The Quick Fix? … Or the Whole Enchilada?

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Managers need information; that’s one of the laws of nature. The uses of information are endless, and managers constantly come up with new needs for reports, analyses and procedures. But information comes at a cost. The cost may be easy to calculate, as in the case of development hours required, or it may be an opportunity cost trade-off with the company’s other priorities.

Weighing Priorities

Whenever you have a need for information, here are the questions you’ll be asked:

1. How badly do you need it?
2. How soon do you need it?
3. If we can’t give you everything you need, what can you live with?
4. What are the projected cost savings or revenue increases?
5. What is the cost of getting the information?

Large organizations have developed sophisticated processes to allocate information resources among competing priorities, often involving some sort of ROI analysis. People do tend to exaggerate, though, so the objectivity and precision of the process comes under suspicion. Smaller companies, in my experience, tend to admit that they use more subjective methods to evaluate priorities.

The result is pretty much the same, though. Unless you have a critical need, such as compliance with a new accounting policy, a new line of business or an actual system breakdown…

You’re going to have to wait. Maybe forever.

The Quick Fix

The alternative to waiting for an exciting new series of reports and procedures, reconciled, actionable and fully integrated with all existing systems is the Quick Fix. This may be a compromise resulting from the answer to Question 3 above, or you may have to take matters into your own hands.

The Quick Fix is usually inexpensive, fast and gives you most of what you need. It can be a viable alternative to waiting for an entire new application to emerge from the murky dungeons of the development process. Or it can get you started on a new initiative without waiting for months, even years, to get the Whole Enchilada.

The Quick Fix isn’t always the right answer, though. Here are some situations I’ve observed over the years.

A Retailer

As CFO of a retailer, we received systems support from the specialty stores division of the internationally known parent company. The problem was that the specialty stores division was a shoe company, and we were a fashion apparel company. Many important issues needed to be resolved to customize the systems so our merchandisers could conduct business. So it was no surprise that when the accountants had a serious problem calculating Gross Profit and Inventory, we were sent to the back of the line, and told to wait.

For a small fee, we hired a programmer to develop a custom report that not only gave us reliable Gross Profit and Inventory results, but also provided the merchandisers with a clear picture of their operating results. It only took an hour or two a month to update the program, so the Quick Fix became a satisfactory permanent solution.

Some years later, a senior executive of the parent company saw our report, and ordered it installed in all the other operating companies. The systems development people jumped on it, and rolled it out to the entire company with great fanfare. But we just shrugged our shoulders… there was no need for the Whole Enchilada.

Real Estate Services

A real estate services company had passed the level of revenues that required them to change their tax accounting from the cash method to the accrual method. They recently asked me to help them make the transition.

The company had grown rapidly, but was still using Quick Books as its accounting system. It was certainly time for an upgrade, and the accounting conversion made it a perfect time to make the change. The only problem was that it would take months of time, and a substantial cash investment to research, purchase and install a new accounting package, and to integrate it with the business operations system. Meanwhile, the tax filing deadline was coming up fast.

My first suggestion was the Quick Fix. I suggested they continue using the methods the accounting staff were used to, and just make journal entries at the end of each month to adjust to accrual accounting. The CEO, however, wanted a deeper change, including a daily reconciliation to the output of their highly sophisticated operating system.

The situation clearly called for the Whole Enchilada, but timing was such that we needed a transitional Quick Fix to meet reporting requirements, and to fill in the gaps while we studied a fully integrated system overhaul.

I reviewed the business operating system, and found it to be sufficiently reliable to use its output as the source of accounting entries. The problem was that there were no accounting cutoffs or similar checks and balances for reconciliation, so I worked with the programmers to develop daily reports that verified the integrity of the data.

As a result of the project, management realized they needed to increase the sophistication of their financial department, and hired an experienced controller. I’m looking forward to hearing how they ultimately proceed.

