CategoryStrategy and Planning Archives — Page 2 of 2 — C. Lynn Northrup, CPA, CPIM
How much appetite for risk does an entity have relative to its pursuit of value? Each entity has to develop its own appetite for risk. This will depend on achieving an acceptable balance between growth, risk, and return and creating the proper relationship between risk appetite and strategy.
Effective risk management and execution of strategy requires appropriate alignment of people, processes, and the supporting infrastructure of the organization and process owners. Appetite is linked directly to strategy and is aligned with the desired level of value creation. Different strategic options will evolve based on the assessment of risk attached to each strategy. Therefore, management style and approaches to strategy will drive varying levels of appetite for risk-taking. When setting strategy, entities will vary in their approaches to risk. Qualitative approaches will categorize the entity’s appetite for risk as green, yellow, or red (high, medium, low). Entities that employ a quantitative approach will consider appropriate goals for growth, return, and risk. Risk management helps the management team choose strategies that blend with the organization’s goals for creating value.
There are a number of considerations that impact an organization’s appetite for risk. These factors will vary from business to business. It boils down to what risks the business wants or is willing to accept and what risks they want to avoid. The desired rate of return on initiatives is one of the factors that will influence risk appetite. Risk appetite will be affected by the current rate of return and the competitive need to accelerate growth. The strategic focus of the entity will directly impact whether a company has a high or a low appetite for accepting risk. Risk management needs to consider the organization’s appetite for risk and then guide management in selecting and balancing their decisions in their choice of initiatives and allocation of resources. The tolerance for entity-wide risk will then enter into the selection of objectives in the pursuit of its strategic vision.
Risk tolerance and appetite represents a balance that helps keep businesses and organizations on course and helps to avoid unnecessary and avoidable surprises. It is like walking a tightrope and then deciding how high you are willing to be, in case you fall.
The first thing to realize is that risk will evolve from either internal or external sources with the potential to affect strategy. Risk represents the possibility that some event will occur. Management’s job is to assess all the risks associated with implementing strategy and achieving the organization’s objectives. It boils down to considering the impact of all the underlying events that might have some impact. Enterprise Risk Management (ERM) is a framework for aligning risk appetite and strategy. Based on application of the framework, managing risk becomes a process of enhancing our risk management decisions. It is about reducing operational surprises and losses through a process of identifying and managing the entire multiple and cross-enterprise risks. It is more than avoiding losses; it is a process of seizing opportunities and looking for ways to improve the deployment of capital.
It is very closely linked to internal control in that is a process that is created and managed by people. It is, or should be, applied in a strategy setting and across the enterprise. It will only provide reasonable assurance and is geared to the achievement of objectives. When we say that risk management is applied in setting strategy is that it sets strategies and then considers risks relative to alternative strategies. It evaluates alternatives and helps decide on a course of action.
Risk management is applied across the entire enterprise and should consider the entire scope of activities at all levels of the organization. You need to consider special projects and new initiatives. Don’t apply the concept too narrowly because taking a portfolio of risks may override the occurrence of a single isolated event. Your assessment should consider both quantitative and qualitative factors in reaching judgments. Also, it is useful to group risks into categories so they can be effectively managed.
Now that we’ve got you started on the road to understanding risk management we will next take up risk appetite in our next post.
EVATM stands for economic value added. It is an economic value-based model to measure performance. It is a metric that holds businesses accountable for the cost of capital used in the business and determines whether or not real value has been created for the owners. The calculation is determined by subtracting a charge for the full cost of capital which includes the equity and debt from the net operating profit after taxes. The method adjusts for accounting distortions such as intangibles and gets back to a cash basis or an economic model of profitability. This is important because it focuses on what is really critical in this economy in contrast to GAAP accounting-based measurement.
If EVATM is a better measurement of value creation, why is it better? The underlying principle of any business is that it must provide a profit that is great enough to justify the cost of capital used in the business. In other words, a business needs to create a surplus of profit after covering all of its costs. Until a business has earned an economic profit, it has not really generated a profit. When the net economic profit of the business exceeds its cost of capital employed, positive value is created. If net economic profit is zero or negative, then value is lost.
In its simplest sense, there are only three ways to increase economic value:
1. Increase operating efficiency
2. Only undertake investments that add value
3. Get your capital out of investment activities that don’t add value
By simplifying your focus, one develops a much better grasp of how value is being created or not created.
