Dimension 2: Assessing Management's Ability to Formulate and Execute Business and Financial Strategies PDF

DIMENSION 2 CRC US Body of Knowledge // Dimension 2 // Assessing Management’s Ability to Formulate and Execute Business......

DIMENSION 2 CRC US Body of Knowledge // Dimension 2 // Assessing Management’s Ability to Formulate and Execute Business... ASSESSING MANAGEMENT’S ABILITY TO FORMULATE AND JOIN. EXECUTE BUSINESS AND ENGAGE. LEAD. FINANCIAL STRATEGIES Financial Strategies.....................................................2 Assessing Alignment of Owners’ and Managers Purpose of Dimension 2.............................................2 Objectives................................................................27 Additional Skill-Building Resources...........................2 Determining if there is a Dispute Resolution Mechanism in Place.................................................30 Management Qualifications.......................................3 Evaluating Likely Future Financial Commitment Management Experience............................................5 to the Business.........................................................31 Management Integrity................................................8 Using Third Party Information in Management Organization, Style the Management Assessment....................................32 and Characteristics...................................................10 Business Credit Information.....................................33 Planning and Control Systems.................................13 Consumer Credit Information.................................35 Assessing Strategic Planning Ability..........................13 Other Third Party Information Sources....................36 Assessing Company Control Points..........................16 Auditors...................................................................18 Company History....................................................20 Inspection and Licensing Organizations...................20 Information Technology Systems..............................20 Critical Business Processes’ Reliance on Information Technology...........................................21 Information Technology as a Competitive Advantage................................................................22 Information Technology Organization and Planning Procedures.................................................23 Information Technology Internal Controls and Risk Management....................................................24 Shareholder/Management Relationship....................26  DIMENSION 2 - 2 NOTES: PURPOSE OF DIMENSION 2 The purpose of Dimension 2 is to provide tools and insights to support evaluation of a client’s management and management’s ability to formulate and execute business and financial strategies. Key topics in this Dimension are: Management qualifications. Management experience. Management integrity. Management organization, style, and characteristics. Planning and control systems. Information technology systems. Shareholder/management relationship. Using third party information in the management assessment. ADDITIONAL SKILL-BUILDING RESOURCES The material in the Body of Knowledge provides an overview of knowledge related to topics covered by the Credit Risk Certification exam. Mastery of topics reviewed here is essential preparation for the exam, but no amount of reading and study can substitute for lending skills that must be acquired through formal classroom and on-the-job training. In addition to reviewing the Body of Knowledge, consider taking the following RMA courses to support your Dimension 2 skill building: Analyzing Industry, Business, and Management Risks CRC US Body of Knowledge Uniform Credit Analysis Fraud 101  DIMENSION 2 - 3 MANAGEMENT QUALIFICATIONS NOTES: Just as you have expectations about the characteristics of financial statements of companies in different industries, because of your own knowledge and experience, you have an idea of what skills are necessary to effectively operate the business to which you are lending money. Skills and knowledge, coupled with an effective management style and Dimension 2 // Assessing Management’s Ability to Formulate and Execute Business and Financial Strategies uncompromising ethics, will generally ensure the success of a company. Core competencies required to successfully manage a company include finance, production, distribution, sales, marketing, research and development, Technology, operations, and human resources. All of these core competencies (with perhaps the exception of manufacturing and distribution in the case of retail companies or service companies) have to exist in some form or another within the company’s management team. These skills will have different emphasis and degrees of importance depending on the company and industry. You need to determine which skill sets are necessary for success. Then you must determine which managers possess those skills and assess how vulnerable the company is to losing the manager(s) with those critical skill sets. Part of your evaluation is to determine whether management acquired skills through: Formal education What academic degrees or other evidence of formal training are necessary to demonstrate the existence of particular skills and knowledge? On the job training (OJT) What on-the-job technical and knowledge-based training has been acquired in these areas? In addition to comparing required core competencies with existing skill sets possessed by management, you need to assess the ability and willingness of management to learn new skills when business requirements change. This can be evidenced by continued education, attending seminars, and an attitude of “learning whatever is necessary” to keep the company moving forward. Make sure your customer is keeping pace with the industry. Required skills fit into three categories: Technical Those core competency-based skills, upon which the company is founded, be it engineering, accounting, legal, chemistry, etc. Organizational  DIMENSION 2 - 4 How does management organize the core competencies required so that NOTES: the company functions efficiently? Are there current organization charts and job descriptions that reflect the needs of the organization and the strategic plan? Is there evidence of orderly workflow and even distribution of work without bottlenecks? Management What is the management style that blends the technical knowledge and the organizational structure and delivers the product or service to the market place? A deficiency in any one of these areas can compromise the potential of a company. Many companies have been started by very intelligent people, but have subsequently gone out of business because they didn’t possess either the organizational or the people skills necessary to operate a successful business. For all categories of required skills, it is important to ask the following questions: Is there an adequate supply of properly trained personnel? What is the rate of employee turnover? What are the hiring, advancement, and firing practices? What kinds of training are necessary? Is there a back-up plan (succession) for key functions? Is there a human resources function within the company and does it have complete personnel files, employee manuals, and policies that reflect current labor laws? CRC US Body of Knowledge  DIMENSION 2 - 5 MANAGEMENT EXPERIENCE NOTES: It is vital to profile the management team’s depth of experience and skills, both to understand current management strengths and weaknesses and to determine if there is backup for the critical management skills needed to operate the business. Dimension 2 // Assessing Management’s Ability to Formulate and Execute Business and Financial Strategies It is especially important when evaluating the CEO to ascertain how he/ she compensates for his/her own deficiencies. Your goal is to understand how the CEO manages the strengths and weaknesses of the company’s management team. Through interviews and your own observation, develop answers to these key questions: What is the experience of each key manager, and how does that experience relate to the core competencies required by the job? If a manager’s skills are not perfectly matched to the requirements, how transferable are the existing skills and experience to the profile of required skills? Is there a track record of willingness and energy on management’s part to acquire new skills and experience? Do