In my request on Twitter for blog post topics I could write about I received a few and I am blogging about them as quickly as I can. One topic was ‘Financial Intelligence’. This could have many meanings so I’ll attempt to explore these.
Businesses do seek to gain financial intelligence; about the market, the economy, their competitors and the business environment generally.
Some information is readily available some not.
Information about demand trends in the market in which they operate. They will look for forecasts regarding demand (and prices) for product they supply – and forecasts regarding supply (and prices) of the inputs they use.
It is also important to obtain the same information relating to their customers as they will be affected by market trends impacting on their customers.
Forecast regarding interest rates, exchange rates, and GDP growth will also form part of the bigger picture that needs to be considered. For example, an increase in interest rates will lead to a decline in the demand for credit and as a result a decline in motor vehicle sales. Or any other products that are largely bought using credit. The outlook in foreign economies would also need to be examined. The decline in motor vehicle sales abroad had a major impact on the SA platinum mining industry.
Listed companies will closely examine the annual reports of competitors to gain information about their market share – and also to benchmark themselves in relation to these competitors. This would include things such as sales per employee, average remuneration per employee and a comparison of profit margins. They would also compare the returns to investors made by their competitors. And clues as to how the directors of competitors feel about their own company’s by looking at the sale and purchase of shares by these directors in their own companies.
The Business Environment
A number of factors in addition to those described above also need to be considered:
- Upcoming legislation – labour, health, environmental and so on.
- Changes to existing legislation – in the areas mentioned above.
- Political risk – Political rhetoric can have an impact on the business environment generally. So too can major unrest by labour – and service delivery process.
Information regarding all of the above is necessary in order for business to make short, medium and long range plans. Not only for medium term budgeting purposes but also for longer term capital investment projects.
I would define ‘financial intelligence’ as financial literacy. Individuals require this in their private lives and in their capacity as business employees at all levels.
The need for financial literacy:
What makes business tick?
Managers are often so engrossed in the running of their departments that they lose sight of the big picture – and how their decisions affect the big picture. Talk of costs, profits, budgets, break-evens, working capital, capex and financial statements can be confusing, yet a familiarity with these will provide an understanding of the consequences of day-to-day business decisions that are made.
Non-financial Managers often feel frustrated because they do not understand the language of business. Many Managers, who do not have a financial background, at one time or another experience difficulty in getting to grips with the financial aspects of a business problem, or, in communicating with financial people like accountants. In addition it is difficult for managers to manage costs if they do not understand exactly what costs are, how they behave and how they have been allocated.
One of the primary reasons for this is the jargon used by the financial people involved. The use of jargon in any situation is of course unnecessary, but is nevertheless a challenge which all managers have to overcome – and this workshop will help them.
An understanding of the financial consequences of any Managers decision is vital. So is sufficient knowledge of the language of business to allow for communication with financial people on an equal footing.
To achieve financial literacy managers need an understanding of the following:
To provide an understanding of these areas:
- how profits are made – the relationship between margins, volumes and expenses
- the effects of price changes on profit
- the difference between profits and cash
- how to calculate break-evens and other business calculations
- the budgetary process
- budgetary control
- how you impact on the business through poor budgetary control
- how to motivate requests for capital expenditure
- how to interpret budget variances
- the profit forecast
- the cash flow forecast and the importance of liquidity
- the management of working capital
- accounting principles and how accounting works
- how accountants calculate profits
- financial statements (Income Statements & Balance Sheets)
- how to interpret financial information
- the key indicators that enable one to check the ‘health’ of a business
In the words of Warren Buffet:
“Accounting is the language of business”
“There are many ways to describe what is going on with a business, but whatever is said, it always comes back to the language of accounting. When Warren was asked by the daughter of one of his business associates what courses she should study in college, he replied, “Accounting – it is the language of business.” To read a company’s financial statements you need to know how to read the numbers. To do that you need to learn accounting. If you can’t read the scorecard, you can’t keep the score, which means you can’t tell the winners from the losers.” Source: The Tao of Warren Buffet
Which brings me to senior managers and even directors. During the course of my work over the past 40 years I have found that many people in senior positions are not financially literate. Sure, they know the buzzwords and jargon and talk about ‘sweating the assets’ etc. but when I do personal coaching, or conduct workshops, in this area I often quickly realise that it is best to assume no prior knowledge and start with the basics.
Directors would do well to take heed of this article of mine which was published some time ago.
No Governance without Financial Literacy
By Mel Brooks
Effective ‘corporate governance’ and ‘transparency’ have become the byword and the buzzword of management circles. However, day-to-day practices often fall short of the levels of control and openness alluded to in the media. Corporate governance simply cannot be carried out using a checklist approach. Sure, one can tick off the existence of succession plans, BEE plans and employment plans, but does the mere existence of plans guarantee effective implementation? Does a comprehensive pre-flight checklist guarantee a successful flight with an unqualified crew?
Without wishing to diminish the importance of the aforementioned elements, it has become clear that those wanting to effect successful governance need to focus their scrutiny on the area of financial reporting within their organisations. This is after all, the source of information about the performance and solvency of the business. It is also the source of a problem – not only in South Africa, but internationally. There is a widespread need for developing a basic level of financial literacy. The following examples (selected from the many one sees) illustrate the commonly seen deficiency in this area – from the top of the organisation, down through the ranks.
Terexko chairman and CEO Cornelis Swart said he was unable to explain much of the information in the financial statement, including exceptional items worth close to R32m.1
Mr Stonecipher was also shocked by how little Boeing managers understood the bottom line. In a culture dominated by engineers, profit was seldom mentioned. Mr Stonecipher asked the company’s finance director how he communicated with Wall Street. He said he did not.2
And from the apparently unaware, to the seemingly deceptive.
