What is the gross margin ratio of the business?
  • In referencing the company's income statement, how does gross margin and bottom line (net income or net earnings) compare with top line (sales revenue)?
  • Consider baselining profit performance against current economic conditions, market trending, and overall industry performance.

2) Cash Flow Generated From Profit:

It is easy to assume that the core mission of a company is to make profit, but there is more to this story. Generating cash flow is equally important. Think of this in one scenario as working hard (invoices going out the door), but actual receivables being delayed (no cash on hand). An income statement will not give you your answer to cash inflows or outflows - you will have to rely solely on the statement of cash flows for this important information. Don't be fooled by a great looking income statement as this is useless if the company doesn't have positive cashflow. Ask yourself, is the company's cash flow from revenue-generating activities (operating activities) higher or lower than the bottom-line profit in the income statement? A great Board Director is constantly looking at cash flow, and comparing against a predetermined and agreed threshold, to avoid an illiquidity event within the company.

3) Comparing Earnings Per Share (EPS):

Public companies report Net Income within their income statements. They also report Earnings Per Share (EPS), typically shown immediately below the profit number for the measured period. The EPS represents the amount of bottom-line profit for each share of stock and is therefore directly considered the bottom-line of the company. Know, however, that there is not always a direct correlation between Net Income and EPS - in other words, a 5% Net Income increase doesn't necessarily equal a 5% EPS increase. Companies that have issued additional stock shares or additional management stock options can cause a per-share value dilution, therefore representing a lower EPS (know the difference between EPS and diluted EPS). Conversely, there are situations where a 5% Net Income increase can equate to a higher than 5% EPS increase. Common examples of how this can happen are typically seen when companies buy back a portion of their own shares, essentially decreasing the number of shares applied in the EPS calculation - in turn, raising EPS. In many cases, stock buybacks are an intentional strategy for increasing EPS above the increase in Net Income.

Although private companies are not mandated to report EPS, it is valuable for private company Board Directors to instill the principles of EPS in their governance processes. This can be done within a private company by dividing its bottom-line net income by the number of ownership shares held by the equity investors in the company. The data gained from this calculation, with the subsequent baseline and long-term trending details generated, is very useful for private company Board Directors to reference in strategic discussions and in performing proper governance.

4) Recognizing Unusual Gains and Losses:

All Board Directors have the absolute responsibility of recognizing and addressing unusual gains or losses in the companies they serve. This is most easily done by thoroughly reviewing the income statement. Income statements, above and beyond their normal ability to call out sales revenue vs. the expense of generating sales plus business operating costs, are also a window into other planned or unplanned expense losses or revenue gains. Unusual gains or losses should be considered nonrecurring, so questioning the nature of the gain or loss is warranted. Was there a disaster that temporarily shut down a revenue stream or required a budget to clean up causing additional expense? Did a competitor go out of business driving additional sales in your direction? As a Board Director, always require a valid and verified reason for these instances.

5) Indicators of Financial Distress:

Think 'solvency' - the company's ability to meet financial obligations and debt on time and in full. Importantly, don't confuse liquidity with solvency. Liquidity is defined as "a company's ability to pay off its current liabilities with its current assets. Solvency, on the other hand, is the ability to pay for long-term debt in the long run" (note that liquidity is a shorter-term concept). If not already mandated, Boards should consider requiring that their frequent internal financial updates include a 'solvency ratio' line item within the balance sheet - after all, investors and shareholders have access to this important data, shouldn't you, too? A solvency ratio measures the size of a company's profitability and compares it to its obligations, including interest on any debt. This ratio allows you to see how likely your company will be in continuing to meet its debt obligations. A stronger or higher ratio indicates financial strength. A lower ratio, or one on the weak side, could indicate financial struggles in the future.

Even with the most astute Board Members and robust review processes in place, the chances of unnoticed and well-hidden fraud still exists. I like to think, however, the chances of these instances are greatly reduced when every Board Member is versed in the 5 review disciplines mentioned in this article. Be one of the Board Members that adds value in this area, even if you don't have a formal finance background. Multiple sets of independent eyes have a proven way of increasing the chances of catching something fishy. Whether it be fraud or error, a company must restate its original financial report and issue a corrected version, usually without restitution for any investor losses. As you can imagine, this can have a negative effect on the overall perception and value of the company ...and make no mistake - in the fickle world of company reputation, perception is truly reality.

 

As a Board Director, are you versed in proper financial review practices?

 

Reach out directly to Mark A. Pfister to elevate your Board and Board Member knowledge with his Board Consulting offerings & International Speaking Tour topics.