Best Practices: Financial Management

The CEO's Role in Financial Management

According to TEC speakers Ron Fleisher, Kraig Kramers, Glenn Waring and John Zaepfel, most entrepreneurial CEOs don't have strong financial backgrounds.

Fortunately, you don't need an MBA in finance to be a good financial manager. Our experts believe you can effectively manage your company's financial performance by focusing on five specific activities:

1. Ensure that the company has timely and accurate accounting and reporting systems.
   
   
2. Identify the right numbers/key indicators to watch.
   
   
3. Know how to read the key financial documents: balance sheet, income statement and cash flow statement.
   
   
4. Manage cash flow.
   
   
5. Use financial information to forecast the future.

"Perhaps the biggest mistake entrepreneurs make (after running out of cash) is thinking that financial management involves only looking at the past," says Kramers. "Yes, the numbers tell you what happened in the previous month or year, but that's only half the story. Smart CEOs use the numbers to forecast the future and make better management decisions going forward."

Fleisher agrees that CEOs need to adopt a forward-looking approach, especially when it comes to knowing which financial management activities to delegate and which to hold onto.

"In most small to mid-size companies, controllers and CFOs focus primarily on tactical activities, such as closing the books in a timely and accurate manner, preparing financial reports, managing accounts receivable and payables, conducting comparative analysis and benchmarking your company against industry figures," he explains. "Your job is to use the financial information they provide to look into the future and generate action plans to improve the company's performance. That's a role you can't delegate to anyone else."

The ultimate goal for CEOs, says Kramers, is to develop financial "intelligence," the ability to scan the horizon at the 30,000-foot level, develop a big-picture perspective, and take appropriate action to improve the company's financial performance.

Developing a Sound Financial Plan

According to Waring and Zaepfel, a financial plan should contain three specific segments: historical analysis, a three-year plan and a one-year plan. In addition, Waring believes the financial plan should also include analytical narrative -- your analysis of what the numbers tell you -- and the assumptions that underlie your projections.

To conduct the historical analysis, gather financial data for the past three to five years from the balance sheet, income statement, cash flow statement and selected financial ratios.

One of the best formats for gathering and interpreting this kind of financial data is the trailing 12-month chart because it allows you to see trends over time. Once you have the information, you can identify problems and outline solutions in your plan.

The three-year plan provides a tool for looking into the future and determining how your company should perform. More important, says Zaepfel, it allows you to grow the business without running out of cash. To develop a three-year plan:

1. Project the income statement. First, develop a sales forecast and determine your expected gross margin percentage. Then estimate your operating expenses and use all three figures to determine your projected profit (or loss).
   
   
2. Project the balance sheet. If your projected net income plus the increase in variable liabilities equals or exceeds the increase in variable assets, the company will have the resources to finance itself. If not, you will have to obtain additional financing.
   
   
3. Project cash flows. Using the information in steps one and two, project how these numbers will impact your cash flow, paying special attention to how much new debt or equity you will need to inject into the business and when.
   
   
4. Project key balance sheet and income statement ratios. You never want to grow at the expense of the balance sheet, argues Zaepfel. If your projected ratios show a weaker balance sheet, rethink your projections. Or, start looking at ways to cut costs, improve margins and run a leaner operation.

The one-year plan involves the same steps as the three-year plan, except projected on a monthly rather than an annual basis.

A good financial plan provides a detailed picture of what is really going on in the business, establishes a benchmark by which to measure your financial performance and tells you when you are getting off track. With that information in hand, points out Waring, you can take action before serious financial deterioration occurs.

Fleisher suggests adding one step to your financial plan -- a "ROI payback analysis." He explains, "This forces you to answer the question, 'If I invest money in this company, how fast will I get paid back and what are the action plans that will get me there?' If you're comfortable with the answer, go ahead with your plan. If not, don't invest until you can develop a plan you can live with."

Developing Financial Discipline

Zaepfel believes that financial success for a business consists of five elements:

• Sustaining profits
• Maintaining a strong cash position
• Building a healthy balance sheet
• Providing adequate return to stakeholders
• Establishing a value that is transferable

He also believes that these things don't happen by themselves. Instead, they come about as the result of practicing financial discipline in the business. To build a culture that supports financial discipline:

• Establish a reliable financial reporting system.
  
