Many business owners receive financial information and do not know what to do with it to enhance performance. Entering into a strategic approach to growth and value acceleration requires owners to look at their business differently. This Article describes key steps owners should take to accelerate growth, value, and achieve Transition-Readiness and sustainability.
This is the eighth in a series of nine articles that follow a business owner, John. He is taking action to increase the value of his company before transitioning or selling it and moving into retirement. In the first article, he learned that Tom—who owns a similar business—had sold it for a much higher price than John was told his company was worth. In the subsequent articles, John discovered the importance of having a business plan, what it should include, and how strong leadership and people drive the value of a business.
Business Value Enhancement 101
Value drivers affect either the earnings or the worth of an operation. Being in business is about making a profit and creating sustainable value.
Value isn’t always about the numbers. Environmental and qualitative value drivers have a dramatic effect on a company and its ability to grow. Knowing what creates—and destroys—value helps owners and managers make better day-to-day decisions. That also allows them to build increasing a company’s value into its culture.
The place to begin is a detailed discussion about the quality of the organization. This should include the owner, the management team, and advisor. At Birkdale, we use the results in our Deep Discovery and an Enterprise Value Assessment and the Value Enhancement Process. An initial conversation broadly examines the eight main value drivers:
- Planning
- Marketing
- Leadership
- Operations
- People
- Finance
- Sales
- Legal
In working with his business advisor to take an in-depth look at each area, John moved to the seventh category: finance.
What Do the Numbers Mean?
John thought he was using best practices in finance. His Finance Department included a competent controller, accounts payable and accounts receivable clerks, and a general accountant who would step into the controller position when necessary. He received information on a regular and consistent basis and reviewed it in detail. However, he didn’t quite understand how he could use this information to improve how he ran his business and enhance its financial performance.
In addition, he was implementing a strategic value enhancement initiative. This required him to look at the business differently than he had in the past. That led John and his advisor to discuss if now was the time to add a full- or part-time chief financial officer (CFO).
What Is the Difference Between a CFO and Controller?
They spelled out what John would want from someone in this position:
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Be the primary fiduciary overseeing every financial and operating function
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Be able to identify and deal with business risks
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Lead financial planning, including capital, debt, equity, cash flow, and other requirements
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Evaluate possible mergers, acquisitions, and a sale of the business
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Support strategic initiatives from John (as the CEO) and the board of directors
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Identify and retain outside independent accountants and legal advisors
The advisor and John recognized that they couldn’t expect a controller to do these things. Instead, their controller (a Certified Public Accountant and Certified Management Accountant) would be responsible for these activities:
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Implement fundamental accounting policies and procedures
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Manage the day-to-day accounting and cash flow, including accounts receivable, payroll, and accounts payable
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Update various financial models, budgets, financial statements, and other reports
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Handle basic human resources functions, such as maintaining files, handling benefit questions, processing 401K activities, and writing offer letters (among other matters)
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Manage the annual financial statement and tax preparation by the accounting firm
Now the difference between the two positions became clear to John. The CFO is a strategist, key member of the management team, and “right-hand” of the CEO. This person has primary fiduciary and financial responsibility for the company.
The controller—a position required by John’s board of directors—is a tactician and responsible for the day-to-day activities. This person has limited decision-making abilities and would report to the CFO.
John’s company was in a dynamic situation: ready for growth and, ultimately, a transition. A CFO’s leadership could be a significant benefit. To control costs, John decided to begin interviewing candidates for an interim CFO.
Financial Statements: Audit, Review, and Compilation
John’s and his advisor received annual compiled financial statements from his accounting firm. The advisor suggested they change to a review or audit. John asked what this meant.
He learned that compiled financial statements are the lowest level of service. The CPA helps management put information into financial statements. However, this person doesn’t do anything to ensure there are no material modifications needed in how the numbers are collected or reported. He or she only needs to understand the industry, and if the statements are formatted correctly and free from obvious errors.
Compiled financial statements are appropriate for smaller companies, where an outside party requires financial statements that were at least read by a CPA.
Reviewed financial statements are reviewed by a CPA, who notes that he or she isn’t aware of any material modifications necessary for them to conform to generally accepted accounting principles (GAAP). The CPA must perform procedures that provide a reasonable basis for this limited assurance. This includes analytical procedures, inquiries, and other tests as appropriate, based on the CPA’s understanding of the industry, knowledge of the company, and awareness that information in the financial statements is not materially misstated.
A review doesn’t include getting an understanding of internal controls, assessing fraud risks, testing accounting records, or other procedures normally performed in an audit. This approach works for privately held companies because outside third parties want to know that there are no material issues with the financial statements.
Audited financial statements are the highest level of service a CPA can render. These provide companies with an auditor’s opinion that the financial statements are presented fairly, in all material respects, in conformity with GAAP. The CPA is required to understand the company’s internal control system and assess the risk for fraud. In addition, to provide an auditor’s opinion, the CPA corroborates the amounts and disclosures in the statements through inquiry, physical inspection, observation, third-party confirmations, examination, analytical and other procedures. Audits are appropriate when outside third parties—such as banks, creditors, current or potential investors, and purchasers—need to rely on financial statements.
The level of assurance—and cost—varies significantly among these alternatives. This means John must consider what is required to achieve his goals. If he plans to transition the company to a third party, he should consider at least a review. When he’s ready to make a transition, he now knows that most third parties require a review or audit for three or more years.
Financial Stability
John was getting more interested in the financial performance and stability of his company. The growing complexities, changing markets, and desire to eventually transition out of his company made him realize he needed to pay particular attention to financial performance and stability.
The company was making money. But John and his advisor realized changes were needed for it to be sustainable into the future. They focused on developing financial and nonfinancial benchmarks, more closely measuring gross margins, and taking an overall approach to shore up financial stability.
Benchmarking measures performance to track current results and improvements made to the business. In addition, trends are created when benchmarks are compared against different accounting periods. This information is used to develop strategies to respond and take action.
Industry and trade associations provide standards against which benchmarks can be measured. The idea is to track benchmarks in all key areas of the business, to monitor company progress and success. This also is an excellent way to engage employees in the improvement process. They get to see objective measurements that show how they can make a clear impact on improving performance, which can engage them and lead to cultural change.
Gross profit is commonly used to evaluate a company’s financial health. It measures the amount of money left over from revenues after subtracting what it cost to create the product (called cost of goods sold). Gross profit margin is the source for paying all other expenses and savings. While a simple concept, many accounting principles, and other issues enter into the calculations:
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Cost of goods sold is determined by considering inventory, which can be calculated using different methods, most often lower of cost or market, weighted average, last in first out (LIFO) or first in first out (FIFO). Each has its own calculation methodology but a significant effect on the cost of sales.
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The cost of holding inventory (overhead) has a direct bearing on gross profit and is calculated differently depending upon the specific situation. These costs include taxes, employee costs, depreciation, insurance, storage or rent, insurance, freight, and many others.
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Product mix and pricing of goods and services have an effect. Products may have different pricing structures, based on scarcity, competition, demand, and other economic factors. Companies must make sure their accounting systems can determine and track gross profit margins on each product or product line and customer.
John realized all of this only scratched the surface of what he needs to reach and maintain his company’s financial stability. Corporate financial stability comes from the interaction of long- and short-term goals, cash and liquid assets, and managing risk.
Our next article examines how John can add value by taking a strategic approach to the legal aspects of his company.
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