Making Your Board a Strategic Asset

Please don’t ever ask that question, suggests Jean Pousson, our Managing Director, as he looks at typical finance Board conversations, that are too ambiguous, or simply incorrect.

The above question is one that I hear often. Although genuine in intent, the question confuses profitability and liquidity.

Most, typically mean profit, but some, will be questioning the cash flow position. The Profit and Loss Statement/Income Statement looks at the trading position and will articulate whether the business has made a profit or not. The Statement of Cash Flow, as the phrase implies, looks at cash in and cash out during the year. It is about liquidity.

Asking, “Is the business making money?”, confuses the two. There are two better lines of enquiry, ie:

• Is the business profitable? (Look at the Profit and Loss Statement/Income Statement.)
• Is the business cash positive or cash negative? (Look at The Statement of Cash Flow.)

They will tell you different things about the performance of the business.

Return on Investment (ROI)

This is often brought up when considering an investment or even an acquisition. There is no singular accepted definition of this metric. Whenever this has been mentioned my first questions have always been, “What do you mean by ROI? How do you calculate it?”

The first misconception is this. An investment means parting with capital, which can be in the form of existing cash or borrowed funds. Measuring the anticipated returns in the form of profits is flat earth wrong. The returns should be in the form of Free Cash Flows. 

In addition, the investment is made now or over a short period, with the returns accruing over time. Dividing one by the other ignores the crucial concept of the Time Value of Money, ie, moneys received at different times have different values. There are better ways to assess viability and profitability, namely by using Discounted Cash Flow methodologies.

Look at our Equity base.

This can mean one of two things. It can either mean the Equity Capital invested by the Shareholders, or that same Equity Capital plus Retained Profits and possibly other type of reserves. The sum total of all these can be described as ‘Net Asset Value’, ‘Shareholders Funds’, ‘Total Equity’, ‘Capital Employed’……….…, sorry! Regretfully, in finance, many terms are used interchangeably and it is crucial for any Director or Executive to ensure that in conversation, the parties are talking about the same thing.

We are going for a growth-led strategy.

There is nothing wrong with that statement or indeed the ambition, but growth cannot simply be measured in market share or increase in revenues. Growth must be accompanied by profitability and ultimately converted into cash. The cash conversion ratio is a measurement that Directors would do well to understand and keep an eye on, ie how quickly are our profits converted into cash? And ultimately value must be created for the Shareholders and other stakeholders, otherwise the chosen strategy
cannot possibly be strategic.

Look at our cash position in the Balance Sheet/Statement of Financial Position.

That figure is the balance on one day of the year. It can vanish tomorrow as liabilities have to get settled. That figure is also the result of a year’s activity, the position at the beginning of the year could have been healthier. What is important, is to understand from the Statement of Cash Flow, the cash drivers and the cash absorbers of the business and whether at the end of the day the business generates or absorbs cash with all the relevant issues.

The fetish of EBITDA.

EBITDA, (Earnings before interest and tax, add back depreciation and amortisation of intangibles), is an operational measure at best. It is a crude proxy for cash flow, no more. It ignores interest, working capital funding, corporation tax, capital expenditure, and loan repayments on existing loan arrangements.

I appreciate that it is used widely in business, for example, to value businesses, as bank lending covenants, to measure operational performance etc. But it should not be viewed as a cash flow measure.

Be wary when you see derivative versions of EBITDA, like adjusted EBITDA, normalised EBITDA, EBITDA pre-exceptionals, etc. While there may be good reasons for the adjustments, do make sure that you fully understand the result, not to mention the rationale for these adjustments, and that you could reconcile your way back to the statutory, (and possibly audited), profit in the Profit and Loss/Income Statement.


The illusion of precision. 

A Psychologist once warned me about Accountants who give results to three, or more, decimal points. This can create an illusion of accuracy.

You have been warned! Trust but verify and all that.

Another nerdy observation for the anoraks. In the current climate of rising interest rates, an increase from 2% to 3% is not an increase of 1%.

It is an increase of one percentage point!