Getting financial management right is one of the things that defines a well-run business. Getting it wrong invariably leads to crisis and often leads to bankruptcy – poor financial management is the common factor behind most corporate failures.
So why does the discipline have such a low profile in the mainstream business media? It could be because, historically, finance departments have had a limited and largely supportive role. Or it could just be that many financial managers are low-key themselves – there are few notable heroes or villains in the field.
Equally, executives who are not directly involved in the finance function often assume that they can take financial management for granted. They also assume that, as a discipline, it does not change very much over time. Both assumptions are not merely wrong, but dangerous. One of the features of good financial management is the active involvement of line managers all the way up to the board. And as a discipline it is undergoing rapid change.
The articles in this series are addressed to all managers and not just to finance professionals because of financial management’s far-reaching implications. Developments in areas such as compliance, risk management and performance measurement, as they apply to finance, have an enormous impact on key decisions across any company, including those related to the allocation of resources.
The impact is not only on line management. It also affects support functions such as HR, marketing, procurement and IT – indeed, in many cases, it determines whether some or all of these functions should stay in-house at all. Furthermore, the quality of financial management directly affects the role and reputation of both executive and non-executive directors, especially in quoted companies.
External pressures
The changes under way in financial management are increasingly being driven by external factors. As in all other areas of commercial life, globalisation has been a major influence – for example, in the form of the international financial reporting standards (IFRS).
Similarly, while the dramatic collapse of Enron may have had little to do with Japan’s economic woes, its fallout, in the form of the Sarbanes-Oxley rules affect the internal operations of a Tokyo electronics business quoted in New York as much as it affects any similar business in the US.
The growth of international capital markets dominated by demands for shareholder value is another powerful set of influences on financial management. Accordingly, Lily Fang and Ayako Yasuda consider the quality of analyst research, while Thomas Chemmanur and Paolo Fulghieri look at the role of intermediaries such as banks and exchanges, and Horacio Falcão and Rony Stefano discuss how to manage investor relations from a negotiation standpoint.
Tilting the balance of power from managers to shareholders, the shareholder value approach has provided a clear framework for major financial decisions as well as strict constraints, such as the ability of companies to conserve cash. Buybacks and dividend distributions, not expensive acquisitions, are the order of the day.
Anant K Sundaram argues that there is no credible alternative to maximising shareholder value which, in turn, has a positive knock-on effect for other stakeholders. Indeed, there are limited conditions where other stakeholder interests can be given equal or more weight to those of shareholders.
The growth of private equity has increased the pressure on listed company performance, as well as giving a potentially attractive alternative financing route. Moreover, as Stuart Read and Maneesh Mehta argue, venture capital techniques offer new methods for increased financial innovation within companies.
Europe has also become an important influence. In the UK, the recent decision to postpone the requirement for UK-listed companies to produce an operating and financial review has not taken narrative reporting off the agenda. The requirement for all large and medium-sized European companies to produce a business review will provide the key information on performance and development, and key performance indicators that are non-financial as well as financial. Auditors will have to state in their audit report that the review’s contents are consistent with the financial statements. (It is an interesting irony, too, that narrative reporting is even more important in the current transitional period when the introduction of IFRS is causing some confusion about the numbers.)
Even in financial aspects of corporate governance, the agenda is becoming more international. Until now, initiatives have been largely national but a number of common themes on key areas are steering them on to a converging path. For financial management, these include giving greater formal emphasis to the role of audit committees and internal audit as well as the financial responsibilities of the board.
Elements of the sustainability debate are also being added to this agenda. Not long ago, the idea of triple bottom line reporting – financial, social and environmental – would have sounded eccentric, not to mention irrelevant. Now, calls for its widespread adoption are growing louder – representing a whole new world for many companies and a new set of challenges for CFOs.
As in the business review, sustainability is likely to be linked to the financial aspects and may, therefore, need to be audited. Inaction here is increasingly likely to affect reputation, since company rankings in sustainability league tables are now watched closely by pressure groups and the press. Sustainability developments particularly affect companies in industries subject to reputational risk. The list of sectors is growing – oil, gas and mining have been joined by pharmaceuticals and even, based on anti-obesity pressure, food production and sales.
Finally, there are the external pressures arising from increased life expectancy and low long-term interest rates on pensions. The question of company (and state) funding of pensions has been a matter of huge interest in recent years. High-profile companies weighed down by pension liabilities are not isolated cases. They are merely the most publicised examples of the pension risk faced by most managements. Less well understood have been the implications for the individual, and Bernard Dumas and Juerg Syz propose a new framework.
Internal developments
The external pressures set out above have been a major factor in the development of internal financial management processes. Most obviously this has been in the possibilities offered by the increased capabilities and reduced cost of technology in data processing, capture and analysis.
