Long Live the 'King'

Lately, I’ve had a number of conversations with board directors who feel they lack a strong financial background. They’ve expressed concern about their organizations’ financial metrics during these times. Specifically, they were wondering, “What are the forward-looking numbers we should be paying attention to?”

Today’s blog post sets out to answer that question. As a non-financial director myself, I reached out to some of the savvy directors in our network with the following question: “What budget line, metric or ratio do your eyes gravitate toward when prepping for your board meeting these days? What is getting your attention and what does it tell you?”

And I received a treasure trove of responses to share with you. Responses like …

“Cash is King … and Queen.”

“Tracking projected cash flow and managing balance sheet strength and liquidity is paramount - not only for survival, but for creating opportunity!”

I heard back from over a dozen board directors, many of whom serve as audit committee chairs or board chairs. Several are CPAs as well as CEOs, presidents, CFOs or Chief Investment Officers. I am grateful for their input and want to say thank you right up front. My goal for today was to synthesize all that great feedback and somehow condense it into one blog post – not an easy job!

If this topic interests you, I think you’ll find value in today’s edition of The Savvy Director™. Read on for more insights into key financial metrics during difficult times.

Your Revenue Sources

The pandemic has resulted in an unfortunate paradigm shift for many entities. Whereas in ‘normal’ times their goal is maximizing profitability ─ or maximizing impact in the case of not-for-profits ─ now their goal has become maximizing the likelihood of survival. Ironically, what has not changed is that the key to success, from a financial perspective, is still managing and optimizing cash flow.

“Nothing else matters if you can’t pay the bills.”

While revenue sources vary widely, cash flow concerns are common to all entities regardless of ownership structure or mandate. Let’s take a quick look at how many organizations generate top line revenue.

• Market-based ─ Your organization may be market-based, subject to the buy-and-sell rhythm of the free market, dependent on external customers – businesses or individuals ─ whose own financial health impacts their behavior. Cash flow inputs are generated by sales of products or services. If sales revenue dries up, there is generally no backstop outside of the organization’s own financial reserves, or its ability to assume debt.
• Government funded ─ Your organization may be government funded, such as a healthcare or human service provider or an arts organization, where having a good relationship with the funder is key. In this case, revenue will probably be relatively stable, unless government makes changes to funding due to political, economic or public pressure. If your government funder chooses to cut back, there are few if any options available to replace the lost revenue, making cost-cutting inevitable.
• Charities and not-for-profits ─ If your organization is funded by community foundations or private donations, there may be multiple revenue streams each with its own characteristics. As private donations have dwindled in the face of the pandemic, some foundations have stepped up to the plate to help fill the gap. A lucky few may have significant reserves to manage their cash flow needs from investment income as long as they keep costs in check.

The directors I contacted all told me the ability to successfully manage cash flow is the most important forecasting mechanism to guide the longer-term sustainability of the organization, especially during these exceptional circumstances. Yet, cash flow analysis is generally not something that directors routinely review or question.

Whereas cash on hand offers a snapshot at a point in time, cash flow is a dynamic concept that looks at the inflows (revenue) and the outflows (operating costs and other expenses) over a period of time.

A cash flow statement provides information about the changes in cash and cash equivalents of a business by classifying cash flows into operating, investing, and financing activities. It’s a key report prepared for each accounting period.

“People have come to realize that there are numerous things you can do to reduce outflows, but all of your inflows are somewhat beyond your control.”

Forward-thinking tools

Today we want to consider some forward-thinking tools that board directors can use to look ahead, to plan for various scenarios, and maybe even to build reserves that will enable the organization to ‘build back better.’ Understanding these tools should help to generate robust board discussions.

Projected Source/Use of Cash Statement. Also called a Flow of Funds Statement or a Statement of Changes in Financial Position, this is a listing of expected cash inflows and outflows for a given period, normally a month or a year. In lay terms, the projected cash flow statement really tells the picture of what management is projecting (and thinking!) It tells the board all the operating, financing, and investing assumptions that management is projecting, and the decisions they are making.

“The projected cash flow statement tells the whole story of the organization and its intended roadmap - all in one place!”

“Without projections, I’m just a rubber stamp.”

