B2B CFO^®    (877) 4-B2B CFO

How do you fix accounts that don’t balance?  Where do you begin with a checking account that hasn’t been reconciled accurately in years, literally?  What do you do with a system spitting out rejected checks from customer authorized direct payments and the staff can’t keep up?  How do you deal with an inventory costing system that shows an inventory shortage every time you take a physical inventory?

 

Fix it backwards.

 

Example with the checking account:  Reconcile the bank, best you can today.  Don’t try to re-audit the prior transactions.  Start now and work backwards.  Balance per the bank today, plus deposits in transit that we know about today, minus outstanding checks that we are confident about (meaning we know they have not cleared and they are less than 90 days old).  What is the calculated balance that the books should show?  What do they show?  What is the difference?  Do the same task next day.  Find out what cleared that we had no idea was still outstanding.  Find what checks or automatic bank draws occurred today that we did not know about.  Post today’s transactions.  When the difference between the reconciled balance and the book balance is the same number for 5 straight days, you are done.  Book the adjustment.  What you did was work current data, current transactions, current bank activity only.  Any old stuff is irrelevant.  But, doing it this way, if old stuff shows up (like old outstanding checks you didn’t know about) now you can catch them.

 

My favorite:  the company I served as CFO was drawing pre-authorized bank drafts from customer accounts every month to pay their monthly bill.  The data system was rejecting hundreds of the drafts every day, because the bank would not accept them.  And the number was growing.  We literally had a room full of rejected bank drafts.  We had two staff people available to fix this. And we had hundreds of unhappy customers.  How to fix?  Backwards.  We had already lost any goodwill with the prior customers.  And we could not keep up with the ever growing number of rejected drafts.  Why not?  We would draw the payment, but if the customer had changed banks, or the amount of the payment was supposed to change (that happened a lot) and it did not match the pre-approved draft, then the transaction rejected.  The systems were so far behind that the staff was working transactions more than 6 weeks old, and working forward.  But, at 4 weeks, a new draft was drawn.  The older one had rejected, so did the new one.  Now we are further behind.  Solution:  Start with today’s rejected drafts, fix all you can (we could fix about 200 with the 2 people we had, 300 were rejecting).  Stop and set aside whatever you did not get done today.  Forget about them.  Work the ones that come off tomorrow, all you can, as fast as you can, then stop.  Start again with today’s rejects.  And so forth.  We were working from the current activity backwards, rather than trying to start from all of the historical transaction problems and bring them forward.  In this case, it took about 6 weeks before the number of daily rejects fell below the number we could clear.  Within a couple of weeks after that, problem solved.  We fixed it backwards.

 

Inventory:  When the physical inventory is always way off, there is either theft (sometimes) or a lousy accounting and manufacturing system (mostly).  Start with now.  Pick a few items and investigate the cause of the current shortage.  Is the raw material, to work in process, to finished goods, accounting accurate at standard cost?  Pick a few products or assemblies and fix them.  Then do a few more.  Work backwards.  The shortages will gradually reduce.  Then figure out which products are priced wrong, based on the now better cost data.

 

If there is no way, no staff, no records, no idea how to bring forward the historical accounting or transactions to current, then start from current activity and work backwards.  It works.

Character, Collateral, Capacity, Conditions, Cash Flow

 

I recently had a discussion with a commercial loan officer about the 5 Cs of Credit.  Some of them are obvious, all are important.

 

Character refers to the integrity of the borrower.  For mid size companies ($2 million to $20 million in revenue) it means the operational and credit history of the company.  But most important, it refers to the reputation and integrity of the company owner(s).  The owner’s credit history is important, his or her credibility is critical.

 

Collateral is easy.  What will be the secondary source of repayment, if the cash flow does not pan out?  What is the liquidity and excess value of any collateral that the lender could look to, before having to pursue collecting on any personal guarantees?  Collateral is the asset the banker or investor refers to when saying:  “Don’t tell me about the return on my money, tell me about the return of my money.”

 

Capacity generally refers to the excess net worth of the company and the owner beyond any current debt balances.  The lender will consider business net worth, and personal net worth.  How highly leveraged is the borrower already?  Can this loan be successfully repaid under agreed original terms, considering current leverage and debt repayment obligations? 

 

Conditions means general market and industry economic circumstances.  Is the economy in recession or expanding?  What about the particular niche in which the company operates? I also use this “C” to remind clients that there will be borrowing conditions:  debt covenants, fixed charge coverage ratios, limits on future borrowings, etc.  Conditions in the economy and particular industry are very important, but don’t forget the conditions that will be placed on the borrower. Constraints would be a good reminder as a 6^th C of credit.

