karen moses boral

Atlas Iron founder David Flanagan FAICD knows from harsh experience the power of the numbers when they’re running against you. After founding the WA iron ore miner in 2004 and helping to transform it from a junior explorer to a mid-tier miner generating nearly $1 billion a year in revenues from the Pilbara, a disaster scenario unfolded that left it at the mercy of its lenders.

The converging of risks in 2015 — a crash in the price of iron ore and the impact of a falling Australian dollar blowing out its debt — put the miner at risk of breaching its debt covenants.

Flanagan, now managing director of Battery Minerals, recalls the intense negotiations and efforts of board and management to save the company as share price plunged. “It was like trying to catch a knife,” he says.

In considering its risk management strategy, Atlas Iron had modelled a “doomsday scenario” with falling iron ore prices and asset valuations. However, as Flanagan says, “We should have modelled a double, triple, quadruple doomsday scenario right at the very beginning.”

The upshot? In 2016, a last-resort debt restructure delivered the company’s lenders 70 per cent of its equity and with it a new chair and two new board members. Flanagan departed the business he’d founded (see story page 23).

Financial sustainability is a vital board priority. Whether you’re a director of a fast growing miner, a small not-for-profit (NFP), a multinational enterprise or juggling conflicting needs of a startup, the issues and life cycles may differ, but the basic principles apply. A decade on from the global financial crisis that cut a swathe through the business world, we spoke to senior directors with deep experience from a range of sectors to gain their insights on the indicators to look for — and what to prioritise.

Getting to grips with financials is vital, not only for the stability and survival of the organisation, but personally and professionally. Directors can be held personally liable for debts incurred if their organisation trades while insolvent.

Paul Kerin from the Adelaide University School of Economics, and a member of four NFP boards, says survival in business requires careful management of both longer-term viability and short-term cash flow.

“Historically, many NFPs relied heavily on government grants,” Kerin says. “Revenues were stable and they didn’t need to be stand-alone viable, nor hold large reserves. In today’s market-based competitive environment, NFPs must pay as much attention to viability and cash flow as businesses do — even more so, given their low reserves.”.

1. Track the cash

“Cash is king” is an often-heard phrase, but no less true for being a cliché. Essentially, directors should know their organisation will have enough cash to cover their future liabilities. But verifying this isn’t always straightforward, says James Beecher FAICD, who has served nearly 20 years on the AICD reporting committee.

“Directors have to understand and be comfortable they know where the cash is coming from and going to — to understand from management how they’re managing cash, what the cash flows are, what the cash balances are and what’s happening in the future with cash,” he says.

Beecher recalls one company he was on the board of, which was unable to access the cash flow report because all of the systems were set up to produce statutory profit and loss accounts. He says the first thing he asked for at every board meeting was where the cash flow report was.

“What are the numbers? What are the assumptions? Why are they meaningful? It took me 12 months to come up with something that was meaningful,” Beecher says.

Fortunately, the company operated in an industry where prices were at record highs and was generating enough cash not to run into trouble.

Directors should see if the financial report is compiled on an accruals basis. This is an accounting practice where payments are booked on the date an invoice is issued or when a bill is presented rather than when the cash actually goes into or out of the organisation’s bank account.

They should have a close look at the notes to the cash flow statement that balance the statement to the profit and loss. “Cash flows have to be done on a cash basis, not an accrual basis, and reconciling items to profit and loss needs to be understood and accounted for,” says Beecher.

Directors should receive monthly cash flow reports from managers at board meetings and ensure that the cash report is actually reconciled back to the organisation’s bank accounts.

They also need to test the assumptions on which the cash flow forecast is based. Are predicted sales realistic, for instance?

2. Solvency test

Darwin based Steve Rossingh GAICD, an accountant, former CFO and executive manager who is also an experienced board member, says it’s vital to look to the balance sheet and put solvency at the base of a board’s hierarchy of needs.

“It’s life and death, the bottom part of the triangle,” he says. “The number-one thing as a director is being able to pass a resolution that your organisation is solvent.”

Rossingh, now Treaty director at the Office of the NT Treaty Commissioner, says the working capital, or current ratio is key.

“I was an Indigenous non-member and skills-based director on the Central Australian Aboriginal Congress (CAAC) medical service board for four years, and I’d say to the other directors, ‘If you take nothing else away from your time here, it’s knowing the importance of liquidity ratios from the balance sheet and how to calculate them’.”