  
• Segment your business by product lines, markets and customers.
  
  
• Benchmark your financial performance against a standard.
  
  
• Focus on the gross margin.
  
  
• Have an accurate direct costing system.
  
  
• Drive velocity through the balance sheet.
  
  
• Measure your cash cycle and manage it.
  
  
• Forecast working capital and arrange your growth financing well ahead of your needs.
  
  
• Build value by establishing targets for EBITDA earnings.
  
  
• Drive accountability and communication throughout the organization with scorecards and key indicators.

Financial discipline also requires aligning the financial side of the business with your strategy. According to Zaepfel, this involves building financial models and templates predicated on a strategic model that answers three questions, "Who are we going to sell to? What are we going to sell? How are we going to sell it?" Once you answer these questions, put some numbers to your answers and drive a financial model so you can build relationships with the alternative financing sources you will need as you grow

The final piece of the financial discipline puzzle, says Fleisher, involves translating your financial goals into specific behaviors that get the results you want. This requires quantifiable, measurable action plans so you can track performance and course-correct and counsel when necessary. Fleisher also recommends using performance-based compensation to get your people tied into the result.

Key Financial Management Ratios

In and of themselves the raw numbers on your balance sheet, income statement and cash flow statement have limited value. Of far more value, say our experts, are certain ratios that can be extracted from these documents. The secret to effective financial management lies in knowing which ratios to track and what they tell you about the state of your business.

"Too many CEOs look at gross sales and revenues on the income statement and nothing else," says Waring. "If sales look good, they figure everything else must be in order. In reality, you can have healthy sales growth and still be headed for financial disaster. The only way to know that is to pay attention to the ratios that tell you what's really going on in the business."

According to Fleisher, the balance sheet gives the truest measure of a company's overall health. Unlike the profit and loss (income) statement, which is a historical recording that never changes, the balance sheet is a living, breathing document that changes on a daily basis. The three most important balance sheet ratios are:

• Current ratio (Current assets/current liabilities)
• Quick ratio ([Cash + receivables]/current liabilities)
• Debt-to-equity ratio (Net worth/total liabilities)

The current and quick ratios measure the company's ability to survive a short-term financial crisis. The debt-to-equity ratio (also known as the safety ratio) measures the company's ability to survive over the long-term. If sales and revenues continue to climb while these three measures show a decline (a scenario that happens all the time in fast-growth companies), you have a real problem on your hands.

The P&L statement focuses on revenues, expenses and net income (or loss) over a defined period of time. It measures the company's ability to turn sales/revenues into profits, a key ingredient for long-term success. Zaepfel identifies the most important P&L formulas as:

• Gross income (Revenues -- cost of goods sold)
• Gross margin (Net sales -- cost of goods sold)
• Net operating profit (Gross margin -- SG&A expenses)
• Net profit (Net operating profit + income) - (other expenses + taxes)

Zaepfel considers gross margin the most important ratio on the P&L. "If you lose the gross margin battle," he cautions, "you can do a lot of other things right and still go out of business."

Key operating ratios combine information from the balance sheet and income statement to provide a more sophisticated look at what is happening with the business. These include:

• Gross profit ratio (Gross profit/sales)
• Pretax profit ratio (Pretax profit/sales)
• Sales-to-assets ratio (Total assets/sales)
• Return on assets ratio (Pretax profits/total assets)
• Return on equity ratio (Pretax profit/equity)
• Inventory turnover ratio (Cost of goods sold/inventory)
• Days in inventory ratio (Inventory turnover/365 days)
• Accounts receivable turnover ratio (Sales/accounts receivable)
• Collection period ratio (Accounts receivable turnover/365 days)
• Accounts payable turnover ratio (Cost of goods sold/accounts payable)
• Payable period ratio (Accounts payable turnover/365 days)

These ratios illustrate how efficiently your company generates and uses cash. They also tell you what's happening to your cash flow now and what's going to happen to it in the near future. The whole purpose in studying ratios, say our experts, is to make them better. To improve your balance sheet:

• Speed up inventory turnover.
• Consider leasing rather than purchasing equipment.
• Reduce the time it takes to collect receivables.
• Get increased payables terms.
  

