The Art of Financial Management

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Mr. Micawber’s famous, and oft-quoted recipe for happiness highlights the importance of strong financial management:

 

“Annual income twenty pounds, annual expenditure nineteen [pounds] nineteen [shillings] and six [pence], result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.” — Charles Dickens, David Copperfield

 

It is important for boards of non-profit and community sector organisations to focus on strong financial management. These organisations typically have external stakeholders on whom they rely for funding. External funders have similar objectives to investors in for-profit companies; they want to see a plan, and they want the organisation to manage their resources according to the plan. Strong accountability and financial stewardship help to build third party confidence, which in turn assists with longer-term financial support and funding.

 

Further, these organisations typically have volunteer directors, who are subject to the same duties, obligations and responsibilities as paid directors. If the organisation does not demonstrate strong financial management, these directors may become concerned that the risk associated with being a director is too high. In the long-term, this will make the organisation less attractive to high quality directors.

 

Our research and experience show that there are three key steps in financial management; getting these steps right will help your board manage its financial resources wisely, build stakeholder support and secure high quality directors.

 

Before we explain these three steps, let’s make sure we’re using the same language.

 

  • Financial managers use financial statements (prepared annually) and management accounts (usually prepared monthly or quarterly) to measure historical financial performance, assess financial position and determine the movement of funds.
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  • Financial managers use forecast financial statements or management accounts to indicate how they expect an organisation will perform, its expected cash flows, and resultant financial position.
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  • Sometimes an organisation will refer to its budget, which usually means its forecast profit and loss statement, forecast balance sheet and cash flow forecast for the forecast period, usually at least one year.

 

Now let’s get back to the three key steps in financial management, which are forecasting, tracking and managing financial information. Each step can be broken down into smaller steps or processes. We’ve described each below, and included some questions you can use to see how your organisation is performing.

 

Forecasting

Financial forecasting involves understanding the organisation’s business model. What goods does it produce, or services does it deliver? To whom does it provide those goods and services, and at what price? Who pays, when and how? What inputs does it need to buy to provide those goods and services, and at what cost? Does the organisation pay to convert inputs to finished goods or services? What other costs are included in the model? Are the costs fixed or variable?

 

Next, the forecasting team need to understand the strategic plan (how the organisation intends to achieve its vision) and business plan (what the organisation intends to do during the forecast period).

 

Do either the strategic plan or business plan specify any financial objectives? If not, what would be an acceptable financial outcome during the forecast period?

 

At St Bartholomew’s House, where I am a director, we have three financial objectives: i) to ensure that each program generates a positive gross margin, that is, each program has to contribute to the organisation’s overheads, ii) to ensure that the organisation as a whole generates a positive net margin of at least 10% of income, and iii) to maintain an uncommitted funds reserve equivalent to three months’ expenses.

 

The first two objectives help us to establish the third. If we have an uncommitted funds reserve of at least three months’ expenses, then we could cope with a significant interruption to our funding, or have time to manage a temporary or permanent change in funding.

 

Next, the forecasting team need to determine the organisation’s financial drivers. For example, in a hostel, occupancy will drive revenue or income, and in turn appropriate staffing levels, so making assumptions about occupancy during the forecast period will be critical to determine revenue or income. Making assumptions about financial drivers is the next step.

 

The board should decide how conservative they want the forecast to be. I prefer conservative forecasts that ought to be achieved unless something goes wrong. However, it is also helpful to understand how the forecast would change, if the organisation out or under-performed. What are the factors most likely to affect the forecast for better or worse?

 

The next step is to develop the financial forecast, which ought to be an integrated income and expenditure, balance sheet and cash flow forecast, and check the forecast is reasonable and likely to achieve the financial objective.

 

Once the forecasting team has prepared the forecast, it is usual to require the board to approve it.

 

Key considerations to check your organisation is on target:

  • The team that is responsible for preparing the forecast includes people with strong financial skills, who have good knowledge of how the organisation’s business model works and of the strategic and business plans.
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  • There is a good process in place for developing and approving financial forecasts, with adequate time for each step.
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  • The forecast is checked to ensure it meets agreed financial objectives, or a plan is established to ensure that the organisation is moving towards achieving the agreed financial objectives with a reasonable period.
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  • The process includes the forecasting team (probably the Chair of the Finance Committee) presenting the forecast to the board, and the board formally adopting the forecast.