senior managers have the experience and skills to appreciate the impact of the other people in the company who deliver the other core competencies? Being willing to work in a team environment is an excellent attribute, but the manager must also have the experience and working knowledge of the other disciplines to be truly effective. Have the managers been successful at adapting to change? How flexible is the management team to take advantage of opportunities or to make difficult decisions in light of challenges to the success of the company? Phrase this question in a way that prompts your interviewees to show specific examples, saying: Tell me about a time when you had to alter the company’s course to respond to an unexpected turn of events. Has the company weathered any adverse circumstances or severe economic cycles? Experience responding to a variety of economic conditions is a success factor. Evidence of effective, ethical behavior in times of crisis or adverse circumstances is a success factor. Is the company in the same business with the same management and ownership it had when it faced those hardships? Has the management team grown in experience and skill to match the evolving size and complexity of the business? A large company with multiple business lines has more complex management needs than a smaller, one-business enterprise. Ask senior managers to describe how the company has grown (internal growth, merger, acquisition?) and how each stage of growth altered the management profile. Ask each key manager to identify the skill or expertise they would be most likely to recruit for if able to add one more manager to the team.  DIMENSION 2 - 6 Has management exhibited a creative track record of developing NOTES: new products and services? Ask key managers to describe the process that resulted in the most recent additions to their product or service. Ask them to explain what has historically motivated the decision to expand the product suite, such as response to competition, desire to be the innovative market player, or request from an existing customer. Have they managed at all levels of a fully integrated labor force? Do they have experience with establishing compensation and benefit programs that attract, retain, and grow qualified employees? Do they possess the necessary experience with organized labor, if applicable? If the customer is a family owned enterprise, to what extent does the family control management decision-making? Has the family brought in outside, professional managers to supplement or succeed family management? Have family managers had meaningful and relevant professional experience outside the family business, to bring outside skills and perspectives into the business? Does the customer have a formal succession plan in place for key managers, and is the plan in active implementation? A company’s succession plan is vital to assuring you of some management continuity in the event of death, retirement or departure of a key manager. In addition, a customer’s commitment to succession planning provides business benefits to the company. Companies that plan for succession are identifying the abilities and qualities needed for individuals to succeed, meaning they are pursuing a management development strategy instead of simply reacting to employment needs. Companies that actively communicate advancement criteria may benefit through higher manager retention. Qualities of an effective succession plan include: –– The company identifies its next leader in advance and communicates the choice of heir apparent to others inside and outside the company. As a result, the new leader has valuable time to adjust and to prepare for the new duties, others have time to adjust to the new structure, and there is continuity for CRC US Body of Knowledge outsiders such as vendors, bankers, and customers. –– The company has a formal approach to developing successor family members’ or employees’ operational, technical, interpersonal, and financial skills needed to run the business. –– Individuals not designated as successor, and other key employees, professionally respect the designated successors; customers and suppliers believe the designated successor(s) will adequately replace the current leader.  DIMENSION 2 - 7 –– In a family owned business, the company provides compensation and other performance-based incentives for key NOTES: non-family members to remain loyal despite not being eligible for family designated top management positions. –– There is a plan in place to fund the senior owner’s retirement and for transferring business ownership in a way that does not Dimension 2 // Assessing Management’s Ability to Formulate and Execute Business and Financial Strategies excessively leverage the company. In addition to the balance sheet benefits of this approach, this strategy can help allay an elder manager/owner’s reluctance to step down by minimizing fears that the transition will impair company financial strength, the elder’s retirement resources, or both. If the company must be sold to facilitate a generational transition, there is a successor financing strategy defined in advance. If the buyer is likely to be a third party, the customer (or customer’s family) has already determined who will identify, profile, and pre-qualify prospective buyers, and who will be responsible for negotiating and managing the transaction. If the company is to be sold to existing family/partners/employees, a formal buyout plan is already in place. –– The plan is being implemented, even if identified only as a contingency plan. In other words, designated successors or successor candidates are subject to performance reviews that include measuring progress in preparing for the next role; the plan is reviewed at least annually by key managers and board members to ensure it continues to be relevant to current circumstances; the company checks periodically to ensure that any designated plans for buyout financing are still feasible. Has management successfully employed outside advisors such as accountants, lawyers, and strategic planners to advise them in the core competencies? Recognizing a management deficiency is only half the battle; management must know how to use internal and external personnel resources to fill the skill voids. Have they demonstrated the mental toughness to defend themselves against internal or external threats to the success of their business?  DIMENSION 2 - 8 NOTES: MANAGEMENT INTEGRITY The assessment results of all areas of risk within a company can be positive, but if management does not possess the level of integrity necessary to make you and your institution feel comfortable, then the relationship should not be established even if you are secured by cash. Previously, you have been evaluating risk factors affecting the ability of a company to pay. In assessing management risk, you will also address the issue of willingness to repay the debt. Many of the other risk assessment criteria are intellectual and formula-based evaluations, whereas the analysis of management is centered on your experience in dealing with people and your ability to assess people as to their abilities and their ethics. The issue of owner managers versus professional managers instills nuances to the assessment process, but does not change the fundamental management questions. The issue of integrity encompasses the following: Honesty Does the individual lie, cheat, steal, or misrepresent facts? Does the individual tell you the whole story when asked to respond to a question? Be careful not to confuse unwillingness to respond to your questions with fear of responding. Some managers are reluctant to share business difficulties with their lender, fearing the lender will apply uncomfortable additional scrutiny to financial statements and business decisions. The best strategy to prevent confusing dishonest omissions with fear of disclosure is to develop a close rapport with the customer, aiming for a relationship founded on mutual trust. Key to developing that rapport is remembering to conduct management interviews and conversations with an approach that does not place the manager on the defensive, but instead emphasizes your need to understand many dimensions of the company’s performance so you and your institution can play a collaborative, partnering role in the customer’s success. Consider also the accuracy of financial reporting. Reporting that is frequently amended or revised, or that is wildly inconsistent from period to period may suggest a lack of reporting controls that can introduce opportunities for fraud. Remember that although the senior manager of the company sets the tone for integrity, fraud can CRC US Body of Knowledge take place at all levels within the organization, and it is management’s responsibility to ensure that controls and monitoring systems are in place that will protect the company (and the lender) from malfeasance. Reputation Does the management team individually and collectively have a good reputation inside and outside the company? Does this reputation waiver in bad times, or do they try to do the right thing under all circumstances? Reputation is something that is earned over a long period of time, but can be shattered with one bad decision.  