A note on Finance Essentials for Directors

Companies around the globe have been working to create high-performance boards made up of directors with diverse backgrounds, not necessarily in finance. However, since accounting and finance drive a significant portion of the strategic decisions that boards make, directors need, and are expected to have, a strong grip on finance and accounting to be effective.

This short note is aimed at board members who are not financial specialists. It provides an essential foundation in finance and accounting from a board-level perspective by showing board directors how to interpret financial reports, read between the lines of financial statements, implement the desired capital structure, apply valuation techniques, make better merger and acquisition (M&A) decisions and oversee risk. A list of sources with more details is provided at the end of this note.

Directors who are well versed in finance are better able to understand what drives a company’s performance, obtain the most from its value drivers and foresee the likely strategic outcomes of board decisions. They also find it easier to resist management fads such as financial and accounting engineering and excessive borrowing as well as avoiding M&A pitfalls that could destroy the company’s value. Instead, they are better equipped to make wise decisions that create long-term value.

Reading financial reports

The purpose of financial statements is to show where the company’s money came from, where it went, and what the situation was at a particular point in time. While board directors are not responsible for producing accounting documents, they are required to approve them, so they must be able to decipher them and detect potential problems. In this section we describe the main elements of corporate financial reports and how to analyze them in a meaningful way.

The main elements of corporate financial reports

Balance sheet

A balance sheet summarizes what a company owns and owes at a specific point in time and provides detailed information about its assets, liabilities and shareholder equity at the end of the reporting period. It does not show all the flows into and out of the accounts during the period. The following formula is the most fundamental principle of accounting and reflects double-entry accounting as the modern process for ensuring consistency in accounts:

ASSETS = LIABILITIES + EQUITY

In other words, the left-hand side of the balance sheet reflects what the organization invests in (the assets) and the right-hand side how it finances itself to fund these assets (the liabilities – notably debt and equity). Overvaluation of assets and undervaluation of liabilities are classical elements of financial fraud, and board members should pay particular attention to these.

Income statement

The income statement (also known as a profit and loss statement) shows how much money a company earned and spent over a specific period. At the top is the income (revenue) from the sale of goods or services, also referred to as the “top line.” Next come the various costs or operating expenses, which are deducted from the income to arrive at the net income (net profit), also referred to as the “bottom line.” The bottom line does not necessarily correspond to the actual amount of money made, because some costs – such as depreciation – are notional amounts (i.e. “non-cash items”) that do not affect the cash position directly. Additionally, some items on the balance sheet are not reflected in the income statement even though they affect the cash position. These include working capital elements such as inventories, accounts payable (i.e. amounts owed to suppliers) and accounts receivable (i.e. amounts due by customers).

The income statement can be set out in two ways. In the single-step method all costs are listed together in one step. In the multi-step method costs are deducted in multiple steps with certain costs grouped together to arrive at intermediary results, such as earnings before interest and tax (EBIT) or earnings before interest, taxes, depreciation and amortization (EBITDA), then deducting depreciations, amortizations, interest and finally tax to arrive at the bottom line.

Cash flow statement

A cash flow statement reports a company’s inflows and outflows of cash. It shows whether the company stayed positive or negative based on cash flow exchanges with other companies over a specific period. This is important because a company needs to have cash on hand to pay its expenses. It is crucial to understand that profits do not correspond to cash. Indeed, depreciation affects profits but not cash while working capital or capital expenditures affect cash but not profits directly. Thus, a good approximation of the cash flow is to add back depreciation and amortization to the profits and to subtract the changes in working capital and capital expenditures.

Whereas an income statement indicates whether a company made a profit, a cash flow statement reveals whether it generated cash. Profits can be notional, but cash is a more substantial economic reality. The cash flow statement shows changes over time and absolute amounts at a point in time and is thus a strong indicator of the health of an organization. Board members should scrutinize cash flow statements carefully because they correct the accounting distortions of income statements to provide a more realistic measure of whether the organization is making money.

Useful ratios for analyzing operating strategies and their success and failure

Ratios are used to turn accounting data into valuable information that allows directors to make sense of operating details, measure progress toward goals, and benchmark performance against competitors within an industry. Shareholders, bankers, regulators and analysts also use ratios to measure a company’s success or failure. Directors thus need to receive regular reports and use financial ratios to monitor the company’s progress. Different ratios reveal different results but they are all based on elements found in the financial statements.

