Steady as she goes will not suffice as rising costs create new operating pressures. Directors, who may have more experience in managing in inflationary environments than their executive teams, will need to be more hands- on and boards need to ask the right questions to ensure a hyper-aware culture.
DiviPay CFO Damon Hauenstein lists important questions directors should be asking in unsettled times:
- What are our largest cash costs?
- Can we reduce these costs if the business environment changes?
- What is the forecast if inflation accelerates?
- Can we mitigate cost increases?
- Can we increase our own prices?
- What is our working capital position?
- Can we improve our receivable or payment terms?
- Do we have an appropriate capital structure?
- What capital do we need to fund our growth ambitions?
- What sources of capital are available?
- Will these remain available if the macro environment changes?
Australia is experiencing its fastest-growing inflation in 20 years and in March, interest rates started rising for the first time in 11 years. Add to this skills shortages, supply chain pressures and a deteriorating economy in China, Australia’s biggest trading partner.
Stephen Parbery FAICD, senior adviser in restructuring at Kroll, believes we face a very interesting period ahead in which credit providers will not be consistent with their policies and behaviours. “Directors and management will need to remain nimble, have lots of contingency plans and be prepared to adapt to changing circumstances in their business models,” he says.
“Ensuring a high cadence of communication with management will be important. We are not in ‘steady as she goes’ territory, so boards should be more curious than ever. The challenge will be in shifting from what was an acceptable way of doing things to seizing what will be opportunities that this new market environment creates.”
Parbery says boards will need to be more hands-on in understanding what key indicators are driving overall performance. They will also need management to be more adaptive. Plus, they will have to press executives for details on their forward planning and what contingency plans have been put in place to adapt to changing conditions. This will have elements of “war planning” to focus management on keeping alert to a changing business environment.
With high inflation out of the picture for many years, boards may encounter executives or peers with no actual experience of dealing with it. “Crafting an urgency around high visibility on spend will be important, but the main challenge will be to avoid doing nothing,” says Parbery. “Creating a culture that is hyper- aware of costs, understands what is driving it and seeks to come up with ways to do things differently will be important. Equally, being closer to your customers and understanding their businesses will also be vital.”
Working in unison with customers and suppliers to manage inflationary pressures will become more important than ever.
“I expect boards will see value in changing transactional relationships to cooperative relationships,” adds Parbery.
Henriette Rothschild GAICD, a partner at KordaMentha, says boards are more likely to have faced rising cost pressures than their executive teams. “Boards, therefore, need to ensure they impart insight and wisdom from past experiences to ensure the resilience and sustainability of their organisations. This is a time that a board needs to be of real support, insight and advice to its CEOs, CFOs and broader executive teams.”
But for those who’ve gone through it before, Tony Schiffmann MAICD, chief executive partner of BDO Australia, warns that what’s different this time is the speed of change.
“I don’t think we were necessarily all looking at inflation last year,” he says. “The Reserve Bank was also saying it wasn’t going to put up interest rates for a couple of years, and suddenly, everything’s been compressed. We’re looking at something that’s happened much quicker than last time we went through this sort of cycle. We’ve just come out of COVID-19, so it’s just an endless rush to get things done. There’s no new normal and we’re not going back to the old ways ever.”
Schiffmann notes that the boardroom conversation is currently around cost pressures and maintaining margins — both in the short and long terms. Companies don’t have a lot of fat to cut, but they can innovate, digitise and become more efficient. However, innovation takes time, so there will be cost pressures in the short term.
Schiffmann doesn’t believe that the global shortage of talent is going to change anytime soon, which creates another dilemma — higher wages in the short term are necessary to retain staff in the longer term.
“For boards that are in industries where they have pricing discretion for their product or services, that’s clearly the first port of call,” says Schiffman.
“That’s an easy process in theory, but in practice, how do you explain to your customers that your prices will rise. That’s a competitive landscape that, again, we probably haven’t looked at for a while. Most businesses for the past 20 years have maybe had a CPI-type increase every year, so it hasn’t been that big a conversation. Some companies will lose customers, others will gain them. The strength of the relationship with the customer or client is going to be critical. Businesses may use the 80:20 or 90:10 rule, and from a board perspective, that’s the mindset I’d be adopting.”
“No matter how experienced, no-one knows exactly how this cycle in the market will pan out,” adds Rothschild, a director of Richmond Football Club and Brown Family Wine Group. “Trying to predict the unknown is simply gambling with your organisation’s future. Therefore, the importance of boards and their risk committees encouraging executives to understand how their business model performs under various scenarios is essential.”
Rothschild notes that scenario modelling needs to include the cash-flow impacts of interest rate increases, wage inflation and increased input costs.
“This will help an organisation to be better informed and more able to respond rapidly to market changes when they occur. For example, interest rates moving from two to three per cent may not seem significant, but modelling a 50 per cent increase in interest rate costs may tell a different story.”