To improve the income statement:

• Leverage sales over fixed costs.
• Increase gross margins.
• Review pricing opportunities.
• Use zero-based budgeting.
• Compensate people for productivity instead of time.
• Outsource when it's economically advantageous.

Key Indicators: Tracking Your Way to Financial Success

One of the primary jobs of management involves reading the trail signs (key indicators) and taking appropriate action to make the company more successful. To use key indicators to their full potential, Kramers recommends five basic steps:

1. Identify the right measures.
2. Use the right increments.
3. See the big picture.
4. Anticipate the future.
5. Take action.

Kramers believes every business should monitor a core set of financial key indicators from the income statement, balance sheet and cash flow statement. These include:

• Income Statement
  
  
• Net sales (dollar growth and percent increase)
• Gross profit margin
• Pretax earnings (dollar growth and percent increase)
• Operating expenses (SGA) as a percent of sales
  
  
• Balance Sheet
  
  
• Receivables turnover
• Inventory turnover
• Debt-to-equity ratio
• Total equity dollars
  
  
• Cash Flow Statement
  
  
• Operating cash flow
• Investing cash flow
• Financing cash flow
• Ending cash

Tracking these indicators will keep you tuned in to the financial side of the business. However, Kramers also recommends tracking certain "non-financial" indicators that have a substantial impact on your company's financial performance. These include:

• Sales
  
  
• Number of transactions per unit time
• Average sales dollars per transaction
• What causes sales
  
  
• Operations
  
  
• Number of widgets produced
• Average cost per widget
• Number of widgets sold
  
  
• Customers
  
  
• Customer satisfaction index
• Number of customers
• Number of new customers
• Ratio of new to existing customers
• Average sales per customer
  
  
• Market
  
  
• Percentage market share
  
  
• "Key-thing" mix change (percentage)
  (Note: Kramers defines "key-thing" as the mix of business in terms of product line, customer segments, geography or the value-added you provide different customers.)
  
  
• New product growth (percentage)
  
  
• Employees
  
  
• Number of employees
• Employee retention
• Average sales per employee
• Number of net new positions

One of the most important non-financial indicators any business can track is "what causes sales" or "what causes growth." Why? Because by tracking the activities that cause sales and growth to happen, you can identify problem areas and take corrective action long before sales actually decline. According to Kramers, the activities that cause sales and growth vary from one company to another. Examples include the number of telemarketing calls, number of sales feet on the street, dollars of advertising, volume of direct mail, number of RFPs submitted or number of contract bids. The trick is to identify the right activity for your business.

"Don't make the mistake of thinking you have five or ten things that cause sales," he cautions. "Every business has one primary activity that causes sales to happen. And don't confuse marketing activities with sales. Identify the one thing that has to happen in order for sales to occur in your company and start tracking it on a 12-month trailing chart basis. Then watch your ability to predict and produce the sales you want grow by leaps and bounds!"

Once you get comfortable using the "what causes sales" key indicator, Kramers suggests using it for all non-financial indicators. What causes operations to improve? What causes an increase in market share? What causes customer satisfaction? What causes employee satisfaction? Answer these questions and then track your answers. That, says Kramers, is how you determine the most appropriate key indicators for your business.

Managing Cash Flow

According to Fleisher, most CEOs pay far too little attention to the cash flow statement, usually turning to it after the income statement and balance sheet, if at all. Such an approach, however, may put your business at risk. "If you run out of cash, the game is over," he warns. "For that reason, you must attend to cash flow at all times."

The cash flow statement is typically broken down into three categories: operating, investing and financing cash flow. Added together, they determine the company's overall cash flow. Like the balance sheet and P&L, the cash flow statement typically comes out once a month. However, our experts strongly recommend tracking cash on a daily basis, especially for companies having cash flow problems. To keep close tabs on your cash flow:

• Review the cash flow statement once a month.
  
  
• Look at your receipts and disbursements on a daily basis.
  
  
• Know how much cash you have in hand and how long it would last if the money suddenly stopped coming in.
  
  
• Know how much working capital you will need for the next one, three and five years.

