‘Wrongful trading’ is what happens when a company takes on credit knowing it won’t be able to pay the money back when it falls due. The debt incurred becomes the legal liability of individual directors - for them to pay back, not the business.
Knowing this tends to focus the mind of directors on why they must give personal attention to company finances, before it’s too late.
Non-Executives and Directors with non-financial specialisms sometimes tend to avoid getting to grips with the financials, to leave anything financial to the Finance Director (FD). They don’t want to expose their lack of knowledge in front of the board; they’ve got enough of their own responsibilities. Finance seems difficult and esoteric - it’s easier to leave it to the expert.
This doesn’t make any sense. All directors have a legal responsibility for the integrity of the accounts - and more than this, the integrity of the business as a whole, as the source of employment, as a contributor to a community and economy. You’re not expected to be an expert, but you are assumed to be taking a well-informed interest. When a business fails and the accounts are exposed as a log of hidden problems and artifice, it’s no defence for directors to claim ignorance of what the numbers were saying.
All members of a board need to have an understanding of the principles behind the company finances. They have to be able to recognise when there’s a problem, and be able to keep asking the right questions of the FD. Directors have to be prepared to admit what they don’t know when it comes to jargon of any kind. I can remember when I joined the board of an NHS Trust being mystified by parts of the accounts, because it was a different world of acronyms, and they were using different concepts to the corporates I understood. I just told the FD I didn’t understand it, and let him and his team spell it all out for me. Several times. It really is okay to ask – and much better than sitting in ignorance.
As a fundamental, directors need a basic understanding of what an income statement looks like, as the essential part of making a diagnosis of what’s happening to a business within its market. You have to know what to expect from the accounts in order to pick up on signals of issues and anomalies. So if profits are looking strong but all you’re hearing from colleagues around the table is everything that’s going wrong, you need to get a grip on why the numbers don’t tally with the reality of operations.
In some industries, the likely problem areas are well known in advance. For example, in the construction industry most accounting difficulties are caused by the valuation of work in progress – how do you assess a half-completed building? So, know the pinch-points in your own industry, the areas of judgement that you should keep under review.
The non-experts need to keep asking questions. Not as an exercise in demonstrating their contribution, in having their voice heard. They need to keep asking questions until they get an answer they genuinely understand, that makes the position of business clear. Continued discussion of the business and the accounts helps you see your FD as a source of insight and information. The best FDs aren’t always creative geniuses, but they are adept with numbers, straightforward, trustworthy. There may be aspects of the accounts you won’t ever understand - derivatives policies come to mind - but there’s nothing about your company’s finances that shouldn’t be open to discussion.
Accounts need to make sense: don’t accept good news at face value when there’s something about it that doesn’t ring true. Look at trends in sales and ensure you understand where the sales and operating profits are really coming from. Track the profits as a proportion of sales. How does this compare with competitors? If your return is a lot higher than competitors’, before you give yourself a pat on the back, ask yourself what makes your business so different from theirs that it can generate that extra profit.
Separately, you also need to keep a close eye on cashflow, and levels of debt. Know how the cash flows in and out of the organisation, and what times of year you’re vulnerable. Look ahead to possible problems. For example, someday your borrowings will have to be paid back. When is that due to happen? How will the organisation find the money to make that repayment? Will you be able to roll the debt over? Raise new money from shareholders? Sell existing assets to get the funds?
If you are sitting on a board you need to know what questions to ask, and how to get the answers. Sometimes this takes tact, as you are querying the FD, who by definition is your board finance expert. That’s another reason for improving your knowledge of corporate finance: you’re able to ask more of the right questions from a position of security, have the confidence to ask questions in the right way, not confronting but able to make valuable contributions and suggestions.
Our work in this area at Cranfield is one of the areas explored within the Finance for the Boardroom programme - one of our specialist programmes designed to develop appropriate skills for non-financial professionals and frameworks to successfully improve financial performance and shareholder value in your organisation.
Blog produced by: Professor Ruth Bender, Emeritus Professor of Corporate Financial Strategy and Programme Director of Finance for the Boardroom, Cranfield School of Management