Can You Skate?

In the team sport called corporate governance every director must play well or the board will lose a lot of games, suggesting that every player brings certain essential skills to every encounter. In Canada's national sport every player on the ice skates well, it is a prerequisite to being on the team, and this article is about an equally crucial skill for any director on any board, a competency sometimes referred to as “financial literacy”. These comments were motivated by a recent conversation with a CEO with the same views.

Actually, we talked about two concerns emanating from the same issue. We have both had far too many experiences where half the directors could barely navigate the financial statements, much less see beyond them. This leads to the twin worries of how those individuals could ever fulfill their duties to the company – and the exposure of other directors as a result of such weakness. I shared with my colleague my uneasiness when directors seem almost proud of their innumeracy, proclaiming that, “I've never known anything about numbers!” We agreed that neither of us want to be on a team with people who cannot skate.

Financial literacy is fundamental to any director's job and while the ability to spot a flaw or inconsistency is prized at any time it is positively golden in emerging companies, especially those where the emphasis has been on the underlying technology and financial sophistication may be in short supply. During the critical early years it may be the board that supplies critical competencies until a new executive team recruits some depth in financial management – and the technical side of the house learns to appreciate it. Those who are start-up veterans know this phase is often somewhat chaotic, with the line between management tasks and director oversight blurred to invisibility. Later, as the new enterprise achieves steady state, the directors' roles evolve and lending a hand with a pro forma or helping value the company, for example, is no longer needed. It would still be a mistake to assume that a practical understanding of the business behind that forecast has somehow declined in importance.

To be clear, I am saying that familiarity with financial statements is insufficient for a director to discharge his or her responsibilities. I suggest that every director should understand how the organization spends or earns money and how it creates value. We have all accepted the fact that financial statements are the primary means of communicating crucial information to stakeholders, internal and external. Fair enough, but they are historical documents telling the story of the previous quarter or year. By the time they have been approved and published, they become the barn door for a horse that has galloped into the next county. If you are a director and “the financials” are your sole insight into the company, you deserve more but you may have to ask for it.

Here is a simple test that you might apply. Ask yourself the question, “Can I track any standard unit of input, such as a dollar, an hour of time or a kilo of raw material, through the company and describe when and how value is added?

Two simplified examples illustrate what I mean. The first is a professional services firm charging $250 an hour for its services. When it quotes $25,000 on a job the hourly fee for 100 hours needed contain the total employee costs (salary and benefits) multiplied by a factor to produce a gross margin expected to cover all other costs and yield a profit. Value is added every time an hour is worked and the resulting revenue is recognized by each invoice over the course of the project. The second example is a real estate transaction, wherein a speculator buys land and holds it while its value increases through a change in zoning or the arrival of an adjacent transit line. The exact time when value is added is almost impossible to pinpoint but it is fully realised when the property is sold again. Directors reviewing the budgets and cash-flow forecasts for these two companies would have a tough time if they did not understand the context.

Real situations are certain to be more complex than either of these companies but directors should receive and be able to understand at least an overview drawn directly from the management accounting system, an extract from the plans, forecasts and internal reports used by the President and his or her direct reports. Without understanding how the CEE Suite makes decisions, it is unlikely that you will be able to understand risks as they appear on the horizon, when something can still be done to avoid them. Such information is fundamental to penetrating — and helpful — inquiries by the directors, but they must possess the knowledge and insight to turn that information into questions.

Understanding the financial workings of an organization is not an “added feature” like call waiting on a telephone. If you have difficulties with financial management either become educated or avoid boards, at least those where fiduciary responsibility has its customary meaning. Going further, if you cannot spot a fatal flaw yourself, it is essential that you understand it when someone else draws it to your attention. This is a business, after all, it exists to make a profit and directors have accepted the responsibility for that result. Please become comfortable with basic corporate finance or stay away from all boards, private or public, for all directors are responsible for their personal Duty of Care. If they cannot accomplish their DOC, how will they ever discharge their fiduciary obligations? Ergo become financially literate – and then some – or please play on someone else's team.