The pre-tax profit of Regal Private Treasury Bank for the year to February may have been overstated by R21,4 million because its management lied to Ernst & Young, Pieter Strydom, a partner at the auditing firm, said yesterday at the commission of inquiry into the bank’s demise.3
Turnover for the 16 months to June last year has been restated as R17,3m, just half of the R34,9m originally logged in the accounts. Operating profit has been revised down R13,7m, leaving a loss of R5,6m instead of the claimed R8,1m profit.4
The bosses of Transpaco, a listed company that makes plastic bags, could have been tempted to hide their heads in their own products yesterday, after admitting to an accounting bungle which distorted the company’s financial performance over an 18-month period. … Yesterday the company revealed that over-reporting to the tune of R13,5m had taken place.5
Questions will also hang over the group’s auditors Fisher Hoffman Sithole, which signed off what is now viewed as a pantomime set of accounts. The banks who loaned money to Macmed are considering taking the auditors to court.6
Macmed was back in the news in Business Report (August 27, 2001). In an article relating to a claim against former directors alleging fraudulent and reckless behaviour, one of the defendants said, “Most of the directors will be vindicated. There were a lot of guys in the company who didn’t know what was going on. But I can’t vouch for all the directors.”7
Such reports are commonplace and serve to highlight the extent of the problem – a problem which is, however, not a new one. In a letter to the Economist (June 1st 2002), David Marks wrote,
Your assertion that confidence in financial statements is badly damaged will come as no surprise to ex-students of Professor Will Baxter of the London School of Economics. More than 30 years ago, he suggested that the proper answer to the question “what profit did you make last year?” is ”what figure did you have in mind?”8
Writing in Business Report (June 6, 2001) Ann Crotty, one of SA’s leading financial journalists commented,
“In any company, in any one year, a profit figure probably has a 30 percent range of flexibility, depending on the accounting policies used.” 9
She is probably being a bit conservative. Also commenting on the matter of financial reporting is the following, taken from a Special Report: The trouble with accounting in the Economist of February 9th, 2002.
The second problem lies in the reading of accounts. Mr Pitt (head of the SEC at the time of the Enron collapse) wants financial statements to be written in plain English, not in the current legalese. As he puts it, “the current system of disclosure is designed to avoid liability, not to inform anybody.” Most controversial of all, though, he wants to end the notion that there is one (and only one) correct version of the accounts. “There is no true number in accounting,” he says, “and if there were, auditors would be the last people to find it.”10
There are many such articles in the Mel Brooks Associates archives but those cited above will have alerted you to the fact that a problem exists in SA – a problem which seems to be on the increase. In order to take steps towards addressing the problem, we need to understand what financial literacy means in the context of corporate governance.
We can start by saying that it does not mean knowing how to do accounting. Most companies have perfectly competent accountants. Why then the commonly quoted adage “Accounting is too important to be left to the accountants”? The answer lies in the need for every non-financial manager, as well as other staff, to question the figures produced by the accountants. In order to be able to do this with any confidence, they need the financial literacy that will give them an understanding of the following:
- profit is an opinion
- cash flow is a fact
- a ‘profitable’ business can go bust.
And it is not only in the area of profit and cash flow that such insights are required. Costs (cost causation, cost behaviour, cost allocation) too need to be questioned and widespread ‘illiteracy’ often leads to poor control and transparency when it comes to the costing figures produced. Finally, one must mention the extremely important need for non-financial managers to know about and recognise the limitations of ratio analysis. Too often a ratio produced by the financial people, and their views regarding whether it is good or bad, is accepted blindly by the financially illiterate as representing the ultimate measure. Consider the following:
Accounting information is the result of subjective judgements. Not all firms use the same methods and techniques in drawing up final accounts. The valuations that are placed on the current assets such as stock and debtors are the best opinions of the directors or management of the company.11
What this all means is that everyone in an organisation, from the board down needs to know:
- what questions to ask about the numbers – particularly those numbers that are subject to ‘massage’ or ‘adjustment’
- how to evaluate the answers given to the questions they ask, and then
- what questions to ask next.
The most important questions therefore must be – “Can we be exercising effective corporate governance without ensuring that all our managers are financially literate?” and “Have we equipped them with adequate knowledge to take responsibility for the numbers they must use in order to manage effectively?”
- Business Day, Tuesday, November 4 2003. Terexko wants detail on audit. Carli Lourens, Trade and Industry Correspondent.
- The Economist, June 9th, 2001. Business. Face Value: Hard man Harry. Pg. 78.
- Business Report, Tuesday, September 11 2001. Regal profit ‘overstated by R21.4m’. Vernon Wessels.
- Business Day, Friday, January 28 2000. Bryant revision reveals losses. Lesley Stones.
- Business Day, Wednesday, June 13 2001. Accounting bungle hurts Transpaco. John Fraser.
- Business Report, Tuesday, October 19 1999. Macmed was once a shining example of growth. Adele Shevel.
- Business Report, Monday, August 27, 2001. Macmed’s creditors file R674m claim. Amanda Vermeulen.
- The Economist, June 1st 2002. Letters.
- Business Report, Wednesday, June 6 2001. Lies, damn lies statistics and what top executives are worth. Ann Crotty.
- The Economist, February 9th, 2002. Special report: The trouble with accounting. When the numbers don’t add up. Pg. 61.
- A Business Approach to Accounting and Financial Management for Non-Financial Managers. Mel Brooks.
This article was published in Boardroom and Management Today