Growth ratios

Organic or internal growth stems from a deliberate strategy, from the natural growth of the market, by creating new markets, or by developing new products. External growth occurs entirely through acquisitions.
Sales growth is the percentage of growth in sales from one period to the next. The ratio used to calculate this is:

Compound annual growth rate (CAGR) = (“ending value” ⁄”beginning value” )^(“1″ ⁄”number of years” ) “-1” 

Profitability ratios

Profitability ratios are among the most commonly used and important accounting ratios. They measure the company’s performance in terms of generating profits. Of course, profits are more meaningful when they require fewer assets (and thus cost less capital) and even more so when they require fewer sales. Thus, profits are typically related to other financial statement items.

Below are some simple, commonly used ratios:

Return on invested capital (ROIC) = (EBIT*(1 – tax rate))/invested capital
Return on equity (ROE) = net income/shareholder equity
Return on assets (ROA) = net income/total assets
Profit margin = net income/sales
Gross profit margin = (sales – cost of goods sold)/sales
Earnings per share (EPS) = net income/number of shares

If we consider that assets = debt + equity, then the ROE and ROA can be inferred from each other once the company’s leverage (debt level) is known.

Operating efficiency

Operating efficiency drives profitability just as much as the margin does. A good measure of efficiency is the asset turnover, i.e. the amount of sales generated per $1 of assets.

Asset turnover = sales/assets

These ratios typically relate to each other. One well-known relation is the so-called DuPont decomposition:

ROA = margin × asset turnover

In other words, the return on assets is driven equally by the margin (here net income/sales) and efficiency. Thus, a 1% efficiency gain is equivalent to a 1% margin gain.

Leverage ratios

Leverage ratios show the extent to which a company relies on borrowing to finance its operations. A high leverage ratio may increase a company’s exposure to solvency risk and business downturns, but this higher leverage also means higher returns for equity holders.

Debt ratio = total debt/total assets
Debt-to-equity ratio = total debt/equity
Interest coverage ratio = EBIT/financing costs

Liquidity ratios

Liquidity ratios demonstrate a company’s ability to cover its current obligations. In other words, they show the availability of cash and other assets to pay all the bills on time.

Current ratio = current asset/current liabilities
Quick ratio = (current assets – inventory)/current liabilities

Many other ratios are of course possible, notably for operations and client engagement. For example, a large proportion of manufacturing defects is an indicator of whether an increase in the number of customer complaints and returns can be expected, which can ultimately hurt the business.

Directors should be concerned about retaining customers. A company loses its advertising and marketing investment when an increasing number of customers are dissatisfied and go elsewhere. Directors need to know what the company’s customer churn and retention rates are.

Constantly hiring and training new employees is expensive and can have a negative impact on a company’s image so directors also need to know what the company’s employee churn rate is.

Reading between the lines of financial statements

What the management might seek to hide and what auditors look for

Sales manipulation

Sales are vulnerable to misrepresentation. Common ways of manipulating sales include recording sales before they have actually been earned or making up sales that do not exist. The timing of the recognition of sales (and expenses) is also a key issue, and a classic manipulation is to record deliveries to storage owners, dealers or independent representatives as sales.

Expense manipulation

Capitalizing expenses refers to spreading the cost of something over multiple reporting periods instead of expensing it entirely in the period in which the expense occurred. One form of manipulation is to deliberately manipulate the way in which expenses are booked, for example by “capitalizing” rather than “expensing” normal operating expenses. Other methods include recording current expenses in a future period to boost current earnings, or booking future expenses in the current period to create a “bottom” so that future earnings appear to have increased.

Incorrect asset valuation

Inventory, fixed assets and accounts receivable may be overstated to inflate company assets. This may include not recording the full cost of raw materials, not writing off inventory that cannot be sold, or misreporting the current inventory. Failing to record the depreciation of fixed assets is also considered a form of fraud.

Hidden liabilities

Manipulating liabilities includes failing to record accounts payable or not including certain liabilities on the balance sheet. Complex related-party or third-party transactions do not usually add value but can be used to conceal debt from the balance sheet. The omission of warranty and product liability could also be a way of concealing debt.

Improper disclosures

Misrepresenting the company and making false representations in press releases and other company filings are all referred to as improper disclosures. Some might be intentionally confusing and incomprehensible. Others may involve deliberately dissimulating significant events or management fraud or changing the accounting policy or the auditors.