 

Financial Forecasting Summary

  1. Establish the forecasting team.
  2. Determine financial objectives.
  3. Determine financial drivers and assumptions that will underpin the forecasts.
  4. Prepare forecast and stress test. If necessary rework the forecast.
  5. If forecast achieves the organisation’s financial objectives, prepare forecast submission for board.
  6. If forecast does not achieve the organisation’s financial objectives, prepare forecast submission for board including steps and time required to achieve the organisation’s financial objectives.

 

Managing

Financial management involves establishing appropriate financial controls, and regularly checking the controls exist and are effective. Some organisations use a delegated authority matrix, so that everyone within the organisation knows their authority limit. For example, the Chief Executive Officer usually has approval to commit the organisation to budgeted capital expenditure and un-budgeted expenditure up to a specified limit. If he or she wishes to incur a capital expense beyond this limit, he or she may need Finance Committee or board approval.

 

Financial management involves monitoring the cash position to ensure that the organisation has sufficient cash to make payments to creditors as and when they fall due, but does not hold excessive cash balances in non-interest bearing accounts.

 

Finance managers will usually be responsible for considering and recommending changes that would improve the organisation’s financial performance, financial position or cash flow. For example, a change in the way clients are invoiced or the date they are invoiced may make it easier for those clients to pay sooner.

 

Finance managers may collaborate with other operational managers to develop performance improvement plans. The degree of collaboration depends on the relative seniority of the managers, and whether operational managers have full visibility of or responsibility for their program’s financial performance.

 

Finance managers will be responsible for producing monthly management accounts, and a financial report for the Finance Committee to explain how the organisation has performed against the forecast (actual versus budget analysis) and against performance indicators, which will usually include the assumptions underpinning the forecast.

 

Indicators can be categorised as lag or lead indicators. A lag indicator tells you something about the past. A lead indicator helps to predict the future. Lag indicators tend to make management reactive; whereas lead indicators may enable the organisation to proactively manage issues.

 

The financial report should provide analysis and insight in to the organisation’s performance to date, and how it is likely to fare during and beyond the forecast period.

 

Key considerations to check your organisation is on target:

  • The organisation sets and adheres to financial policies and controls. Any breaches are identified promptly and reported to the Finance Committee in a timely manner. Control weaknesses are identified from time to time, and reported to the Finance Committee with recommendations for improvement.
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  • There is appropriate segregation of responsibilities to ensure that controls are effective.
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  • The Finance Committee Chair periodically reviews reconciliations and source data. There are good explanations for all journals.
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  • The organisation has implemented a Delegated Authority Matrix.
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  • The organisation’s current cash position is checked and short to medium-term cash requirements are reasonably predictable, enabling the Finance Manager to maintain minimal non-interest bearing bank account balances.
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  • The finance manager and operational managers are empowered to consider and recommend changes to the CEO to improve financial performance.
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  • The organisation’s external accountants audit the annual financial statements – note this may not be appropriate for organisations with annual income of less than $500,000.

 

Tracking

Financial tracking includes reviewing regular financial reports and management accounts to ensure they are timely and accurate. When there are strong financial controls in place, the financial results are often quite predictable. Significant variations or financial surprises may indicate that strong financial controls do not exist.

 

Tracking includes reviewing the key performance drivers and a small set of lead or lag indicators (established during the forecasting phase) that can be represented graphically on a 1-page dashboard to give the reader a complete picture of the organisation’s key metrics.

 

Financial information and performance indicators should be used to assess whether the organisation is on track to achieve its forecast. When the organisation fails to achieve or over-achieves against key forecast assumptions, the effect of this under or over achievement needs to be understood to assist in projecting the likely performance during the forecast period.

 

Key considerations to check your organisation is on target:

  • Monthly management accounts are timely and accurate.
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  • The leadership team and Finance Committee receive the information they require to track performance against forecast.
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  • The financial report assists the Finance Committee to monitor the organisation’s financial performance against the strategic and business plans.

 
 

In conclusion, Mr Micawber advised people to ensure their income exceeded their expenditure. Nowadays, we advise our clients to implement systems and processes to ensure that they understand the financial consequences of the past and accurately forecast the future. Failure to do one or both effectively can lead to financial surprises, which tend to destroy stakeholder confidence and make it more difficult to retain high quality directors – result misery.

About Andrew Birch

Andrew Birch is a managing director in Western Australia for Vantage Performance, an awardwinning national business transformation and turnaround firm. Andrew is a chartered accountant and business consultant with 20 years' experience successfully managing troubled businesses. He has spearheaded change initiatives, led full-scale restructuring plans and turnaround efforts, overseen sale negotiations, and delivered best-practice corporate governance and risk management solutions.

Comments

  1. Really comprehensive and sensible article Andrew. Good advice for nonprofits to improve their financial management information suite.

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