However, Rossingh says it’s also important to understand what’s behind its calculation. To get the working capital, or current ratio, you divide current assets by current liabilities. It indicates whether a company has enough short-term assets to cover its short-term debt.

Once you make that calculation and compare it to benchmarks then you know whether you can satisfy debts, when they are due and payable. “A healthy working capital ratio depends on many factors including the organisation, the industry, the location — so each organisation needs to set its own benchmarks to compare against,” he says.

Dianne Azoor Hughes MAICD, a governance, risk and audit consultant and the author of the AICD publication Financial Fundamentals for Directors, explains that if the current asset ratio is close to one, this means there is likely to be just sufficient cash flow for current liabilities to be paid out of funds received in the next 12-month period.

If the ratio sinks below one, there is a liquidity risk, which means there is the danger that there will be insufficient cash to settle debts when they fall due. In severe situations, this could mean insolvent trading, which would bring personal risk to directors. Hughes says in this situation, directors need to ensure cash flow is closely monitored and ensure management has implemented strategies to improve cash flow such as improving productivity, billing cycles and debtor collection times.

“If net current assets are at a low level or if there are net current liabilities this is a big red flag.”

3. Dashboard view

Karen Moses FAICD says it’s not just about surviving, but thriving. A well set up financial dashboard will give directors a short, medium and long-term view, and can help them focus on what’s material for the company.

karen moses boral

Moses, a non-executive director of Boral, which reported a 49 per cent net profit for 2017–18, is also a director of Charter Hall, Orica and the Sydney Symphony Orchestra. She spent more than two decades at Origin Energy, including as executive director of finance and strategy.

“If a company is going to survive, you’ve got to anticipate a range of possibilities. If it’s going to strive, you’ve got to be efficient, effective and competitive. And for thriving, you’ve got to be in a position to capture growth and address your headwinds on both of those counts,” she says.

The dashboard should reveal tolerances and boundaries for different financial and operational indicators — for instance, how much of a cost overrun on a project could be tolerated — and help directors gain a good understanding of the causes and mitigations of financial indicators that sit outside those tolerances.

“You want insightful answers to those questions about what are the consequences of being outside those tolerances,” says Moses. “It means things don’t just drift away — ‘We’re over budget, we’re under forecast, we’ll come back next month’.”

Moses says directors should be sure to look carefully at the quality of their organisation’s earnings. Are they being boosted by unsustainable one-offs — such as a change in the way depreciation is calculated or a one-time big order from a customer? Or is it perhaps the underlying business itself that is actually generating the profit margins?

It’s important that the business has “a single source of truth”. Organisations can run into problems when they have different definitions for the same piece of information. For instance, to a regional sales force, sales might mean one thing, but when the sales are aggregated by the finance team, they might well mean something different.

Moses says that financial sustainability rates among the top concerns for NFP directors. The financial metrics still apply, but rather than seeking a financial return, NFPs are seeking a social return.

“Your measure around stakeholder engagement and stakeholder satisfaction are different types of measures, so your dashboard would look different but the principles are still the same — you still set the tolerances and you still look to what’s material,” she says.

4. Long-term thinking

Financial sustainability is about more than whether an organisation has enough cash to pay its bills, says Michael Coleman FAICD, director of Macquarie Group and AICD. Coleman, who is chair of the Macquarie Group audit committee, says one of the important issues to consider when you’re dealing with an entity is this focus on the longer term,” Coleman says. “Are the resources

I have available to me — whether they be cash, the capacity to raise capital, the capacity to borrow more — sufficient to enable me to achieve the longer-term objectives of the business?”

Coleman says there is little point in preparing a strategy document that might, for instance, involve improving gross earnings by a large margin if it doesn’t have the capacity to fund the longer-term debtors’ requirements.

“It’s amazing how many people prepare glorious strategies then forget about the cash they might need to get there and the supply chain logistics they need to grapple with. They forget that many debtors may not pay as quickly as you like, or creditors might not consider giving you the 60 days’ credit you’ve always had in the past.”

Integrated reporting — which provides an integrated picture of how an organisation’s business model and strategy, governance, performance and prospects lead to creation of value over the short, medium and long term — can help directors determine their organisation’s financial sustainability, says Coleman. Macquarie Group has incorporated elements of the long-term value reporting framework in its annual reporting.