DIMENSION 2 - 9 Litigation NOTES: Does the company or any of its principals have a history of litigation? Individuals who are quick to sue for personal reasons may transfer that behavior to the job. Also, carefully evaluate the nature and scope of lawsuits levied against the company. It is certainly true that a company can be sued without merit, and some industries, such as Dimension 2 // Assessing Management’s Ability to Formulate and Execute Business and Financial Strategies tobacco and alcohol products, are understood to incur significant litigation risk. However, if a customer is a chronic target of lawsuits, it is wise to investigate the frequency, reasons, and outcomes of the litigation to determine if litigants have legitimately needed to use the courts to elicit appropriate corporate behavior. Conflicts of interest Is there an environment of true independence on the part of board of directors and outside advisors? You should evaluate the effectiveness of the customer’s board of directors for this and other reasons. See the discussion of board effectiveness that appears later in this Dimension. You can ascertain the answers to these questions through your own personal observations and by checking with industry associations, community groups, and other centers of influence. Sometimes it is difficult to document, but a gut feeling that is making you queasy should be a warning signal to proceed very cautiously. By walking around a company’s manufacturing plant or administrative office, you can develop a sense for the respect that management has from the employees. Respect for an individual is generally a fair indicator of good ethics. Also follow your institution’s guidelines for accessing third party information through review of public records, credit bureau reports, peer reports, and references from the community. These can be valuable resources for detecting hints of compromised integrity, or of course an overt history of criminal convictions. For a discussion of how to use the most common third party information sources, see the section titled Using Third Party Information in the Management Assessment, located at the end of Dimension 2.  DIMENSION 2 - 10 NOTES: MANAGEMENT ORGANIZATION, STYLE, AND CHARACTERISTICS How a company is managed, is critical to its financial success and ultimately its ability to repay debt. All management teams, collectively and individually, have flaws. As the lender you need to recognize these flaws and address their impact on the company. These flaws may exist with the person with whom you have the relationship, so the discussion can sometimes become sensitive, but nonetheless very important. Some useful questions to pose to management are: Does management effectively anticipate outside influences? How do they react to unplanned situations? Ask for specific examples of how management responded in the past to unexpected events, both internal and external. Does management regularly conduct a SWOT analysis—a review of their strengths, weaknesses, opportunities, and threats? This activity requires management to step out of their day-to-day focus and forces them to look at the big picture. Does the company have contingency plans in place, at least for the most critical areas of the business? Contingency plans should provide clear guidance for response to business interruption, including relocation of assets or access to alternate physical plant; chain of command for decisions, including procedures when key managers are incapacitated or unavailable; and a communications plan to ensure the contingency plan can be communicated and executed. Does management exercise control at the critical points and with the appropriate amount of authority? In your management interviews, ask several senior managers to share with you examples of when and how the management team has made hard personnel decisions to correct management behavior or remediate poor management decisions. Your goal in this discussion is to determine if managers are decisive, proactive managers of people, or if they are more likely laissez-faire managers who are reluctant to intervene, or confront people. This discussion also gives you an opportunity to assess the CRC US Body of Knowledge practical function of management’s decision-making organization. If it is not clear who has responsibility for key personnel hiring/firing decisions, the customer’s ability to respond quickly and appropriately to internal or external problems is in doubt. Has a management succession plan been developed for the company? Be sure to review the management succession plan evaluation points included earlier in the Management Experience discussion.  DIMENSION 2 - 11 Is there an effective management organization in place? You should review and discuss with management the formal leadership NOTES: organization in place, to understand the designated chain of command for key decisions. Within this discussion, watch for pitfalls such as: –– Inadequate use of the board (or no outside board). Dimension 2 // Assessing Management’s Ability to Formulate and Execute Business and Financial Strategies –– An organization that is too flat, limiting the development of competent functional management. –– An organization with too few functional managers. Senior managers may be stretched too thinly, or they may be managing and making decisions well outside their expertise. –– An organization that is suited to plan either operationally or strategically, but not both. Organizations with strong functional managers may excel at operations management and budgeting, but lack the vision and market focus to plan for strategic change. An organization driven and controlled by a strong marketing manager may lack the knowledge, focus or discipline for effective operational planning and plan execution. Both planning dimensions are needed for companies of virtually any size. –– An organization that has inadequate financial management infrastructure. As companies grow, it is common for the financial organization to evolve from a bookkeeping function to a controller function, and then to be augmented with treasury and ultimately chief financial officer functions. The treasury and CFO functions typically arise when the company’s capital needs become complex and must be satisfied with a variety of external sources. A company that has an undersized financial management organization may be missing growth opportunities for lack of access to capital, and it may also be susceptible to poor financial decision-making (such as pricing strategy) based on a poor understanding of critical financial functions such as cost accounting. Compare your customer’s financial organization with similar sized companies in compatible industries to help determine if the financial organization is adequate.  