Finance is a mission-critical function for any company. The financial pressures on companies are never-ending throughout their life cycle, whether they are in early-stage development, mid-stage growth, turnaround, or late-stage exit. It is critical that any company has a comprehensive and detailed Financial Management System. This will underpin all of the other management systems within a company, including Operations Management, HR Management, IT Management, and Supply Chain Management, in the sense that the Financial Management System provides the financial analysis and capital resources that all other management systems require. Companies that lack in-depth Financial Management Systems are more likely to fail than those who have these systems in place, despite having great products. Companies with strong Financial Management Systems have a distinctive competitive advantage over those firms that lack these systems, due to having more efficient operations, a clearer understanding of their sources of profitability, a more efficient capital structure, a better awareness of the financial risks entailed in future growth plans, and greater access to capital.
The essence of a successful Financial Management System for a company is having an in-depth understanding of the details of the financial operations of the company. This includes understanding the precise sources of profits and losses at a micro level, the company’s current capital structure of debt and equity, the financial implications of management policies (such as terms of sales, and leasing versus purchasing), the measurable costs and risks of future growth plans, the weighted average costs of all capital raised including the opportunity cost of using retained earnings, and the opportunities for an M&A transaction, buy-side or sell-side.
A successful Financial Management System therefore incorporates
(a) developing an understanding, at a micro-level, of the sources and causes of the company’s profits and losses (as broken by product, location, marketing campaign, sales distribution, and other metrics);
(b) examining the company’s capital structure of debt and equity and calculating the Weighted Average Cost of Capital (WACC) of the company;
(c) reviewing all growth strategies and opportunities through feasibility studies and discounted cash flow (DCF) analyses of their future operations and strategies;
(d) analyzing the company’s dividend policies;
(e) examining different options for raising the External Funds Needed (EFN) for future growth strategies, including using retained earnings, and different options for debt and equity capital raises;
(f) reviewing the company’s foreign exchange (FX) practices and policies, including mitigating exposure risks; and
(g) reviewing, on a continual basis, the opportunities for an M&A transaction.
Following a rigorous Financial Management System strategy increases the odds that any company, no matter where it is in its life-cycle, will be successful and prevail in a highly competitive and uncertain industry. It is a very structured approach, yet flexible enough to continually adapt to changes in the company’s competitive, financial and regulatory environment.
The essential components of a Financial Management System include:
1) Analyze existing financial operations
An important first step for a company to improve, maintain and sustain profitability is to understand, in detail, the sources of the company’s revenues, costs and resulting profits, breaking these down by product line, technology, location, market area, sales campaigns, personnel, supply chains, operational procedures, and other metrics. For example, the company may find that by disaggregating its financial data, what appears to be a profitable enterprise at the macro level will obscure the fact that some elements lose money while other elements are highly profitable. This information, when disaggregated to the micro level, can assist the company in making decisions on products, technologies, market areas, sales methods, marketing campaigns, personnel and locations.
Data is key to understanding a company’s financial profile. The Financial Management System develops a data-driven and statistically analyzed information base that allows managers to examine in depth the underlying structure of the company’s financial operations. You can’t make more money until you understand how you are making money now.
Companies use advanced Managerial Accounting methods to develop this complex understanding. Once the company understands these underlying dynamics of profits and losses, the company can make reasoned and data-drive decisions on its various strategies of product selection, technology adoption, sales and marketing campaigns, personnel, and locations.
2) Review capital structure; determine Weighted Average Cost of Capital, and devise the most efficient capital structure for future funding needs
All companies have some level of a capital structure, even if it is only the owner’s equity and a bank loan. As company’s financial needs grow and become more complex, their capital needs escalate rapidly, to the point where a company, especially ones in a capital-intensive industry such as manufacturing or medical-tech, will be continually seeking additional sources and forms of capital, both for Capital Expenditures (CapEx) and Working Capital.
All forms of capital are essentially categorized as forms of debt or forms of equity. Our Financial Management System will help the ownership understand its true cost of capital, by calculating the company’s Weighted Average Cost of Capital (WACC). The WACC is calculated by looking at each form of capital, calculating the effective cost of that specific form of capital, and then aggregating those costs by their weighting in the overall capital structure of the company. It is important to account for the tax impact of capital, since interest on debt is tax-deductible while dividends on equity are not. This tax structure tends to favor debt over equity.
Once the company understands its WACC, it can then develop future funding campaigns to result in the most cost-efficient capital structure possible, reducing the overall cost to the company, and, as future funding campaigns are planned, implement the most cost-efficient structure for that capital.
The other implication of the calculation of WACC is that the WACC then becomes the discount factor used in future capital budgeting analyses, and the discount rate used in the analyzing the Net Present Value (NPV) of proposed budgeting decisions. The lower the WACC, the more feasible a project; the higher the WACC, the less feasible a project.