“Integrated reporting has the same capacity to drive your thinking internally, to think about what your resources are, what the future might have, what could go wrong, and what you might need to do if things do go wrong and make sure that the enterprise itself continues to be sustainable,” he says.

Directors shouldn’t only focus on financial measures when determining financial stability says Tracey Horton FAICD, chair of educational services provider Navitas. “Directors need to look at a wide range of indicators to understand the sustainability of their organisation.”

tracey horton navitas

Financial stability also depends on other non-financial measures, such as technology, employee engagement and retention, and customer satisfaction. “For example, on the board of Navitas, we’re constantly looking at what’s happening in technology. In education, we need to be investing in today so that five years from now, we don’t find we’ve missed the boat on major technological innovations,” she says.

5. Days in debtors: ensuring you get paid

Days in debtors is a measure that shows how quickly cash is being collected from debtors and is important for directors to watch if their organisation has a tight cash flow, says Dianne Azoor Hughes.

It shows how many average days sales are owed by debtors. The longer it takes to collect payment the greater number of debtor days.

Professional services firms such as accountants, lawyers and engineers are reliant on issuing invoices to clients and getting money in the bank when the client pays them. So they need strong debtor management systems and support to ensure debtors are paying quickly enough.

“If cash flow is tight and debtor balances are increasing, then days sales in debtors [outstanding] indicate to what extent credit terms are not being enforced,” says Hughes. “If terms of sales are payments within seven days, but debtors to sales shows more than 30 days in sales, then directors know that the sales terms are not working.”

In such a scenario, the company would need to improve credit control processes so old debts do not go unpaid without action. The ratio helps ensure that the costs to provide services or goods to a client are recovered within an acceptable period.

6. Return on capital

Organisations that have a small capital base must closely monitor their reserves to ensure they adequately underpin operations through seasonal fluctuations in cash flows and can sustain investment, as well as afford a risk buffer, says Gene Tilbrook FAICD, director of Woodside and Orica, former finance director of Wesfarmers who is on the AICD WA Division Council and AICD board.

Return on capital (ROC) is a ratio that can highlight short-term performance as well as help directors plan for the longer-term, he says.

ROC is the ratio of earnings before interest and tax (EBIT) to capital, which is the sum of debt plus equity and is expressed as a percentage. Benchmarks will differ from industry to industry.

An effective way to make use of ROC is to compare it with the organisation’s weighted average cost of capital (WACC), which is how much a company pays for the capital it uses, also expressed as a percentage. In general, the return on capital should be higher than the weighted average cost of capital because if it isn’t, it indicates either that the organisation is paying too much for its capital or isn’t getting a good enough return for its capital.

“That is a discussion boards should be having — why is our return on capital greater than or less than our weighted average cost of capital and what does that mean for the organisation?” says Tilbrook. “If it’s above, then how should we be growing and if it’s below, then what should we be winding up. Should we wind up the whole company or can we fix it?”

He says ROC can often be overlooked by boards caught up in discussions about growth, winning market share or making an acquisition.

“They forget those decisions should be made only having regard to whether such a transaction or an expansion will generate a satisfactory return on capital. It needs to be part of the five-year planning horizon. When a company updates its corporate plan to build a new plant and invest a lot of money — ROC tells whether it will still generate good returns once it’s done that.”

7. External advice

All large companies and many other organisations are required to have their financial statements audited by an independent registered auditor. Beyond that, Tracey Horton says, some organisations will need to get additional outside advice if they do not have the internal capability for necessary financial functions — for example, specialist tax advice or internal audit functions.

“Making poor decisions can be more costly than seeking external advice,” she says. Dianne Azoor Hughes says for complex transactions and legal matters boards should seek external advice in addition to the explanations they are receiving from management.

“In both circumstances the way performance is measured will depend on the way an arrangement is structured and how the outcomes are interpreted,” Hughes says.

“Whenever there is more than one way of looking at a situation, and the outcomes produce different results, it would be prudent for directors to obtain external advice to confirm that the treatment adopted by management is consistent with industry practice and/or the validity of taking a different course of action.”

Azoor Hughes says that it is critical to have the right governance processes in place in order to hold management accountable for financial performance.

“The quality of these governance processes underlie how well the board can hold management accountable for performance.”