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Finance skills

An introduction to finance skills, for non-financial managers
by

Tim Fowler

on 15 October 2015

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Transcript of Finance skills

Tim Fowler, 05 Sep 2012
AN INTRODUCTION TO FINANCE
An introduction to Finance
Setting off
Financial control
Safeguarding the group’s assets; ensuring a level of precision and accuracy underpins all other Finance objectives.
Who are Finance, and how can they help me?
Financial reporting
Internal management reporting – measuring financial performance, efficiency, solvency and risk. Providing a common language enabling management to understand and control the business.
Who are Finance, and how can they help me?
Tim Fowler, Group Financial Controller
Round table – names and level of financial knowledge / experience
Introductions
Provide you with the information you need to perform in your assignments – both regular monthly data and specific ad hoc requests.
What can Finance tell me?
Base camp
We need to know three key things -
How do we measure a business?
Exercise - Feisty Foods Limited
The double-entry bookkeeping system was codified in the 15th century and refers to a set of rules for recording financial information in a financial accounting system in which every transaction or event changes at least two different accounts. In modern accounting this is done using debits and credits.


An essential component of accounting is what is referred to as the accounting equation – the assets of an entity (what is owned or owed to the entity) is equal to the liabilities of the entity (what is owes).


Thus, every transaction affects the financial accounts in two ways; a debit and a credit.


The accounting equation serves as a kind of error-detection system: if at any point the sum of debits does not equal the corresponding sum of credits, an error has occurred.
Debits & credits
Every transaction has a double impact – on either financial performance or financial position

To record this, we use double entry bookkeeping (debits and credits)

We measure financial performance using the Profit and Loss (P&L)

We measure financial position using the Balance Sheet
How to measure success?

She sets up a company (Feisty Foods Limited), with £30,000 of her own savings, plus she borrows £20,000 borrowed from a relative.
Exercise - Feisty Foods Limited
Balance sheet
Income statement
Debits
Assets
Costs
Credits
Liabilities
Incomes
Debits & credits
But this a partial picture at best - there are many important facts about Feisty Foods this does not tell us. For example :
Fixed assets

Fixed assets degrade over time. When we purchase a fixed asset, we assign it a useful economic life ('UEL'). We assign similar lives to similar groups of fixed assets, through judgement and experience. Examples include;
a sales license - 2 years
some laboratory equipment - 5 years
an ERP software application- 10 years
an autoclave - 15 years
a building - 50 years

The carrying value of the asset is reduced, and cost recognised in the P&L, over the UEL. For fixed assets, this is called depreciation; for intangible assets, amortisation.

one-off, or sudden reductions in the value of an asset are called impairments.

Depreciation, amortisation, and impairments are non-cash costs to the business - this is important when we come to making decisions about the business
A balance sheet is a snapshot of a company's financial position at a single point in time.

A standard company balance sheet has three parts: assets, liabilities and ownership equity. The main categories of assets are usually listed first, and typically in order of liquidity.

The difference between the assets and the liabilities is known as net assets. This will equal the equity of the company – the amount repayable back to the owners.

Non current versus current:
Current (short-term) implies that an asset or liability will be settled/ consumed within one year.
Non-current (long-term) therefore implies an asset or liability will be settled or consumed after more than one year.
Reading and understanding the balance sheet
Cost of sales, gross profit, and operating profit
When do we recognise revenue?
Working capital

Current Assets
All assets of the business expected to be sold or otherwise used up within one year
Examples include cash, cash equivalents, accounts receivable, inventory, the portion of prepayments which will be used within a year, and short-term investments.
Typically listed in order of increasing liquidity

Current Liabilities
All liabilities of the business that are to be settled within one year.
Examples include unpaid supplier invoices, payroll tax liabilities, or payments for goods ordered not yet invoiced
Liabilities payable over a term exceeding one year are long-term liabilities - however, long-term loan payments due within the year are current liabilities

Together, net current assets or liabilities make up working capital – the life-blood of a business.
Reading and understanding the balance sheet
Recognising and valuing assets and liabilities requires judgement – examples include:
estimating the % of credit risk within a portfolio of credit customers;
estimating the carrying value of stock;
quantifying possible future liabilities for environmental damage at a factory site
Reading and understanding the balance sheet
Income Statement
The income statement is usually referred to as the profit and loss account (P&L). Other names include statement of financial performance, earnings statement, or operating statement

