According to entrepreneur Mike Southon, “The main reason for a company failure is running out of cash, and every financial expert I have met bemoans entrepreneurs’ reluctance to address the problem earlier in the process.” [“Sometimes cash flow is king,” Financial Times, 18 October 2010]. In past posts, I have discussed how difficult and time-consuming raising working capital can be [see, for example, my posts entitled Through the Looking Glass: Two Sides of Start-Up Financing, Part 1 and Part 2]. Raising money, however, is only half the battle. Once you have the money you need to mind it carefully. Southon insists that there are “simple steps [that] can be taken to avoid later catastrophe.” The best step, he explains, is to hire someone who is good at handling money. He writes:
“Just as many successful entrepreneurs are dyslexics, many also have a similar blind spot with regard to money. … If you want to scale your business, hire someone who has an in-built understanding of cash flow. They might be a qualified bookkeeper or accountant, or simply someone who has no personal debt other than a modest mortgage and whose wallet contains debit, rather than credit cards. These people are comfortable in recessions as they always have cash rather than debt. A good finance person is worth their weight in gold, and will use spreadsheets and other instruments of torture for the average entrepreneur to make sure that the great idea also makes money over time.”
Entrepreneur and venture capitalist Luke Johnson agrees with Southon that hiring the right person to handle your finances is critical if you want your business to grow [“Custodians of finance make the difference,” Financial Times, 18 January 2011]. Hiring the wrong person, however, can be disastrous. He writes, “The weak link in many failed companies is the finance director. Better custody of borrowed or invested money by them would so often have prevented disaster.” Johnson goes on to discuss what he calls “classic” Financial Director (FD) or Chief Financial Officer (CFO) “lines” that should sound alarms when spoken. He acknowledges that he is “indebted to John Dewhirst of Vincere, the turnaround specialists, for collecting” the lines.
“‘I don’t do cash forecasts. I’ve never found them useful.’ A lack of focus on cash is perhaps the greatest sin. A finance professional who does not prepare reasonably accurate projections of liquidity on a rolling basis is guilty of a dereliction of duty. Often FDs drop such nitty-gritty as they ascend the ranks, while some have historically enjoyed a cash cushion and never felt the pressure. They are the ones exposed when conditions deteriorate.”
On that point, Southon and Johnson are in complete agreement. Johnson continues:
“‘Sure we’ve made some losses but look how much we’ve grown turnover.’ Finance directors should not be sales directors. Their role is to think about risks and funding. Of course they must possess an all-round understanding of operations, but their core task is to be the numbers expert. They are the conscience of the company, worrying about the financial statements, not the latest brochure, showroom or advert. They are the ones who should argue against taking on unprofitable business, or working with customers who might not pay.”
Your FD or CFO is charged with minding the money not growing the business. He or she should be the conservative voice in your head that reminds you that money matters and that your future depends on being able to turn a profit. That thought segues into Johnson’s next warning line.
“‘I don’t know whether this customer account is profitable. What I do know is that we can’t supply them enough. They love us!’ A finance director who doesn’t understand the margins of a business byproduct and customer is falling down on the job. I have seen a number of companies go bust being busy fools, adding volume by discounting. The one person in the organization who should stand up to such madness is the FD. If she or he cannot do the analysis and provide the data to counter such folly they should be replaced.”
I’m reminded of the two would-be entrepreneurs who decided to go into the watermelon business. They bought a truck, drove it to the fields, and paid farmers a dollar per watermelon. They then drove back to the city and sold their watermelons for a dollar a piece. They soon realized that they weren’t making any money. At that point, one of them said, “I don’t get it. We’re selling all of our watermelons and should be getting rich. Maybe we need a bigger truck!” When your CFO recommends getting a bigger truck, put him on the old one and wave goodbye. Johnson continues:
“‘You just don’t understand our business. We’ve always done it this way.’ Complacency and laziness are enemies of a strong finance function. Every industry I have ever come across considers itself unique. But cash behaves the same no matter which sector. The best FDs understand about lifelong learning and are open to sharing ideas and new methods to discover best practice. The objective must be to improve their competence and the way a business runs. Poor FDs are secretive and deliberately obfuscate to hide ignorance or idleness.”