Parbery believes boards will need to pay more attention to product profitability than ever before. This may require redefining how customers purchase their goods and understanding ways to increase their margins. They may also have to spend. For example, organisations may have to put short-term strain on working capital while the pricing models or customer focus and retention changes.
“Trying to move the position of a brand can be expensive, but over the long run, it will provide more opportunities to adjust pricing and in turn, manage the increases in costs caused by inflation,” he says. “Boards should also be considering R&D and capex, assess what is strategic and non-strategic, and decide what can be shelved for later, keeping in mind that energy will need to be deployed elsewhere in the organisation.”
Parbery says boards need to get into the detail of the working capital cycle of the business to understand where the strains are and to test assumptions previously inputted, which now may be inappropriate. They should ask for more in-depth information than normally. “In some respects, this market presents the ‘feet to the fire’ moment — boards and management need to ask why they have been doing something a particular way and to consider whether it can be done differently.”
Rothschild warns that blunt cost-cutting is not the answer. “The last time the market faced similar inflationary pressures, there were still many organisations ineffective at managing cost control, effective cost attribution and margin management,” she says. “For this reason, the simple answer was a ‘cost-out’ exercise — for example, 10–20 per cent across the entire organisation — which galvanised focus and helped to address margin erosion quickly. However, this approach in today’s environment is likely to be too blunt for the complexity we face, and unlikely to lead to sustainable profitability. In a low-growth market with a challenging workforce proposition and talent shortages, these generic approaches will likely lead to disengagement and potentially cutting many growth opportunities, more so than effective cost management.”
Culture of openness
Rothschild adds that boards need to ask management to better articulate investment in future growth and transition of legacy business models and cost structures. She says this requires good business insights as well as effective use of data and financial information.
“Challenging executives to really interrogate legacy costs and essential investments is a critical role of the board,” she says. “This will help ensure organisations move to focus on more sustainable future growth while reducing legacy costs and increasingly outdated ways of working. It may also require the insights of an external adviser to help the executive more fully question existing cost structures and effectively consider new approaches to better future-proofing.”
Schiffmann agrees. “Boards are going to have to lean a lot more on their finance function and their CFOs to understand the likely impacts on the business,” he says. “Finance functions and CFOs are going to be put under a lot of pressure — but boards will need to ask the right questions to get the right answers. It’s easy to ask a broad question and get lots of data. Boards need to be succinct and specific about what they’re looking for.”
The chair needs to drive a culture of openness by ensuring that the CFO has a direct line of communication to the board, adds Parbery. “Encouraging site visits, social contact and work sessions between the CFO and individual directors will assist in building better communication,” he says. “The chair should also encourage directors to make regular contact with the CFO so they become better acquainted with the key financial drivers of the business and the day-to-day challenges facing management. Open communication helps break down silos, which ensures a much healthier business culture within organisations.”
For directors who’ve been through past cycles of inflation and rising interest rates, Rothschild says a key difference this time around is how companies access growth and profit improvement.
“Since 2020, much corporate growth has come from mergers and acquisitions, with the aggregate value of deals over $50m increasing from $32.8b in 2020 to $130.5b in 2021 [Gilbert + Tobin Analysis of Australian public mergers and acquisitions],” says Rothschild. “With high- priority opportunities taken and cheap debt driving high prices, this may not be sustainable going forward. Boards may increasingly need to focus inwards to promote organic growth and drive profit through innovation, margin improvement and efficiency.”
Calm, respectful stewardship
Rothschild notes that in the past few years, the biggest corporate “failings” have been less about pure financial failures and more about those of governance, behaviour and integrity — often wrapped up in ESG issues. “Boards that will differentiate themselves in this next business cycle will help their executive teams focus on long-term growth, and manage the new inflationary pressures on financial performance, doing so while modelling good governance and a strong respect for the community in which they operate,” she says. “The need for good insightful advice, clarity of focus and a calm and respectful tone from the top, provided by the most effective boards, has never been greater.”
Frequent concerns currently being raised by board and executive teams include how to maintain connectivity with staff. It is important to ensure that the organisation’s culture does not move into negative spaces as the sands shift, warns Parbery.
“That position is now exacerbated by what will be uncertain economic times and the hard economics of some decisions that will need to be made,” he says. “It’s not the case that both agendas cannot coexist, though. Smart boards will be looking for their executive teams to think of new ways to do things. Rather than retreating, market changes like these present an opportunity to test new ways of doing things and challenge the old paradigms.”
Alice Tay GAICD, a director of the Heart Foundation and CHC Australia, and a member of the University of Canberra Council, agrees that unsettled times can be a good catalyst for positive change.
“While the boards I sit on are challenged, we are not stressed,” she says. “But being challenged has given us opportunities to pivot in ways we probably wouldn’t have considered. As an example, it has allowed us to restructure one organisation I am a director of to be more purpose-driven and efficient in how we do things. Taking this opportunity allows you to do things without making everybody upset.”
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