Directors Must Understand Financial Statements

The judgement in the Centro case has set the bar for financial literacy by company directors. To fulfil your responsibility as a director, you don’t have to know all the ins and outs of accounting and accounting standards but you do have to:Directors' Duties & The Blind Freddy Proposition of Financial Literacy

• read and understand the accounts of the business; and
• ask yourself if the accounts portray a true and fair picture of the business given what you know (or should know) about what’s actually going on within the business

This became known as the “blind Freddy” proposition during the hearing of the case brought by the Australian & Securities Investment Commission against eight Centro directors and executives for failing in their duties of care and diligence when they approved the 2007 accounts.

In particular, they should have known that some $2 billion in borrowings should have been classified as current rather than non-current liabilities in the accounts and should have disclosed a $2.8 billion financial guarantee. The current vs non-current classification of liabilities isn’t semantics: the difference in maturity profile makes a huge difference in liquidity (solvency) risk profile of the business.

Bean Reading Vs Bean Counting

If you are a company director, you are supposed to know what’s going on in the business and you are expected to know whether the company’s financial statements reflect what is happening in the business. Understanding and interpreting of the accounts in the context of the business is what I call “bean reading”. That’s your responsibility regardless of whether your business is large or small, listed or unlisted.

You can delegate the work of preparing the financial statements – the “bean counting” – to an accountant and have an auditor – the “bean checker” – confirm that they have been properly prepared and comply with the accounting standards.

However, accountants and auditors are not fallible. Think about how many high profile legal actions there have been against even the Big 4. As a director, you have to have sufficient mastery of the art of bean reading to know when there’s a mismatch between the story that the accounts are telling and the business reality.

Why SMB Owners should Master the Art of Bean Reading

Even if you don’t have external shareholders to report to, shouldn’t you still understand the financial position of your business?

Shouldn’t you know whether your accounts are correct and that you aren’t making business decisions based on incorrect information?

Can you explain your accounts to your bank when you are seeking review of your facilities or additional finance? The worst response you could give when queried about your accounts is: “Oh, I don’t deal with the accounts. Speak to my accountant.” Your accountant, especially if you use an external accountant, doesn’t necessarily have the business context that you as a business owner would (or should) have to properly interpret your numbers into the ‘real story’ about your business.

If you’ve ever read interviews with fresh juice entrepreneur Janine Allis, who sold a 70% stake in her Boost Juice empire to a US buyout firm for around $65 – $70 million last year, she almost invariably makes the point that not understanding her accounts was one of the biggest business mistakes when she started up in business. Like many business owners, she relied on an accountant for advice. Unfortunately, the accountant didn’t understand her business and she got burnt by poor advice. Thereafter, she made it her business to understand every figure in her accounts.

2 Bean Reading Essentials

1. Always review a complete set of accounts

A complete set of accounts means the Profit & Loss Statement, Balance Sheet and Statement of Cash Flow. Work with anything less and you will not have a complete picture of the business.

The Statement of Cash Flow is the one financial statement that is commonly ‘missing in action’ in monthly accounts of SMEs. It provides a lot of very valuable information including:

• how much cash has been generated by or used up in the operating activities;
• whether there are errors in either of your Profit & Loss or Balance sheet;
• whether there have been prior period adjustments to your other two statements (altering the accounts in previous months or accounting periods is like changing the score during a game!)

Unfortunately, it remains the least understood (even by accountants) component of the accounts. Admittedly, the Australian International Financial Reporting Standards (AIFRS) have made comprehension of this particular statement (and the rest of the accounts) even more unfathomable than it used to be. However, the Statement of Cash Flow is too important to be ignored. So do make the effort to get your head around it.

2. Look behind the headline numbers (and ratios)

Are You Really Making A Profit Or Loss? This is about understanding the quality of the key Profit &Loss or Balance Sheet items.

Are you really making a profit or loss? Have a look at the ageing profile of your Debtors and Creditors:

• Is there a high proportion of your Debtors which are well beyond your normal trading terms? What’s causing the blow out? Are there issues with your invoicing system or the debtor collection systems or are debtors not paying because they are disputing quality issues? A sale isn’t a sale until you’ve collected the money.
• Are you stretching payments of Trade Creditors to the point where you could damage the credit standing of your business?
• What about your Inventory? Are you kidding yourself about market value of your stock? Are there items in there that haven’t moved since the Ice Age? Is there an unusually high amount ‘work in progress’?

Likewise with ratios and key performance indicators: they can flag issues but then again they may not. For example, the current ratio could appear to be pretty consistent at 2:1 from month to month. On the face of it, everything seems hunky-dory…BUT

• What if the ‘stability’ of this ratio is because your debtor balances have increased because of slow paying (or worse non paying) customers and you are stretching creditors or running up your overdraft for your working capital funding?
• Are you sure that the current ratio of 2:1 this month means the same thing as the 2:1 of 6 months ago?

The Value of Bean Reading: Beyond Compliance

Your business’ financial statements provide important information about the health of your business. They are one of the most powerful management tools you have at your disposal.

In fact, basic financial literacy is a capability that that all key staff with profit centre responsibilities should be empowered with.

You could go even further and adopt the principles of “Open Book Management” (a term coined by John Case of Inc. Magazine). With OBM, all staff are given access to all relevant financial information about the business. They are obviously also provided with the necessary training to help them understand financial accounts. The premise is that staff who understand how their efforts can contribute to the success of the business can and will use this knowledge to drive improved performance.

Adopting OBM requires a very high level of mutual trust between business owners and their employees. It takes transparency and employee engagement to a whole new level. However, it has been proven to be extremely successful. You can check this out at The Great Game of Business website.

Getting A PRACTICAL Understanding Of Financials

You don’t have to do a degree in accounting to achieve financial literacy. The aim is to be able to understand and interpret financial statements in the business context.

Professional organisations such as the Australian Institute of Company Directors and Chartered Secretaries Australia have courses that provide practical understanding of accounting.

Games are great way of learning. Contact Peter Tibbitts (ex-Partner of Ernst & Young) about his group training workshop called FUNdamentals of Finance. In this program, you and your staff can actually have fun whilst achieving a sound working understanding of finance using a computerised board game.

And finally, watch out for the release of Cash Flow Kung Fu^TM, an online finance coaching program to assist small business owners in mastering the art of bean reading! No jargon! That’s a promise!