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The five greatest risks to financial security

ARTICLE

If clubs are to run like businesses, they must adopt common business practices—such as risk management. In this article we take a deep dive into an area of risk assessment and management that most clubs perennially struggle with, including the five greatest risks to financial security:

  1. Incremental budgeting
  2. Not raising dues
  3. Believing depreciation isn’t a real expense
  4. Managing to metrics, not with metrics
  5. Going cheap with your internal financial advisors

Risk 1: Incremental budgeting

To put it bluntly, incremental budgeting was exposed for the lazy sham that it is when the great recession sunk its teeth into the private club industry. Years of bloated, padded budgets that covered up mediocre management and poor boardroom governance were exposed at a blistering pace as club after club found they had to adjust to rapidly declining revenue streams. Suddenly, unnecessary expenses that had become institutionalized in some clubs were stripped bare as boards woke from their slumber and challenged management to run their clubs like businesses. But what about the clubs with strong management that did everything right but have been negatively affected by members who still have reduced resources due to the recession? What about the Sunbelt retirement community clubs, whose members are outliving their retirement nest eggs? Realistically, for some community clubs, keeping it affordable is important to resell the real estate. There needs to be a balance between member cost and the availability of amenities. Again, this goes to the strategic plan and mission: is being open seven days for all services really a viable option? Incremental budgeting will only accelerate decline in these tricky scenarios.

Zero-based budgeting has become the new norm for many clubs and has been a life saver for many others. Rather than slapping an arbitrary percentage increase on prior year numbers, management has challenged those responsible for budget development to justify expenditures, down to the underlying performance drivers such as number of people needed for a restaurant shift or the number of times the fairways are mowed. Zero-based budgeting actually provides a mechanism for doing the unthinkable in the club world…quantifying quality.

Once strategy has been agreed by the club’s board and membership during a thoughtful and deliberate strategic planning process, management can actually place cost estimates around the operational element of that strategy with zero-based budgeting. How? Consider the mission statement that refers to a high quality dining experience. What does that mean when preparing a budget? We can agree on how many staff will serve a certain number of covers. We can cost those staff in terms of payroll dollars and budget accordingly. If the cost is questioned as too high by the board, we can then show them the changes we can make in terms of reducing the quality of the dining experience—either by reducing the planned number of staff per cover, or by using less experienced, and presumably cheaper, staff.

Of course the board, and not management, is then faced with the dilemma of not living up to the club’s mission statement. Simply put, budgeting without a strategic plan is like sailing after the lights of another ship in the dark of night, only to find you have been following the Titanic. Conversely, why invest so much time and resources in strategic planning if we are not going to link strategy to operations using a zero-based budget that associates cost to the mission and action plans agreed on by the membership?

Risk 2: Not raising dues

In the most basic terms, not raising dues is a short-term approach to keeping a portion of club membership happy while jeopardizing the economic stability of the club for all. Why would we not raise dues? Because we fear that we will have a mass exodus of members? If that is the case, then we failed miserably with our member acceptance procedures—we admitted folks that simply could not afford to make the lifestyle investment that private club life requires. Too often we see clubs run initiation fee specials to lure individuals to join the club. The membership admittance questionnaire for these types of offers usually consists of one question: Do you have a bank account and a checkbook? Sign here. What a disservice this approach is to the existing members of the club. Do we ever stop to think about the credit line we are advancing these new members? How many months will it be before we cut off their membership privileges? 60 days? 90? How many companies would grant an effectively unlimited credit line to a new customer without rigorous credit checks? What does this have to do with not raising dues? Frequently it is the fear of losing these newest members, those that, had we done our financial due diligence, we would never have admitted, that causes boards to freeze dues levels. Think outside the club world for a moment: have we seen prices of goods and services continue to rise? Inflation is real!

Too many club boards have tried to cut their way to success – the proverbial circle of death:

While clubs may have fought hard to expand revenue sources over the last few years, the fact remains that the reliance on the dues dollar as a percentage of operating revenue has grown significantly. As in any business, if we are to avoid the downward death spiral associated with trying to cut our way to the future, then we must increase our largest revenue source: dues must increase. How much must dues increase? Again, only a zero-based budget can truly give us a method to justify just how much our dues levels should be and any budget should also contemplate macroeconomic factors that might affect our members’ spending ability. For example, all clubs are concerned about health care changes affecting club expenses, but what about their impact on club revenue? How many of our members have business interests that will be affected by changes or revisions to current health care laws? Will that reduce the salaries our members earn or the profits they can draw on from those businesses? Probably, but it is rare to see that factored into club budgets. Might it be better for clubs to raise annual dues rates at the start of the year, to hedge against these economic impacts, rather than wait to see decreased use of club amenities and a related decrease in revenue as the year progresses?

