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The Case for Automation & Internal Controls

Why do companies automate?  The answer is typically some combination of the following reasons:

  • Better Results, i.e. to provide a better product or service
  • Error reduction, especially reducing accidental human mistakes
  • Scalable – Need to address an ever-increasing number of transactions
  • Practical – Enabling the business to do something that is otherwise impractical
  • Reliability – Assuring continuing operations regardless of what is happening around it. The latter is particularly true in the age of pandemic.

These reasons involve automated process controls.  Yet when someone mentions internal controls, the knee jerk response is to push back, i.e. ‘we don’t want no stinking controls – ‘cause they take longer, chew up resources, interfere with business…’  You understand the argument.

Consider Amazon, arguably the most successful online retailer, at least in the US.  Amazon could not be the success it is without automation.  Key to that automation are the controls built into its systems to prevent a host of problems, such as offering to sell items it doesn’t have, mis-pricing items, selling items when credit card charges are denied, sending orders to wrong addresses, putting the wrong items in the box and so on.

The goal of automated controls is to provide assurance that the business operates in compliance with its standards and practices. An IT Audit is an evaluation process designed to provide that assurance.

The twin goals of IT Audit are the development of these controls and the confirmation that they are working as intended.  While this may seem straightforward, configuring the application software to work within these constraints and knowing how to confirm that the controls are operating effectively requires specialized knowledge and skills.

To this end, our firm through its network of associate firms has the ability to assess your business systems and confirm they are doing what they need to do.  If their operation is compromised, we will recommend changes to get the controls back on track.  If your controls are insufficient, we will suggest automated, or manual, controls to plug these holes.

In either case, our objective is to ensure your business is operating reliably and effectively in compliance with your approved standards. We are Your CFO for Rent.

This post was written by our valued partner, 
Jerald Savin, President and CEO of 
Cambridge Technology Consulting Group, Inc.

Noses in, Fingers out

That expression will be familiar to readers who have served on boards of directors or have had some board governance training. They will agree with it or not, often largely depending on their financial involvement. I was reminded of this axiom while reading a post from Dave Berkus, a very smart investor/educator I once interviewed for my print newsletter. It got my attention, thus this post.

The phrase, for those not familiar with it, refers to the role of board directors as they work with CEOs of the companies on whose boards they serve. The concept of “noses in” means board members need to monitor the company’s activities, to ask the hard questions about all those areas that impact the success or failure of their companies. The job of a director – whether in a public or private company, or even a nonprofit organization – is to try to make sure no surprises will either damage the company or cause it to lose an opportunity to be better. They do that by asking the questions, evaluating the quality of the answers, supporting the good responses and pushing back at the bad ones. But none of that implies they should burrow into the details of company operations and try to direct management actions and give orders to the management team. That’s the “fingers out” part.

The board has authority over the CEO. The CEO has authority over the management team. That authority gives the board the right to hire, evaluate and fire, if necessary, the CEO. They do not have that same authority over the CEO’s management team, or the actions of those team members. And that’s where it sometimes gets messy. Board members are often corporate leaders in their own right, and accustomed to having their expectations acted upon by those under them. It’s sometimes hard for them to keep in mind that they’re not in charge when they serve as directors. But it’s critically important they do just that.

On the flip side – there’s always a flip side, don’t you know – what if the answers to directors’ questions just aren’t right, or a situation has arisen that the CEO is clearly not prepared or willing to handle? If it involved outsiders – lenders, investors, regulators – the hands-off approach may expose directors to liability because of their responsibility to the company. Yet if they were in a “fingers in” mode when the situation came up, they may be deemed a part of the problem, and they could even find their D&O insurance less than supportive.

The best course of action for a director? Diligent review of the information you get; alert monitoring of company operations in support of approved strategy; and don’t try to be the backup CEO. And make sure your insurance is solid, just in case….

If Cash is King, What’s the King Doing Anyway?

Virtually every CEO or business owner knows how to read their company’s income statement – Revenue, then Gross Profit, then Operating Profit, then Net Profit. Many only look at the top and bottom numbers, some delve deeply into the details in between. But they all know that the bottom line doesn’t ever translate dollar-for-dollar into an identical change in their bank account, unless they’re the corner ice cream store that only takes cash (are there any of those even left on the planet?)