DIMENSION 2 - 12 Are the individual managers’ leadership and decision-making NOTES: styles functional and appropriate to the size and complexity of the business? The impact of an individual’s management style on interpersonal skills and relationships has implications for both internal management success as well as success in external negotiations with suppliers, customers, regulators, and of course, lenders. To assess management styles and their effectiveness requires meeting with key managers individually and in groups, both asking targeted questions and simply observing how the managers interact. Consider asking individuals to describe management styles of others on the management team, and look for common themes as you compare notes from the diverse interviews. There is no correct management style, but be aware of signals that management styles may be dysfunctional: –– Visible tension in the room when one individual takes the floor, particularly when the discussion topic is sensitive. –– Appearance of in-fighting, fiefdoms, or power struggles. When your interviews with separate managers suggest alignments with senior managers that fall outside the formal organization chart, probe deeper to try to learn if decisions are being made outside the formal chain of command. –– Surprising lack of information sharing. Lenders often ask interview questions that assume the interviewee has access to relevant information, such as recent financial results. Investigate further if you believe a manager’s function suggests he or she has access to the information, but the manager tells you or implies that this is not the case. If key information is controlled by one individual, there may be an autocratic manager running the business or a key function. Autocratic management styles can sometimes be effective in a crisis, but a more consensus-oriented style is generally more productive for a company’s long-range performance. CRC US Body of Knowledge  DIMENSION 2 - 13 Also look for positive signs that your customer’s senior managers are effective leaders. Good personal leadership indicators include: NOTES: Other individuals describe a manager as fair and ethical. In meetings, a manager encourages open discussion and debate. Dimension 2 // Assessing Management’s Ability to Formulate and Execute Business and Financial Strategies The manager has a strong track record of recruiting, developing, and retaining very strong and effective colleagues and subordinates. The manager is regarded as open to new ideas and change. The manager supports training and development needs with commitments of both time and financial resources. A variety of stakeholders expresses a favorable opinion of their relationship with the manager, including employees, customers, suppliers, and board members. PLANNING AND CONTROL SYSTEMS ASSESSING STRATEGIC PLANNING ABILITY It is essential to determine whether business and strategic planning are formal disciplines within the company. Questions to consider are: Is there a working long-term strategic plan with components for each functional area of the company (finance, sales, marketing, production, distribution, operations, human resources)? Does the plan outline relevant business risks and how the company proposes to respond to them? If there is not a formal written plan document that is updated at least annually, that does not necessarily mean that the company is not engaged in effective strategic planning. In the absence of a written plan, it is your responsibility to make effective use of management interviews to understand the company’s strategic direction and decision-making approach. The goal of your interviews should be to determine if management understands its market, including customer base, suppliers, and the competitive environment. You also must determine if management understands and responds appropriately to business and industry risks.  DIMENSION 2 - 14 MAXIMIZING THE VALUE OF YOUR NOTES: INTERVIEWS ABOUT BUSINESS STRATEGY In Dimension 1, we discussed how to profile these issues for an industry. When interviewing your customer on the specific opportunities and risks they face, consider the following suggestions for maximizing the value of your interviews: Elevate the discussion beyond simple who/what/where questions. For example, your customer may tell you that a critical risk in the industry is losing control of costs for a product that needs to be top of the line, but also competitively priced to retain market share. You certainly need to ask for facts about the product in question, such as what it is, how it works, current costs to produce, and its selling price. However, you should dig deeper by asking questions that require manager to interpret and to draw conclusions about cause and effect: What would happen if a major supplier increased prices by 10%? What would be your choices in how to respond, and which direction would you most likely pursue? How would your competitors be affected by changing supply costs, and how would you expect them to respond? Validate the manager’s response to your questions about strategy by asking for specific examples of strategies that worked, and that did not work in the past. To continue our example, ask the manager to tell you about a time when there was a need to increase a product price to cover growing costs, and how the customers and competitors reacted. Prepare your questions in advance, and ask to schedule a specific meeting to learn about the customer’s strategic vision and plans. Preview some of the topics you plan to cover to allow the manager to think in advance about the answers. This approach will help avoid putting management on the defensive. Ask the manager up front to share his or her greatest concerns about managing the business in the future, and be sure to include those concerns in your questions and discussions about company strategy. Think carefully about what you are being told in the strategy CRC US Body of Knowledge interview. Is this company merely responding to change or are they planning for it? Does management take note of and understand the moves of competitors? Are they applying creative solutions in response to competitive challenges?  DIMENSION 2 - 15 EVALUATING THE STRATEGIC PLAN’S NOTES: EFFECTIVENESS Evaluating a strategic plan’s effectiveness involves not only comparing plans with actual business outcomes, but also finding out the extent to which company employees are involved in the planning process. A company’s ability to successfully execute a business plan is greatly Dimension 2 // Assessing Management’s Ability to Formulate and Execute Business and Financial Strategies enhanced when participation—and thus plan buy-in is widespread. Consider the following questions as you discuss planning effectiveness with your customer: Is there evidence that planning has been fruitful in the past? Evaluate management’s presentations of prior plans (or discussions of them if no formal documents exist) by analyzing financial performance for relevant time periods. Look especially at appropriate time periods to validate answers to your questions about specific strategies that have been tried in the past. How often is the strategic plan re-evaluated for relevancy and focus? Are policies and goals, established by the strategic plan and other directives, communicated to employees? Do employees get routine feedback about the company’s results? Do managers and supervisors meet regularly to compare individual employee performance with stated goals and discuss the effects of external/internal trends or events? Is there a reliable, continuous, and safe system in place for employee feedback to management? Pay particular attention to the existence of mechanisms for employees to safely report internal malfeasance. If the company is public, Sarbanes Oxley requirements ensure that whistleblower protections have been installed. In a private company, whistleblowers enjoy legal protections, but it is less certain that whistle–blowing mechanisms have been created and communicated to employees. You need to ask about these mechanisms when interviewing senior management of private companies, and it is wise to ask the question of several individuals. You should review with management any meaningful deviations from plan, meeting routinely with management as you monitor the relationship.  