Another factor has influenced dues rates growth over the last few years: the decline in traditional methods of capital funding.

Risk 3: Believing depreciation isn’t a real expense

This mistaken idea that depreciation isn’t a real expense is arguably one of the best examples of clubs burying their heads in the proverbial sand.

For most businesses, depreciation is included in the determination of net operating income. The reason for this is because depreciation really is an operating expense! Every other business in the world includes depreciation expenses in operations. Private clubs have historically excluded it under the argument that capital inflows from initiation, joining or entrance fees covered that cost. Since many clubs would struggle to make that argument today, it is time to revisit how depreciation is portrayed in financial statements. Warren Buffett famously asked, "Does management think the tooth fairy pays for capital expenditures?” Should clubs try to fund depreciation from operating revenues? Probably—if they are to act like most commercial enterprises. This inevitably provides more support for our previous contention that dues must increase regularly. Yes, some clubs will continue to push the capital funding problem down the road and charge a capital assessment to whoever happens to be a member of the club at the time a major capital asset needs replacement. Hopefully the members at that time will be more cognizant than today’s members that they have a responsibility to maintain the club amenities at desirable levels. Current members may argue that they have paid for the asset once and should not have to pay again. To those members, clubs must ask what they think depreciation expense represents. It is a measure of the enjoyment they get from using the asset. Certainly clubs that have a residential real estate connection can testify that the ability of residents to sell their properties at reasonable prices is directly affected by the condition of club amenities. What often gets missed in this discussion is that almost all clubs have a residential real estate component—even those without homes behind the club gates.

It has always been a struggle to comprehend the rationale for basing cost estimates of future capital purchases on what was paid for the same asset any number of years earlier. Inflation alone suggests that such an estimate would inevitably result in a shortfall when it comes time to write a check in the future. Questions continue to be posed regularly about whether private clubs should conduct reserve studies. The answer to such a question is a resounding yes. After all, how could a club president or treasurer ask for any level of capital assessment at the annual meeting if they do not possess an independently researched study to support the need for the amount being requested? In no other business with major facility and equipment needs would management approach the capital or debt markets without professionally prepared documentation of the funding levels required.

Our final thought on funding depreciation brings us to how depreciation is calculated—over the estimated useful lives of the assets purchased. When was the last time you took a serious look at those useful life estimates? For most clubs, the answer is never. This can be seen when a major renovation takes place and the club has to write the old assets off the books. So many times the result is a significant book loss for the club because depreciation accumulated to date is so much less than the original cost of the asset. This tells us that the useful lives we had been using were arguably too long. For example, imagine we spent $4 million on a clubhouse renovation in 2001 and decided to depreciate it over 40 years. Assuming we put the asset in service at the start of our fiscal year, depreciation expense each year would be $100,000 ($4 million over 40 years). Let’s also assume we are good stewards of the club’s assets and fortunate enough to be able to begin building a capital reserve by setting aside $100,000 a year, in effect funding our annual depreciation expense so that we can, ignoring the impact of inflation, have the money to replace our 2001 asset when the time comes. Twenty years pass and it is time to renovate the clubhouse again to stay competitive. At that point, we have recorded $2 million ($100,000 x 20 years) of accumulated depreciation on our 2001 clubhouse renovation and tucked away $2 million in our capital reserve account. When we complete our 2021 clubhouse renovation, estimated at another $4 million, we will be removing the old asset from our books at a $2 million loss ($4 million original cost minus $2 million accumulated depreciation) and will find ourselves with a $2 million shortfall in our capital reserve fund. Had we taken a hard look at how long our 2001 asset was really going to last, we would have depreciated that asset over twenty years, not forty, and might have realized sooner that our depreciation funding was insufficient. Because of the inherent estimates and biases involved in setting depreciation lives, it appears obvious that while funding depreciation is good, funding a capital reserve study is better.

Risk 4: Managing to metrics, not with metrics

Managing to metrics is going to become an increasingly greater risk for club executives and boards.

CMAA, NCA, PGA and NGF are just a few of the industry bodies that publish volumes of incredibly useful industry data. RSM of course also has almost forty years of published club financial trends extracted from our clients’ audited financial statements. All in all, there is more data than most club executives will ever have the time to sift through, analyze and apply to their own, unique operations. Yes, consultants like ourselves and others can help, but ultimately it is club management that will be held accountable by boards for meeting, or not, some of the yardsticks that the industry has published.