A Homebuilder

A homebuilder had developed an elaborate and sophisticated construction management system, and its reporting mechanism was tied to an accounting package. Oddly enough, they also continued to maintain the original general ledger system that dated back to the 1970s. The problem was that the two systems generated very different information, and the senior managers each had favorite reports that didn’t agree with those used by other managers. Massive amounts of time were wasted in meetings, and one vice president spent most of his time reconciling the divergent reports. Needless to say, accounting was a nightmare.

The CEO had been instrumental in developing both systems, and was unwilling to see the need for change. The Quick Fix was practiced on a daily basis, but by the time the results were available, it was often too late to act on the information. An irreverent senior executive used an automotive metaphor, suggesting that when you opened the hood, the engine was run by squirrels on a treadmill.

The situation was crying out for the Whole Enchilada, and the Quick Fix just wasn’t working. Yes, the company went bankrupt.

A Land Developer

When I arrived for my first day as CFO of a land developer, I asked the controller for the most recent financial statements. “What do you mean?” she asked. That was the first sign of trouble. I soon learned that we had land on the books that we didn’t own, just as we owned land that wasn’t on the books. It was the same thing with loans and other assets and liabilities. In an organization with over 60 different companies, each with its own separate equity and debt financing, this was intolerable.

There was no Quick Fix to be found, so we shortly purchased a well-known industry-specific accounting package, and herded the numbers into their proper places.

The Whole Enchilada was the only option.

How does your company weigh the costs and benefits of implementing the Quick Fix or the Whole Enchilada?

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Your Business – From a Buyer’s Point of View

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When you sell your business, you want to do everything possible to get the right price. That often means forgetting about how you have run the business, and looking at it from the buyer’s point of view.

What the Buyer is Buying

Generally speaking, a buyer will be willing to pay a price that is a multiple of the company’s annual cash flow. The multiple varies widely depending on the industry, the economy and many other factors. The price the buyer pays, though, will be a multiple of his expected cash flow – not yours.

The harsh fact is that the buyer doesn’t care how you ran the business. Certainly, he will keep what he sees as the best practices and procedures, and will probably keep most of your people, but his ideas on executive compensation, business development, human resources, inventory control, and a host of other subjects will probably differ from yours.

I actually saw a deal fall apart because the seller insisted on dictating how the business would be operated AFTER he was gone.

The trick is to know what the buyer believes he is buying.

Normalizing Results

It’s a useful exercise to adjust historical earnings for unique, unusual or non-recurring items, so future cash flow projections reflect the results the buyer is likely to achieve. This is called “normalizing” cash flow. Depending on how you’ve been operating the business, this process may identify certain assets or liabilities that should be valued separately.

Here are some examples:

Owner’s Compensation

A homebuilder’s owner paid himself a salary that was much higher than the CEO of any similar company would normally receive. It was his decision as to whether he wanted to receive the funds as salary or as a draw against earnings, but it did cause widespread resentment within the company, especially during lean times.

The important point here, though, is that by adding back the excess owner’s compensation into the cash flow projections, the company’s value increased by a multiple of say, 6 or 7 times that amount.

Below-Market Rents

A retailer had been in business for many years, and was such a desirable tenant that it could drive a very hard bargain with landlords. It was common to find 20 year leases at below-market rates, with 10-year extensions. A careful reading of the lease on the ideally-located head office revealed that it ran in perpetuity.

The low rents increased the company’s cash flow, and would have been taken into account if the company had been valued strictly on a multiple of that cash flow. Valuing leases uses much the same arithmetic as arriving at a multiple of earnings, but the terms of these leases were so unusual that we saw the need to evaluate them as a separate asset.

Ultimately, we prepared cash flow projections using much higher market-rate rents. This reduced the amount a buyer would pay for the company based on its projected cash flows, but it was more than made up by the higher value assigned to the leases as a separate asset.

Unusual Expenses

The owner of another company had a unique set of personal beliefs, and insisted that all of his employees and vendors share or participate in them – at considerable cost. Everyone was required to attend expensive week-long seminars by a California-based consultant who taught them how to deal with their personal fears. Another consultant was flown in from San Francisco for a week to realign the chakras of the executive staff. The owner catered lunches several times a week, so the entire staff would attend his meditation sessions. The company sponsored a project in which meditation experts gathered in Sedona to effect world peace.

