Board oversight and control responsibilities are complex and continue to grow. Directors are expected to be the financial, operational, and ethical guardians of the company, and can no longer leave it to management or shareholders to take responsibility for performance. The economic downturn intensified the pressure on boards, with more attention directed to liquidity, operational risk, and market risk.
It is increasingly clear that boards must focus more on operational and capital cash flows. Troubled companies understand the importance of their cash flows; for some, unfortunately when it is too late. Too often, companies deemed to be healthy have not focused on cash flows which are an important indicator of a company’s chance of survival. Understanding how to interpret cash flows and continuous oversight of them by boards is essential. Cash flows are the lifeblood of a business.
Cash flows can be measured in an effective, timely manner. Cash data can be much more understandable and give a clearer financial picture than an income statement.
The need for this oversight tool provides an excellent opportunity for boards and chief financial officers to interact in focusing on cash flows to monitor their company’s performance and financial health. Fortunately, these flows can be measured in an effective, timely manner, and there are many options for doing so that are easy to implement.
CFOs can clearly explain why this data is so useful and can make the required data available to the appropriate directors, drawing on internal and external auditors, and others. Following are some thoughts and ideas about the importance of cash flows as a tool to monitor company performance.
Large, sophisticated businesses recognize the importance of tracking cash flows. One of the authors served as the CFO of a diversified holding company that was the managing general partner of two sizeable general partnerships. In one, the other two general partners were Northwestern Mutual and Equitable Assurance Company. In the second, the partners were Metropolitan Life and American General.
Each partnership met quarterly. An important component of these meetings was the CFO’s review and discussion of financial and operational results. Every one of these discussions focused on partnership cash flows, basically the receipts and disbursements from the normal course of operations, investment income, capital expenditures and other significant cash items.
All the partners agreed that this was more useful than reviewing the income statement because it avoided esoteric accounting entries and footnotes that were confusing and distracting. The cash data was much more understandable and gave a clearer picture of financial performance that was supported by money in the bank or other liquid assets.
These meetings were an exercise in highly effective governance. The general partner representatives were informed, involved, and their institution had “skin in the game.” They understood the business and recognized that tracking the cash flows was the most effective way to stay on top of the business.
Directors of any company, in any line of business, would do well to adopt these techniques to improve their financial oversight.
Cash flows can be budgeted, and measured effectively and efficiently with basic cash management systems that are well understood. Furthermore, a comparison of actual cash flows to budgeted cash flows is straightforward. The various receipts and disbursements can be compared to budget, and variances identified. Discussions on the causes of the variances can uncover problems or opportunities. There should be no need for approximations or adjustments. The cash flows either did or did not occur within the particular time period.
Operational and capital cash flows are not easily subject to manipulation. They are a safeguard against efforts to manipulate income, such as reclassifying operational expenses as capital expenditures, as occurred at some companies. Should capital expenditures exceed budget, this variance would be identified, and an analysis of the variance would identify the actual causes.
Onetime charges, if not budgeted, can produce a serious negative variance in operational cash flows. Comparisons of annual or quarterly net income amounts may exclude these onetime events; but cash flow analyses make this impossible. Such outflows impact cash balances for the period and, if unbudgeted, create a negative variance that must be analyzed and understood.
The board should look to the CFO to play a major role in structuring the team responsible for budgeting, measuring and explaining cash flow anomalies.
Who should be given the authority for budgeting the operational cash flows, tracking the actual cash flows, developing the variance reports, and providing explanations of the variances that occur? There are many options. However, an effective approach involves having the company’s operating units working with a financial unit such as treasury, financial analysis, accounting or some combination of these financial units.
The board can look to the CFO to play a major role in structuring the team responsible for budgeting, measuring and explaining cash flow anomalies. Both internal audit and the external auditor can provide input to the team, and assist in insuring accuracy.
CFOs can devise different methods to present cash flow data, and interpret it for their board. The analytical framework shown on page 13 will aid in understanding and monitoring operational and capital cash flows. To analyze performance, a model is developed and monitored for each business unit that generates cash flows. This model identifies basic requirements such as working capital, capital expenditures and debt service and determines if cash flows will be adequate. If operational cash flows do not provide enough for adequate working capital, do not fund budgeted capital expenditures, and do not cover the required debt service, the business operation is in the “crisis” zone. The options for the business operation are to “fix” or to “liquidate.”
The model also determines a Risk Adjusted Return on Equity. When added to the Basic Capital Requirements, this establishes the Market Capital Requirements. As can be seen in the cash flows model, if the operational cash flows exceed the Basic Capital Requirements but fall short of Market Capital Requirements, the business operation is “under performing.” While not in “crisis” mode, steps need to be taken to improve performance.
If the operational cash flows exceed the Market Capital Requirements, the operation is in the “Performing” zone. This shows an opportunity to invest and grow, pay down debt, or to make cash distributions to equity holders.
This relatively simple presentation of cash flow data can give the board a solid understanding of whether their firm generates a positive cash flow, and if it is adequate to meet present and future needs. This ability to monitor whether a firm is generating a sufficient cash flow will improve a board’s oversight and control system, in good times or bad. A board that understands the components of basic capital and market capital requirements, and how they are affected by cash flows, has considerable insight into the risks confronting the firm, and can effectively address its oversight responsibilities.
The cash control activity comprises two parts. The first involves managing the firm’s receipts and disbursements. The second involves monitoring the company-wide cash position.