We see great wisdom for club managers and boards in this quote from Irish playwright George Bernard Shaw, “The only man I know who behaves sensibly is my tailor; he takes my measurements anew each time he sees me. ... The rest go on with their old measurements and expect me to fit them." Given the volumes of data in the marketplace, we urge club boards to view their club financial performance through the multiple prisms available. While we see most clubs fit within a relatively well defined range of financial metrics, be it departmental reliance on dues or member to employee service ratios, the devil does lie in the details. Think back to our earlier discussion on strategic planning and zero-based budgeting. Presumably each club’s strategic plan is unique to that club or else someone would just publish a boilerplate document that all clubs would follow in order to avoid the time and cost associated with the strategic planning process. If that is true, and each club should budget operationally for its own specific plan, then how useful can data from other clubs really be when measuring one club’s performance relative to its strategic plan? Of course industry data is useful for defending the sometimes counter-intuitive club financial model, but club boards should not be setting goals for club management teams that is forcibly driven by generalized statistics. Understand the data, understand what drives it, understand the source and understand how it may, or may not, apply to your club’s unique strategic plan. Then, manage with the metrics, not to the metrics

Risk 5: Going cheap with your internal financial advisors

At a time when members and leadership are demanding more financial accountability and knowledge than at any time in our history, skimping on internal financial staff is, at a minimum, foolish and more likely downright reckless. We spend countless hours in board and committee meetings with our clients discussing as wide a variety of industry topics as you might ever imagine, but a consistent theme in the discussions is evident: how strong is the club’s financial team? It is a tough question to answer. As consultants, auditors and tax advisors, we are not there 24/7 in every meeting, formal or informal, that takes place around the club’s finances. We do get a privileged view of the club’s collective financial acumen when we deliver our various suite of products and services, but the truthful answer to the question really begins with another question: how strong do you want your financial team to be?

Many clubs believe that they need to improve the quality of their financial team. Controllers and chief financial officers (CFOs) shouldn’t panic—this is not a dire prediction of wholesale job changes in the industry. Rather, there is a growing appreciation that we need to continually invest in our people if we want to improve results. This comes not only in the form of funding continued education and training for our financial team, but also in the form of making them truly part of the management team. It still shocks us that many clubs do not allow or require the senior accounting executive to attend board meetings. How can we possibly expect these individuals to provide us the level of service we need when they are not granted a seat at the table? Perhaps we may find that our evaluation of the individual will change, admittedly for better or worse, when we see them interact with club leadership and management in the rarified air of the club board meeting. More worrying is that a decision is made in a board meeting that has a financial management impact that is missed among the passionate debate of board members. Our club controllers or CFOs at least have the chance to point out the impact immediately if they are in the room. If they also miss the impact of the decision, or elect not to voice their concern, well that also provides a measure to evaluate their value to the club.

In corporate America, most CEOs would refuse to step into a boardroom without their chief accounting employee at their side. Clubs need to follow suit or truthfully understand why their controller is not in the boardroom. Is it because the club needs to upgrade the position? The marketplace is changing. The great recession has seen a number of financial executives enter the club job market for the first time, coming from varied industry backgrounds as far ranging as public accounting, real estate, health care and insurance. They have brought with them a highly visible and often technical skill set as well as an appreciation for a range of standard business practices that were not commonplace in the club industry. Club boards and chief executives have responded enthusiastically to these new club CFOs and the industry has demanded more. Niche club executive search firms had previously not seen tremendous demand, or willingness to pay, for recruitment assistance for controllers or CFOs. That has changed, as have the job descriptions for the chief accounting role at clubs. A recent advertisement at a leading club sought a controller to provide financial leadership contributing to the vision of the club, and the club’s business and financial objectives. Other attributes sought were “strong and passionate financial leader with a proven track record of providing supportive, timely and accurate information; a team player who has a history of supporting and developing staff; a proven courageous thought partner; an intuitive style resulting in a trusting and nurturing perception by all and a fundamental understanding of the club business.”  Most importantly, the club in question was willing to pay the market rate for the right person—the market not necessarily being the club industry market, but the market for high-level financial leaders.

This discussion has been about financial risks to clubs. Ultimately, the clubs that have the right financial leaders on staff to complement and support the club’s chief operating officer will recognize and manage these risks and execute the club’s strategic plan.