It was highly unlikely that a buyer would continue these human resource policies, so we added back their cost to normalized cash flow, and substantially increased the asking price of the company.

Historic Land Values

A land developer and homebuilder had been in business for many years, and owned properties it had purchased up to 30 years previously. The profit margins on the houses it sold were significantly higher than they would have been if the land were acquired more recently.

There had been talk within the company of separating the land component of the business from the homebuilding component, in order to clearly see where the profit and returns on investment really came from, but the initiative never got off the ground.

The low historic land values were reflected in profits, but not in the actual operating cash flows, so a valuation based on a multiple of cash flow didn’t make sense. We prepared normalized cash flow projections for the homebuilding business based on market prices for the land, and did a separate valuation of the land reserves, based on those same market prices.

Non-Recurring Costs

Most companies have expenses they needed to incur a single time, or for a limited period. Examples I have seen include legal fees and settlement costs for lawsuits, discretionary bonuses for unusual personal or company performance and employee termination costs. I worked with a company that had incurred huge expenses trying to start a new line of business that was never realized. Another committed to a year-long sponsorship of a local sports team in a marketing effort that was judged a failure.

None of these costs can be expected to be repeated by a buyer of the company, and so should be added back to the normalized historic earnings, and to the cash flow projections used to place a value on the company.

Does your CFO understand the value of normalizing your cash flows from a buyer’s point of view?

Losing Perspective

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The story is that if you drop a frog into a pot of boiling water, it will jump out immediately. If you put it into a pot of cool water, however, then turn on the heat, the frog won’t notice the temperature change, and will eventually die when it gets too hot. Who knows if it’s true, but it’s a great metaphor, and we see it happening everywhere.

It’s easy to lose perspective.

We Are the Best

I worked on the conversion of a newly-acquired retailer’s systems to those of the acquiring parent company. Although the new system was much more sophisticated and comprehensive, fundamental accounting controls were missing, and it was so difficult to acquire, verify or reconcile certain information that we had lingering doubts over its overall integrity.

The parent company had a unique corporate culture based on the belief that they were the best – had the best stores, the best products, the best people, the best systems, etc. – and there was no room for discussion of improvements. The corporate controller explained to me that the systems were terrible before he joined the company, but they were great now. He listed examples of how bad they used to be, and every one of the deficiencies still existed… but they were the best.

Years later, there was an accounting scandal that hinged, among many other things, on the system’s inability to properly account for cost of goods sold.

They refused to look at their systems with a critical eye, and they lost perspective.

Director’s Cut

A well-known filmmaker invited me to see his new film while it was still a work in progress. He had been editing it for weeks, and was ready to show a rough version of the finished product. It was a demanding film, with dense dialog requiring concentration, and a limited budget for production values, and I was drained by the end of the screening. I looked at my watch several times during the film, so I was very aware of the fact that it was well over 2 hours long.

Called on for comments, I sincerely praised the film for its merits – a respected film critic eventually included it in his annual “Top Ten” list – but I felt the length of the film undermined its overall success. Surprised, the filmmaker responded: “You should have seen it when it was 4 hours long.” I attended the screening of the final film, and still found it much too long.

Art is subjective, of course, but I believe he lost perspective.

Competing Systems

A homebuilder developed an elaborate and advanced construction management system, and its reporting mechanism was tied to an accounting package. For reasons lost in history, they also continued to customize the primary general ledger system that had been in use since the 1970s. The result was that there were two very complex systems, but the reported results were often materially different.

Each member of the management team had his own favorite reports from both systems, and every meeting started with an argument over whose report was correct. One member of senior management knew how to reconcile the results, and he spent more than half his time doing so. By the time the reports were reconciled, the meetings were often over. Important business issues were never addressed, and the managers made their decisions based on different information.

This was one of the first issues I raised when asked for my observations on the company and its operations. The CEO, early in his career, personally directed the customization of the ledger system, and he wouldn’t listen to any criticism. He and his managers had developed the construction system, and were so proud of it that they invited homebuilders from around the country to show it off. There wasn’t going to be any discussion of problems there, either. When I tried to address the gap between the systems, the response was: “It’s great now – up until 6 months ago, all the computer terminals had green screens.” I hadn’t seen a monochrome screen in over 20 years.

