Tim Richardson

A modern finance function should be more than a scorekeeper: we read that everywhere. Well, it's true, and it's true at small companies as well. Transforming finance at a Small to Medium sized Enterprise (SME) has specific challenges. The Finance team is smaller, the IT infrastructure is less sophisticated and the management team may not be driving Finance to do more. If management does want more from Finance, they are often unable to express a coherent view of what they want. Culture challenges such as a reluctance to share information come into play, and there may be strong resistance to change. This is the third part of a series which begins here.

A key measure of a transformed finance function is an increase in business influence. For finance, this links to "decision support":  helping management know what they should focus on, and estimating the future cash-flow consequences of various alternative decisions.

How can finance increase its influence in decision making?

That's not the correct question. Why should anyone in an SME give more influence to finance? Does the CFO or Controller have years of experience with the customers, suppliers and competitors of the business?

The correct question is: what skills, techniques and perspectives does a good finance team offer for better decisions? Imagine that you are participating in a decision about investing in a new machine on your first day of work, and you don't have much idea how the machine works. Consider how you could usefully contribute to the decision. This is a good mind experiment to concentrate on the toolkit of a finance professional.

In this article, I am going to focus on tactical decision making: the decision to be made is already known. Finance can play a vital role in strategic decision making, such as identifying long term opportunities worthy of further investigation. But here, I focus on contributing to decisions already facing the management team.

This article is the third in a series "Transforming the finance function at an SME". The first article, an introduction,  is here. The second article is here.

Key skills that finance brings to decision making

If finance doesn't have years of experience with customers, suppliers, manufacturing or coding, what can it offer?

• A quote from an article in The Age about government infrastructure:   "Back then, there were just 33,000 telephones across the nation and it took until 1935 for the network to be extended to Perth and finally Tasmania, all at enormous expense. It was an era when engineers dominated, when grandiose plans were dreamt up and turned into reality and when the costs were simply borne by the taxpayer in the quest for nation building. These days, economists and accountants rule. Everything has to be costed. Stringent financial tests are applied in a thousand different ways. Discounted cash-flow models, net present value, return on capital invested and replacement cost models are plugged into every major policy and project."

  We like numbers and measuring things: ultimately, finance sees a business as cash flows, which is a series of numbers. This is a strength: the ability to compare an hour of my labor with products for sale in your shop is one the reasons we have money. Converting ideas and plans into numbers representing value requires estimates and assumptions. Some people don't like that because they are afraid of the errors introduced by those estimates and assumptions, and this is a legitimate concern. But sometimes people don't like the process of translating plans and ideas into money because the process is too revealing.

• Timing counts: finance people are drilled in the time value of money concept: expecting an income of $100,000 is not enough information: when is it coming? We will ask what investment is needed now to get benefits later.

• Sensitivity analysis: Converting ideas and plans into numbers is very powerful, but it only works because it takes the complex real world and simplifies. Simplicity has dangers. For example, a business plan may make a simple assumption about the development of gross margin over three years. In reality, gross margin will depend on product mix and customer mix.. Don't fix this by adding complexity back into the model. Model a range of gross margin values to see what effect inaccuracy in the assumption has. This is “sensitivity analysis”, and it is more than a way to work around the simplifications of a model. It's a key tool: a decision about how much to bid for a tender may crucially depend on inflation assumptions as well as gross margin assumptions. We can use sensitivity analysis to show how different inflation outcomes affect the profitability of the tender. The model can't tell us what inflation will be, but it shows what are the most important unknowns or uncertainties to master for confident decision making; this is a very useful contribution.

• Risk: Technically, risk means an unknown, which could be positive or negative. Shares are risky, which means that shares are a higher return investment than government bonds. In common use, “risk” means something which can go wrong, and “opportunity” is the common use for the positive side of risk. I say “upside and downside risk” to eliminate all confusion. In any case, finance people are always looking for risks and how to measure them. This comes back to our world view, which requires us to translate ideas and plans into numbers. This focuses us on building models, and finding key drivers of the outcome. This necessarily forces us to think about what are the important risks and opportunities, and which are less important. Another tradition of finance is control: processes to eliminate certain types of risk, and an audit mentality, where we ask for proof. Combined, it means that finance people will probe uncertainties, working out when they are important. This leads to a systematic investigation and ranking of upside and downside risks.

• Truly understanding relevant consequences: In cash flow analysis, we learn about relevant costs. In my experience, this is a surprisingly hard concept to grasp. I know an experienced business leader who complained to me about the fervour of a staff member who wanted to replace a lot of traditional light bulbs with energy savers. The MD wanted to wait until the existing light bulbs burnt out; throwing them away even when they still worked seemed wasteful. Of course, to finance professionals this is immediately obvious as a fallacy. If CFLi lamps have a positive NPV, then delaying their use is a poor decision. The old light bulbs have already been bought, and waiting for them to fail doesn't change that. The discipline of relevant costs forces a focus on what the real decision is, and what the real consequences are. Personally, I think this is one the most important things I learnt from my finance studies.

The process is at least as important as the outcome

In my experience, the process that a finance leader uses to arriving at a recommendation is equally important to the outcome of the analysis ... if the process is collaborative. The process involves smart questions and a focus on what really matters.

The outcome still matters completely, because the integrity of the process depends entirely on delivering and standing behind the conclusion. At times when I was younger and less experienced, I sometimes felt that the financial conclusion was window dressing to justify a decision already made. There is no doubt this can happen. But in fact it is healthy if the outcome of the financial analysis is not a surprise. A strong financially-oriented decision making process will involve all members of the management team, leading to agreements on timing, key assumptions, the true decision being faced and what is needed to make the project happen and stay on track. By the time the numbers are crunched, the analytical and focused approach of Finance will have already contributed enormously.

