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CEO Best Practice: Financial Management

Executive Tools

  • Executive Summary
  • Self Assessment Checklist

Expert Practices Articles

  • The CEO's Role in Financial Management
  • Developing a Sound Financial Plan
  • Developing Financial Discipline
  • Key Financial Management Ratios
  • Key Indicators: Tracking Your Way to Financial Success
  • Managing Cash Flow
  • Improving Your Financial Management Skills
  • Don't Shoot Yourself in the Financial Foot

Tools & Analysis

  • Determining Your Sustainable Growth Rate Worksheet
  • Top Ten Tools for Maximizing Cash Flow
  • Determining Your Z-Score
  • Trailing 12-Month Charting
  • Daily Cash Report
  • Best Financial Formats (BestFins)

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The CEO's Role in Financial Management

"Perhaps the biggest mistake entrepreneurs make (after running out of cash) is thinking that financial management involves only looking at the past," says Kramers. "Yes, the numbers tell you what happened in the previous month or year, but that's only half the story. Smart CEOs use the numbers to forecast the future and make better management decisions going forward."

Fleisher agrees that CEOs need to adopt a forward-looking approach, especially when it comes to knowing which financial management activities to delegate and which to hold onto.

"In most small to mid-size companies, controllers and CFOs focus primarily on tactical activities, such as closing the books in a timely and accurate manner, preparing financial reports, managing accounts receivable and payables, conducting comparative analysis and benchmarking your company against industry figures," he explains. "Your job is to use the financial information they provide to look into the future and generate action plans to improve the company's performance. That's a role you can't delegate to anyone else."

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Developing a Sound Financial Plan

a financial plan should contain three specific segments: historical analysis, a three-year plan and a one-year plan. In addition, Waring believes the financial plan should also include analytical narrative -- your analysis of what the numbers tell you -- and the assumptions that underlie your projections.

To conduct the historical analysis, gather financial data for the past three to five years from the balance sheet, income statement, cash flow statement and selected financial ratios.

One of the best formats for gathering and interpreting this kind of financial data is the trailing 12-month chart because it allows you to see trends over time. Once you have the information, you can identify problems and outline solutions in your plan.

The three-year plan provides a tool for looking into the future and determining how your company should perform. More important, says Zaepfel, it allows you to grow the business without running out of cash. To develop a three-year plan:

  1. Project the income statement. First, develop a sales forecast and determine your expected gross margin percentage. Then estimate your operating expenses and use all three figures to determine your projected profit (or loss).
  2. Project the balance sheet. If your projected net income plus the increase in variable liabilities equals or exceeds the increase in variable assets, the company will have the resources to finance itself. If not, you will have to obtain additional financing.
  3. Project cash flows. Using the information in steps one and two, project how these numbers will impact your cash flow, paying special attention to how much new debt or equity you will need to inject into the business and when.
  4. Project key balance sheet and income statement ratios. You never want to grow at the expense of the balance sheet, argues Zaepfel. If your projected ratios show a weaker balance sheet, rethink your projections. Or, start looking at ways to cut costs, improve margins and run a leaner operation.

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Developing Financial Discipline

Zaepfel believes that financial success for a business consists of five elements:

  • Sustaining profits
  • Maintaining a strong cash position
  • Building a healthy balance sheet
  • Providing adequate return to stakeholders
  • Establishing a value that is transferable

He also believes that these things don't happen by themselves. Instead, they come about as the result of practicing financial discipline in the business.

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Key Financial Management Ratios

In and of themselves the raw numbers on your balance sheet, income statement and cash flow statement have limited value. Of far more value, say our experts, are certain ratios that can be extracted from these documents. The secret to effective financial management lies in knowing which ratios to track and what they tell you about the state of your business.

"Too many CEOs look at gross sales and revenues on the income statement and nothing else," says Waring. "If sales look good, they figure everything else must be in order. In reality, you can have healthy sales growth and still be headed for financial disaster. The only way to know that is to pay attention to the ratios that tell you what's really going on in the business."

According to Fleisher, the balance sheet gives the truest measure of a company's overall health. Unlike the profit and loss (income) statement, which is a historical recording that never changes, the balance sheet is a living, breathing document that changes on a daily basis. The three most important balance sheet ratios are:

  • ·Current ratio (Current assets/current liabilities)
  • Quick ratio ([Cash + receivables]/current liabilities)
  • Debt-to-equity ratio (Net worth/total liabilities)

The current and quick ratios measure the company's ability to survive a short-term financial crisis. The debt-to-equity ratio (also known as the safety ratio) measures the company's ability to survive over the long-term. If sales and revenues continue to climb while these three measures show a decline (a scenario that happens all the time in fast-growth companies), you have a real problem on your hands.