Although I’m from the conservative school when it comes to handling money, Johnson has a point about being open-minded to new ideas. Mike Michalowicz is certainly in favor of breaking old financial habits. In fact, he insists that Generally Accepted Accounting Principles (GAAP) are wrong [“How Entrepreneurs Can Fill the ‘GAAP’,” Wall Street Journal, 12 December 2010]. He writes:
“Replacing GAAP to track spending, enhance cash-flow management and assess the health of your company makes you a Galileo since you’re going against what ‘everyone knows.’ Just because something appears to be true and ‘everyone’ goes along with it, doesn’t mean it makes sense—and it doesn’t make it true.”
Michalowicz recommends something he calls Profit First Accounting. He explains:
“I propose a new type of accounting: Profit First Accounting (PFA). The difference between GAAP and PFA is simple: Deduct profit first, from the top down. On a PFA income statement, the first line item is revenue, followed by a profit deduction, then your salary, followed by cost of goods and all other expenses.”
I’m not convinced that PFA is an accounting principle that will lead to success; but Michalowicz insists that “there are many benefits to PFA, such as the ability to track growth in a consistent, proven pattern, which will appeal to investors and potential buyers should you decide to sell.” He concludes:
“But the best part is you will be in control of your costs from the get-go. Since your revenue will first go toward profit and then your salary, there will be less to spend on expenses. Many small-business owners determine how much they can spend based on the cash they have in the bank. The PFA method automatically forces frugality, since your profit is deducted every time cash comes in the doors.”
Michalowicz insists he has used the method for years with great success. Regardless of whether or not an FD uses Generally Accepted Accounting Principles (which I recommend), he or she must be intimately familiar with financial statements. Johnson continues with FD lines that should worry CEOs. He writes:
“‘I don’t actually prepare the management accounts.’ FDs who have risen to such grand heights that they are only interested in sexy things like mergers and acquisitions or investor relations are missing the point. They must take full ownership of the financial statements, and know them backwards. Their job is about detail and precision. Only by having such an intimate grasp of the information can they provide answers to the difficult questions.”
Having a good set of books is also important if you are trying to raise cash. Hiring an outside auditing firm can help you assure investors that the company is worth risking their capital on [“Audits Add Shine to Firms,” by Angus Loten, Wall Street Journal, 13 January 2011]. Loten reports:
“Small businesses whose books are audited—by a hired certified public accountant, not the Internal Revenue Service—improve their chances of getting a loan, and at far better terms, than businesses with less scrutinized financial statements, a new study shows.”
Loten admits that audits don’t come cheap; but, he insists, “the benefits might outweigh the costs.” He explains:
“Based on data from more than 10,000 closely held companies—about half of which have less than 500 employees—a study by the University of Chicago Booth School of Business found audited businesses save an average of $6,900 for every $1 million in outstanding debt every year as a result of lower interest rates, which were more than half a percentage point below rates paid by nonaudited businesses. For a loan of $3.3 million, the average size of loans analyzed in the study, the savings was about $23,000. … Similarly, a joint study last year by Michigan State University and Indiana University found small businesses with audited financial statements were ‘significantly less likely’ to be denied credit from banks.”
The most surprising thing that Loten reports was that “audited or not, less than a quarter of businesses with fewer than 500 employees keep financial statements of any kind, according to the Federal Reserve Board’s National Survey of Small Business Finances.” You simply can’t mind the money without good financial statements. Financial Directors and CFOs have critical roles to play. When they abandon those roles, a company can falter. No one likes to be the bearer of bad news, but a good CFO speaks plainly and factually about money matters. That leads to Johnson’s final FD line that should cause concern.
“‘The chief executive doesn’t like to talk about things like that.’ An FD needs sufficient strength of character to stand up to assertive individuals like founders. They must possess independence of mind and command enough respect within an organization that their views are heeded. They also need the confidence to listen to challenges themselves. In one company I part-owned, it was the financial controller who drew the board’s attention to a significant cash shortfall – the FD was in denial and had attempted to silence the whistleblower. Unsurprisingly, the FC assumed his boss’s job shortly thereafter.”
Johnson’s conclusion that “a great FD is a tremendous asset, but a bad one is a dangerous liability who can kill even a sound business” shouldn’t surprise anybody. But as Loten reported, in far too many small businesses nobody is minding the money. If that is the situation in your company, change it. Find a good accountant (full- or part-time) and start putting your enterprise on a firmer financial foundation.