SPOON-FED FINANCE
How should a finance manager talk numbers with the boss?
By Ken Fowler

Security officer, reporter, ambassador, banker, spy, hit man, preacher, teacher - most of these occupations don't come to mind when one thinks of the job of CFO. But the CFO can serve any and all of these functions within a company. The most frustrating of these is the role of teacher, especially when the student is the CFO's boss. CEOs are generally assumed to have a fairly keen understanding of financial statements, but too often this is not the case. I've worked with CEOs who have risen to their jobs from a variety of backgrounds, including sales, operations, technical, legal and financial. It never fails to surprise me when one sits down with me one-on-one and asks a question like: "This Ebitda figure ... can you help me get a handle on what that actually means?" Or better yet: "We have a net profit this month, so why are we burning cash?"

It is unlikely that a CEO will have a good understanding of how to read financial statements and how to analyze them unless they climbed up through the ranks on the finance side. The result is that the CEO must be spoon-fed financial information by the CFO. The CFO's job then becomes even more difficult - how to put all those complicated numbers and formulations into a brief, easy-to-follow format that empowers the CEO to make decisions?

Short and Sweet

In the short time I know I will have with my CEO, I generally handle it like this: first, I show how the company is performing compared to the plan; how the company is progressing toward specific targets and perhaps responding to recent strategic initiatives; and then I point out where the red flags are popping up. I spend about ten minutes on variance analysis, 25 minutes on trends and 25 minutes on statistics. At the end of this hour, my CEO is hopefully thoroughly briefed on the critical aspects of the business as shown by the numbers.

Within each segment, I pay particular attention to three aspects of the company's financial health: the income statement (the P&L), the balance sheets and the cashflow statement. Too often, CEOs focus solely on the P&L. This is a mistake that has driven companies to early liquidation. A strong P&L does not necessarily imply that the company is a going concern, while profitable companies can die from improper management of working capital. A review of the consolidated balance sheets and cash report is the only way to determine if a problem exists.

Veritable Variance

The time spent on variance analysis is when the CEO and I review how the company is performing compared to the industrial sector we operate in. At this time, focus on the P&L, the easiest report for most CEOs to understand. Most companies do a poor job of budgeting balance sheet items, which can make variance analysis of the balance sheets and cashflow report a waste of time. Start from the top - revenues (or sales), then go straight to the middle - EBITDA, and then to the bottom to net income or loss. Ask the same questions for all three figures: which divisions/products are performing under or over plan?

Even if the consolidated figure is on budget, this question should be asked because one division or product could be making up for the failures of another. Pay attention to which divisions/products are performing better than plan - later, you will want to follow up to determine what is being done right. Look for inconsistencies as well. For example, is the EBITDA variance higher than the revenue variance? If so, the division/product is likely underperforming on sales, yet continuing to spend as if the revenues were on target. Often, a good manager can achieve on-target EBITDA, despite lower than planned sales, by properly managing the expenses.

For those products/divisions that are performing under plan, why? No need to review the detailed revenue and expense variances for divisions/products that are operating on or over plan: focus on the problem areas. When EBITDA or net income variances exist, the CFO should be prepared to explain why revenues are under plan and why expense items are over plan.

On the cash report, only look at investing cashflow. This is normally the sole place where one can determine whether capital spending, such as fixed asset purchases, is on target. Normally, companies will want to focus on the year-to-date variance, as capital asset purchases are often behind schedule. However, the purchasing timing can be quite important in some industries when slow spending is an indication of projects falling behind schedule.

A History Lesson

In the time I spend on trends, I compare the results against recent history to determine whether the company is heading in the right direction. Start with the P&L, but go beyond it, carefully reviewing both the cashflow report and the balance sheet as well.

On the P&L look at the side-by-side consolidated monthly results for at least six months running: include a look at detail line items and division/product detail. Focus on breaks in the trend and on undesirable trends, but consider how material these trends are to your business.

Next, move to the cashflow statement. This is perhaps the most difficult report for non-accountants to understand. Do not dive into the details, but instead focus on the three primary sub-totals: cashflow from operating activities, from investing activities and from financing activities. Focus on operating and investing, as these totals generally represent the true cash that is being generated or used in the company's operations. The financing cashflow generally only provides information as to where the operating and investing cash is placed (or is found).

Consider the operating cashflow plus the investing cashflow to be the company's true cashflow before financing. Given the current trend, and the current cash balance, what does the company's general health look like? Healthy and getting healthier? Or six months to live before new financing will be required? Looking through the line items, identify lines that flip from positive to negative (or vice versa). These are signs of inconsistent operations and possible working capital management problems.

Compare the operating activities cash to the company's EBITDA. If EBITDA is positive but the operating cash is negative, then a working capital problem is evident. Do not focus on the inventory, accounts receivable or accounts payable lines yet - save these for the time allocated to discussing statistics. For most companies, investing cashflow will be negative since capital assets are not normally disposed for cash (on a regular basis). Pay attention to changes in the trend, especially if significant changes in capital purchases are not anticipated. There is no need for a detailed review of the balance sheets at this time, because any significant changes in balances would be noted when reviewing the cash report.

Counting on Numbers

During the final 25 minutes I allocate to reviewing statistics, I compare actual statistics against standardized benchmarks. The first step is to determine the average daily revenues and operating expenses.

To determine average daily revenues, divide the total revenues by the number of days in the reporting period (normally 30 or 31 days). This provides a nice figure for trend analysis. Since time is taken out of the equation, the daily revenue statistic can be used for an apples-to-apples comparison against previous reporting periods.

Next, total the third-party cash operating expenses, which equals total operating expenses less salaries, bad debts, depreciation and amortization, plus the cost of sales. Divide the total by the days in the reporting period to yield the daily third-party expenses. Now thoroughly whisk these ingredients with the balance sheet line items to prepare a fluffy statistic that is suitable for serving to special guests (garnish with a dollar or percent sign).

These figures will be used to determine the company's ability to collect on sales and pay its bills. On the balance sheet, consider the total uncollected revenues. Note that in some companies this may include more than accounts receivable. For example, in service companies this will include accrued revenues (revenues recognized but not billed).

The information you provide through this process allows your CEO to focus on the activities of the finance team. The CFO becomes more proactive towards detecting issues and recommending solutions, and the CEO, as a result, with a new understanding of the company's finances, can make decisions based on sound financial rationale. What could be better?

Ken Fowler is CFO for DeliriumCyberTouch, a Hong Kong-based web applications provider. He has held chief finance posts for Chinadotcom in Hong Kong, and SkyTel International, a division of MCI Worldcom.