DIMENSION 2 - 16 NOTES: ASSESSING COMPANY CONTROL POINTS You also need to depend on several company-imposed control points in order to be comfortable with the financial and management integrity of the company. These control points are also the company’s mechanism for monitoring its progress and adherence to business plans. In your overall assessment of management, look in the following areas to assess control points: board of directors, auditors, company history, and inspection and licensing organizations. BOARD OF DIRECTORS The most effective boards of directors provide many dimensions of management support. Ideally, an effective board is truly independent and looking after the interests of the shareholders, especially in a public company. In a private company, the board’s role may be less clear, although the ideal board nonetheless should offer an independent perspective and have a voice in company decision-making. To assess the effectiveness of a company’s board, meet with both senior management and several board members separately, focusing each interview on the following questions: Is the board a working board, where members meet often and actively participate in strategic discussions and direct company managers to follow specific courses of action? Less effective boards meet fewer times per year to receive status reports, offering little guidance unless serious problems surface that require emergency attention. Ineffective boards have no influence on the company at all, serving as rubber-stamp organizations. These boards may exist to satisfy, on paper, a lender’s requirement for outside input. Does the company have a formal plan for its board duties, including a statement of purpose, description of committees, and formal decision-making rules? Effective boards have mutually clear expectations. That is, the board members understand what is expected of them in terms of management and governance CRC US Body of Knowledge support, and company management understands exactly how and when they are accountable to the board. Less effective boards have few formal organizational guidelines and no clear decision- making responsibility. These may be advisory groups with little accountability for business outcomes, and to whom company management is in turn, not at all accountable.  DIMENSION 2 - 17 Do boards and their subcommittees capture detailed minutes of each meeting, and are these minutes formally reviewed and approved NOTES: by meeting attendees? Effective boards and their committees hold themselves accountable for discussions and decisions by ensuring that meeting details are recorded and entered into the formal minute books of each body. Less effective boards and committees keep Dimension 2 // Assessing Management’s Ability to Formulate and Execute Business and Financial Strategies minimal records of discussions and decisions, which allows room for subsequent misunderstanding or even re-interpretation of board proceedings. Are board members recruited to complement and complete management’s experience and skills? As a company grows in size and complexity, it can gain access to experience and expertise through its board that the company might not be able to afford to pay for as full time management staff. Effective companies actively recruit board members to fill in skill gaps and to gain access to business wisdom. They identify skills and experience needed and mount a purposeful search for the most qualified board members. Less effective companies avoid recruiting board members that will challenge management’s perspectives or decisions. Does the company provide legal protections for its board, including directors’ insurance, to communicate their commitment to true board governance input and to facilitate the board members’ willingness to fully participate? Effective boards are willing to make decisions because they have a full understanding of their legal responsibilities as well as their protections. Less effective boards are reluctant to engage in decisions because of fear of litigation or because they lack understanding of the legal limits of their governance roles. Are board functions organized for maximum efficiency and effectiveness? Do company managers and board members fully prepare for board meetings, with formal meeting agendas supported by advance information? Less effective boards attend meetings with little or no advance agenda information, relying on in-meeting information as the basis for recommendations or decision-making. Is there a board performance evaluation mechanism in place? Ranging from simple attendance standards to formal performance assessment criteria, the most effective boards assess their performance regularly, including taking periodic time outs for the board to focus on and improve its own standards for effectiveness. Less effective boards engage in little or no self-evaluation, which can be a strong signal that the board actually enjoys little or no independence from management.  DIMENSION 2 - 18 If the company is small, and/or a family enterprise, has the company NOTES: used outside consulting services to help develop an effective board, including help with board design and education? Higher performance private/family companies recognize the need for a well designed, effective outside management voice that a strong board can provide. However, the company may have difficulty achieving consensus on board design and composition when family agendas are not uniform. Well managed companies may choose to pay for outside board consulting to initiate the board function or to improve its effectiveness as the company’s governance needs grow. Understanding the role of your customer’s board through interviews that cover these topics will help you ascertain how helpful they can be in protecting your institution’s interests. A strong board will consist of individuals whose skills and experience complement your customer’s management team and who have formal decision-making input. The board’s combination of skill and voice can considerably enhance the likelihood your customer will recognize and successfully navigate daily business risks as well as unforeseen changes to its operating environment. AUDITORS Are the auditors truly independent and qualified to conduct the audit? A public company subject to Sarbanes-Oxley rules must comply with strict independence requirements. Private companies are not subject to Sarbanes-Oxley, although the auditing profession itself is now governed by heightened independence standards. Auditor qualification is much more difficult to assess. The size and complexity of the customer suggests whether a large regional, national, or local firm is the best choice to meet the company’s audit needs. If the customer is receiving full audit services (as opposed to a review or a compilation) and there is a local firm unfamiliar to you, consider asking for details about the CPA firm’s peer review. All firms engaging in audits are required to have a peer review of the audit function, and the firm can be asked by its clients to share results of the most recent review. CRC US Body of Knowledge  DIMENSION 2 - 19 Has the auditor issued a management letter to the customer? Under generally accepted auditing standards, auditors are encouraged to NOTES: report concerns regarding a company’s internal control structure noted during an audit, and they are required to report certain of those concerns. Issues that are required to be reported are significant deficiencies in the design or operation of the internal control Dimension 2 // Assessing Management’s Ability to Formulate and Execute Business and Financial Strategies structure that, in the auditor’s judgment, could adversely affect the company’s ability to record, process, summarize, and report financial data consistent with the management’s presentation of information in the financial statements. Auditors’ management letters always point out that the audit may not have discovered all internal control deficiencies, but if the customer has engaged an audit, the audit procedures will provide a degree of assessment of internal controls that would not otherwise be available. Keep in mind that review and compilation engagements do not include the requirement for a management letter and are much less likely to uncover material control flaws. Ask to see the management letter if one is available, and also find out if the management letter was presented to the company’s board of directors with a formal response to each control issue noted. If there is no board of directors or advisory board to review the management letter, ask the managers/owners of the company to explain how they remediated the control issues. Companies are often reluctant to provide this information, although public companies subject to Sarbanes-Oxley rules are now required to certify that control systems are adequate to ensure financial report accuracy. If your private customer is reluctant to share its management letter with you, discuss their reasons to try to understand why. If the company does not engage an audit that would result in a management letter, consider strategies such as requiring audit-level procedures only on accounts you are taking as collateral, such as receivables or inventory.  