Bipin's GuruShaala

Introduction

Independent directors (IDs) play a crucial role in the board, especially in ensuring transparency, accountability, and protecting the interests of all stakeholders as emphasised in the Companies Act 2013.

With stakeholders demanding greater transparency and accountability from companies, IDs are entrusted with the responsibility of ensuring that the organization’s actions align with broader stakeholder interests.

But here lies a challenge: not all independent directors come from a finance background, yet they are routinely confronted with financial statements, audits, and other fiscal matters in board meetings. How does an ID, without the nuances of finance, effectively navigate this terrain? The answer lies in understanding the right questions to ask. This article provides a conceptual framework to guide non-finance independent directors as they engage in board proceedings related to finances and audits. Whether you’re an experienced ID looking to bolster your financial oversight or new to the boardroom, this guide aims to equip you with the essential tools to make informed decisions.

The Framework

Listed are the six key tenets that forms the foundation of the conceptual framework accompanied by a set of questions an independent director might leverage when reviewing board proceedings related to finances and audits:

Understanding the Financial Health

Financial Statements

These are the main reports (Balance Sheet, Income Statement, and Cash Flow Statement) that detail the financial position and performance of a company. Some of the questions that could be crucial to get an understanding on could be –

Is the company profitable? If not, what are the reasons?

Are the company's assets in line with its industry peers?

Is there any significant change in the company's liabilities? What's driving that change?

Are cash flows from operating activities positive? If not, why?

Balance Sheet (Statement of Financial Position):

Assets

What constitutes the majority of the company's assets? 

Are they tangible (like machinery) or intangible (like patents or goodwill)?

Liabilities

Is there a high proportion of short-term vs. long-term liabilities? Short-term liabilities could indicate liquidity risks.

Equity

Has the equity position been eroding? A decreasing equity position might hint at sustained losses.

Illustrative Example: If a tech company’s assets are primarily intangible (like software or patents), it’s different from a manufacturing company which may have significant tangible assets (like machinery or buildings).

Income Statement (Profit & Loss Account)

Revenue Growth

Is the company growing its top line consistently?

Expense Management

Are any expense categories growing faster than revenues?

Profit Margins

Are margins improving, steady, or declining? Declining margins may indicate competitive pressures.

Illustrative Example: A sudden spike in marketing expenses might be justified if the company launched a major advertising campaign or a new product.

Cash Flow Statement:

Operations

Is the company generating positive cash flows from its core operations?

Investing

Are cash outflows for investments consistent with the company's growth strategy?

Financing

Is the company heavily reliant on external financing? This could indicate challenges in self-sustaining growth.

Illustrative Example: A negative cash flow from operations for a start-up in its early days might be acceptable, but it would be concerning for an established company.

Financial Ratios

These are calculations using the financial statement figures, useful for comparison and analysis. Some of the questions that could be crucial to get an understanding on could be –

How does the company’s key financial ratios compare to industry benchmarks?

Are there any financial ratios that have changed significantly from the previous period?

Liquidity Ratios

Measures like Current Ratio or Quick Ratio can tell you about the company's ability to meet short-term obligations.

Profitability Ratios

Return on Assets (ROA) or Return on Equity (ROE) can provide insights into how efficiently the company is generating profits.

Capital Allocation and Financial Strategy

Capital Expenditure

Money spent by a business to acquire, maintain, or improve its long-term assets.

What are the major capital expenditures for this period? Are they aligned with the company's long-term strategy?

How are these expenditures being financed?

Project Analysis

Are capital expenditure decisions based on thorough project analysis, including future revenue projections and potential risks?

Return on Investment (ROI)

What's the expected ROI on significant capital expenditures?

Illustrative Example:

• A retail company investing heavily in online infrastructure expects increased online sales, but are there projections to justify this expenditure?
• If a company spent $5 million on a new factory that’s expected to generate an additional $1 million profit annually, the ROI would be 20%.

Dividends and Share Buybacks

Is the company returning money to shareholders? If yes, is it sustainable given the company's cash flow and future financial needs?

If there are share buybacks, what's the rationale behind them?

Dividend Payout Ratio

The portion of earnings paid out as dividends. A very high ratio may limit the company's growth potential.