All too frequently managers are making decisions without considering the cost of capital in making their investment decision. They also think they are making a profit, when in fact; they are losing value by not covering the total cost of capital.
It is critical understand the reality of whether or not you are making an economic profit. If you can’t earn economic, cash based, profit, then why pursue the investment or continue the business?
Well 2009 is here. Now we have a chance to put the trauma of 2008 behind us and move forward to new beginnings. I already have. My goals are set and I’m moving on to where my dreams are going to take me. 2008 was a pretty good year for us. First and foremost was creating the new look to my web site and this blog. That said, there’s even more to do now 2009 is under way.
My advice is always to be patient, focused, and disciplined because in the long run this type of thinking and action is what gets the job done. This motto combined with a habit of always set goals and objectives is crucial. Then you need to monitor your results and adjust as quickly as possible if things aren’t going the way you anticipated. It’s a process – and not a short one.
Some of the things we are pursuing for this New Year include actions in multiple areas. I want this blog and web site to be an authoritative resource for CPAs, family businesses, and retirees as they navigate the difficult journey ahead. My plans include new training programs, up to date information on the potential adoption of IFRS, solid support for building business value, and guidance for family-owned businesses seeking to develop succession and transition plans to a new future. Plus all the other material we have always provided.
A new mission will include retirees and those looking toward retirement. This will include a new book and lots of guidance on how to make the transition. I am flunking retirement, but have put ourselves into a place where I can play, work, and live like I always dreamed we would. I learned a lot in making our journey, so it’s time to share this knowledge and information with others. I hope you will enjoy and benefit from this initiative.
Well, Happy New Year and stay tuned as we move forward and enjoy! We’re looking forward to the challenge that lies ahead.
How you do survive the worst economic downturn since the great depression? This is a big question. Many people never experienced the depression or even the big recession of 1981 and 1982. I was a controller of a large corporation back in 81-82. This got me thinking about how could I provide guidance to those who haven’t experienced such turbulence.
Based on my experiences I created a toolkit to package all the tips and techniques of how to get through the tough times. One of the key elements of the survival toolkit is developing a plan and a budget for recession survival. The toolkit contains a cash flow and budgeting template. The process of developing a plan should include an assessment of whether the business needs a tune up, a turnaround, or is in a state of crisis. When you can’t cover payroll, you’re in a crisis. This is why cash is king. If you don’t have adequate liquidity or access to cash, the chances for survival get pretty slim.
During a recession it is time to get aggressive with your sales and marketing. It isn’t always just pricing. Make sure you reach as many potential customers as possible. It’s a numbers game, and having more leads in the pipeline is crucial. Understanding your profit margins is another essential step so you can make price adjustments and at the right level to secure a greater share of the market.
The Recession Survival Toolkit outlines tips and techniques for reducing costs on every facet of the business. Just reviewing all of the potential opportunities to reduce costs is a healthy process. Usually the first step in cutting back is reduction of headcount. There are numerous ways to control payroll costs without reducing headcount. Consider adjusting hours worked or vacations with out pay as a way of keeping your valuable employees.
Another opportunity is to use lean workflow techniques and paperless systems to streamline the office and accounting functions. Not only is it cheaper, but it speeds up data retrieval, improves accuracy and saves time. It also minimizes the cost of paper and storage space.
Getting financing and having a relationship with your banker is a key element of making it through tough times. When your bank is your partner, your survival chances get a lot better. The toolkit reveals the techniques used by banks to make loan decisions. When you understand what the bank wants, you are in a better position to get the necessary financing.
Having developed a recession survival toolkit for businesses, I am now motivated to provide more guidance for individuals and retirees. I think CPAs have a responsibility to help citizens achieve a higher level of financial fitness. The AICPA and the Virginia Society of CPAs have launched a website that offers a great deal of information and advice on financial management.
Remember, it took a while for us to get in this mess, and it is going to take focus, patience, and discipline for us to get healthy again.