The P&L statement focuses on revenues, expenses and net income (or loss) over a defined period of time. It measures the company's ability to turn sales/revenues into profits, a key ingredient for long-term success. Zaepfel identifies the most important P&L formulas as:

  • Gross income (Revenues – cost of goods sold)
  • Gross margin (Net sales – cost of goods sold)
  • Net operating profit (Gross margin – SG&A expenses)
  • Net profit (Net operating profit + income) - (other expenses + taxes)

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Key Indicators: Tracking Your Way to Financial Success

One of the primary jobs of management involves reading the trail signs (key indicators) and taking appropriate action to make the company more successful. To use key indicators to their full potential, Kramers recommends five basic steps:

  1. Identify the right measures.
  2. Use the right increments.
  3. See the big picture.
  4. Anticipate the future.
  5. Take action.

Kramers believes every business should monitor a core set of financial key indicators from the income statement, balance sheet and cash flow statement. These include:

  • Income Statement
    • Net sales (dollar growth and percent increase)
    • Gross profit margin
    • Pretax earnings (dollar growth and percent increase)
    • Operating expenses (SGA) as a percent of sales
  • Balance Sheet
    • Receivables turnover
    • Inventory turnover
    • Debt-to-equity ratio
    • Total equity dollars
  • Cash Flow Statement
    • Operating cash flow
    • Investing cash flow
    • Financing cash flow
    • Ending cash

Tracking these indicators will keep you tuned in to the financial side of the business. However, Kramers also recommends tracking certain "non-financial" indicators that have a substantial impact on your company's financial performance. These include:

  • Sales
    • Number of transactions per unit time
    • Average sales dollars per transaction
    • What causes sales
  • Operations
    • Number of widgets produced
    • Average cost per widget
    • Number of widgets sold
  • Customers
    • Customer satisfaction index
    • Number of customers
    • Number of new customers
    • Ratio of new to existing customers
    • Average sales per customer
  • Market
    • Percentage market share
    • "Key-thing" mix change (percentage)
    • New product growth (percentage)

(Note: Kramers defines "key-thing" as the mix of business in terms of product line, customer segments, geography or the value-added you provide different customers.)

  • Employees
    • Number of employees
    • Employee retention
    • Average sales per employee
    • Number of net new positions

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Managing Cash Flow

The cash flow statement is typically broken down into three categories: operating, investing and financing cash flow. Added together, they determine the company's overall cash flow. Like the balance sheet and P&L, the cash flow statement typically comes out once a month. However, our experts strongly recommend tracking cash on a daily basis, especially for companies having cash flow problems. To keep close tabs on your cash flow:

  • Review the cash flow statement once a month.
  • Look at your receipts and disbursements on a daily basis.
  • Know how much cash you have in hand and how long it would last if the money suddenly stopped coming in.
  • Know how much working capital you will need for the next one, three and five years.

While watching the daily cash flow is essential for survival, Zaepfel also cautions against overlooking the long term. "As companies grow, they tend to outgrow their people, systems and cash," he explains. "You can fix the first two, but running out of cash will put you out of business. For that reason, you have to understand how much cash you will need to grow the business and plan accordingly."

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Improving Your Financial Management Skills

To take your financial management skills to the next level, our experts recommend several tracking tools and financial management practices.

Tracking tools:

  • Best financial tool. This three-page report includes summary information from the income statement, balance sheet, and cash flow statement for the month-ending, year-to-date and full calendar year. The page with the income statement summary also includes a reforecast for the full year. According to Kramers, the best financial tool causes you to look at the income statement, balance sheet and cash flow statement at the same time, which gives you a quick 30,000-foot snapshot of the company. More important, it allows you to see what the rest of the year will look like before it happens and take appropriate action as necessary.
  • Four charts "cause-and-effect" tool. This tool combines four charts on one page to give a quick overview of selected key indicators. It also enables you to better manage critical indicators by tracking and managing the activities that cause those indicators. For example, suppose you want to improve pre-tax earnings. First identify what causes pre-tax earnings (i.e., net sales, gross profit margin percent and operating expenses as a percent of sales). Next, track these indicators (along with pre-tax earnings) using a trailing 12-month chart. Finally, combine all four charts onto one page. By tracking and managing the three "cause" indicators, you will automatically cause pre-tax earnings to go up.

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Don't Shoot Yourself in the Financial Foot

In today's markets, it's tough enough to turn a profit even when you do things right. To avoid making things harder on yourself, our experts recommend steering clear of several common financial management mistakes.

Poor cash flow management

  • Having the wrong mixture of debt and equity in the business
  • Failure to plan
  • Absence of timely and accurate business records
  • Inability to read and understand financial statements
  • Lack of knowledge of costs
  • Failure to renegotiate bank relationships
  • Failure to understand what causes results
  • Failure to see the big picture

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