An attempt is made to create a Practical Hand Book for the benefit of Independent Directors to effectively deal with the implicit and explicit challenges being posed on them by regulatory authorities as well as society in general.
First part as follows is dedicated to Budget or Business Plan Presentations to Audit Committee.
Part 1
Audit Committee
Subject: – Presentation of Annual Business Plan – Budget
Annual Business Plan – concept and context
Annual Business Planning (Budgeting) exercise of a business enterprises comprises of following key elements : –
1. Blue Print of Business Operations for the Financial Year
2. Setting management targets of Performance
3. Setting the direction for future
4. Resource utilization, mobilization and channelization
5. Approach to doing business, changes, if any
6. Expected addition to Shareholder Wealth
7. Identifying critical challenges, risk factors etc.
General Practices
It is not uncommon to observe extra pressure on the executive teams to roll out the annual business plan with series of internal meetings, reviews, revisions and iterations with intense inter personal engagements. Some common observations surrounding this process are as follows : –
1. Voluminous presentations, papers
2. Display of burning the midnight oil, changes till last minute and signs of stressed finance / business teams
3. Inadequate prior circulation or last minute replacements making prior circulation less relevant
4. Challenge to decipher Key Points with clear Interpretation / Implication
5. Too much being tried to be communicated in the realm of limited time, human attention of Committee members
Audit Committee Review and Approval
As per regulatory guidelines, audit committee reviews and approves the annual budget. Usually, such presentations are lengthy and seeking indirect sympathy for having sleepless night of the team to approving the budget after making few broad comments. To help, the audit committee members summarily review the budgets, following paragraphs discuss some core points with general rules of thumb to gain quick reflex sense while overseeing the presentations.
Broad Check List for IDs to Ask, Seek, Look into…to Cut the Clutter….
1. Gross Profit Plan – Incremental Generation
General phenomena of a business scenario hovers around inflationary increases in fixed costs, increments to employees and usual price increases to absorb the increase in costs. Therefore, the key principle in drawing a business plan of going concern is to reap the benefit for incremental profitability arising on account of incremental sales whereby most of the gross margin gets converted to net profit.
Seeking approval for higher costs to producing growth in gross margin is not relevant since costs get committed, whereas revenues remain subject to uncertainties of market.
2. Key Levers of Incremental Gross Profit i.e. Volume, Price or New Propositions
Summarily it is important to dissect the core levers of increase in gross profit attributable to price increase, volume increase and new initiatives (new products, markets etc.). Margin generation on account of Price increase needs broad attention in the realm of strategic positioning, market forces and scenario of more value at same price. For instance, cars carry more features at the same point of price.
3. Significance of Gross Margin Percentage to Sales
It is important to keep an eye on the Gross Margin percentage to Sales ratio and never compute this ratio by adding Other Income. Secondly, drops in percentage of gross margin indicate erosion of efficiency of sales and gives a concise Data Point to probe the reasons. More often than not drop in gross margin indicate assumptions of rising cost of sales which escapes the attention of reviewers translating to salient approval to possibly challengeable assumptions in planning the sales.
4. Incremental Costs
Cost structure changes to give room for inflation and increments every year. In many situations, substantial portion of increase in gross margin is consumed by increase in fixed costs translating to very little addition to net profit or even reduction in net profits. Such a scenario should be carefully reviewed and subjected to a thumb rule of conversion of addition to gross margin by at least 50-60% in a normal business scenario.
5. Map Key Risk Factors of Business Plan
Applying the principles of risk management to insulate the business and organization against the shocks of uncertainty where expenditure hikes in budget become certain whereas revenues remain uncertain or subject to market conditions, it is pertinent to map key risk factors to revenue assumptions of business plan. Mapping the risk factors give a view to applying conservatism to keep costs under check juxtaposed to budgets becoming entitlements and shortfall in projections of gross margins inevitably stressing the organization.
6. Capital Expenditure
Usually, capital expenditures are shown as one line item and it is important to Divide the Capital Expenditure in 3 categories as follows : –
i. Maintenance Capex,
ii. Project Capex
iii. Administrative Capex
Maintenance capex should be equated with the Depreciation and Project Capex should be subject to rigorous evaluation with respect to risk, return, sensitivity and mode of financing. Administrative capex being a dragger to ROCE should be kept at bare minimum. This acts very useful tool for administering an overall risk management philosophy of the organization.
7. Pressure test the Business Plan for the following: –
i. Stretch in Goal Setting
ii. Incentive to Beat or Outperform
iii. Distinguish between Realistic vs Ambitious vs Dream / Aspirational
iv. Challenge unrealistic Numbers presented to please
v. Marry the Business Plan with Organization Bottlenecks to Avoid plausible excuses
vi. Insist on Two / Three Qualitative Targets hovering around Quality, New Products, New Markets, New thinking….
vii. Marry the Budget with Preceding Past Pattern i.e. Gross Under or Over Budgeting…
8. Separation of Key Assumptions for Approval / Endorsement
It is important to take prior approval / endorsement of committee members for certain key assumptions driving the business plan. To illustrate as follows: –
i. Entry in new markets
ii. Launch of new products
iii. Introduction of inter divisional transfer pricing resulting growth in sales
iv. Change of sales philosophy i.e. Trading to bump up Sales
9. Equivocated Presentations – Exercise Caution
It is not uncommon to notice equivocated presentations from management points which require an alert and incisive attention from the Directors. Few illustrations as follows: –
i. Growth in Sales, Drop in Gross Margin and No Increase or Marginal Increase in Net Profit
ii. Unreasonable skews in One Quarter generally the last quarter
ii. High export becoming trigger for Sales Growth with overall Profits going down due to Export margins much lower than Domestic. Prima facie the Top Line Growth looks very attractive, however, bottom line looks flat or very marginal..
Conclusion
Keeping an eye on some vital indicators / principles and comparisons can quickly discover the integrity of business plan.
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