And yet there is a clear relationship between your net income and the net change in your cash balance. That relationship is described clearly on a routine report that every accounting system produces, but that most CEOs and business owners never look at. Its name, strangely enough, is the Statement of Cash Flow. OK, maybe that sounds a bit smart ass, but it has puzzled me for decades why this is still true in most of the small and middle market companies we see that don’t have a competent and communicative CFO or Controller. Or an aware and inquisitive board of directors or advisory board. If the ever-changing relationship between net income and net cash flow isn’t apparent by reviewing the company’s monthly reports, then the CEO’s choices are to:

  • ask for an analysis of the causes,
  • guess at the causes, or
  • review a statement of cash flow, which sets out those causes in a clear and standard format.

Duh.

Full disclosure: this report is admittedly not as simple to read as an income statement or a balance sheet. But that’s no reason to ignore the immense amount of valuable information it contains. At first some of the ins and outs of cash generation will give pause – how did the write-off of previously paid insurance or property taxes produce cash? But it doesn’t take long to get the relationships clear if you’re serious about it. And if you trend it over 6 or 12 months, Wow! Years ago we were engaged by a small aerospace firm run by brothers who didn’t even have a working cost accounting system in place when we met. But within a few months the brother who was not responsible for the front office was able to explain the cash flow statement to me instead of the other way around. And he didn’t even have the advantage of the excellent explanation outlined in Chapter 6 of my book.

If you’re running a company or any organization that is designed to produce a profit – or more likely, a positive cash flow – make this report an addition to your monthly financial package, and review it in at least the depth you devote to your other reports. If you do, you will soon appreciate its power to inform and guide management decisions. And you too will be puzzled that every CEO doesn’t get it.

We are Your CFO for Rent®

There’s Always a Good Reason to Spend Money

How many times has a member of your management team,  or a valued worker, come to you with a “great new idea” to help the company get better at something – a new machine that will shorten processing time, a new software service that will help you sell more products or services, or cut the cost of whatever? How many times has it delivered the promised results and been the best use of the money? And of course the idea is always presented with enthusiasm and reasons why it’s a great idea.

“Almost always” would be a phenomenal answer – and hard to believe. “Most of the time” would be a tribute to your team’s expertise and your leadership. “Almost never” would be a problem, and “I really don’t know” is a BIG problem, and the subject of this post.

Leaders can often see if a change delivers on its promise of doing something better. Processing time indeed shortened, sales indeed went up, etc. The second part is the tough one – was it the best use of the money? Very often ideas get implemented in the excitement of seeing improvements without taking stock of the total cost across the organization and comparing that with the net income improvement produced by the new shiny thing.

  • How much did it really contribute to the company’s bottom line?
  • How did its net profit improvement compare with a different idea that would have required the same amount of capital needed to carry out the idea you adopted?

The part of the decision making process that typically gets overlooked is the analysis that answers those questions. Of course if there is something that’s critically broken that must be fixed now, there’s no real opportunity for that hard look. You’ve got to fix it now. Understood. But let’s be honest: most of the time that’s not the case.

You see, there’s always a good reason to spend money. The question that’s harder to answer, given we all have limited resources, is the one that asks: Is this the BEST use of our money at this time, and down the road? Taking the time to do the analysis and answer that question, before giving the go-ahead, can be frustrating to the avid proponent of the great idea, but essential in doing what is best for the company.

Tools that are available to answer that question – besides reining in the boundless enthusiasm that you don’t want to discourage – include:

  • having your finance team calculate the Internal Rate of Return (see our post of October 22), based on the real Contribution Profit expected (see our post of September 3),
  • comparing it with what can’t be done elsewhere if the money is spent here and now,
  • determining if this supports the long term direction of the company (as outlined in your strategic plan, of course), and
  • assessing the likelihood that your management team can utilize the full effectiveness of the new idea, an assumption likely adopted without challenge by the presenter of the idea.

Your job as the leader of the team is to resist the urge to jump on the bandwagon until the idea has been fully vetted using the options list above. That’s how you build a great company.

Does Your Business Need a Loan?

For a small to mid-sized company, whether startup or emerging go-getter or well established company during a coronavirus era, it’s harder than ever these days to get a bank to lend you the money to build the momentum you need to succeed. Many banks are still afraid of the current economy and its implications for loan defaults. You will invariable get questions like:

  • How long have you been in business?
  • How much profit are you generating?
  • Do you have enough cash flow to easily make loan payments?
  • How reliable is your accounting?