The company went bankrupt. They had lost perspective.

Hey, What’re You Gonna Do?

Another retailer was very dependent on its highly complex systems. The nature of the business is that there is a high rate of turnover among line managers, and the corporate training systems placed more emphasis on sales and marketing than on administration. Unfortunately, the systems, while comprehensive, were not user-friendly, and there were constant problems requiring many long telephone calls to explain and resolve issues.

There was constant finger-pointing and redirection. A manager would direct associates to call the technical support hotline, only to be directed to the regional office, who might then send it back to the original manager. Certain employees became known for their ability to resolve certain types of problems, and everyone had a favorite go-to fixer.

Frustration abounded, but there was no feeling at the field level that there was anything fundamentally wrong with the systems. The company had been in existence for a long time. There was no problem with customer service, but the amount of employee time wasted by awkward systems was huge. When I asked why nobody complained up the corporate ladder, they just shrugged and said it wouldn’t do any good.

They had lost perspective.

That’s How it Should Be

In a construction company, it was highly unusual for accounting reports to tie out to the general ledger. It was a constant problem, and drove me crazy, because I could never trust that I was working with reliable information. We were involved in huge projects and equally huge financings, and acting on wrong information could have major consequences.

The CFO and IT director had been with the company for many years, and together had implemented most of the systems in use at the time. They knew them so well that they could tell me how to do elaborate reconciliations of the reports, which would often involve writing special programs. Their default question would typically be: “What do you need that for?” This exercise turned up problems with the original reports often enough that we had the battle many times.

When I pressed the CFO to set up a task force to streamline and clean up the accounting systems, he would argue that the systems were good, and that the reports actually shouldn’t tie out. “That’s how we designed them.”

They had lost perspective.

Does your CFO encourage taking a fresh look at long-established systems and methods?

Cap Rate … What is it?

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For every commercial real estate opportunity, someone is going to tell you the Cap Rate. We all know that the Cap Rate, when divided into Net Operating Income (NOI) gives you the purchase price. We also know that the Cap Rate roughly represents the return for one year on a commercial real estate investment. But does that mean it’s the right rate for you?

It’s useful to break down the Cap Rate between the mortgage component and the equity component. Here’s an example:

What We Know

The things we know (or should know) when we’re contemplating a real estate purchase include:

Net Operating Income (NOI) – $1,000,000 annually. Remember that a property’s NOI does not include debt service – principal or interest payments. This isn’t the time for a lengthy discussion, but be sure to do your due diligence to prevent unpleasant surprises.

Mortgage rate – 5.0%

Mortgage term – 25 years

Loan to value ratio (LTV) – 75% of purchase price

Mortgage Component – Calculate the Mortgage Constant

The mortgage constant is the annual payment, or debt service, expressed as a fraction of the total mortgage. From the bank’s point of view, this is the Cap Rate on their investment in the loan.

In this example, the annual payment on a $100,000 mortgage (any amount will give the same result) at 5.0% amortized over 25 years is $7,015.08. This is the portion of NOI that goes to make debt payments.

Annual debt service of $7,015.08 is 7.0158% of the $100,000 mortgage in this example, so the mortgage constant is .0701508

Equity Component – Calculate the Equity Constant

How much do you want to make on your equity investment? Let’s say you’re looking for a 15% cash on cash return.

Your return is 15% of your equity investment, so the equity constant is .15.

Calculate the Cap Rate

Mortgage component of the Cap Rate:

Mortgage constant (.0701508) x LTV (75%) = 5.26%

Equity portion of the Cap Rate:

Equity constant (.15) x Equity contribution (25%) = 3.75%

Cap Rate:
Mortgage component (5.26%) + Equity component (3.75%) = 9.01%

Calculate the Purchase Price

Net Operating Income ($1,000,000) ÷ Cap Rate (9.01%) = $11,097,165

If you pay more than $11,095,165 for the property, you won’t make your target return. This may limit you to certain types of property investments, so you may want to adjust your expectations. If you are willing to accept a 12% return on your equity investment in this example, your Cap Rate would drop to 8.26%, and you could pay $12,104,617 for the property.

