The CFO effect

Mar 27, 2012   //   by Alexander Lyon   //   News  //  Comments Off on The CFO effect

What topic is the start, middle and end of most board meetings? What single item is repeatedly chosen by companies to evaluate the validity of a project or strategic decision? What is the overwhelming majority type of objective employees are given?

Financial. ROI, Cash Flow, CAGR, EBIT, Iso-Perimeter Growth, Productivity, Sales… Businesses make their choices essentially on financial aspects. A project that can’t show it’ll at least break even won’t see the light of day. Investments that don’t meet the ROI targets are postponed or cancelled. These metrics are integrated to employee performance reviews and contracts, helping management separate the wheat from the chaff with a simple spreadsheet.

As I was reading Economia, I came across Amy Duff’s article “Beyond Numbers“. Whilst I agree with the conclusion the article holds, the premises and the reasoning are deeply flawed. Yes, board members need to be much, much more than just specialists in their domain with little capacity to see beyond their sphere. But that’s a general remark, not one particularly attributable to CFOs. Building a strong corporate strategy is something that’s best done when given insight from all possible angles, including corporate finance. However, CFOs should not be earmarked as “#2” in corporate hierarchy, nor the “power behind the CEO’s throne”.

People tend to forget what a recent notion the “CFO” is. Until the 70s, Chief Accountants or Finance Directors were almost never board members, and when they were, it was a non-executive position. Their job was to provide accurate figures regarding the business, ensure correct reporting of the business’ finances to the relevant authorities and certifiers, and vet proposals submitted to the board for financial soundness. It’s only in the 80s that the position of CFO started to take form as we currently know it : executive board members, often #2 or #3 behind the CEO, regularly linked with the position of CEO… Dirk M. Zorn’s paper “Here a Chief, There a Chief” looked at the board of the 400 biggest companies in the USA, and found that in 1978, less than 10% had a CFO. By 1996, over 80% of these businesses had one.

Why such a change? Two reasons. Firstly, the late 1970s lead to a new macroeconomic situation, which made investments more risky and difficult to evaluate. Secondly, regulatory changes to anti-trust laws in the late 1970s meant businesses were forced to undergo mergers, acquisitions and divestitures. Both these factors meant a stronger financial view of the company was necessary. The CFO’s role was to ensure that the business was managed like a “good portfolio” : sufficiently diverse to mitigate risk, but at the same time providing good returns to investors, and thus attracting the capacity to fuel M&A activity.

By the 1990s, though, the stagflation period of the 1980s had ended, and businesses were in the process of re-focusing on their core competences. The two reasons that lead to the initial massive growth of CFOs had vanished, and were being replaced by the CFO’s ability to manage growth to achieve analyst predictions. Financial optimisation became particularly important during the 1990s and 2000s, and CFOs’ influence on boards was boosted by the spread of financial management theory in MBA courses during the 1970s and 1980s. Boards took an increasingly abstract view of the business by focusing extensively on the figures provided by the CFO, thus reinforcing the importance of the position.

The only problem is that finance is far from being a perfect tool to analyse a business, and choices that are sound financially can be disastrous for the business. By focusing extensively on a few financial metrics, and putting the weight of the board behind those metrics by turning the CFO into the #2 or #3 in the corporate hierarchy, employees are encouraged to disregard the overall business perspective and solely pursue those very limited metrics. The CFO’s importance is attributed to his ability to “create value” by making the right choices thanks to his greater financial insight, but that’s hardly an argument that holds up to scrutiny.

Let’s get back to Amy Duff’s article. I’m not going to comment on each aspect that I wish to debate, but several aspects are almost absurd. The crux of the article is that the role of CFO has changed, from numbers-cruncher to participant in the general business strategy. As part of this change, CFOs are now “creating value” and “innovating”, whilst standing up to the CEO and other executive board members to defend their point of view. This makes boards comfortable with the idea of giving the CFO the top job, and is meaning potential CFOs should start expanding their skills outside of accountancy and financial reporting in order to fulfil this new role.

How does a Finance Director “create value” though? In a financial institution, the CFO can delve deep into the business’ operation, making them effectively the COO, with added reporting duties. But outside of financial institutions, CFOs have little possibility of affecting operations, judging promising lines of research or even finding the appropriate methods to increase marginal productivity. Finance can certainly “innovate” in many respects, but I doubt that innovation is central to any business other than a financial institution. Accounting tricks can help decrease tax owed, change figures a little to meet a promised target, or have otherwise marginal effects on the financial reports; however, these innovations can do nothing more than mask the underlying problems businesses have, not provide a remedy.

Of course CFOs, like all board members, need to be able to converse fluently in the common language of strategy, risk analysis and general business management. But some of the claims in the article border on the ridiculous : “Businesses are seeing the value of having someone at the top who uses what the numbers are telling them to understand what is happening at all levels”. Not only does this sound ridiculous because it implies that every other member on the board is numerically illiterate, but it also implies that numbers can accurately represent reality. As any member of the ICAEW (Institute of Chartered Accountants of England and Wales) should know, numerical data represents only one facet of reality, and even then only within the limits of the tools used to gather the information. Numerical data cannot show a store manager is creating a negative atmosphere within the store, and despite posting good results key members of his team are searching employment elsewhere. Numerical data cannot show how an employee posting below-average after-sales figures is creating massive brand loyalty by being considerate and going “beyond the norm” for each client. Of course, one can retort that with enough dimensions considered, infinite time and attention to detail to process this data, it could be possible to identify these aspects. But we all know that is not how businesses work. Data is only subject to very light treatment, at best a few simple pivot tables, and then it’s considered “final”.

For all Amy Duff’s enthusiasm about how CFOs will help create a better business by being more involved in strategy, creating value where there was one before and so forth, I still wonder why the best financial minds money could assemble crashed so miserably between 2008 and 2010. It’s not even the first time either that finance betrayed its promises, since the early 2000s had also seen a rash of CFOs landing their firms in big trouble. I’m sure most CFOs are a safe pair of hands, and that they almost always act in good faith for the business. But when a company puts the CFO above the COO, above the CMO, above other executive directors on the board, the business is signalling openly to everybody inside and outside the company that their financial results are more important than their products, more important than their customers, more important than any other single consideration within the business.

I don’t think this is a viable strategy. Businesses need to look at their customers first, and their product second. Finance can augment these visions, but should not take precedence over them. In particular at board level.

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