Identifying red flags in financial statements

Directors should be vigilant about anything in a company’s financial statements that raises a red flag. Below are some important red flags to look out for.

• Overly high leverage ratios indicate that the company is taking on too much debt. If this is accompanied by falling sales and margins, the company may not be in a sound financial situation. In cyclical companies this combination is of huge concern.
• Several years of declining sales will cause a company to lose its long-term growth momentum. Although cost-cutting could help improve profitability, if sales do not pick up, the company should consider revisiting its growth strategy.
• A sudden and unexplained increase in sales, as well as sales to unknown entities and sales made through complex transactions, should also be thoroughly checked to ensure that revenue figures are not being manipulated. Between 1996 and 2000, Enron’s sales increased by more than 750% from $13.3 billion in 1996 to $100.8 billion in 2000, an annual expansion of 65% that was unprecedented in any industry. Enron’s financial statements were confusing and complex and it had reportedly been misrepresenting its earnings and “modifying its balance sheet to indicate favorable performance,” which eventually brought about its downfall when the fraud was discovered.
• Conversely, a trend of declining profit margins could mean that the management is sacrificing profitability for growth. Although an economic downturn can naturally lead to lower margins, companies need to maintain healthy profit margins to cover their operating expenses and the costs of delivering products and services.
• If a company’s management proposes to extend the period of time over which assets are depreciated, directors should question the reasons for this. Reducing depreciation expenses can artificially boost profits. Waste Management employed such a fraud scheme when it extended the duration of the depreciation of its physical assets. Such schemes may involve additional tricks to manipulate other accounting rules.
• Items marked “other” (e.g. “other expenses,” “other assets” or “other liabilities”) should be closely scrutinized by directors, particularly if the percentage value of these items is high in relation to the whole business. Directors should find out exactly what they are, how often they occur and why the management does not specify them clearly. Are the managers hiding secrets? Companies can also hide problems under categories such as “restructuring,” “asset impairment,” “goodwill impairment” and so on. Expense trends that are inconsistent with previous periods could signify that expenses are being manipulated and should thus also be investigated.
• A simultaneous increase in both sales and customer returns could indicate that management is manipulating sales figures with “bill and hold sales.” In this case, the company creates the perception of a sale by billing a customer but not shipping the goods, then reporting a customer return in the following accounting period. This allows the management to report higher sales in the current period. Directors should thus thoroughly look into the reasons for such occurrences.
• Growing sales coupled with a stagnating cash flow points to another accounting anomaly. A shortage of cash could indicate rising accounts receivable or inventory, meaning that cash is tied up in customers or stocks. This signals poor management, in particular the inability to forecast demand and manage the supply chain.
• Cash flow is difficult to manipulate and is therefore a good indicator of a company’s state of health. An unsteady cash flow could signal accounting tricks such as capitalizing purchases instead of expensing them, as explained above. Capitalized costs are costs that have been spread over several years rather than being reported entirely in the current year, leading to overstated assets and income. This is the fraud scheme that WorldCom used to fake its strong performance – until it went bankrupt in 2002.

Implementing the desired capital structure

One of the board’s key responsibilities is to ensure that the company is sufficiently funded to achieve its business objectives. The capital structure often depends on the availability of internal funds and the company’s risk appetite. A firm can choose from many different capital structure possibilities. If it opts for external capital, it can choose which instruments to use. The two main sources of external financing are equity and debt.

Equity

A company is generally formed by investors subscribing for shares in return for a slice of ownership in the company. When it generates a profit, the directors may decide to pay a dividend to the shareholders. Profits retained can be used to fund future growth or future dividend payments. From the company’s perspective, equity funding is relatively low risk because the company is not obliged to return the funds invested or to pay dividends.

Stock markets allow investors to buy and sell shares in publicly traded companies and thereby own a slice of one or more companies, with the potential for gains based on the future performance of those companies. For companies, stock markets provide access to capital. The stock market can be split into the primary market, where new issues (i.e. initial public offerings) are first offered, and the secondary market, where subsequent trading takes place.

