Focusing on Risk

For whatever reason, my conversations during the first month of 2017 have focused disproportionately on risk - quantifying it, understanding it, controlling it, or avoiding it altogether. I don't know if it's the prevailing social and political winds or just a random sequence of discussions, but risk seems to be on the mind of all of my clients, prospects, and partners.

Here are two highlights from my risk-laden January:

Middle Market Risk

I presented to the Exit Planning Exchange this month on how operations can be used to increase the value of a business prior to an exit. The case study we worked through, which was based on a real business, involved a lower middle-market company that couldn't drum up any interest from 30+ strategic buyers, and only a little low-value interest from 120+ PE firms.

The company certainly had some value drivers to explore, but my judgement was that to increase the pool of potential buyers, the main thing they needed to do was decrease the risk of acquisition.

I explored the three main areas I felt were the likely reasons for this lack of interest:

 

1. Key Man Risk

Where you see it: Most middle-market companies have key-man risk in spades. As they grow, and especially as they grow towards a majority investment or exit, that key man risk becomes more and more costly

Control it by: 1) Building a professional management team; 2) developing management disciplines like project planning, portfolio management, implementing smart performance management frameworks; and 3) understanding KPIs and start holding managers accountable for them

Pay particular attention to: 1) Sales organization - if most sales are relationship-based, those cannot be replaced just with business processes. Reducing risk will involve warm intros to other salespeople - either up or down the chain; 2) Operations - if only one or two people know all the ins and outs of your production process, that means everyone else is operating in a silo. Use small improvement projects, technology projects, and promotions to expose other people to and create accountability for end-to-end business processes

2. Geographic Risk

Where you see it: Most lower middle market companies. It's far easier for founders and owners to manage people who are physically close to them. Any company outside of the high tech sector that has grown from an SMB to a larger business is susceptible to this risk

Control it by: Build disciplined core business processes, implement easy-to-use cloud-based enterprise systems, roll out management KPIs, and then hire great people

Pay particular attention to: It may be tempting to hire the most technical, specialized people you need for a new region first. In reality, you also need to know how to manage them. A slightly larger upfront cost structure to an expansion may result in faster, more sustainable results.

3. Vendor / Customer Risk

Where you see it: Companies that have a concentration in a small number of products or who serve industries that are dominated by a few large companies

Control it by: For vendors, diversify the portfolio a little bit. For customers...well you're going to need to sell more. Nothing overly complicated there.

Pay particular attention to: For vendors pay attention to quality. If you need to, institute stringent quality thresholds before adding new vendors to the portfolio - at least for critical goods. For customers, build some relationship walls around existing customers and be very strategic about how to/whether to sell to their direct competitors.

Cybersecurity

It seems that not a month goes by without being exposed to some new information about the prevalence and cost of cybercrime. Middle market companies are especially vulnerable.

At a January conference organized by Staffleader, several people spoke about the trends and costs of these intrusions to the community. I had three key takeaways from the event which apply to nearly every organization I interact with:

  1. You are vulnerable and, if you haven't been compromised yet, will at some point
  2. If your business is compromised it will be expensive to fix, even if the only cost is figuring out who you are legally obligated to report to. If customer data is compromised, the cost will be exponentially higher.
  3. Malware is a pain, ransomware is a pain, and viruses are a pain. But if you have good IT infrastructure and a well-designed (and tested!) backup system these risks are largely mitigated. Data breaches are much worse, and most of them will occur because of human error from people who work for you.
    • Staff training is key and something you can start now
    • Spending a little money on prevention and a good data breach response plan now can save you a lot of money and significant reputational damage later
    • Your current insurance probably does not include breach insurance. If you don't have a cyber policy, it's worth pricing one out. From the numbers I've heard here and elsewhere they are not terribly expensive 

Thanks to Michael Menapace from Wiggin and Dana, Jeff Welsch from Fairfield County Bank Insurance, and Frank Ballatore from NECG for their presentations.

In Summary

Value is always the most fun thing to think about, but when choosing where to invest don't forget about risk. Some risks need to be controlled for now, others can wait for later, but either way they should be included in your roadmap.

Value investments will compound over time, risk will not, so pick your value investments for the most long-term potential and your risk investments for when they will most need to be controlled.

It will just take a few poorly controlled risks and one piece of bad luck to unravel years of great results from value-focused investments.

Subscribe to Ronan Consulting Group - Steve's Blog by Email

Evaluating Your Finance Function

Does your finance function stack up to your scale?

One of the early functional areas that businesses outgrow is their finance function. The processes, systems and skills that are required to track, maintain and report on organizational finances as companies grow change dramatically. Think of finance as the core of your enterprise – not most critical, but certainly most foundational. Absent a strong finance foundation, it is very difficult to scale, grow and integrate your other functional areas and it makes your management of the business enormously more challenging and less discrete.

Today we will examine three common challenges within your finance function. This is not intended to be an exhaustive list of every problem you may encounter. Instead, these are some of the most common issues that occur and, more importantly, the issues that are most visible to non-finance executives. The solutions may be simple, they may be wide ranging. But once you know where your challenges are, it becomes much easier to establish a clear path to resolving them.

1. Your business makes a lot of manual journal entries

Why it’s a problem

Manual journal entries are error-prone, are not recorded on a timely basis and do not provide adequate control over your books. Since most categories of journals should be automatically generated during the course of business, they often indicate underlying issues with your systems and processes.