Capital Appreciation

Of course, 101 other questions arise when you are contemplating this sort of decision. Foremost among them is how you view capital appreciation. With a 75% mortgage, if the property value increases by 1% a year, you gain 4% on your invested funds. If you build appreciation and/or rent increases into your projections, you can pay a lot more for the same property and still make your target return. That’s how high quality properties can sell at a 4% or 5% cap rate.

Do you know who to call to discuss Cap Rates?

Profit Improvement – Delay of Expenditures

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Pretty much every company wants to increase its profit, and most managers devote a large portion of their time to trying to increase revenues and margins, or reduce costs. As a financial manager and consultant, I have been involved in many profit improvement initiatives. Here are some examples – they are mostly from construction, retail and land development, but the concepts can be applied to any business.

Delay of Expenditures

Time is money. Delaying expenditures until absolutely necessary reduces interest, storage and other carrying costs, reduces pressure on borrowing limits and has a positive impact on return on investment. Speeding the receipt of funds has the same impact.

Financial Review

A land developer traditionally let marketing decide when certain tracts would be made available for sale to builders. The sites they selected appeared to be random throughout the communities, and they professed no particular strategy. I proposed marketing contiguous tracts to delay the outlay on roads and other infrastructure costs. As a result, we delayed the spending of tens of millions of dollars, and there wasn’t a grumble from marketing.

Looking Around

A retailer’s distribution center was designed to service a fixed number of stores, and the time was upon us to start construction on a new, larger center. The limiting factor was the number of boxes that would fit on the conveyors that passed in front of the merchandise pickers. I observed that if we simply changed the shape of the boxes, we could serve up to 50% more stores without incurring the multi-million dollar capital expenditure.

Process Review

Homebuilders often sell their model homes to investors, and lease them back until the community is sold out. The process is rather complex, involving the buyer, various attorneys, appraisers, the construction and marketing departments, accounting and treasury, among others. Meanwhile, the clock is ticking on interest and carrying costs until the transaction is completed. I led a Six Sigma team to look into speeding the inflow of cash. We flow-charted the process, identified bottlenecks and delays, and established a standard timetable to be followed on all future transactions. We reduced the cycle time by three weeks, and calculated annual savings at $400,000.

Does your CFO get involved in planning your major expenditures?

Thinking About Year-End? … You Should Be

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Year-end is almost upon us again. Now is the time to get your house in order – it will take a huge amount of stress off the closing process a couple of months from now.

Being truly ready for the auditors can save audit time and fees, reduce stress on your staff during the audit, and maybe make your financials available for lenders and investors a little earlier. Equally importantly, audit-readiness is a good indication that your accounting department is organized and up to date. How many other ways do you really have to determine that? Here are a few things you should consider:

Preparation of Financial Statements

Do the auditors historically require that you make embarrassing changes to the financials? What has been done to avoid that this year?

–          Does your accounting department prepare the financials, including notes?

–          Have you questioned any balances or accounts that seem surprising or unusual?

–          Did you do anything different this year? Are you sure it is accounted for correctly? Now is the time to sort that out, not during the audit.

–          Have any changes in accounting rules affected your business? Are there any changes not yet required that you could implement early?

Reconciliations

Reconciliations provide explanations for changes in Balance Sheet and P&L accounts, and your accounting department should be able to show them to you every month.

–          Do you know exactly what is in every balance sheet account?

–          Can you explain every change in the balance sheet?

–          Have expenses been calculated consistently every month?

–          Can you show how cost of goods sold affected inventory every month?

If you can say yes to all of these items, updating to year-end should be a piece of cake.

Updated Estimates

Where your monthly accruals and amortization calculations are based on volume or other estimates, have they been updated to be sure the year-end balances are correct? Again, a 2 month update at the end of the year is a lot easier than doing it for the entire year.