While watching the daily cash flow is essential for survival, Zaepfel also cautions against overlooking the long term. "As companies grow, they tend to outgrow their people, systems and cash," he explains. "You can fix the first two, but running out of cash will put you out of business. For that reason, you have to understand how much cash you will need to grow the business and plan accordingly."

To improve your cash flow, say our experts:

• Collect your receivables on time.
• Negotiate better terms for your payables.
• Work to increase inventory turnover.
• Work to increase sales of high-margin products.
• Use performance-based compensation.

Improving Your Financial Management Skills

To take your financial management skills to the next level, our experts recommend several tracking tools and financial management practices.

Tracking tools:

• Best financial tool. This three-page report includes summary information from the income statement, balance sheet, and cash flow statement for the month-ending, year-to-date and full calendar year. The page with the income statement summary also includes a reforecast for the full year. According to Kramers, the best financial tool causes you to look at the income statement, balance sheet and cash flow statement at the same time, which gives you a quick 30,000-foot snapshot of the company. More important, it allows you to see what the rest of the year will look like before it happens and take appropriate action as necessary.
  
  
• Four charts "cause-and-effect" tool. This tool combines four charts on one page to give a quick overview of selected key indicators. It also enables you to better manage critical indicators by tracking and managing the activities that cause those indicators. For example, suppose you want to improve pre-tax earnings. First identify what causes pre-tax earnings (i.e., net sales, gross profit margin percent and operating expenses as a percent of sales). Next, track these indicators (along with pre-tax earnings) using a trailing 12-month chart. Finally, combine all four charts onto one page. By tracking and managing the three "cause" indicators, you will automatically cause pre-tax earnings to go up.
  
  
• Sustainable growth rate. This tool involves figuring out how fast you can grow without running out of cash or damaging the balance sheet.
  
  
• Z-score. The Z-score gauges how near or far a company is from bankruptcy at any given point in time.

Best practices:

• Track "dissatisfiers." "One of my members tracked late deliveries with gross profitability and found a high correlation between the two," says Waring. "When he delivered on time, his customers were happy and he could get a great price. When his on-time delivery rate slipped, so did his margins. He built the company around on-time delivery and he gets the margins he needs to stay profitable."
  
  
• Defend yourself! Present and defend your pricing strategy and your capital strategy (debt versus equity in the business) in your TEC group. Have your fellow members ask questions and challenge your thinking so that you get the absolute best pricing and debt-to-equity mix in your business.
  
  
• Continually improve your reporting process. The goal with financial reports is to modify and improve management behavior. Have your financial people continually look for new ways to help you see what you don't see.
  
  
• Don't buy into seasonal business cycles. When conducting financial planning, don't automatically succumb to the seasonality of your business. Instead, look for ways to increase your slice of the pie. "If you have less than 50 percent of the market, the issue is market share, not seasonality," argues Fleisher. "I'm not suggesting to expand your business at all costs. But if you can create a reasonable action plan for increasing sales, there's no reason to pull in your horns just because competitors are pulling in theirs."
  
  
• Translate all financial plans into action plans. Turning financial goals into reality requires action plans. Never create a financial plan unless it also includes specific action plans for who will do what by when.
  
  
• Improve your forecasting skills. In the public market, missing your forecast can cause your stock to take a nosedive. In a private company, it can cause you to spend money ahead of time or commit to long-term capital expenditures that place an untenable burden on the business.
  
  
• Use extra care when hiring financial people. Never rush through the hiring process for a CFO or controller. Take the time to interview in-depth and check references carefully. Don't assume that because someone has the background or credentials it automatically qualifies them to do the job.
  
  
• Run your business like you're preparing it for sale. Constantly strive for a stronger, healthier balance sheet and an ever-increasing return on equity.

According to Zaepfel, a TEC Chair as well as a speaker, your TEC group can serve as a powerful ally in developing your financial management skills. It all starts with a willingness to share the numbers and hold each other accountable. TEC groups use a variety of formats for sharing the numbers, including:

• Reviewing financials with the chair in one-to-ones
  
  
• Having the host give an in-depth financial update each month
  
  
• Posting key indicators on a flip chart at the start of the meeting, with any strongly negative numbers going on the agenda for discussion in the afternoon
  
  
• Quarterly, biannual or annual all-day executive sessions to review financials
  
  
• Group retreats devoted to an in-depth look at everyone's numbers

This represents only a partial list. The key is to find a format that you and your group will use on a consistent basis.

