Mastering the financials

It’s not just for ‘numbers people’. All leaders should be able to speak it. Only then will they be able to cope with the demands of their current job or will they be ready for the next steps on their career path, says Irem Tuna. Here, the professor of accounting and Academic Director of the School’s Finance for Non-Finance Executives outlines how executives can break the ice with numbers and improve their confidence in asking the right questions when faced with financials.

1. Appreciating accounting as an information system

While executives don’t have to become accountants, the ability to make sense of financial information is a crucial skill. So it is useful to know how typical transactions get transformed – by the accounting process – into the financial information people use to make decisions. Many executives may well have seen financial statements like balance sheets, income statements, and statement of cash flows before, but they might not be able to relate these statements directly to the underlying transactions.
The first step to getting fluent in financial language is to make the connection between typical business transactions and the relevant components of financial statements. For example, what happens when a company like Singapore Airlines buys a new aircraft to address its demand? Where does the fact that the company got a new aircraft get reflected in financial statements? What about the fact that the company hires a new pilot to fly the aircraft? What judgements need to be made for the company to be able reflect the economic consequences of the actual use of the aircraft in the normal course of business operations, for instance flying passengers from Singapore to Sydney? Being able to understand these connections and appreciate accounting as the information system that it is, is crucial. Business decisions generate the economic transactions, which are then translated into financial information.
Resulting financial information is a crucial component of how executives communicate with stakeholders. Although this transformation is ruled by reporting standards, executives should remember that reporting involves judgement, and they need to feel confident enough to engage in a conversation that challenges the assumptions used in the reporting process that translates business decisions and transactions into financial information.

2. Taking a careful look at the drivers of profitability

It is likely non-financial executives have reached a relatively senior level without needing to systematically analyse financial statements and take a careful look at the drivers of their organization’s profitability. Regardless of how the company is funded, it is vital to assess whether the business is generating a surplus over the cost of undertaking the operations and cost of finances used. Separating profitability into its component parts, namely how much profit each dollar of revenue generates (i.e. profit margin) and how efficiently the company uses its resources to generate the revenue, helps identify priorities for action. Can the company cut prices to gain market share? Does it have the capacity to handle the additional demand that comes from reduced prices? How does the company compare to the other players in the industry in terms of its profitability drivers? Executives can start formulating answers to these questions by studying the drivers of their organization’s profitability.

3. Making smart comparisons

In principle, assessing a company’s performance is no different than assessing the performance of an athlete. First, you need to choose the dimension of performance to assess (e.g. profitability of the company/speed of the runner). Just as one would compare the runner’s speed to that of the other athletes on the field on the race day, to his or her personal best, and to the record time for the same event, executives need to compare the profitability of the company (and the drivers of the profitability) to the levels achieved by the company in the past, and the levels achieved by its competitors, as well as some absolute thresholds, such as cost of capital. A particular number computed to capture profitability will not mean much unless it is compared with past performance or a competitor’s equivalent. There lies the importance of identifying smart benchmarks.

4. Understanding your costs

Understanding how the costs of a company behave is crucial for executives to be able to make strategic decisions. Before you can decide whether you should add a new item to your product line or discontinue an existing one, you need to understand the cost structure of the company and be able to assess how these portfolio decisions affect this cost structure. For example, do you need to add a large amount of fixed costs to introduce a new service or product? How about the variable costs, i.e. costs you incur for each unit of the product you produce and sell? How much of this new service or product would you need to sell to recover these costs? The quality of the answers to these questions will depend on how sensibly the company allocates the costs it faces across the variety of its activities and products. If your decision making relies on poorly allocated costs, you can find yourself agreeing to add a value-destroying product to your offering, or holding on to a non-performing one, or even entering into the wrong price war.

5. Evaluating investment opportunities

As they rise up the company hierarchy, executives are increasingly called upon to take part in investment decisions. That could be anything from pursuing a new business idea to an acquisition of a company. Regardless of the scale of the investment decision, it involves comparing expected future benefits that could be reaped from undertaking the investment to the costs that will be incurred from undertaking and operating the investment. The net benefits that could be generated from alternative uses of the funds needed for the investment also need to be considered (i.e. opportunity costs). Critical in this process is the ability to challenge the assumptions made in developing the expectations of the future benefits and costs. Are the assumptions relating to sales growth realistic (or have you assumed that you will take over the world)? Have the costs been projected to increase proportionately with expected sales growth or are you expecting some cost savings due to a larger scale? Are the assumed cost savings due to larger scale too optimistic?

6. Setting the right objectives

If used correctly, value-based management is an invaluable framework to have in place to enable an organization to achieve its strategic objectives. Once the executives are able to set the strategic objectives that they are convinced will create value, having a system of incentives to encourage the actions that would help the organization reach those strategic objectives is also necessary. However, successful implementation of value-based management hinges critically on executives’ understanding of the drivers of the company’s profitability and how they can continue to lever these drivers to sustain or improve performance. If executives are confident in communicating in financial language and appreciate the link between drivers of the company’s profitability and creating value, they can set the right strategic objectives, ask the right questions to challenge assumptions and ensure that strategic objectives incorporate realistic expectations on what the company can hope to achieve. And that’s good news for everyone: numbers people or not.