 

Cash Flow.  This is most important.  All other Cs notwithstanding, the lender wants to know how the cash flow will repay the loan.  And how reliable are the cash flow projections?  Will the loan still cash flow if the projected increased sales, or reduced costs, or investment returns don’t turn out to be as strong as projected?  How aggressive are the assumptions driving the cash flow model?  Lenders want the loan to pay back with conservative assumptions.  Will it?  The demand for cash flow from use of the loan proceeds is what causes banks to avoid lending to start ups, because start ups invariably suffer start- up cash flow losses for expenses, marketing, design, business development, etc.  That is not cash flow in, that is cash flow out.  Banks lend on positive anticipated near term cash flow in.

 

5 Cs of Credit.  Clients seeking new loans, or expanded loan capacity, must consider them.  Because the banker wants to know.

This is a true story. 

 

Several years ago the audit firm finished the exam of a mid size food wholesaler and issued a clean audit opinion.  There was one comment in the internal control letter to the owners:  the same employee receives cash payments, prepares and posts billings and accounts receivable, and sends out past due notices.  She had been doing it for years.  The owners ignored the comment, concluding separating those duties would be too costly in additional payroll expense.  Besides, they trusted her.

 

The auditors contacted the company about 10 months later to schedule the interim field work for the next year’s exam.  The compromised employee left.  Subsequent police investigation concluded she probably left the country.

 

Forensic audit work by a different audit firm, which was hired by the insurance company at risk on the errors, omissions and theft insurance policy, showed that she had begun taking cash and underposting the sales receipts within a couple of weeks from the conclusion of the prior year audit.  The forensic audit ended once $50,000 in losses were proven, although informed estimates placed the loss likely in the hundreds of thousands of dollars.  The company was extraordinarily profitable, so the owners never missed the money.  It only showed up when the audit firm asked to schedule the next exam.  That’s when the employee disappeared. 

 

Subsequently, the company hired an additional bookkeeper to separate the transaction and posting duties.  Eventually, upon the long standing recommendation of the original audit firm, the company hired a full time controller.

 

The point is not to be so profitable that you don’t miss the dollars stolen.  The point is that following some simple accounting control rules is critical.  Separate duties. Have checks and balances.  Have someone supervising and reviewing the activity.  That can be a full time controller, or a part time CFO.  But there must be oversight.

 

Even small companies, where the owner is hands on, need to at least address the internal control issue.  Unless the owner is truly processing all of the transactions, doing all of the postings and financial statement preparation, personally reconciling the accounts and signing the checks, separation of duties is critical.  If there is just one other person involved, besides the sole owner (that includes partners, married couples, long time friends, and family) prudence requires that proper internal accounting controls be put in place.  It does not require lots of expense, often just a reassignment of duties and proper supervision.

 

Sometimes, the internal controls will still fail to prevent theft or fraud.  The procedures might not be followed, there might be collusion among employees, the checks and balances might be poorly designed.  But, without any separation of duties in critical cash processing, billings, payments and posting, the business has no protection at all.  You might as well change your logo to a big bulls eye  because the temptations are high, and you are a target.

 

Oh, and I would recommend theft loss limits higher than $50,000.

I just finished a discussion with the controller for a golf course, and a potential client.  Their circumstance is not atypical.  Cash is tight, vendor payments are delinquent, fixed costs (particularly employee salaries) are high, accounting systems are not producing accurate nor timely information, and the business is seasonal.  Spring and summer are the critical times, and the business is into their busy season in not very good shape.  Owners are having to contribute capital to keep it going, as they have for the prior few years.

The controller, who is only 3 months in to the position, tells me that for the past two years there weren't really any financial statements and now the owners want the numbers accurate, and right away.  Nearly impossible to get done, right away.  What to do?

I told the controller to set aside history for right now.  I suggested she put together two forecasts:  One showing where the business and its cash are headed under the current volume and cost structure, and a second  forecast under a structure that at least starts from cash flow break even.  I told the controller to set aside worries today about the delinquent vendor payables, the property taxes now coming due, and the bank lines that may not be renewed.  None of those can be fixed until the business is cash flow break even to start, and then cash flow positive going forward.  The controller believed the bank would provide additional funds to tide them over, as they had for the past two years.  I thought not.

The forecast of the current circumstance is easy:  project from current revenues, subtract the current expenses and minimum vendor and bank payments and the result is the net cash deficit.  Calculate a time to exhaustion of the remaining cash resources and show the owners how much they will have to contribute to the capital and when.  Their pain threshold will be sorely tested.

Then show the results after the tough decisions.  What decisions?  What amount of payroll dollars must be cut, and who?  Which ongoing monthly costs must be eliminated?  Travel, meals, advertising, excess space and rents, equipment, repairs...  Review every line of expense and lay out what it takes in cost cutting to get to cash break even.  From there forecast forward the cash flow and match to the delinquent vendor payables, back taxes, bank loans, etc. 