It is a statement of the financial performance of the entity over a set period

It indicates what we have done with the assets and liabilities of the business, and whether, overall, they have created a profit

Accounting for many transactions, especially non-cash transaction, requires judgement.
Examples include;

when to recognise revenue on a long term contract (e.g. in the defence industry)
estimating the useful life of a fixed asset, and therefore the correct annual depreciation charge to apply;
estimating the likely costs associated with customer returns, or warrantee claims
Reading and understanding the P&L
Exercise - The stone mason
A local stone mason manufactures hand-crafted fireplaces. He purchases
5 tonnes of Normandy limestone, which he expects to use over the coming
6 months.
The limestone cost €12,000 from the quarry
Delivery and handling cost £2,000
Cutting the 5 tonnes of limestone into finished fireplaces cost £500
Insuring the limestone in transit cost £250
Insuring the fireplaces in the warehouse over the coming 6 months will cost £250
Selling the fireplaces to customers will cost a further £2,000
The FX rate was £1:€1 at the time of purchase, and £1:€1.2 at time of delivery
Purchasing limestone from the UK would have cost £16,000 plus £500

What should be the value of the freshly-cut fireplaces recorded in the mason’s accounts?
The stone mason
The historical cost of the freshly-cut limestone is £14,750. This is the cost to bring the asset to its present location and position.

BUT – do these additional facts impact the value of the stone?
Exercise – the stone mason
Assets are typically valued at the lower of
the historical cost to bring the asset to its present location and condition, and,
net realisable value – the anticipated disposal proceeds, less costs of sale
Valuing transactions
Exercise - the stone mason
Exercise – reviewing
financial accounts
Recap - accounting glossary
Please split into teams of two.
You will each be given a set of accounts

Take some time to review the data you have and draw some
conclusions about what the accounts tell you about the business.

What can you tell about the market the group operates in?
What can you tell about the financial position of the company?
What would you be concerned about, as an investor?
Climbing higher
Shows how changes in the balance sheet and income statement affect cash and cash equivalents.

Cash movements are broken down between operating, investing, and financing activities.

Essentially, the cash flow statement is concerned with the flow of cash in and cash out of the business, capturing both the operating performance and the accompanying changes in financial position.

Whilst elements of the BS and P&L can be subjective, cash is not : therefore the cash flow statement is terribly valuable in understanding an entity’s performance and position.
Cashflow statement
Cash is King !
These two climbers have ensured they are carrying everything they could possibly need - but they'll never progress due to the weight of it.
Working capital
How good businesses go bust
Supplier payment terms and prompt payment discounts (2)
Cost of capital (WACC)
Building financial models
DCF/NPV, IRR
The time value of money
Supplier payment terms and prompt payment discounts (1)
Working capital
Recap - accounting glossary (2)
Reaching the summit!
Activity Ratios
Liquidity Ratios
Financial ratios quantify many aspects of a business and are an integral part of financial statement analysis

Profitability ratios measure the firm's use of its assets and control of its expenses to generate an acceptable rate of return.

Liquidity ratios measure the availability of cash to pay debt.

Activity ratios measure how quickly a firm converts non-cash assets to cash assets.

Debt ratios measure the firm's ability to repay long-term debt. (not covered here)

Market ratios measure investor response to owning a company's stock and also the cost of issuing stock (not covered here)
Financial Ratios
Profitability Ratios
Key Ratios
Dangers on the way
UK Bribery Act
Fraud
Cash versus profit
Finance as policemen
Souvenirs of the journey
Key messages
Recap - accounting glossary (3)
Reading and understanding the balance sheet
Over the year, the following transactions occurred –
Financial planning and analysis (FP&A)
Decision support for everyday decisions large and small – e.g. pricing, investment, customer profitability, staff performance, strategic planning.
Financial operations
Processing the everyday financial transactions of a £500m business – invoicing customers (and collecting the cash), paying suppliers, payroll, …
Stakeholder relations
Provision of information to the market, shareholders, banks, suppliers, customers and staff.