Debt

Debt is money borrowed from others. It has to be repaid over time or at maturity, usually with interest. A company that uses debt financing will pay lower taxes in many jurisdictions. Debt financing has other advantages such as being less expensive and involving no dilution of shareholder interest. However, it usually has covenants attached that require the company to agree to certain conditions, and a large amount of debt can burden the firm and cause financial distress. Debt is thus the origin of credit risk, and indeed a substantial risk for many organizations, and suppliers, clients and partners need to keep a close eye on it.

Some debt instruments such as corporate bonds can be bought and sold by investors on credit markets around the world. This market is referred to as the debt, credit or fixed-income market. Debt markets are much larger than the world’s stock markets.

Understanding valuation fundamentals

The discounted cash flows (DCF) method is a way of assessing, in present value terms, a sequence of net cash flows over time, taking into account the cost of financing (or any given discount rate).

Estimating cash flows

The most common valuation method is the free cash flow to the firm (FCFF) method. By discounting all the cash flows over the life of the project or company, it is possible to determine the current value of a project or company.

FCFF = EBIT*(1-tax rate) + depreciation and amortization – annual change in working capital– capital expenditure required by the project each year

An equivalent expression is:

FCFF = net profit +interest expense – tax shield on interest expense – annual changes in working capital – net capital expenditure

Note: net capital expenditure = capital expenditure – depreciation and amortization.

Cost of capital (or weighted average cost of capital, WACC)

The cost of capital is the weighted average cost of equity plus the cost of net indebtedness after tax, weighted relatively according to the debt/equity ratio of the capital employed. For example, 75% of the capital employed in a company is equity and 25% is debt. If, in addition, the cost of equity is 13.33% and the cost of debt adjusted for tax is 6% in the same company, then the cost of capital is {(13.33 x 0.75) + (6 x 0.25)}% = 11.5%.

Net present value

How can a business determine whether a new project is financially feasible? The net present value (NPV) is the most-used method for valuing a project or company:

The NPV compares the initial costs of a project with the total value of the future cash flows from that project. Because future cash flows are not worth the same amount as cash earned today, a discount rate is applied to the future revenue, allowing the company to compare future revenue of the project in question with initial investments.

Real options

The real options method is a way to value flexibility, future opportunities, rights and abandonment options in investments. Based on mathematical option-pricing methodologies, it does not rely directly on discounted cash flow methods. It can bring valuable insights when contingencies make DCF methods difficult to use.

Market multiples

A comparable company analysis is a process used to evaluate the value of a company using the metrics of other businesses of similar size in the same industry. The assumption is that similar companies will have similar valuation multiples. The method requires reviewing a list of available statistics and calculating the valuation multiples for comparison.

Making better M&A decisions

Ensuring synergy in M&A deals

Synergy is defined as a state in which two or more things work together to produce an effect whereby “the whole is greater than the sum of its parts.” Good reasons to go ahead with M&As include reducing costs and increasing capabilities, market pricing power or product offerings. Despite many successful cases, M&As are sometimes pursued just because leaders want to build empires and boost their individual egos, regardless of whether synergies exist. Directors therefore need to undertake a rational analysis to determine if a proposed M&A is justified.

The key decisions in M&As

First, a strategic rationale is needed for the M&A to be successful. The M&A should be designed to increase the company’s scale and scope, by redefining the business and industry to achieve a long-term competitive advantage. The rationale must be clearly communicated to the stakeholders.
Second, risk analysis is necessary. There is no doubt that acquisitions can offer growth opportunities, but they are, by nature, complex and prone to risk. When considering an M&A strategy, opportunity often comes with risk and uncertainty.

Third, due diligence is crucial – pre-merger planning needs to include a formal review of the targets and an evaluation of the culture, organizational fit and other non-financial elements. The price paid and the financing ought to be appropriate and beneficial. Pre-merger planning could include key integration processes, coordinated decisions, efficient communication, marketing planning and targeted milestones. Active management is essential to achieve these milestones and ensure the success of the M&A.

Fourth, deal negotiation, pricing and structuring are fundamental. Taking great care to avoid overpaying is at the heart of a good acquisition.

Fifth, merger integration should include the new company design, including human resources, technical operations and customer relationships, and it should be completed quickly.

Finally, a post-integration analysis should be carried out to review the post-acquisition integration. How successful was the acquisition? Have the strategic goals been achieved? What lessons have been learned in the process to improve the success of the next deal? Ideally, this step should be planned at an early stage in the deal negotiation.

