Understanding financials: what directors need to know
You’re on a board. You’re not financially-trained but you appreciate that reviewing the finances to ensure they’re under control is an important aspect of good governance. What should you be looking for? What questions should you ask? Is there a cheat-sheet or checklist you can use?
Craig Fisher & Wayne Tukiri
In our experience as accountants who advise a wide variety of organisations, these are reasonably common questions.
Usually they are asked by people in governance roles without an accounting background but who are conscientious and want to do a good job.
Interestingly, the question seems more common with not-for-profit (NFP) and charitable entities rather than profit-seeking commercial organisations.
But while these questions are reasonably short, the answers sadly are not. Nor is it nearly as simple or concise.
The reason is context.
To answer the questions, you need to consider a range of factors including:
- The purpose, nature and complexity of the organisation;
- The experience and level of general financial knowledge of the director in question;
- The level of financial resources and competencies within the organisation and the board.
Entire university courses and post-graduate degrees are devoted to understanding financial information.
Countless (and often very dense and technical) books have been written on the topic. Some people devote their whole careers to teaching this financial specialisation.
Similarly, there is a huge variety of entities and part of this variety is in respect of their financial operations, and the complexity of these.
So, the request for a one-size-fits-all checklist or quick cheat-sheet is a tad unrealistic.
Just because it is hard, though, does not mean the issue can be ignored.
With for-profit commercial organisations, the profit and overall financial health is a primary purpose and a key measure of success.
For NFP/charitable organisations, many are more concerned about purpose than profit.
But their financial health, while not a primary aim, remains important: without it, these organisations are unlikely to have the resources needed to deliver on their purpose, or in some cases to even survive.
But the fact that profit is not usually seen as a primary purpose for charities or NFPs means even more focus might be needed on financial health.
Board members do not need to be accountants or have extensive financial training to be competent in their financial oversight role, though some financial training is always useful to improve knowledge and skills.
But board members need to understand the context and economic drivers of their organisation and the expected results so they can identify when things are going off course and corrective action needs to be taken.
Good monitoring of finances is all about understanding and awareness of what should be happening and what is happening, and why.
This monitoring and any corrective action must also be timely. Like a ship taking on water, if a leak is identified early, the problem can often be fixed. Left too late, the ship might sink.
The right questions
Board members need to understand, at an appropriate strategic level, the business’s economic drivers.
In most cases, this requires a general interest and understanding rather than a deep, specialist level of accounting knowledge.
For example, for a trading concern, directors need to understand the nature of the trading process and financial cycle.
When do costs occur? Do we carry stock? If so, what are the implications? When do we receive income and are there any collectability concerns? How do we fund the fixed assets and other resources needed for production and trading?
Contrast this with an NFP entity that may be funded by grants and donations.
When do we receive funding? Is it in lumps or spread evenly over the year? Is it in advance of costs or after? If after, how do we fund the timings are unlikely to have the resources needed to shortfall?
How secure is our funding? Is it a multi-year contract or a one-off? What cost levers can we pull if necessary? Which costs are fixed and which are flexible?
Once the economic drivers are understood, boards need to understand the desired or expected results.
A profit of $1 million may be a fantastic result - or a disaster. It depends on the scale of the operation required to generate that profit and the expected return on the investment.
This is where the ability to create detailed budgets is important.
If directors are confident in the quality of the budgeting process (from past experience and high-quality management and systems), monitoring against the approved budget by a board can be a simple variance analysis.
This means boards invest their time and effort focusing only on variances outside sets of parameters.
This can often be translated into key performance indicators (KPIs), reporting key economic drivers and measures of financial performance and position.
This allows dashboard reporting so boards can assess the levels of key measures quickly and easily.
Again, there is no-one-size-fits-all list of KPIs. They are contextual.
But the experience of developing a set of appropriate KPIs for an organisation can be extremely valuable for board members, working alongside management.
It will greatly enhance their understanding and awareness of the organisation’s economic drivers. It should also help boards ensure there is a connection to their organisation’s strategy and allow effective monitoring of progress towards that strategy.
While not all KPIs will be financial in nature, many will.
Cashflow vs profit
This topic requires a special warning. While profit or surplus is generally important for the ongoing growth and financial sustainability of any organisation, cashflow is critical.
The best analogy is that profit can be likened to food and water. Both are necessary to sustain life but you can survive for a while without either as long as this is not a long-term situation. But cashflow is akin to oxygen: you won’t live long without it.
The other important understanding is that growth generally costs money because entities must invest in new people and resources to create future income and, ultimately, profit.
But while the costs are immediate, the results generally don’t come immediately. This explains why seemingly-profitable, high-growth entities often go out of business. They simply run out of operational oxygen, being cashflow.
Hence, it is important for boards to not only monitor profit or loss but also to have a timely understanding of their entity’s cashflow implications.
Boards should be able to rely on management to explain information presented to them. If financial information is not being presented in an understandable way, boards should request management to modify it until they are satisfied.
Formats will differ, depending on the context of the organisation (nature, scale, complexity etc) and board members’ level of understanding.
In our experience, too many boards allow management to present copious quantities of financial information without rigorously questioning it.
Quality financial information is often subsumed by the quantity. And that leads to the all-too-common glazing-over of board members’ eyes when it comes to analysing the finances.
Boards hold the power to request and receive the information they desire and need. If they aren’t getting it, they have the power to address that. No excuses.
And finally, as auditors it would be remiss of us not to note that if the entity is audited, boards need to be proactively involved to ensure they are receiving the most value from that relationship.
But that is a topic for a future article.
Craig Fisher FCA is a consultant at RSM and an ADLS council member. Wayne Tukiri FCA is an associate director at RSM.