Variance Analysis

Has there been a thorough analysis documenting all significant P&L and Balance Sheet variances from last year? Are the explanations reasonable, and the underlying facts correct?

Documentation of Procedures

–          Are the fundamental internal control procedures properly documented?

–          The auditors typically make recommendations for improvements in procedures and controls if they find any deficiencies. Were last year’s recommendations fully implemented?

–          Have changes in staffing or procedures resulted in changes to the control environment? Now is the time to correct them.

Not sure if you’re going to be ready for year-end? Do you know who to call?

Hmmm… Didn’t Think of That

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There are executives who rely on their ability to move quickly. They are often the ones who loudly declare that if we sit around analyzing things to death, we’ll never get anything done. Sometimes, they’re also the ones who are willing to bet the farm before the analysis has been thoroughly completed.

I love working with these high-velocity types, but they often need someone like me watching their back. Someone with a strong business sense and analytical capability who doesn’t slow down the process.

Here are some examples of how things can go wrong:

Catalogue Stores

A well-known retailer operated discount department stores nation-wide. To reach a wider customer base, they also operated a successful chain of catalogue stores in communities too small to support a full-service store. A customer would place his order at a catalogue store, and the item would be delivered within a week.

Meanwhile, changes in technology and inventory management techniques had resulted in a substantial reduction of inventory carried in the full-service stores. These were large stores, so quite a lot of physical space was freed up.

A senior executive came up with the idea to put catalogue stores in the available space in the full-service stores. His analysis showed that not only would the new catalogue stores add substantial revenue and profit to the existing outlets, but they could easily be placed in the least desirable selling areas, often in store basements.

There was much fanfare as the project was launched. The executive in charge even ran afoul of his boss and colleagues when newspaper articles praised his brilliance beyond their comfort level. Then the catalogue stores were abruptly shut down as a disastrous failure. Why would a customer walk through the store, passing by the merchandise he wants to buy, only to order it in a dark basement for delivery a week later? Hmmm… didn’t think of that.

Paper Shortage

A young warehouse worker at a large office supplies distributor showed such ability and intelligence that he was rapidly promoted to be the company’s purchasing agent. This was a long time ago, in the mid-1970s, when the oil crisis resulted in chronic shortages of a surprising range of products.

One day, the purchasing agent called to place a routine order of reams of 8 ½ x 11 inch printer paper. “6 months’ delivery” he was told, and he realized he would be unable to fulfill his customer orders for much of that time.

He was a smart kid, so it didn’t take long to figure out that when the shipment did arrive, he could be looking at another 6 months for the next delivery. Of course he didn’t ask for advice. He started placing orders every couple of weeks, based on historical usage, fully expecting to be back on his regular schedule at the end of the 6 months. Yes, he was a smart kid.

The only problem is that it was a big company, and after a while, the orders accumulated into a quantity large enough to justify an entire separate mill-run by the manufacturer. There were delivery trucks at the door for days on end, and you had to walk sideways through the warehouse to get past the stacks of paper. Hmmm… didn’t think of that.

Demographics

A retailer launched a new business based largely on demographics. It was the early 1980s, and the Baby Boomers were just starting to have children of their own. It was the beginning of a huge increase in births that the industry was calling the Echo Boom. What better time to start a chain of stores specializing in children’s apparel?

After establishing a solid base in California, the plan was to follow the demographic projections that showed high percentage population growth in the southern states. The company made an aggressive move into Texas, and suffered from an economic downturn and some bad real estate decisions, resulting in the prompt closure of about half of the new stores. Still, the roll-out through the south remained the CEO’s plan.

This is the only example in this article in which I was able to play a part, so of course, I’m the hero of this story. I pointed out that the southern states were in fact projected to grow at high percentage rates, but the population density was insufficient to achieve the economies resulting from tight clustering of stores. After all, 10% of nothing is still nothing. Hmmm… didn’t think of that.

The management team listened to my presentation, and we headed instead to the northeast, where large populations were already in place. Our strategy shifted to taking business away from the department stores.

Does your CFO sit in on strategy meetings and tactical problem-solving sessions? He might just bring an important new perspective.