Questions to ask:

• What are the sensitivities and how might they impact the projected sources/uses of cash?
• What are the capital expenditures or capital allocation decisions that are inherent in the financial model?
• What are the financing options that underpin the financial model? Cash reserves? Bank line of credit? Raising cash by selling assets? Other? And what are the inherent risks to that kind of financing?
• What is the conclusion for the time period being examined (1, 3, 6, 12 months)? Are we constantly updating the projections?
• Are we expecting to generate or utilize net cash during the period and how might changes in any of the variables impact these levels? Do we have a sensitivity analysis to help us understand the impacts?

Financial Reserves. The reserves are a clear indication of the organization’s long-term health. Reserves can be used to support the business through short-term downturns and cash flow problems, but they need to be maintained at the appropriate level over time. One thing a board does not want to hear is that the business is no longer a going concern because its assets are depleted and its reserves are no longer adequate to weather the storm!

Question to ask:

• How many months of reserves does the organization have?

Sensitivity Analysis/Scenario Planning. A common response from our contributors was that that boards should challenge management to ensure cash flow is an integral part of all financial reports and projections. Sensitivity analysis based on a number of different scenarios is helpful to navigate the uncertainties of the current crisis, its depth and its duration.

Scenario planning can lead the board to consider strategies for dealing with whatever comes your way. Declining revenue can be captured in a worst-case scenario. Once a revenue stream starts to decline you are already behind the curve. If there are plans in place, you can pivot quickly.

Questions to ask:

• What is the monthly cash burn? What are the impacts in the various scenarios?
• What will our response be if this revenue stream declines by X percent?

Human Resources. Healthy, involved and safe supported employees are key. While not captured in the projected statement of cash flows, updates on how management is keeping employees safe, including managing through mental health aspects of the pandemic, help forecast potential impact in terms of absenteeism and utilization of sick days and disability benefits.

Negative (or positive) impacts on productivity include output/revenues per FTE or person-days/hours. Another important metric is the management of contingent liabilities through efforts to reduce vacation accruals and carryover.

Questions to ask:

• How are staff handling the situation?
• Has productivity increased or decreased and by how much?
• What is the turnover rate? How does it compare to prior to the pandemic?

Bank Lines of Credit and Government Support Programs. Many companies have survived by drawing cash from previously unused bank lines and/or access to government support programs. Credit lines can get used up and government support programs will eventually come to an end. Applying for government programs can be a complex process and some companies may lack the internal expertise to do so.

Questions to ask:

• Do we have enough cash flow to meet our debt service obligations? For how long?
• Is there still sufficient room to continue to fund the operation from the bank line of credit?
• Has the organization applied for all the government support programs it’s eligible for?
• When will government support programs end? What will the impact be?

Impacts on Cash Flow

Accounts Receivable. Revenue is not real until you collect it. If receivables are increasing, it’s a signal for concern. Management should pay attention to their customers’ ability to pay, and directors should be wary of optimistic projections when there are external indications that the industry is in trouble.

Average Days Receivable. Management should monitor and report on the aging of accounts ─ the average number of days for credit customers to pay their bills. An increasing average is cause for concern as it impacts cash flow negatively and provides further evidence customers are under financial duress.

Accounts Payable. You may expect your payables to grow. While the organizations does not want to damage key vendor relationships or miss out on early payment discounts, directors can still question management as to whether they have reached out to suppliers for extended payment terms that could improve the organization’s cash flow.

Inventory levels. If your organization produces or distributes hard goods, you might notice the company getting long on inventory. Old inventory inhibits positive cash flow. Directors might want to probe into whether inventory levels are rising without a corresponding customer demand.

Sales funnel indicators. For some organizations, sales metrics tell the most important story. These metrics are all about top line revenue generation that drives positive cash flow. Metrics surrounding the sales funnel – such as salespersons’ telephone and Zoom usage, incoming call volume, quotation requests, quotation close rates, social media post responses, and future order bookings – are items of interest to private companies with operating boards. All these have an impact on future cash flow from a cause and effect perspective.

“Any leading indicator I can get access too.”

Financial Ratios

Financial ratios are a useful way to analyze and understand the impact of the financial information in front of you. Here are a couple of the most important ones to monitor during this crisis, along with an explanation of how to derive them from the raw financial data.

If management is not already providing you with financial ratios regularly, consider asking for these if they are relevant to your organization.