You cannot fix delinquent accounts, past due bills, late installment loans, line of credit advances, past due mortgages, etc. until you triage the cash flow.  Once you stop the bleeding, only then do you have a chance to make the patient well. 

I repeat:  the critical step is to detail what it will take to triage the patient and get to cash flow break even.  That is what the owners need to hear and understand from their financial experts.  Only then is there any future.

What is ONE JND?  Is that some kind of military code?  A GPS coordinate?  A password?  A typo? 

None of the above. 

ONE stands for ONE, as in the number 1.  JND stands for "JUST NOTICEABLY DIFFERENT".  As in the saying:  "I need at least one thing that is just noticeably different."

One of the most successful entrepenuers (in the B2B CFO® firm we call you "finders") that I worked with over the last 25 years used to say, in reference to products and marketing, that to be successful, you need at least one feature, one benefit, one trait that is just noticeably different.  More JNDs are better.  But one JND is required.  He marketed health insurance.  What was the JND?  "We pay 90% of our claims in 5 days or less, 98% in 10 days or less."  Worked pretty well, sold millions in premiums, the customers all knew what was unique.  It became the claims time payment standard in the industry.

I have a current client whose JND is his web site.  His competitors have no such presence.  He markets and installs stone kitchen tops, stone floors, stone bathrooms, granite counters.  All of the marketing is done via the web.  The site is clean, simple, emaculate, powerful.  It shows pictures of new kitchens. He has video of how the stone is cut and installed.  People do a search for stone or granite and where they live, and they end up on my client's site.  As soon as my wife saw the site, she pointed at the monitor and said:  "I want one of those [kitchens]".  ONE JND.

But the JND idea does not just apply to products and marketing.  I prepared a loan syndication package for a major refinancing.  It included all of the standard information about products, markets, competition, management, historic financials, etc. and of course, projections.  Other than providing data unique to the company and our particular financing, it was pretty standard fare.  But, we had ONE JND:  the projections included a forecast with two down years - lower projected revenues and profits.  The senior officer with the lead bank told me, after they had approved the transaction and funded us, that what he remembered in particular, and what they appreciated, was that our loan application package was different.  Nobody projects a down year!  ONE JND.

ONE JND is the minimum.  More is better.  Our firm B2B CFO® has lots of JNDs.  One in particular stands out to clients.  We have no contracts.  When a partner begins work with a client, it is done on a handshake.  No contract.  We lay out the amount of time we expect to spend, and the initial and ongoing tasks to be done, plus a guideline of the expected cost and time commitment (two days per month, or 1 day per week, or ½ day per month).  But no contract, no financial strait jacket for the client.  That is just not done in the consulting industry, nor by other firms in our particular niche as CFOs.  It is just not done.  Clients notice our willingness to commit without a contract.  They appreciate it and understand the vote of confidence we have in what we do.  ONE JND.

A senior lending officer at a large commercial bank said to me some years ago that when he reviewed loan application packages, he wanted the answer to three questions:

1 - What is my primary source of repayment?

2 - What is my collateral or other security?

3 - What is my third source of repayment?

By primary source of repayment he meant the cash flows to cover the borrowed money. That could be profits from new equipment purchased with the borrowed funds, higher volumes for which a credit line would finance accounts receivable and inventory, additional sales and margins from new or expanded plant capacity, current profit levels, and the like. The cash flow projections were most important here.

The second question as to collateral is easy to answer. The collateral or other security is the asset financed, like the inventory, receivables, equipment, land and buildings, maybe sinking fund payments, and so forth. And the banks use some simple rules of thumb that my clients can easily incorporate in our loan applications. Rules like: borrowings will be limited to 80% of the current accounts receivable, 50% of the inventory, debt coverage and fixed charge ratios higher than 4 to one, and so on.

But, it is the third question that is most important. Even after showing good primary repayment and solid collateral, which were simply minimum requirements to fund any borrowing, the issue became what is the added source of protection? If the primary source of repayment does not work, meaning that the cash flow projections are not met; if the collateral proves inadequate: if real estate declines in value, if inventory is damaged or won't sell, if receivables are slow being collected; what is the added source of protection for the bank?

That third source of repayment, in privately owned mid-market companies (like my clients: $2 million to $50 million in revenue) can be overcollateralization, liens granted on other assets, and the like. But, as a practical matter, what it really means is the bank wants the personal guarantee and assets of the owner as that third source of repayment. Over the years the bank had done a number of studies on its mid-market clients, and had learned that the single most important statistic, as to whether the business loan would be paid back under its original agreed terms, was the personal credit history of the owner. When granting or renewing a credit was a marginal decision, the owner's personal credit was the deciding factor in the bank's decision to make or deny the loan.

