CFO Role, Corporate Governance, and Financial Decisions
Board of Directors and Corporate Structure
The Chief Financial Officer (CFO) has several key functions within a company. Reporting lines typically place the CFO under the Chief Executive Officer (CEO). In addition, the company has directors who form the Board of Directors (BoD). The BoD elects the CEO and oversees the company’s executive team. At the top is the CEO, who makes the company’s major strategic decisions.
The BoD members are representatives of the company’s owners: the shareholders. Shareholders are those who have invested in the company, receiving shares in return. A share represents partial ownership in a company. As owners, shareholders have an interest in the company’s well-being. Large public companies like Amazon or Inditex have numerous shareholders.
To manage the company effectively and represent diverse shareholder interests, shareholders elect representatives: the board members. These members represent the shareholders and their interests. They form a committee, the Board of Directors (BoD), which makes significant long-term decisions for the company.
The BoD holds extraordinary meetings as needed and an ordinary meeting annually. In these meetings, they decide on resource allocation for projects and periodically elect the CEO, whose term varies according to company policy.
A company comprises many departments. One of the CEO’s functions is to build the executive team, appointing leaders for various functions (e.g., operations, marketing, finance). Key subordinates of the CFO often include the Treasury Department and accounting staff. This department manages the company’s finances and accounting records.
CFO Responsibilities and Decisions
The CFO oversees crucial financial decisions, including Capital Budgeting. Companies need to invest their financial resources effectively in various projects. These projects can be operational (internal) or financial (e.g., investment funds). Idle cash should be invested productively, as uninvested cash loses value over time due to inflation. Therefore, investment is crucial. Consequently, the CFO evaluates the profitability of proposed projects, deciding whether investing in them is advisable.
Another key function is Financing. This involves securing the necessary resources to carry out projects. Funding sources can include:
- Internal funds (retained earnings)
- External equity (issuing new stock)
- Debt (bank loans or bonds)
A fourth area involves the company’s Audit process. An audit involves controlling and verifying financial accounts, ensuring adherence to established criteria. Due to potential conflicts of interest, the audit function isn’t solely the CFO’s responsibility.
In parallel, the Audit Committee (CoA), often with similar authority to the BoD on audit matters, provides oversight. This committee aims for independence from management. Its purpose includes preventing financial misrepresentation. Internal auditors typically report to both management (often the CFO) and the Audit Committee.
Additionally, companies undergo External Audits conducted by independent organizations. Normally, there is no conflict of interest. However, conflicts can arise from long-term relationships where a company might pressure its auditor. Regulations often address this; for example, laws may mandate auditor rotation (e.g., every 5 years) to maintain independence.
Types of Audit Findings
There are four main types of audit opinions:
- Unqualified Opinion: The auditor found no material misstatements; the financial statements are presented fairly.
- Qualified Opinion: The auditor found misstatements or was unable to obtain sufficient evidence in specific areas, but the overall financial statements are still considered fairly presented, except for the qualified items.
- Disclaimer of Opinion (No Opinion): The auditor could not obtain sufficient appropriate audit evidence to form an opinion, or the uncertainties are so pervasive that an opinion cannot be expressed.
- Adverse Opinion (Denied): The financial statements are materially misstated and do not present the company’s financial position or results fairly. This is a very negative outcome.
Ensuring Good Corporate Governance
To ensure Good Corporate Governance, the chain of oversight must be independent. Ideally, the BoD should primarily represent shareholder interests with significant independence from day-to-day management. Board members should maintain independence from company management.
The Chair of the Board is a key figure. Sometimes, the CEO also serves as the Chair (as seen historically at companies like Inditex). This dual role can raise concerns about independence and control, potentially reducing board independence.
Governance Policies and Incentives
Policies can be implemented to promote good corporate governance. Certain incentive structures, like bonuses tied solely to easily manipulated metrics, might encourage misrepresentation. An alternative is linking bonuses to stock market performance. Since the stock market reflects public information and is difficult to manipulate directly, this aligns management incentives with shareholder value creation. The primary objective of management, and the entire company, should be to increase company value. Company value is often defined as the market value of its debt plus the market value of its equity (market capitalization).
Impact of Activities on Free Cash Flow (FCF)
How do certain activities impact a firm’s Free Cash Flow (FCF)?
Increase in level of inventories: An increase in inventory implies cash was used to purchase or produce goods not yet sold. This typically decreases FCF (represents an investment in working capital).
Distribution of cash dividends to shareholders: Dividend payments are distributions to owners and occur after FCF has been generated. They are a financing cash flow, not typically included in the calculation of FCF itself (FCFF or FCFE before dividends).
Payment of interest expenses: Interest payments are cash outflows related to debt financing. How they impact FCF depends on the specific definition. For FCFF (Free Cash Flow to Firm), interest is typically added back (after tax) if starting from Net Income, as FCFF represents cash available to all capital providers (debt and equity) before financing payments. For FCFE (Free Cash Flow to Equity), interest expense reduces the cash flow available to equity holders.
Payment of taxes: Cash taxes paid reduce the amount of cash available. FCF calculations typically use taxes based on Earnings Before Interest and Taxes (EBIT), so cash tax payments directly reduce FCF.
A decrease in the level of payables: Decreasing accounts payable means the company paid its suppliers faster or paid off more than it incurred in new payables during the period. This is a cash outflow and decreases FCF (a reduction in a source of operating financing).
Understanding the Pecking Order Theory
The Pecking Order Theory suggests a hierarchy for financing company needs. The core idea is to prioritize funding sources, starting with the ‘cheapest’ or least impactful options:
- Internal Funds: Retained earnings are preferred first as they don’t involve issuance costs or send negative signals to the market.
- Debt: If internal funds are insufficient, debt is preferred over equity because it typically has lower issuance costs and is perceived by the market as less indicative of potential overvaluation than equity issuance.
- Equity: Issuing new equity is considered the last resort due to higher issuance costs and the potential negative signal it sends to investors (suggesting management believes the stock is overvalued).
Prioritizing funding this way aims to minimize the cost of capital and issues related to information asymmetry. A lower cost of capital allows the company to undertake more value-enhancing projects.