Financial Literacy for Directors — Maryann Bruce
It was a pleasure and honor to participate as a panelist for the UNC School of Law’s Director Diversity Initiative Webinar on the Introduction to Financial Literacy for Directors. The webinar was moderated by Lissa Broome, Director Center for Banking and Finance at UNC School of Law. My fellow distinguished director colleagues Wendy Burden, Nora Crouch, Lloyd Johnson, and I discussed:
How to learn about a company through the financial statements prior to your board interview;
The importance of financial literacy even if you are not serving on the audit committee, given the capital allocation and business decisions the full board will be required to make;
And the similarities and differences between public and private companies.
It was an informative session given the unique experiences and different perspectives among the moderator and panelists.
Panelists’ Key Takeaways
Public company financial documents can help you learn a great deal about a company by providing insight into the financial health of a company, its strategy, and operating model, as well as prospects for the future. The critical documents to review are the annual report (10-K), quarterly report (10-Q), proxy statement, and the earnings call materials. If applicable you may also want to read the annual shareholder report.
Given the extent and length of these documents, where should you begin?
While it is important to review all these materials to enhance your understanding of the company’s vision, mission, core values, and strategy, I recommend starting with the Investor Relations or Investor Resources section of the company’s website. This section typically provides investor presentations, earnings call scripts, and company FAQs.
The investor presentation PowerPoint includes the most salient information and is like the ‘cliff notes’ version of a book. It contains introductory remarks, a company overview, a brief description of the company’s strategy and current initiatives including results, financial and investment highlights and trends, and any challenges the company is encountering. This information is usually presented in an easy to understand and graphically pleasing manner.
The goal for reading these materials is to have a solid understanding of the company’s organizational structure, history, and products or services; not to be an expert on everything that is happening with the company.
Rather than reading the earnings call transcript, it is recommended that you listen to the call (or replay) as it allows you to hear the voice of the senior executives, typically the CEO and CFO. You also get to hear how it was said, giving you a good sense of these executives’ personality and presence. Earnings calls are scripted in advance to ensure compliance with SEC requirements and consistency with public filing information.
The question and answer session by its very nature cannot be scripted and is less predictable. This allows listeners to hear how the executives think on their feet as well as deal with potentially difficult questions from analysts, shareholders, and other stakeholders.
The balance sheet and the profit and loss (P&L) statement are two of the three financial statements companies issue regularly. Such statements provide an ongoing record of a company’s financial condition and are used by creditors, market analysts, and investors to evaluate a company’s financial soundness and growth potential. The third financial statement is called the cash-flow statement.
The balance sheet shows the company’s assets, liabilities, and shareholder equity at a specific point in time. It provides both investors and creditors with a snapshot of the resources that a company owns or controls and how it financed those resources. A strong balance sheet implies current assets (those that will convert to cash within the next year) exceed current liabilities. It provides a foundation for the company to ‘weather the storm’ in case of an economic downturn, acquire other businesses, raise capital for future expansion, and return capital to shareholders in the form of a dividend.
A profit and loss statement (P&L), summarizes the revenues, costs, and expenses incurred during a set time period. It provides information about whether a company can generate profit by increasing revenue, reducing costs, or both. A P&L statement lets the company’s management team, including its board of directors, understand the business’s net income, which helps decision-making processes.
The cash flow statement summarizes the amount of cash or cash equivalents entering and leaving the company. It’s important because it measures how well a company manages its cash position, meaning how well the company generates cash to pay its debt obligations and fund its operating expenses.
As a director, you should not be intimidated by these financial statements as you do not need to understand every single figure. You just need to be able to use the information to ask thought-provoking questions about potential ways to improve or enhance the financial trends or redeploy resources to drive better future results.
The annual report includes items that you may not find in the 10-Q such as a comprehensive list of key risks, critical accounting policies and estimates, the external auditor's opinion, potential litigation, and the management discussion & analysis (MD&A).
The MD&A provides an explanation and summary of a company’s financial statements that enables investors to see the company through the eyes of management. It also enhances the overall financial disclosure as well as provides the context within which financial information should be analyzed. Unlike other disclosures, it is written as a narrative, which allows it to offer key information in a more digestible way.
A proxy statement is a document containing the information the SEC requires companies to provide to shareholders so they can make informed decisions about matters that will be brought up at an annual or special stockholder meeting. It provides information on the current board members which will help you determine how best you could contribute. It also describes the director selection process, the various board committees, and who is serving on which committee. And it provides the compensation policies for certain executives, often referred to as the named executive officers (NEOs), and the board of directors.
Boards are expected to use the financial information to make informed decisions regarding capital allocation.
The five methods of capital allocation are mergers and acquisitions, investing in organic growth, repurchasing shares, paying down debt, and paying dividends. Dividends are the distribution of some of a company’s earnings out of its profits or reserves to a class of its shareholders, as determined by the company’s board of directors. In short, dividends are a way for companies to return value to shareholders.
The board of directors can initiate, omit, increase, cut, or simply not pay dividends as it sees fit. Declaring cash dividends can be a tough decision for a board of directors as they reduce the amount of equity a company can invest in profit-making operations. It requires directors to spend some of the company’s profits to pay cash to shareholders or find a different use for the money. The board needs to carefully consider what new or existing projects would benefit from the cash used for payouts and whether those projects would increase the company’s return on equity. The answer can affect shareholders’ pocketbooks, taxes, and stock price value.
The business community takes note when a board of directors changes its dividend policy. Dividends, or the lack of them, also send a message to potential investors, competitors, and the entire business community. A dividend cut will cause many to wonder whether the company is in trouble. A dividend boost tells the world that the board of directors has great confidence in the company’s future. But it also might signal that the board can’t find suitable investments, implying the industry is stagnant or in decline.
The financial information is largely the same for private companies but is typically not publicly available. A private company board director usually plays the role of an advisor; you are more inclined to roll up your sleeves and help the CEO and management team develop and implement their strategic plan. A public company board director, on the other hand, must follow many more elaborate procedures, rules, and requirements because of greater liability.