Frequently, the answers to those questions are not the ones your bank wants to hear, but they are the very reason you need the loan in the first place. We had a client in just that position a few years ago. Our approach was to first take a look at the various borrowing options that are available to smaller companies. This was our list:

Type of Borrowing Duration of Loan Collateral Use Cost
Revolving credit line Credit line one-year renewable, but borrowing revolves indefinitely Accounts receivable, inventory, other assets owned, not pledged elsewhere Temporary cash needs; replacing the cash tied up in receivables and inventory until they can again become cash Low
Accounts receivable loan Credit line one-year renewable, but borrowing revolves indefinitely Accounts receivable Early access to cash tied up in receivables, similar to revolving credit line Medium
Factoring Invoice by invoice 30-90 days, revolving as new sales are made Accounts receivable Getting cash from receivables, passing on risk of collection to the lender High
Flooring One to three years renewable, but borrowings revolve indefinitely High-priced inventory, such as cars and boats Financing showroom inventory of items for sale, which are also the collateral

 

Low
Term loans Various annual terms depending on type of loan and life of asset financed—one to 30 years Various, from collateral being purchased to all assets the company owns Long-term purchases of assets or real estate or to provide capital for long-term projects to companies without adequate internal cash generation Medium
Equipment loans and leasing Three to five years, or longer, depending on life of the asset The asset being acquired, or refinanced in case of sale-and-leaseback Acquisition of large pieces of equipment or large amounts of equipment Medium to High
Bonds Variable, with lengths to 30 years and more None, although some are mortgage-backed and others are insured as to default Major long-term projects for large companies, including expansion and acquisition programs Low
Convertible debt Variable, with lengths to 30 years and more None, although conversion privilege adds value, especially in a good market Major long-term projects for large companies, including expansion and acquisition programs Low

We determined that the best option was a medium length term loan from a bank, the optimum compromise between cost and flexibility. Here was our approach:

  1. We hired a strong bookkeeper (temp-to-hire at first, then permanent) that could take direction and help us clean up the books and do some restatement of the past couple years.
  2. We engaged a CPA firm to perform a review of the most recent year, to validate that the books were now acceptably accurate and processes were in place to keep it that way.
  3. We helped the company develop a financial projection for a couple years into the future, using realistic costs, market pricing, and a defensible growth strategy (a strategic plan came later – for now the story was delivered verbally, helping to build rapport as well as tell the story).
  4. We invited a new banker to listen to the story, which was well structured and presented with a plausible path to success.
  5. Oh, and we convinced the founder to offer some of his personal real estate as added collateral for a limited time until the company could demonstrate the validity of its forecasts.

No question the collateral helped. But what got the job done was finding a bank that would listen to the story with an open mind, and then telling the story in a powerful and credible way. There’s a lot of money wanting to be put to work, You just have to convince the source that they can be certain it will get paid back. Hah, piece of cake.

The best description I’ve ever read

Ken Fisher, an investment advisor, just wrote an article that is the clearest explanation I’ve ever read describing the credit markets, why interest rates impact economic cycles, and how that affects stocks (value stocks in this case). You can get it from Ken HERE  or ask me to send you my copy. Great read from a guy who’s not only smart but understands how to speak in non-technical language. You gotta know I appreciate that. 

Understanding IRR – It’s Not Accounting 101

Every well-run company that is considering making an investment in new equipment, a new facility, upgraded technology, or a new product or development project, considers at some level what return it will earn on that investment. They will often calculate Return on Investment (ROI), Discounted Cash Flow (DCF), Payback Period, or Internal Rate of Return (IRR). Oops! Wait! Most of them get that last one wrong. Often a well-intentioned analyst will calculate ROI and call it IRR, maybe because it sounds more technical or more elegant or whatever. But the calculation and the information conveyed are very different. Look at these definitions:

Return on Investment – a comparison of the total amount an investment will earn over its effective useful life compared to the total cost of that investment, expressed as a percent of that total cost. A simple enough calculation if you have the correct numbers.

Internal Rate of Return – that rate of return, stated as a percent, at which the return on the investment and the cost of capital used to make the investment are at least equal, with both at present value. Put another way, it’s the discount rate that makes the net present value of all cash flows from a particular project equal to or better than zero.