"Design your own financial management 'instrument panel' -- the five to ten indicators that really drive your company -- and never take your eyes off it," advises Zaepfel. "Ask your fellow members, 'If you were running my business, what indicators would you watch?' Then use their feedback to refine your design and develop an instrument panel that gives you a highly effective early warning system."

Don't Shoot Yourself in the Financial Foot

In today's markets, it's tough enough to turn a profit even when you do things right. To avoid making things harder on yourself, our experts recommend steering clear of several common financial management mistakes.

• Poor cash flow management
• Having the wrong mixture of debt and equity in the business
• Failure to plan
• Absence of timely and accurate business records
• Inability to read and understand financial statements
• Lack of knowledge of costs
• Failure to renegotiate bank relationships
• Failure to understand what causes results
• Failure to see the big picture

Ernest Hemingway once wrote about a character who, when asked how he went bankrupt, responded in the following manner: a little bit at a time and then all of a sudden. That, says Kramers, is the financial management mistake most CEOs make.

"Running out of cash is the best example," he relates, "because everyone has done it at one time or another. You don't pay attention, you don't see the big picture, and the cash dribbles out a little bit at a time. All of a sudden you look up, the cash is gone, your bank is firing you and you're in a total panic. You have to put in place the tools that allow you to see the big picture. Otherwise, you'll end up just like Hemingway's character -- except in real life, not in fiction."

Contributing Experts:

Ron Fleisher

Ronald Fleisher is president and CEO of Creative Bottomline Solutions Inc., a consulting company specializing in improving employee performance and company profits. He has worked for both small companies and major corporations including Sears and Dayton Hudson. Fleisher has been the president of several companies and now serves on the boards of four companies. He has been a member of The Leadership Mastermind Group, an international think-tank of business leaders whose mission is to define and advance the art, science, and practice of leadership. A former TEC member in Atlanta, Fleisher has given more than 200 TEC presentations on the subjects of negotiations, compensation and financial management.

Kraig Kramer

Kraig Kramers is president of Corporate Partners Inc., a leading business-acceleration consulting firm, based in Atlanta. He coaches CEOs on rapid, profitable growth of their businesses using success tools he has proven personally as CEO and with hundreds of other chief executives. Kramers has been CEO of eight different businesses in widely diverse industries. He has negotiated more than 70 acquisitions, served on three-dozen boards of directors/advisors, and consulted with hundreds of companies. In addition, Kramers is a nationally acclaimed business speaker, offering audiences a unique view of what makes companies, managers and leaders successful. His topics include business tools that dramatically accelerate profitable business growth, tools for conducting acquisitions that work and ways to strategically position companies for success. A TEC member in Atlanta for more than a decade, Kramers is also a member of the prestigious "TEC 200 Club."

Glenn Waring

Glenn Waring is president of EffectiveOrganization.com, a company dedicated to increasing understanding of organizations through its Web site at www.effectiveorganization.com. A C.P.A. and M.B.A. instructor, Waring spent 20 years in two Fortune 100 corporations, where he served as vice president in several capacities, including CFO. In private practice since 1992, Waring works with medium to large organizations to build clarity around what needs to happen to make them truly effective. He presents financial management seminars throughout the U.S. and Canada, and serves on the boards of several companies. A popular TEC speaker, he has given more than 150 TEC presentations on the subject of "Effective Financial Management." He also chairs two TEC groups and a KEY group in Columbus, Ohio.

John Zaepfel

John Zaepfel is CEO of the Zaepfel Group, a Newport Beach-based consulting and investment firm that helps companies design and implement strategy, improve their competitive advantage and build transferable value. He has 15 years experience as a hands-on CEO. In addition to his current consulting practice, he chairs two TEC groups in Southern California and sits on the boards of 19 different companies. A TEC speaker for more than a decade, he currently addresses TEC groups on "Managing by the Numbers," and "The Board: Effective Utilization of the External Viewpoint."

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