Lessons learned regarding M&As from empirical studies

• Larger companies and those that are cash-rich typically make bad deals, and private companies make better deals than public ones.
• Size matters. Acquirer announcements are negatively related to company size. The returns are more negative if the deal is large relative to the size of the acquirer. It usually leads to integration issues later.
• Mergers that focus on the core activity increase shareholder value, whereas diversification typically destroys value.
• Payment methods make a difference. Cash payments are positive for the acquirer, whereas stock-for-stock exchanges bring lower returns to the acquirer.
• M&As between companies with greater cultural differences are less successful. Cultural conflicts lead to managerial issues in the combined company.

Overseeing risk

Regulators and other stakeholders have pushed boards to oversee risk more actively. Failing to manage risk properly can threaten the board’s reputation. Through their risk oversight role, directors can decide upon the company’s risk appetite, design its risk policies and procedures, and monitor the management’s implementation of the policies. Grasping the risk-related language can help board members to communicate better. Below are a few important definitions that give a good sense of these terms:

• Arbitrage: The purchase of one security and the simultaneous sale of another to give a risk-free profit. Some professionals also call arbitrage the purchase and sale of two securities that are similar but have risks that do not cancel out.
• Basis risk: The residual risk that results when the two sides of a hedge do not move exactly together. Basis risk is at the heart of optimal hedging theories such as minimum variance hedging and the failure of hedges. It is thus important for board members to supervise this when an explicit hedging program is in place.
• Break-even analysis: Analysis of the level of sales at which a project would just break even.
• Call option: An option to buy an asset at a specified exercise price on or before a specified exercise date. They exist on financial instruments (stocks, currencies, etc.) as well as on commodities.
• Correlation coefficient: A measure of the closeness of the relationship between two variables. It consists of the ratio of the covariance to the product of the standard deviation of the variables.
• Decision tree: A method of representing alternative sequential decisions and the possible outcomes of these decisions.
• Derivative: An asset with a value that derives from another asset. Major derivatives include futures (traded on exchanges), forwards (traded over the counter), swaps, options and credit derivatives.
• Hedging: Buying (or owning) one asset and selling another to reduce risk. A perfect hedge produces a riskless portfolio. The differences between the asset to hedge and the hedging instruments as well as changes in the time horizon make perfect hedges extremely rare.
• Future: A contract to buy a commodity or security on a future date at a price that is fixed today. Unlike forward contracts, futures are generally traded on organized exchanges and are marked to market daily.
• Market risk (systematic risk): Risk that cannot be diversified away. The capital asset pricing model (CAPM) measures an asset’s exposure to systematic risk via the beta coefficient.
• Monte Carlo simulation: A method for calculating the probability distribution of possible outcomes, for example from a project.
• Moral hazard: This occurs when one party takes more risks because another party bears the cost or consequences of the risk (as in the case of subprime loans), or one party’s behavior changes to the detriment of the other after signing an agreement.
• Normal distribution: A symmetric bell-shaped distribution that can be completely defined by its mean and standard deviation.
• Risk appetite: The level of risk that an organization is willing to take. It often reflects the management’s attitude to risk, so it is a good idea for board members to keep a close eye on this.
• Sensitivity analysis: Analysis of the effect on project profitability of possible changes in sales, costs and so on.
• Spot exchange rate: The exchange rate on currency for immediate delivery.
• Spot interest rate: The interest rate fixed today on a loan that is made today.
• Spot price: The price of an asset for immediate delivery (as opposed to the forward or futures price).
• Standard deviation: The square root of the variance – a measure of variability.

Conclusion

It is crucial for board members to be financially literate to efficiently and effectively oversee a company’s activities and make the best decisions. The board is responsible for the integrity of the firm’s financial reports, so its members need to carry out more analyses and interpretations of financial statements. When a company is making a decision on financing, the directors must ensure that both shareholders’ expectations regarding their return on investment and bondholders’ expectations regarding repayments are carefully managed. The desired capital structure should balance the pros and cons of each financing alternative.

Understanding valuation fundaments helps directors make better M&A decisions. Although board directors should not be involved in the day-to-day risk management, they should be able to communicate in “risk language” as this will send the message that risk management is an integral component of governance.

Didier Cossin is Professor of Finance and Governance at IMD and director of the IMD Global Board Center. He directs High Performance Boards, a program for supervisory board members and chairpersons.