DIMENSION 2 - 20 COMPANY HISTORY NOTES: Any activity or result that varies from historic results can be a critical control point for you. Meaningful changes to the company’s historic pattern of conducting its business should be reviewed with management immediately. Carefully evaluate the customer’s prior attainment of its business plan, comparing stated goals and objectives to subsequent business results. Your review of actual performance compared to objectives provides you with insight about the credibility of management’s current plans. Moreover, it provides an important test of management’s own control systems: have they demonstrated the ability to monitor their own goal attainment and to take timely and appropriate steps to change course when needed? INSPECTION AND LICENSING ORGANIZATIONS Any outside agency or group that must perform inspections or audits is a good source for information that might not otherwise surface. You should require copies of the documentation of these inspections and audits as a part of your loan documentation. INFORMATION TECHNOLOGY SYSTEMS The purpose of interviewing a borrower’s management about information technology (IT) is to: Learn the extent to which the company’s business processes rely on critical information technology systems. Understand the role that information technology plays in the company’s ability to compete in its industry, and how the company compares with its competitors in effective use of information technology. CRC US Body of Knowledge Identify the company’s information technology organization and determine if planning procedures are adequate to assess IT expansion/upgrade needs and to secure financial and human resources to meet those needs. Verify that company management has developed policies, procedures and plans to identify and manage the company’s IT internal control and physical risks. Following are questions to ask that will enable you to develop a basic profile of your customer’s information systems adequacy. In a large company, you should include the company’s chief information officer  DIMENSION 2 - 21 (CIO) in the discussion, along with an appropriate financial officer such as treasurer and/or controller. In smaller companies, there may NOTES: not be a designated CIO, and it is important to identify the individual whose duties include managing the IT function. Often this will be the company controller. In a very small business, the outside accountant may have a voice in the company’s IT choices, particularly if the information systems revolve principally around financial accounting. Dimension 2 // Assessing Management’s Ability to Formulate and Execute Business and Financial Strategies Companies of all sizes may outsource some or all of their information technology management to IT consulting firms. CRITICAL BUSINESS PROCESSES’ RELIANCE ON INFORMATION TECHNOLOGY Ask your customer: Which business processes rely on critical information technology support, and how have you determined these are the critical processes? Show the customer an outline of common business processes to ensure the customer’s answer is not limited to a narrow view of the enterprise. Ask the customer to consider which of the following business processes have the most critical information technology design and maintenance requirements: Sales and marketing, including selling, advertising, and product development. Manufacturing, including purchasing and receiving, product manufacture or assembly, packaging, shipping, quality control, and regulatory compliance. Finance and accounting, including controller functions (accounts receivable, accounts payable, credit and collections, payroll, fixed assets planning/purchasing, budgeting and forecasting, accounting/ bookkeeping, travel expense reporting, internal financial reporting, tax compliance) and treasury functions (external financial reporting, debt and capital structure management, banking and cash management, insurance). Customer relationship management, including customer service and technical support. Human resources, including hiring and termination, benefits management, staffing and compensation analysis, workers compensation claims, training and development, and employee assessment. Legal, including litigation support, intellectual property, and contract management. Management and board functions, including management policy development, administration of management and board meetings, and corporate governance committee, policies, and procedures.  DIMENSION 2 - 22 Plant and other infrastructure, including facilities management, NOTES: security, physical records management, distribution and logistics, and telecommunications. Corporate communications, including employee communications, and investor and public relations. Information systems, including IT strategy and planning, systems implementation and integration (project management, software selection, software development), IT systems maintenance, network administration, disaster recovery planning, information and records management, and help desk. Consider asking your customer to rank each business process according to the degree of dependence on information systems, using a scale of 1 to 3. Then, focus your discussion on each business process rated as highly dependent as you continue your interview. INFORMATION TECHNOLOGY AS A COMPETITIVE ADVANTAGE Ask your customer to describe how information technology provides a competitive advantage in their industry and market. Ask how the company compares to strong competitors in its use of information technology as a competitive tool. Many growing businesses are quick to embrace physical technology change that has an obvious payback in terms of cost or efficiency. For example, bar-coded product labels long ago eliminated the need for retailers to individually price-ticket most merchandise. More recently, radio frequency identification tags are being embedded in products themselves, transmitting whole trailer loads of product and price details to a retailer’s receivers. Manufacturing technology is quick to evolve as well, with increasing robotics applications in many industry sectors. These kinds of technology upgrades are viewed as competitive essentials. However, not all companies view information technology as a source of key competitive advantage. In light of the Sarbanes Oxley rules, many public companies have had CRC US Body of Knowledge to begrudgingly upgrade IT resources to ensure compliance with higher standards for financial reporting accuracy. Many private companies have been nudged by outside auditors or lenders to adopt accuracy standards similar to those established by Sarbanes Oxley. As a result, it is likely that your customer will initially think of financial reporting when responding to questions about IT. However, it is important to probe for IT’s competitive advantage perspectives by returning to the previously identified business processes that have critical IT design and maintenance requirements.  DIMENSION 2 - 23 For each identified business process, ask the customer to explain how the IT system in place helps the company compete, and ask which NOTES: competitors, if any, have stronger IT capability. Engage the customer in a discussion of company plans to implement IT upgrades or changes that will enhance competitiveness. Likely areas of focus for many companies include quality control (defect analysis), customer relations management, investor and public relations. Larger companies are Dimension 2 // Assessing Management’s Ability to Formulate and Execute Business and Financial Strategies likely to mention enterprise-wide software, in which business processes throughout the enterprise are integrated into one comprehensive information system. INFORMATION TECHNOLOGY ORGANIZATION AND PLANNING PROCEDURES Ask: How does your company make information technology decisions, and who is responsible for managing the IT systems? What is your process for identifying needed information technology upgrades or expansion and for prioritizing related financial and human resources? Ask to develop a profile of the IT organization. In a very small company, IT may be the responsibility of the controller or the entrepreneur/owner. Larger companies will have a dedicated IT department or division. Small or large companies may outsource IT management. As you discuss the company’s IT organization, ask questions that will help you determine: Are IT planning and decision-making integrated within the business planning process, or they secondary (afterthought)? Does the company have access to competent IT expertise, either in- house or outsourced? For a company subject to Sarbanes-Oxley compliance, who is responsible for auditing and certifying that adequate controls exist to protect financial reporting systems? Are IT development and maintenance resources priorities consistent with the business processes’ critical IT needs, as identified earlier in the interview? Are the scope and formality of the IT organization consistent with the complexity of the enterprise?  