However, that is only true if the finance process gets buy-in from everyone making the decision. SMEs have a different profile of decision makers from large blue chips, so (finally) I will give an example focused on SMEs.

Most literature about management accounting comes from the world of large companies. How are SMEs different? The differences are that SME managers are less likely to have MBAs, are more likely to be genuine entrepreneurs rather than professional managers, have more expertise in their market, are more likely to have skin in the game, are more likely to be involved in the execution of the decision, and are much more inclined to fast decision making. Nearly all of these points seem very positive to me.

An example

I'm not going to produce an example which goes through all the points above; that would be overwhelming. Instead, I want to give a simple practical example of how finance techniques can be used to support an SME management team. The biggest challenge is keeping things clear, to use decision support tools to keep focus on important points, and to get involvement and buy-in to the financial decision making process. Those three points are the theme of this article.

I'll show a model with is simple and easy to use, encouraging participation and ownership. I've chosen a generic example; it's an EBIT model designed to show a few key drivers of the business result, and come to a break-even sales level.This model should leave the management team very clear about what type of fixed cost level the business can support.

The model concentrates on a few key drivers.The spreadsheet can be downloaded here for Office 2007.

Such simple models can be used often, so they're worth getting good at. Simple models are perhaps not very technically satisfying (I learn programming languages as a hobby and I'm strong at maths, so I enjoy technical challenge, but I try not to inflict it on my colleagues). Simple models are satisfying because they help other members of your management team quickly move to a deeper understanding of where they should be focusing, and how the management team should be co-ordinating efforts. Focus and co-ordination are great outcomes of a process.

A useful model for non-financial people should allow the user to understand how one or two key drivers affects the business. Then it should lead to what-if questions. It should do this in five minutes. You know you have the model right when people start joining dots like never before, when they're having fun using the model and when they use it after you've left the room

Here are some tips, most of which ensure simplicity because this is the best way to get ownership and involvement (in the words of Captain Barbossa, these are more guidelines than actual rules).

1. One screen and printable

2. Use spinners, avoid keyboard entry of numbers and use Excel protection to avoid accidental breakage of formulas.

3. Provide tips about sensible ranges of inputs

4. Make the model tactical, not strategic, short term focus not long term focus. Make the inputs things which can be influenced, or which are likely to change.

5. Make the model narrow in focus: it's a simple model, focus on one thing.

6. Don't make it too much of black box: help the user with "signposts". If your model is based on monthly figures, show the annualised value of certain key lines to help the user do reality checks. Show interim formula calculations

7. Use consistent terms and link the terms back to other reporting. Don't say "wage bill" if your P&L says "Employment costs". Don't say "margin" when you mean "gross margin".

8. SME managers may not be very financially sophisticated, but they are good at numbers. Think hard before presenting answers as charts instead of numbers.

If a model looks like becoming something with a lifetime beyond a few weeks, congratulations. Keep what you have achieved; probably the only thing you need to add is a way to store and retrieve scenarios (with a few simple macros).

Illustrated example

The best way to view this is to download the attachment.

• here for Office 2007
• here for OpenOffice v3.2

This simple model shows a some important points. This is not supposed to be a lesson in spreadsheets, but a lesson in how to make simple, playful models that focus minds on a few key drivers and how they impact results.

This model was designed to allow management team members to quickly understand how gross margin, variable costs, fixed costs and sales lead to an operational result, and then to understand what level of fixed costs would be appropriate.

This model is based on a real example, and it was highly effective. It may seem simplistic, but this model kept discussions extremely focused on what really mattered. A key insight was the equivalence of fixed cost reductions to sales. If the contribution margin is 15%, then $1 of fixed cost reduction has the same EBITDA benefit as increasing sales by around $7. This model brought this point home; it was an unforgettable insight.

The spinner controls (the up/down arrows) are linked to values in the blue cells. In Excel, the spinner controls can't drive negative values and they can only drive integers. So the percentage values are the integer divided by 100. To get negative percentages, you would make the value of 50  = 0 so that the percentage value = (the linked cell - 50) / 100.

Spinners seem to really encourage playing with different values.

This model is based on monthly figures because the idea was to take a short term focus. However, signposts to annual figures are shown, because they are very familiar.

A macro to reset the model to breakeven sales is linked to a button at the bottom of the model. Having a reset is important if you want people to feel comfortable playing with values. The model has notes suggesting reasonable ranges for the key drivers.

The temptation is to make the model more sophisticated. Questions will arise: for example, "what if the sales stay constant but channel X increases to 50% of total sales" or "what about exchange rate effects". You can ask questions all day. However, are they points which can be influenced? Are they important? And do they bear on the decision being faced? In this case, the decision was about fixed costs levels.

About the author

Tim Richardson is an experienced finance professional who differentiates himself by his versatility, his IT and system skills, and his people skills.He has an enormous range of leadership experience gained in the FMCG sector, online B2C, manufacturing and international supply chains, and he has worked in emerging Asia, mature Western Europe and transforming Central and Eastern Europe. His qualifications span the communication strengths of an Arts degree, the analytical skills of a Computer Science major and the professional skills of a Masters degree in Finance. His has built teams of all kinds of talent mix and lead them through change, and has a strong record in recruiting and developing people. His practical IT skills and systems background is very strong in maximising the value of information spread throughout the organisation, and his ability to help experienced management focus on the issues and consequences of decisions enables him to add value very quickly. He is currently enjoying his CFO role with an Australian SME with a major international online presence.