Current Ratio. The current ratio, also called the working capital ratio, compares all of a company’s current assets (assets that are cash or will be turned into cash in a year or less) to its current liabilities (liabilities that will be paid in a year or less). The current ratio helps you understand the company’s ability to cover its short-term debt with its current assets.

Current Ratio = Current Assets / Current Liabilities

For example, a current ratio of 2.0 tells you that the company has two dollars of current assets for every dollar of current liabilities. On the other hand, a current ratio of less than 1.0 would tell you that the company does not have enough current assets to meet its current liabilities and some sort of response is needed.

Questions to Ask:

• Do we have enough short-term assets (cash and cash equivalents) to pay our bills?
• If not, how will that be addressed ─ reduced spending or increased debt?
• Can we afford to pay all short-term liabilities if required?

Debt to Equity Ratio. The debt to equity ratio (D/E ratio) is a measure of how much the company is financing its operations through debt versus wholly-owned funds. More specifically, it reflects the ability of the company’s total equity to cover all outstanding debts in the event of a business downturn.

Debt to Equity Ratio = Total Liabilities / Total Equity

A growing D/E ratio is accompanied by higher risk, as it indicates the company is taking on more debt. Taking on debt in order to grow or expand is one thing, but taking on debt in order to stay in business might be problematic, depending on the prospects for business improvements in the future. This situation warrants probing from the board.

Questions to Ask:

• How much debt can the organization handle?
• Are we close to being tapped out?
• Is a default on debt a possibility?
• What is the monthly cash burn rate?
• How long can the organization survive a cash crunch?

In Summary

To a certain extent, monitoring your organization’s cash flow, whether to meet operational requirements or to set aside for a rainy day, is basic board oversight. You want to make sure your organization has a good amount of capital, good liquidity, and a strong business model.

All of these have come under threat during the pandemic. The best boards are working with management to plan for a variety of scenarios as far ahead as can be reasonably projected, and to have back-up plans ready for the unexpected. It’s not easy, though.

Start with the basics:

• Acknowledge that your 2020 budget is irrelevant. Up to date forecasts are far more important (understanding that it is challenging to forecast well in this environment.)
• Reach consensus with management on the assumptions that underlie the Projected Source/Use of Cash Statement.
• Task management to look for areas to decrease costs without impairing the long-term viability of the organization.
• Insist on a rolling statement of cash flows report to stay current on the organization’s ability to pay its bills.
• Challenge management to make sure cash flow is an integral part of all financial reports and projections.
• Be cognizant that every request for analysis increases management’s workload. Only ask for what is truly necessary for the board to fulfill its role.

So, understanding all of this ─ take a step back. 

Given the environment, ask yourself if what you are seeing in the financial statements makes sense? Is it reasonable? And then, adjust expectations.

Your takeaways:

• The board works with management to ensure the organization has the liquidity assets to meet its short-term obligations.
• The current ratio (working capital ratio) is a critical measure of the organization’s ability to meet its short-term debts.
• Be aware of the organization’s financial reserves ─ how much money is available to weather the storm?
• During this period, the cash flow statement is as important, if not more important, than the statement of operations. Use sensitivity analysis and scenario planning to project possible impacts on the organization’s ability to meet its objectives.
• If the organization has debt, does it have sufficient assets to meet its debt service obligations?
• Pay attention to revenue streams for leading indicators of potential problems to top line revenue.
• Request a training session to learn about the organization’s financial statements if you sense there are directors who would benefit (including yourself.)

I would like to take this opportunity to thank the following savvy directors who shared their time and knowledge so I could pull this blog together.

In the order in which their material was received: Thank you to Greg Doyle, Fiona Webster Mourant, Greg Arason, Brad Peacock, Rick Duha, Judy Murphy, Stuart Duncan, Mike Fata, Barry Feller, Wilf Brock, Tom Bryk, Ken Kustra, Sara Stasiuk, Bob Lafrenière and Dr. Aaron Chiu.

Leave a comment below to get in on the conversation.

Thank you.
Scott

Scott Baldwin is a certified corporate director (ICD.D) and co-founder of DirectorPrep.com – an online hub with hundreds of guideline questions and resources to help prepare for your next board meeting.

Share Your Insight: What suggestions do you have for a non-financial director to learn about cash flow projections?