DIMENSION 2 - 24 INFORMATION TECHNOLOGY INTERNAL NOTES: CONTROLS AND RISK MANAGEMENT Ask your customer to describe specific steps the company has taken to ensure the integrity and reliability of automated systems that support the business processes, and that collect and report financial information. As companies grow, management’s ability to monitor and control business activities becomes increasingly dependent on information systems. There must be sophisticated controls in place to ensure that management’s information is accurate (integrity) and protected from interruption (reliability) and unauthorized access (security). Companies complying with Sarbanes-Oxley must document, control and secure business processes that directly and materially contribute to reported financial results. One valuable by-product of Sarbanes-Oxley compliance is better and more consistent monitoring and control of business process information, which can enhance business management. Better control of business process information can disclose efficiency opportunities, protect trade secrets and help prevent costly losses from internal fraud. Auditors of internal control have generally accepted best practices that are defined by the Committee of Sponsoring Organizations (COSO), a voluntary organization formed in 1985 to study factors leading to fraudulent financial reporting. COSO identifies five essential components of effective internal control:1 Control environment, or the tone at the top of the company, including integrity, incentive and temptation systems, commitment to hiring and maintaining quality people, and the roles of the board and Audit Committee. Risk assessment or procedures to verify the existence and accuracy of assets/liabilities, completeness of transactions, valuation of assets and revenue in accordance with accounting principles, and correct presentation and disclosure. Control activities, or the actions taken to implement policies and standards that are driven by objectives of completeness, accuracy, validity, and asset protection. CRC US Body of Knowledge Information and communication that ensure information is available that makes it possible to run and control the business—providing the right information to the right people, at the correct level of detail, on a timely basis. This control element also includes enabling a whistleblower process. Monitoring procedures to ensure the control system continues to operate effectively, including regular management and supervisory activities and the work of an internal audit department. 1 COSO Back in the Limelight,” Mike Bridge and Ian Moss, Perspectives on Financial Services, April 2003, PricewaterhouseCoopers.  DIMENSION 2 - 25 If your borrower certifies that it is compliant with Sarbanes-Oxley, you have some reassurance that these controls are in place. To learn more NOTES: details, or if your borrower is not a public company, use the following questions to help assess the borrower’s development of appropriate information controls.2 How would you describe your IT controls? If you have established a Dimension 2 // Assessing Management’s Ability to Formulate and Execute Business and Financial Strategies formal IT control framework, what process did you use to design it? How often do you require all your managers to step back from other duties and evaluate risks and controls within their scope of authority? Has each manager specifically: –– Considered current and planned operational changes to evaluate risks to business processes and/or financial information? –– Determined appropriate mitigating controls, and evaluated effectiveness of those controls for the identified risks? –– Established an effective monitoring process to verify the controls are working? –– Reported their assessment up the chain of command to the chief executive officer? Have the results of this management review process been reported to the audit committee of the board of directors? Have you or other senior managers personally reviewed and do you understand documents of all internal controls in place? These should include technical safeguards for key IT areas such as: software change management, password management, security of remote access, communication encryption, access controls, monitoring, auditing and reporting, network security, intrusion detection, prevention and firewalls, end user training and support. Are the company’s financial systems consolidated, or do you maintain multiple financial accounting systems? (Consolidated financial systems pose fewer control risks.) Has an independent party tested all internal controls, and if so, have you addressed any control issues identified in the test findings? Is there a board- or senior management-appointed project team to assist with the test process to validate management’s internal controls, and have test findings been reported to the audit committee? 2 Based on “SOX Internal Control Self-assessment Readiness Checklist,” CIO Guide to Sarbanes-Oxley: Building a Secure Access Infrastructure, Lee Lassiter, Reymann Group, Inc., January 2005.  DIMENSION 2 - 26 Describe the nature and scope of training you provide to staff with NOTES: custody or access to company or customer records to ensure they understand their duties and responsibilities. In addition to discussing the company’s internal IT controls, you should also ask your management contact to verify that the company has formal procedures in place to ensure physical security of the IT resources, including protection from theft or damage through fire or other hazard. Finally, you should ask for information about the company’s business continuity plan, verifying that there are procedures in place for disaster recovery. Ask about the chain of command to declare a disaster, notification of employees, existence and accessibility to backup systems, offsite IT recovery team, and communication plan for key outside contacts such as customers and vendors. Also ask if there are disaster recovery plan test procedures, and how often these tests are administered. SHAREHOLDER/MANAGEMENT RELATIONSHIP As a lender to a company, you have a safety net: the equity provided by the shareholders. It is important to understand their ownership objectives. How shareholders exercise the control feature of ownership is important to you and needs to be addressed in your loan documentation. If the owners are involved in the day-to-day operation of the business, and are qualified to be so, this is generally a success factor. When owners are not involved in the business (whether shareholders in public companies or passive equity investors in private companies), potential exists for managers to make business decisions to their own benefit instead of to maximize shareholder value. In public companies with widely held shares, shareholders are too dispersed to exert influence on managers and must rely on the board of directors to enforce their interests. Sarbanes-Oxley rules now ensure that public company boards include directors who are truly independent of management. The related rules for auditor independence and information controls assure CRC US Body of Knowledge an independent supply of accurate information to shareholders, whose ability to “vote with their feet,” i.e., sell shares, introduces an indirect means of accountability to company managers. Sarbanes Oxley provisions do not apply to private companies, however, so owners not actively managing the business must rely on a board of directors whose composition is not subject to regulatory scrutiny. Many private companies have multiple owners with divergent objectives, and with a mix of active and passive owners. Family-owned businesses are especially prone to the active/passive ownership mix as ownership passes through generations. There can be significant risks to the business when owners disagree on the company’s vision, strategy and resource  DIMENSION 2 - 27 management. Natural conflicts between management and passive owners occur even when managers are also part owners. For example, NOTES: a younger generation of managing