These are economic conditions that I have not seen ever in a career of over 45 years. It will impact and hurt all businesses, particularly the smaller family-owned entrepreneur. One of the reasons for this is that driven entrepreneurs prefer to go solo and either do not want to ask for help or are unwilling to pay for advice that could save their business. The entrepreneur likes to break the rules and often feels they can get away with things. The danger of this approach in this tumultuous environment is there is a good chance of going down blind alleys with no escape.Now is the time to think strategically about the business. Get the help of advisors who can help lead businesses out of trouble before they get in too deep and go too far. The thinking and planning process is where entrepreneurs need to listen to advisors. If they don’t have an advisor they should go find one. Setting here writing this blog, I can think of several examples where companies didn’t want to seek advice or if they did, they didn’t listen. In some of these instances the results might be fatal. Companies failed to expand credit lines when they could and now getting credit isn’t an option. They also purchased assets when they should have save their cash.
I have had bankers tell me they wished some of these companies would seek help because it makes their job easier and reduces risk. It is all about being penny wise and pound foolish. A little money spent on planning and prevention could be the difference between solvency and bankruptcy. You would think more entrepreneurs would pay the price and choose solvency.
Another issue where procrastination is high is succession and transition planning. Time and effort devoted to putting good succession and transition plans in place allows business owners to preserve the wealth achieved over a lifetime of work. The failure to implement these plans either due to lack of time or not wanting to spend advisor fees results in the loss of all the accumulated wealth or in excessive estate taxes. It also produces a mess for the survivors to clean up when it could have been avoided.
One final caveat is that advisors do their best work when they can focus on fixing the business rather than managing a short-term cash crisis. It is easier to prevent the fire than to put it out after it gets started.
I thought it would be useful in this troubling economic environment to explore complacency. Linked together with complacency is a false sense of urgency. These are the two biggest issues that I wrestle with in my consulting practice and in dealing with clients.Complacency emerges from a sense of success or perceived success. Hey, I know what I’m doing because I built this successful business. The wagons might be circled and the bank has shut me down, but I know what I’m doing. Perception might be nine tenths of the law, but here reality is a different story.
Then the urgency level starts to spike. The trouble is this is a false sense of urgency because the complacent paradigm has these people doing the same things they’ve always done except they’re doing it faster. All they are doing is digging the hole deeper when they should stop digging.
I try to invoke the unvarnished truth and get them out from under the covers and feel how cold it really is out there. Maybe it is time to slow down and really think through the business and what we need to do going forward versus the same old things that aren’t going to work anymore. We need to change.
This is the challenge for CPAs in today’s economic reality. Stop doing what we have always been doing and start dispensing real business advice to our clients. It is going to be tougher and it’s likely that the same products and services won’t get the job done. It’s time for innovation to kick in and start thinking different about what to change and how to change.
Tough economic conditions will stress all businesses and present challenges and hardships. Dealing with these challenges is the key to survival. The survivors will be those business owners who utilize an effective strategy combined with the right accounting and measurement tools to keep their business on track. I think this is a good time to talk about profit focused strategies and how to apply profit focused accounting techniques so they work to your advantage.
Profit focused strategies are based on developing effective strategic plans using lean accounting and throughput analysis to increase sales and cash based profitability. Whether your business produces a product or provides a service it is important to understand which customers, products and services generate the greatest amount of profitability. A lean accounting analysis is critical in determining the variable margin by each product and customer.
This information should be utilized to assess your productive capacity and then focus on adding volume and capturing market share based on your strategic plan. Another management and analytic tool that should be utilized is the application of activity-based management. Use these concepts to evaluate your capital investments and overhead costs in order to make the best decisions for the long haul. Another key element is developing a balanced scorecard to help select the right measurement and indicators to monitor progress toward achievement of your strategic goals and objectives.
I know this sounds complicated, but in reality it isn’t that difficult. It is a process of analyzing the sales or throughput for your business and getting it aligned with the variable costs and other expenses associated with generating those sales. Based on this information it is critical to develop strategies for increasing market share together with the pricing strategies that will provide the desired market penetration. Effective analysis of the cost drivers within your business will allow you to make more informed decisions about where and how to strategically focus your efforts. When selecting your key measurements be sure to identify both financial and non-financial indicators for tracking your strategy using a blend of financial, customer, process, and employee related factors.
Remember that cash is king. You need to install the discipline in your business processes to make sure you are focused on the creation of cash from your market penetration strategies. It is the economic profit that shows up in your bank account that really matters. Therefore, put your emphasis on creating economic profit and cash flow. This is where lean accounting and profit focused strategies will pay off. Another benefit of applying profit focused accounting is that understanding your financial statement is a lot easier. It is like looking at a breakeven analysis every time you review your profit and loss statement.