Big difference, huh? ROI does not consider the cost of the capital used to make the investment, only the earnings from it. And, there is no comparison to the cost of the money, or the significance of the time value of money. So, some lessons you can draw from this: First, Never invest in a project with a net present value less than zero or a negative IRR. Second, you can’t decide on the first until you actually do the math.

Dashboard anyone?

Every company beyond the corner candy store – remember those? – has complexities to their business that management must be aware of in order to manage. How to maintain that awareness? Lots of ways, including touring your facility with regularity, getting special analyses from all the important departments (which is hopefully all of them, otherwise why are they there?) and quizzing your management team at regular staff meetings. All good ways to get the information, if it’s reliably delivered and you can keep it all in your head. Want a better way?

The literature typically calls them KPIs, or Key Performance Indicators. Whatever you call them, they should be collected and reported in your dashboard, a 1-page essential addition to your monthly financial reporting package (if not needed even more frequently). Ideally in graph or chart form for easy absorption, here are 5 ideas for financial KPIs you might want to consider:

  1. Current Ratio – Easily gleaned from your monthly balance sheet, this is a quick way of seeing if your current assets are enough to cover your current obligations. Any ratio close to 1:1 is a problem. If you don’t have inventories the equivalent metric is called the Quick Ratio. If you’re spending time pleading with creditors or bugging customers, this is likely why.
  2. Days Sales Outstanding – How much of your sales is still tied up in receivables? If your terms are 30 days and this number is 60, 75 or more, you have a collection problem.
  3. Inventory Turnover Ratio – How often does your entire inventory turn over each year? We all know the slower it moves, the sooner it dies. You’ll have to decide what is a good number for your company, but then track it and manage it to lower the fatality rate. Perhaps even by product category?
  4. Debt Service Coverage Ratio – If you have a bank loan, your bank almost certainly follows this, and requires it to be at a certain minimum. You should follow it too, especially if you’re in a low margin business. Don’t let your bank surprise you.
  5. Firm Order Backlog – How much business is on your books for future delivery? If you have to make what you sell, or buy it from overseas, there are lead times to consider. Not to mention the anticipated trend in sales in the upcoming months. If this is dropping, look out!

And now the kicker – your dashboard should chart each of these KPIs over time – for 6, 9, or 12 months, so you can see the trends developing before a leak turns into a gusher. Lots more details in Ch. 7 of my book if you want to read further.

Who needs a fractional CFO?

This is a question that often comes up as we get referred to CEOs who need help but aren’t quite sure if a non-employee relationship is a good idea, especially in the sensitive area of finance and accounting. Our firm offers several distinct services which can be valuable to many companies in the small to mid-sized revenue range. But in the interest of generalizing for clarity, a picture often really is worth a thousand words. Here’s the picture that tells the story best:

Again, just a generalization, but it has described nicely where most of our client assignments have fallen over the years, and the size of companies that have found the most value in what we do.  In recent years our services have proven valuable to companies up to $200M in revenues, but the most predominant need has been seen in the $5-75M range, and that continues today. Some of the areas in which financial management expertise is critical to the success of every business:

  1. Manufacturing cost control – do you know what each product really costs you to make?
  2. Banking relationships – are you really getting the best service and lowest rates from your bank? How do you know?
  3. Cash forecasting and budgeting – Do you know what your cash position will look like in 6 months, a year? Are you doing profit planning?
  4. Administrative cost control – Are you getting your money’s worth from the team that supports you?
  5. Employee benefits and regulations (including COVID) – A huge area for cost management and regulatory risk.
  6. Accounting and financial reports – Are you getting in usable form the information you need to make the best financial decisions?
  7. Business insurance – Do you have the right mix? The lowest premium from a reliable insurer? When’s the last time you checked?

Just something to think about…If you want to think about it with someone who thinks about this stuff every day, call us.

Why your business needs an advisory board and how to start one

This topic was the basis of an article written for the AICPA’s Financial Management magazine, and since they paid for it I promised not to publish it anywhere else. But they’d love for me to share a link to their publication, a win-win-win (the last one is yours). And since it was also well received by the Private Directors Association (well, by one if its founders anyway), The point of the article is valid regardless of who it came from.

Here’s the article:  AICPA FM Magazine

If this article brings questions to your mind, I didn’t promise not to answer them. 310.645.1091 or Gene@CFOforRent.com

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