I repeat: at the margin, assuming the primary source of repayment was credible, and the collateral and covenants met the bank's standards, the credit committee decision was swayed by the personal credit history of the owner. The bank would require the guarantee simply as a matter of policy, but it was the personal credit that caused a favorable or unfavorable decision at the margin, even for very large (multi-million dollar) loans.

As my banker friend said long ago (I paraphrase here because it has been a while): "If he has trouble paying his personal bills, he will have trouble with our loan to his company. If his personal financial house is in order and has been over time, we are comfortable that we will be paid back and we are willing to take the risk". Still true today.

Sometimes, when I am working on new loan packages or refinancings for clients, the first place we focus is the personal credit, because at the margin, it makes the difference.

 

As everyone knows, the economy is, and has been, horrible.  I thought I would describe how one of my clients has begun to respond.

My client is in the commercial and residential heating and cooling business.  In our region, I am informed that 8 similar businesses have failed in the last 12 months.  By the time I became involved (referred in by the client bank) my client is on COD (cash on delivery) with all of its major suppliers.  Although they continue to receive product, the suppliers have required additional weekly funding with each COD delivery.  The bank loans are current, but straining the company.  Weekly and monthly cash flow was negative.

Our first step was to match the monthly and weekly expenses with the available cash flow from the service business and the margin after equipment costs from installations and repairs.  Fortunately, most of the expenses are variable and rise and fall with the sales.  So, labor, payroll taxes, fuel, installation costs of equipment, and the like, move up or down with volume.  The fixed expenses were the hardest to reduce:  salaries, office, warehouse, health insurance and in particular monthly installment loan payments, plant mortgage, and the additional vendor payments.  Further, there is no supplier credit available.  We downsized the fixed expenses to match current, and much reduced volumes, assuming no fast recovery.  If it happens, great, but we are planning for the worst.  So, we budgeted to cash flow break even.

With a little bit of additional owner capital, we are approaching the suppliers.  The suppliers would like to continue working with my client. After all, there are only a few still operating in our region, and the suppliers need customers too.  So, we are offering some up front cash with two requirements:  1 - the gross supplier balance will be permanently reduced 50% and 2 - the additional weekly and monthly payments, above the COD payments, will be cut by 50%.  In the event my client does not make the now reduced additional weekly payments to fully pay off the reduced balance we negotiate, the full balance will be restored.   And, important to the suppliers:  they are all treated equally, so that none get in front of another.  These adjustments free up weekly and monthly cash flow to 10% of sales.  That extra cash will be used to reduce bank and installment loan balances.  But, once the economy turns (it will) we will have freed up resources by having reduced the payables balances, and we will recover faster.

It is not easy, but in this economy, the suppliers are willing to help, my client is taking the drastic but necessary cost reduction steps, and they will survive this economic crisis.

The point is to be proactive.  Start with the cash available from sales, and match the expenses to that level.  Work with the banks and the suppliers, and the business can pull through.

 

Randy Suttles has been a business advisor to me personally and professionally for over 20 years.  His financial and general business knowledge combined with his hands-on understanding of practical operations uniquely positions him as a strategic financial and business advisor for mid-market and emerging companies and organizations.  Having worked in an accounting and business advisory services firm early in his career and then having served as one of the youngest CFOs in the country of a major financial institution, he cut his teeth early as both an internal and external key financial consultant and in multiple industries.  His experience leading a nationally recognized fast-growth start-up company to maturity as President has also added to his comprehensive understanding of a company's lifecycle.  At CHORUS^®, we have appreciated Randy's counsel and value the impact he has and continues to have on our business.

 

Michael A. Evans

President & CEO

CHORUS, Inc.

 

In 1983  Randal E. Suttles joined Golden Rule Financial Corporation and Golden Rule Insurance Company as its Chief Financial Officer.  When Randy joined Golden Rule he was new to the insurance industry.  Within a very sort period of time he mastered the insurance accounting and tax idiosyncrasies and became a very effective financial executive and member of senior management for Golden Rule leading our financial affairs including accounting, tax, financial reporting, banking, treasury, and  rating agencies.  Randy also served on the company's investment committee and retirement committee.  Randy made a difference for Golden Rule.

Jack Whelan
President & CEO 1979 - 2004
Golden Rule Insurance

 

 

Randy Suttles stands out as the best CFO with whom I have worked during the 35 years that I have provided investment banking services to mid-sized companies. I have found Randy to be extremely knowledgeable about financial matters, to have excellent judgment in assessing financial issues, and to be decisive in taking the appropriate course of action. I highly recommend Randy to any company seeking effective financial counsel.

Peter W. Mattingly
Managing Director
P. W. Mattingly & Co. Inc.