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This is my 4th article in my Corporate Governance miniseries. To recap, my first article is the introduction of corporate governance followed by Parts 1 and 2 on the red flags found in financial statements and the importance of financial statements as a management tool. In this article, I am sharing the benefits of incorporating corporate governance in the daily operation of your business.

 

In general, the operation functions of any business could be overlapping, interconnected and will not be easily separable into clear independent defined categories. However, it is still very important to ensure that the functions should be carefully framed to avoid conflict of interests that ultimately would bring detriment to the business in the long term.

 

A good business operation process is able to instill accountability and transparency. Hence, let us look at the 5 basic elements below.

 

Power of Executive

Executive here means directors and top management personnel who are entrusted to make decisions to grow the business, preserve its assets, ensure proper fund utilisation and to find ways to sustain the business in difficult times. Any power given to the Executive should incorporate a check & balance strategy. In the Start-Ups and SMEs environment where limited number of persons are operating the business, it is important to have an independent capable ethical advisor to be brought in to provide check and balance to safeguard the interest of the business.  Approving power should not rest upon one person unless it is a sole proprietorship. This is to prevent the wrongful use of power or undue influence on the board of directors.

 

Payment Approvals vs Payment Execution

Personnel with approving authority should not be involved in payment execution. This is a form of independent checking process and financial control transparency to ensure that payments are appropriately made.  Any questionable cash movement can be detected early.

 

Accounts Recording & Independent Auditor

Many business owners may view financial recording is only to fulfil Government requirement for taxation purpose. However, it is essential that business owners must understand that an up-to-date set of accounts serves as audit trails to detect wastage of resources, incorrect recordings, financial irregularities, revenue and expenses patterns and as a management tool to sustain the business, promote its growth and monitor the cash flow. An independent auditor serves as a helpful investigative eye and provides good insights into the business.

 

HR – Hire & Fire

Hiring is a very important process to ensure only people of the right fit in terms of qualifications, experience, ethics, work attitude, their expectation in career growth and wages will join the company. In a situation where termination of employment is unavoidable, separate HR personnel should be brought in to provide a fair assessment of the situation. This strategy provides a fair chance for the employee in question to present his side of the story. When an HR issue is carefully managed, potential wrongful dismissal claims against the Company may be avoided.

 

Legal Process

First, it is important to understand that the business legal structure you choose will affect your personal legal and financial liability on business debts accumulated during the course of the business if your business could not pay its debts. If your liability is unlimited, you may lose all your personal assets to settle the business debts or even be made bankrupt by your business creditors.

 

Second, a well-thought business structure should incorporate important legal documents which are properly placed to help the business to minimise the negative legal effect or any future unwarranted claims. Important clauses to protect the company should be incorporated into agreements such as the merger and acquisition, investment in subsidiaries, joint ventures, employment and consultancy agreements, inclusion or exit of investors and shareholder agreements.

 

Third, legal agreements should contain terms and clauses to protect the interests of stakeholders but fluid enough to allow the business to grow. Any legal clauses which are overly restrictive may pose challenges to business expansion. A good balance should be achieved depending on the risk appetite of the business owners.

 

I hope this article creates your interest to find out more to benefit your business venture.

 


Balance Sheet

  1. High Inventory Rate Vs Low Sales

When a high inventory rate is recorded, it means the turnaround of the stock is fast to produce the finished goods. However, it does not make sense with a high inventory rate but a registered low sales volume. Leakage in the supply chain could likely be one of the reasons.

 

  1. High Loan Amount to Directors

When excessive amounts of loan to the director(s) are recorded, lenders view this as the company is not using its cash inappropriate manner, or directors are misusing company funds or moving cash out of the company.

 

  1. High Receivables Vs Unhealthy Aging

Trade receivables are acceptable if it falls within 1-2 months or within the industry credit terms offers to clients. However, a high percentage of receivables for more than 4 months is showing signs of an unhealthy collection pattern.   

 

Cash Flow Statement

It is inaccurate to conclude that the total cash collected is the same as total revenue for the accounting period unless your business is based on hard cash received upon issuance of invoices in the same accounting period. 

 

  1. Cash paid out to questionable investment.

Cash has been paid out to invest in companies where directors have personal interests, for purchase of assets/properties/stock in individual names or assets which has no relation to the generation income for the company.

  

  1. High Revenue vs Low inflow of Cash

Such situations exist when a company has made lots of sales by issuing invoices but cash from sales is yet to be collected. Any uncollected cash from concluded sales of more than 6 months should require the attention of key executives.   

 

  1. High Paid Out to Directors/Key Management Vs Low cash for Business Operation

It is acceptable to pay out good remuneration but not when the business is facing tight cash-flow to pay the expenses of the business.  

 

As mentioned, this is not an exhaustive list. There are many other observations in financial statements that would benefit business owners. I hope the above 9 Red Flags help in your strategy to excel in your business or new startups. Don’t forget to follow me on my next article to get some insights on Red Flags revealed in Operation Process. 

 

This is a continuing article in my series on Corporate Governance (CG). This series is dedicated to Start-Ups and SMEs as issues of CG in large corporations are complex and require multivariate observation to understand. I would probably write a series for large companies sometime in the future.

 

The purpose of this series is to guide business owners and to-be-entrepreneurs to understand the critical areas in financial statements and use it as a management tool to strategize plans to sustain or grow the business. Do bear in mind that banks, government agencies, lenders and investors would analyse these areas to gauge the health of your company and to make their decisions to lend or invest in your company or otherwise.

 

This list is not exhaustive and is presented in short points without detailed explanation but sufficiently to serve as a preliminary guide. It is important to note that managing financial risk is the responsibility of directors and key persons. When auditors detect any irregularities in the financial statements and have signed them off as a qualified report, it may be a little too late to save the company from a black mark.    

 

Financial Statements are made of 3 key parts comprising Income Statement (P&L), Balance Sheet and Cash Flow. These parts should be read as ONE to understand the correlation between all three within the same accounting period, be it the same month, same reporting quarter or same financial year-end.

 

Let’s begin with the Income Statement.

  1. Aggressive Revenue Recognition

Usually, revenue is defined as actual sales invoiced and it does not include ‘agreed’ sales. It is always excellent news when a business is generating good sales. However, when sales surge unprecedentedly high as compared to previous accounting years or disproportionately with the industry benchmark, this should certainly invite a detailed look. Checking the reasons behind sudden high recorded sales should be high in your checklist.

 

  1. High Revenue vs Low Expenses

Cost of goods and other operating costs would increase proportionately with the increase of sales. When there is a big disparity between these figures, it may trigger suspicion that the numbers may be cooked up unless the disparity is justified.

 

  1. High Growth Profit Margin vs Low Industry Margin

Profit, profit margin, and profit margin growth rate, co-relate with price, sales and cost. When a business is growing with an increasing profit due to better margin which is not in line with industry performance, this will trigger suspicion. Certainly, there are businesses which have shown such a sudden increase in profit margin. This could be brought about by utilizing essential raw material acquired earlier at low costs, or by merger or business acquisition, or in the case of property development, and inherited land.    

 

We have Part 2 to be published on Friday, 19th Feb 2021. Do follow me in my next article.