The combination of IT and globalisation has, of course, provided the opportunity for outsourcing on a massive scale, including providing direct benefits to the finance function itself in outsourcing transaction processing. The implications of outsourcing more generally are still being worked out, and Marek Szwejczewski offers an idea of the hidden risks and costs of outsourcing.
Another area where internal developments have been driven by external pressures is that of risk management. The requirements in the UK for listed companies to explain if they don’t meet the requirements of the combined code on corporate governance have given a strong impetus to systematic risk management processes. The results of a worldwide survey of non-financial companies are revealed by Henri Servaes and Peter Tufano, covering not only what companies do to manage risk but how and why they make a number of key choices. Viral Acharya and Stephen Schaeffer look at causes, consequences and implications of liquidity risk. And at a time of significant hikes in oil and other commodity prices, there is pressure on CFOs to address questions of hedging. As Didier Cossin and Dinos Constantinou make clear, this comes down to a better understanding of risk management.
But in many cases, companies have not exploited the opportunities offered. Poor IT procurement and implementation have been as much a feature of the last few years as cost reduction and greater efficiency. A few companies have integrated risk management into operations, regular monitoring and internal audit procedures, but many have not.
In other areas, too, there are opportunities still to be seized. The logic of following a value-based management approach is that it should be reflected in all decision-making, with the cost of capital taken fully into account and the focus on cash flows rather than earnings-based decisions. But in practice, many organisations have found this to be too demanding, and have exercised cost-of-capital disciplines in contemplating acquisitions, but not comprehensively in internal decision-making.
With performance measurement, too, there are opportunities. Many organisations have been reluctant to break away from traditional backward-looking and financial measures. The use of non-financial measures remains limited and while balanced scorecards are increasingly used, poor implementation (for example, where measures are too numerous, too financially focused or linked poorly to overall strategy) has resulted in many being abandoned. Andy Neely’s article on performance measurement not only uses examples of the ways in which managers have failed to find solutions on performance measurement, but challenges them to do better.
Old yardsticks versus new pressures
More traditional financial management processes show a mixed picture. Techniques such as activity-based, target and kaizen (continuous improvement) costing have been adopted by many organisations. Control systems have generally become more sophisticated and their operation has become less mechanistic. Some budgeting processes have been streamlined, with an understanding of the need to respond to a fast-changing commercial environment by, for example, re-forecasting where necessary.
In part, the pressure has again been external – Sarbanes-Oxley has given rise to demands about the quality of internal controls that are not negotiable for companies quoted in the US. But studies show consistently that most organisations have been slow to capitalise on improved best practice. In particular, there is constant and understandable sniping at the annual budget, which is often not seen to be delivering enough value for the time spent.
Overworked CFOs may understandably feel aggrieved. A plethora of requirements driven by regulatory requirements has been added to existing commercial pressures – and more are to come. It has been argued, with some justification, that the expense and effort of implementing these initiatives is disproportionate to the result. Yet once the initial effort of providing systems is over, the results will give CFOs even more clout and better means to deliver good financial management.
So too will most of the internal developments. Continuous IT change processes, extending performance measurement to new non-financial dimensions and the integration of risk and financial management provide as big a set of technical and managerial challenges as the volume of new regulations increases. They are also providing powerful new tools for improvement.
In organisations with good financial management, the CFO has successfully guided the transition from being inwardly focused and largely process-driven to being at the heart of corporate decision making. Those functions that have not made the transition are in danger of, at best, holding back the organisation and, at worst, destroying it. And as the function has changed, the role of the CFO has needed to change with it. Meeting externally imposed change is currently an urgent issue, and many CFOs have risen to the challenge. Sadly, some have not. A few have not even realised how much change is required from them. The role has never been more difficult, rewarding or fraught with personal risk.
Conclusion
Adequate financial management isn’t good enough. The problem is that senior management is often not aware that things are not what they might be. Outsiders – including non-executive directors and the audit committee – are potentially valuable resources for improving corporate governance practices and increasing value. They need to help the organisation respond as fast to developments in managerial best practice as to externally imposed changes. Taking risk management as an example, UK companies will benefit from increased board awareness of risk by being asked to sign off on the combined code requirements. But really getting the benefit means ensuring that a risk management culture is embedded and that risk is a regular feature of board discussions.
Considering the prizes for first-class financial management and the downside of being poor or just adequate, this is an area to which all senior management needs to pay attention. The CEO has a particularly important role to play in supporting the change agenda by giving the company a competitive advantage. The mark of good management in this, as in other areas, is that change is driven by a culture of continuous improvement, not by external requirements and certainly not by crises.
Sir Andrew Likierman is professor of management practice at London Business School and a former President of the Chartered Institute of Management Accountants.