Buyback Motive

Is the buyback to boost earnings per share, or because the company genuinely believes the stock is undervalued?

Illustrative Example: If a company decides to buy back shares when the market price is perceived as undervalued, it’s effectively betting on its future growth. However, if the same company had high debts, the decision might be questioned.

Audit and Internal Controls

Audit Reports

Review by an external agency to ensure financial statements present a true and fair view.

Were there any qualifications or remarks in the audit report? If yes, what are their implications?

How has the management responded to those qualifications or remarks?

Auditor Tenure

Has the company been with the same auditor for an extended period? Periodic changes can provide a fresh perspective.

Management’s Discussion and Analysis (MD&A)

Does the management's take align with the auditor's findings?

Illustrative Example:

• For instance, if a pharmaceutical company’s audit report highlighted concerns about its R&D expenditure accounting, this might need further investigation.
• An MD&A might state that a decrease in sales is due to external factors like a recession, but the auditor’s report might highlight internal issues, like production delays.

Internal Controls

Are there adequate internal controls in place to prevent financial fraud or misreporting?

Were there any instances of lapses in these controls? How did the company rectify them?

Frequency of Review

How often are the company's internal controls reviewed and tested?

Whistleblower Mechanisms

Are there systems in place for employees to report financial irregularities without fear of retaliation?

Illustrative Example: If a major bank reported a significant fraud, questions would arise about the adequacy and efficiency of its internal controls.

Compliance and Regulations

Regulatory Filings

Reports and forms that are required to be filed with regulatory bodies.

Are all regulatory filings up-to-date?

Were there any penalties or warnings issued by regulators?

Disclosure Quality

Are disclosures detailed and transparent, or is the company doing the bare minimum?

Past Incidences

Are there any past regulatory issues, and how were they addressed?

Illustrative Example: A biotech company might need to make regular filings about clinical trial results. A delay or lack of detail in these filings can be concerning for stakeholders.

Risk Management

Financial Risks

What are the significant financial risks the company currently faces?

How is the company mitigating these risks?

Hedging

If the company faces risks like currency fluctuations, are there hedging strategies in place?

Insurance

Does the company have adequate insurance cover against potential financial losses, such as litigation or natural disasters?

Illustrative Example:

• An export-oriented company might face significant currency fluctuation risks. Hedging strategies, like forward contracts, can be employed to mitigate this risk.
• A company located in a flood-prone area should have insurance against potential flood-related damages.

Debt Management

If the company has taken on debt, is the level manageable?

What's the strategy to repay or refinance the debt?

Debt Covenants

Are there restrictive clauses in the debt agreements that could impact company operations?

Interest Cover Ratio

Can the company comfortably meet its interest payments from its operating profits?

Illustrative Example: If a company has a debt covenant that restricts certain financial ratios, a sudden downturn in business might put it in violation of these covenants, leading to potential penalties or accelerated repayments.

Stakeholder Communication

Earnings Calls and Investor Presentations

Is the communication to investors and other stakeholders clear and transparent?

Are there significant discrepancies between what's presented to stakeholders and what's discussed in board meetings?

Consistency

Are the messages conveyed in public forums consistent with internal discussions?

Forward-Looking Statements

Are the company's projections and outlooks realistic based on current operations and market conditions?

Illustrative Example: If a company highlights its strong revenue growth in presentations but doesn’t discuss declining profit margins, it might be painting an overly rosy picture, warranting deeper investigation.

Summary

As the corporate world evolves, the role of independent directors (ID) takes center stage in ensuring company integrity, especially in financial matters. However, not all IDs have a finance-heavy background, potentially leading to oversight gaps in understanding and interrogating financial details. This article presented a comprehensive framework tailored for non-finance independent directors. Through it, we explored the key financial areas, from understanding the basics of financial health via statements and ratios, to diving deep into capital allocation, audit nuances, compliance, risk management, and stakeholder communication. This framework, armed with its guiding questions, serves as a vital toolkit for IDs, allowing them to effectively navigate board proceedings related to finances and audits. Regardless of one’s finance expertise, being equipped with the right set of inquiries ensures a proactive approach to governance, benefiting both the company and its stakeholders.