Other forms of this problem

a) you have non-accountants submitting requests for journal entries; b) your accountants are doing a lot of offline calculation (probably in Excel) to generate the journal entries (revenue recognition and asset depreciation are common areas for this); c) when something doesn’t look right in the general ledger, it is hard to locate the backup documentation

Common manual journal entries:

Revenue recognition, asset depreciation, lease payments, payroll, purchasing accruals, inventory valuation, receivables backlog

How to diagnose

Look at your previous three months of manual journal entries. If the number of entries is relatively limited, then you probably do not have a major issue. If there are many entries for the same category, you have an isolated problem that you can probably address on its own. If the entries are spread across multiple categories or there is not a distinct pattern for why the entries are occurring, then you have a bigger issue to address.

Possible Solutions

For one, you should evaluate your chart of accounts and make sure it is structured appropriately for your business. Many companies start with a simple chart of accounts and then grow to the point where it no longer provides enough data or structure for accurate reporting. Then, evaluate the integration between the general ledger and your various sub-ledgers (receivables, payables, fixed assets, project accounting, inventory, etc.). If there is manual intervention required during the transfer of financial data between these systems and the GL, then you have a systems issue you need to address. Finally, evaluate your overall finance strategy. If the system is not able to generate the accounting entries you need, it’s probably time to start looking at alternatives.

2. Reporting takes a lot of time and some desirable reports aren’t possible

Why it’s a problem

Reporting and analytics should be your easiest, most accessible tool for managing your business. If you can’t review your key metrics on a regular-enough basis, your ability to effectively manage your business suffers. Lots of time generally equates to lots of effort which means lots of error-prone, manual work.

Other forms of this problem

Let’s briefly distinguish management reports from operational reports. Operational reports are used by your managers to execute the operations of the business on a day-to-day basis and are not what we are addressing here. Management reports are used by leadership to make decisions about how to run the business and these are what we are discussing here. If your set of monthly or quarterly reports is variable (i.e. the exact same reports are not generated every month/quarter/year), if your reports change in form or format based on monthly or quarterly activity, if your finance department needs more than a few days to close the books and generate reports, or if you want to see some new types of reporting but they cannot be generated with your systems or numbers, then you have a problem that should be addressed promptly.

Common problem areas

Profitability and margin reporting is a common pain point for growing businesses - it’s fairly complicated and requires highly structured underlying data. Budget-to-actual reporting tends to maturate later on for many businesses and forecasting is often cobbled together from several imperfect sources of data (note: forecasting usually matures faster in manufacturing environments while lagging in professional services). It is unusual for basic P&L and balance sheet reporting to be an issue – most businesses have this down pretty well. If you have issues with this type of reporting you should probably address them immediately. In addition to being your only true source for good numbers, it probably means something unpleasant lurks beneath the surface.

How to diagnose

Look at your management reporting and see how replicable it is. Talk to the accounting department about how and on what platform they generate these reports. Talk to an expert about what reporting you should, reasonably be able to generate for your type and size of business and ask your managers to put them together. If you can report on most of what should be required then you’re probably in good shape; otherwise it is likely you have some technology/talent/process issues to address.

Possible Solutions

Solving your reporting issues may or may not require changes to your software. Many business actually possess the necessary tools but need to resolve issues in underlying business processes or data structures. This is less expensive to fix and can often be executed in-house, although you probably need some basic outside guidance on structuring the project. If you do not have a strong reporting platform and your finance systems are very old, then you may need a multi-step roadmap to fix the underlying systems and processes before implementing a more robust reporting platform. The good news is this can be done along with better operational reporting and sometimes real analytics so you won’t be fixing just one problem – you’ll be setting yourself up for more exciting management tools as well.

3. You don’t really trust your numbers

question_dkblue.png

Why it’s a problem

I probably don’t need to elaborate on this one

Other forms of this problem

a) If you have questions for the accounting department after reviewing your monthly/quarterly/semi-annual reports, the answer is frequently an adjustment in the ledger and reissuance of the reports that is required. b) It is not uncommon for your summary financials and the expected numbers from each department to not match up (inventory levels don’t seem in the ballpark of what your warehouse manager expects; PO accruals don’t seem to match what the purchasing manager thinks they bought this month, etc.). c) Your outside accountants have a hard time figuring out your numbers each period from the materials you provide.

Common problem areas

This could happen anywhere in the business, but start by looking at areas that a) have an offline process and toolset; b) Have a high monthly volume of transactions; or 3) Have the most people touching the transactions

How to diagnose

Have departments sign-off on the final accounting numbers for each period. If you currently only “close the books” annually or semi-annually, begin to move towards monthly or quarterly close cycles. Although they will be more frequent, they will also be less work and it will be much easier to perform a root cause analysis on any issues you find. After doing this, then start to see how many discrepancies you have on a regular basis.

Possible Solutions

This is more than likely going to start with a systems solution. The hardest part of performing root cause analysis on questionable numbers is finding all the data you need to back it up. The transactions for those numbers are the result of a process somewhere in your business and having a platform for that process that integrates with your finance systems will make your numbers more reliable, generate them with less effort, and cut overhead.

Closing Guidance

One thing to note on finance systems in general: the number of technology solutions available, level of automation that is now considered “normal,” and leading practices that have emerged over the past 4-6 years have substantially changed the expectations of a “corporate” finance department. The next tier of possibilities for your business are more exciting than anything in the recent past – real, insightful analytics, understanding customer profitability based on social media data, operational and sales automation. These are all tools that can dramatically improve how your business grows and can allow your best people to add more value than ever before. Start by improving your core finance operations and then understand how you can begin taking advantage of the new technology available to your business.

Have you encountered any other major problem areas in your finance area? Post them in the comments!

It’s always valuable to get a new perspective on your finance function and Ronan Consulting Group is here to help. Contact us today at info@ronanconsultinggroup.com or (203) 313-9480 to talk about what challenges you are facing in your business and understand what your assessment, diagnosis and improvement options are. 

 

 

Subscribe to Ronan Consulting Group - Steve's Blog by Email