3) Develop and refine a rigorous capital budgeting process, including conducting feasibility studies and cashflow proformas of proposed projects
As companies continue to grow, especially for companies in capital-intensive technological industries, it is important to develop an on-going and rigorous capital budgeting system, both for the constituent elements within the company by unit or division, and for the overall aggregated company. This is not just a one-time end-of-year effort, but a continual effort throughout the year, identifying growth opportunities and replacement needs, determining the incremental revenues and costs associated with those opportunities, and matching them against the available capital, either current retained earnings or funding potentially available from the market.
The process begins with a review of all growth opportunities available to the company, and all requests for funding from the individual units or divisions. Then the incremental impact of each specific project – whether a new R&D campaign, changes in products, new locations, new or replacement equipment, added personnel – is calculated, both on the revenue and cost side. This incremental impact is then projected into the future through a cashflow proforma, making various assumptions of inflation, market size, sales efforts, competitive risks, Costs of Goods (COGs), and pricing. These future incremental net gains are then subjected to a Discounted Cash Flow (DCF) analysis, where each year’s net gains are reduced to the current time through present value. Here, the WACC discussed above becomes important, since the WACC is the discount rate, in most cases, at which the future cashflow is discounted back to the present. Once the sum of present values is computed, the upfront costs of the new opportunity are subtracted, which results in a Net Present Value (NPV) analysis. If the NPV is positive, then the project is viable, at least by financial standards. If the NPV is negligible or negative, then the project is most likely not viable, again by financial standards. The NPV method can also be used to compare multiple alternative projects available to the company, allowing it to rank-order various opportunities.
A Financial Management System can provide the platform for a company to engage in this process of capital budgeting, feasibility studies, cashflow proformas, and Discounted Cash Flow (DCF) analysis, to determine the optimum growth strategy from a financial perspective.
4) Identify growth needs and potential M&A transactions that could accelerate the company’s growth; assist in conducting buy-side and sell-side M&A transactions. M&A
Companies typically seek continuous growth, and one avenue for growth is to acquire other companies, in either a horizontal or vertical diversification strategy. Acquisitions can be tremendous engines for growth, or disasters that can severely damage a company (think of Daimler acquiring Chrysler). Acquisitions can help a company to absorb competitors, expand its technology and IP portfolio, gain market share, consolidate a fragmented market, gain market share through new territories, and acquire additional assets of plant and equipment.
Using its Financial Management System, a company can engage in buy-side transactions. Your consultant can assist the company in identifying its needs for growth, and opportunities for potential acquisition. Then a feasibility study of this acquisition can be conducted, using different assumptions of valuation, incremental costs and revenues, and acquisition costs. Then the company, through its consultant, can develop a Discounted Cash Flow (DCF) proforma to project future net gains, present-valued back to the present at the company’s Weighted Average Cost of Capital (WACC), as discussed above. Part of this analysis is to analyze how the company will fund this acquisition – through a combination of retained earnings, outside debt and outside equity. The costs of this acquisition capital becomes part of the analysis in determining the Net Present Value (NPV) of the proposed transaction to the company. In all of these steps, the company’s consultant can play a pivotal role.
In a sell-side strategy, if a company wants to divest a unit or subsidiary that no longer meets the long-term corporate needs of the company, or exit entirely, your consultant can assist the company in valuing that candidate for sale, identify likely buyers, assemble a disclosure package, approach likely buyers, and assist in closing the transaction.
5) Develop a capital funding strategy; assist in conducting capital funding campaigns
Companies continually need additional capital for maintenance of current operations, and for growth and acquisitions. This is a combination of Capital Expenditures (CapEx) and Working Capital. The capital can come in the form of using retained earnings (which is in part a function of the company’s dividend policy), external debt of various sources, and external equity. Debt can come in the form of bank or non-bank senior secured debt, subordinated unsecured debt, Accounts/Receivable (A/R) financing, Purchase Order (PO) financing, leasing, sale-leasebacks, owners’ promissory notes, and various government grant and loan programs (such as the Export/Import Bank). Equity can come in the form of owners’ contributions, private angel equity, institutional equity, public equity versus private equity, and common stock versus preferred stock.
Raising capital is a complex and multi-layered process. It begins with a clear vision of the company’s directions and growth opportunities, its capital budgeting process (see above), and its analysis of the capital needs for growth and acquisition. Using the Weighted Average Cost of Capital (WACC) calculated earlier, the company can then determine its optimum and most cost-efficient form of capital structure, typically a blend of various debt sources and equity methods.
Your consultant can assist the company in developing a strategy of acquiring the most cost-effective forms of capital, through its Financial Management System, and in conducting capital funding campaigns. This process begins, as discussed above, with the analysis of current operations and financial management, growth strategies, a capital budgeting process, a Net Present Value (NPV) analysis of potential opportunities and competing opportunities within the company, a calculation of the company’s Weighted Average Cost of Capital (WACC), acquisition opportunities, and then the optimum capital structure for the company.
Expected OutcomesA well-structured and robust, and regularly used, Financial Management System will result in the following outcomes: (a) improved profitability and return to investors; (b) increased efficiency; (c) greater access to capital markets at a lower net cost; and increased opportunities through M&A transactions.