owners may have a more aggressive risk appetite than the retired generation of owners, and disagreements (including withholding financial resources) can arise. In such a case, it is vital to determine what process the company and its owners have established for dispute resolution (common dispute resolution Dimension 2 // Assessing Management’s Ability to Formulate and Execute Business and Financial Strategies approaches are discussed later in this Dimension). ASSESSING ALIGNMENT OF OWNERS’ AND MANAGERS’ OBJECTIVES If the company is managed wholly or in part by non-owners, it is particularly important to ask questions about alignment of owners’ and managers’ objectives. In your management interviews, discuss the following topics to assess the compatibility of owners’ and managers’ objectives: Is the board of directors an independent, effective body that will govern company managers from the shareholders’ perspective? Earlier in this Dimension we suggested questions to ask about the effectiveness of the board. To determine if the board is sufficiently independent, consider the membership composition. An independent board is one that has a majority of members who are unrelated to management and have no business or other relationship with management or the company that could be perceived as interfering with their ability to act in the shareholders’ interests. In addition, if there is a dominant shareholder who can vote or control votes of a majority of shares, the board should include members who have no family or business relationships with that dominant shareholder, to play the role of devil’s advocate on behalf of minority shareholders. Is there a free flow of information from managers to shareholders? Public companies must conform to many regulations that ensure that shareholders are informed of the risks of ownership (through financial reports and other public filings). Private companies with a mix of managing and passive owners may not provide adequate information to the passive owners, opening the company to costly minority shareholder litigation and potential business disruption as the dispute evolves. Generally, the greater the transparency of information between managers and owners, the less likely that shareholder/ manager disputes will arise.  DIMENSION 2 - 28 Is there a formal executive compensation plan that is designed to NOTES: align management behavior with the shareholders’ interests? Ask for details about compensation arrangements for the CEO and other key managers. Public companies publish significant details in their regulatory filings, but these details will generally not be available for private companies unless you ask. Key questions to consider include: –– How was the plan established, and by whom? If the compensation program is to align management behavior with shareholders’ interests, the compensation plan should be developed with the help of outside compensation expertise, and under the direction of the company’s board of directors. There should be a board compensation committee comprised only of independent directors, responsible for developing and updating the plan, in accordance with the board’s performance objectives for the company. –– How often is the compensation plan reviewed, and by whom? Periodic review should be the responsibility of the board’s compensation committee, which should also have responsibility for reviewing the job performance of managers included in the plan. This committee’s duties should also extend to review of compensation philosophy, methods, and specific programs for layers of management below the executive level. –– What are the plan’s characteristics? Effective executive compensation programs have a mix of elements designed to attract, motivate and retain managers who will drive the company’s success. Where some ownership is possible (such as a public company), there should be a balance between cash and stock compensation. For both public and private companies, a significant portion of the senior manager’s total compensation should be tied both to annual and long-term financial performance of the company and to the creation of shareholder value. There should be performance criteria that enable the board to distinguish strong management performers from weaker performers, and to compensate them accordingly. CRC US Body of Knowledge  DIMENSION 2 - 29 The mix of compensation elements will naturally vary by company, with larger, more complex organizations using more sophisticated NOTES: compensation programs. For example, cash compensation can include salary and bonus. Long-term incentives can include stock options or grants of restricted stock, with additional conditions such as granting stock options only to managers who have used some Dimension 2 // Assessing Management’s Ability to Formulate and Execute Business and Financial Strategies portion of their cash compensation to increase their personal stock ownership (most likely in a public company). In private companies where professional managers will not have ownership opportunity, long-term incentives are more difficult to engineer. Absent a readily measurable market value for company equity, owners need to develop fair but challenging incentive measures to ensure that managers remain focused on the owners’ long-term performance objectives for the company. Pensions and other post-retirement benefits may be effective elements of a plan to incent long-term performance. Have the plan and the subject managers’ compensation levels been validated using comparable compensation study data? Studies are available that profile compensation and related business metrics for all but the smallest enterprises. These studies are generally available through engagement with compensation consulting companies, and the cost may be prohibitive for very small companies. However, if the data are available, comparison to like enterprises enables both you and your customer to determine if compensation of key managers is appropriate given not only the company’s market and industry, but also in light of its financial characteristics and capital needs. As an indicator of strategic performance, comparisons also help determine if the company is paying a competitive amount that will help ensure executive management retention. Are there other forms of management compensation outside the formal plan? For example, loans to managers and personal use of company assets such as aircraft can be legal transactions if handled according to appropriate accounting policies. As you consider the appropriateness of management remuneration, it is important to understand the full compensation picture; ask the customer for help in quantifying the full amount, if needed.  DIMENSION 2 - 30 NOTES: DETERMINING IF THERE IS A DISPUTE RESOLUTION MECHANISM IN PLACE When a private company’s management and shareholders’ interests are not aligned, there is significant risk of costly shareholder disputes. Dissident shareholders, even minority shareholders, can be a significant distraction to management and keep them from focusing on their day-to-day strategic objectives. You should inquire about significant blocks of stock that, if sold to another party, could significantly alter the strategic direction of the company and could foretell a change in management. Also ask management to describe any formal dispute resolution processes that exist in the form of shareholder or partner agreements, to verify there is a mechanism to resolve disputes that avoids litigation. A good shareholder or partner agreement should clearly define the shareholders/partners’ roles and responsibilities, as well as prescribe a method for separation of the shareholders/owners in the event of a dispute or other event. Ask if the customer’s shareholder/partner arrangements include such provisions as: Buy/sell agreement, describing the events and circumstances, such as termination or retirement, under which an owner may be required or allowed to sell shares/partner interests back to the corporation or other partners. Included in this agreement might be descriptions of the circumstances under which an owner may sell his/her interest to another, the method for valuing the owners shares or partner interest, and under what circumstances a departing owner may compete with the current business. Agreement outlining how the company will be operated when a majority owner retires or dies. Agreement specifying in advance how disputes will be resolved,