Compliance
Compliance with external reporting, taxation and regulatory requirements.

Minimise the impact on you of day-to-day financial transactions, so that you can focus your efforts elsewhere.

Maintain financial processing and reporting systems to be efficient in how we deliver financial outputs to you

Act as the “Gatekeepers” to ensure we share the same accurate, complete, and comparable information.
BUT – at the end of the year, how can she quantify the financial position of her
company, and its financial performance over the year?
Repayment terms on the loan
State of repair of the van / catering kit
Credit status of the unpaid debts
Customers’ perception & future intentions
The mason knows he can sell all the fireplaces for a total of £30k
A third party, desperate for Normandy limestone, offers £40k for the cut stone
Closure of the quarry creates a spike in stone prices; to replace the 5 tonnes of stone would today cost +£10k more
The arrival of a cheaper rival product intensifies price competition; the mason is now unlikely to recover more that £10k from the sale of the cut stone

The mason goes bust; when the business is being wound up, the best offer received for the fireplaces is only £5k
Quarrying, transporting and cutting the limestone generated 2 tonnes of CO2
Anna leaves her job as a chef, and decides to set up her own catering business.

The company purchases a van for £10,000, and catering equipment for £5,000

Business swiftly picks up, and Anna has a busy year winning catering contracts and
delivering her services to the customers.
she employed 2 staff for a year, for £15,000 each
she purchased a stock of foodstuffs for £31,000; £1,000 is unpaid at year end
she spent £7,000 on office costs, and £8,000 on marketing
Sales to customers amount to £70,000; £15,000 of this is uncollected at year end

£2,000 of credit sales were not collected due to the bankruptcy of a customer
At the end of the year, foodstuffs costing £2,000 are held still available for use
Before the year ended, she had paid a rent deposit for £2,000 on a new premises
Quality control in their product
Reliability and quality of the staff
Financial information tells us some important things, but never all of the picture...
Historical cost is different to :
replacement cost
current or future value
public cost
Using historical cost is consistent and reliable – but not always helpful
Working capital is an encumbrance; you need to strike a balance between what is essential and what is simply unproductive.
What have we done with it?
Where did we get it?
What do we have?
Distinction between resources which must be returned (liabilities) and those which are permanent (equity)
Investors, lenders, or retained profits
In's & out's - revenues and costs
eg cash, buildings, machinery - assets
Income is recognised when an increase in future economic benefits has arisen that can be measured reliably

Revenue from the sale of goods is recognised when all of the following are true:
Example Income Statement
Revenue (sales)
Cost of sales
Gross profit (gross margin)

Operating expenses
Sales and marketing
Administrative expenses
Depreciation
Operating profit (EBIT)

Financing expense (interest)
Profit before tax (PBT)

Taxes
Net profit / loss (PAT)
£
£
£


£
£
£
£

£
£

£
£
When do we recognise costs?
Costs are recognised when a decrease in future economic benefits has arisen that can be measured reliably

We attempt to match costs with their associated revenues

Where economic benefits are expected to arise over several accounting periods, and there is only an indirect link between a cost and this revenue stream, we recognise costs using a sensible allocation method

e.g. depreciation, warrantee expense, bad debts
the seller has transferred the risks and rewards of ownership of the goods to the buyer;
the seller does not retain control of the assets;
the amount of revenue can be determined reliably;
it is probable the economic benefits of the sale will transfer to the seller;
the costs incurred or to be incurred to complete the transaction can be measured reliably
Cost of sales; gross profit
A business' cost of sales represents all the principal costs incurred to generate customer sales. What makes up these costs will differ from business to business.
Overheads; operating profit
All other operating costs of the business - often referred to as overheads. Those costs not directly incurred to generate sales.
Non-operating costs; profit after tax
Financing costs and tax are not part of the operation of the business and so are excluded from operating profit
Non-current assets:
Tangible fixed assets
Intangible fixed assets

Current assets:
Inventory (stock)
Receivables (debtors)
Prepayments and accrued income
Cash

Total assets

Share capital
Retained earnings

Current liabilities:
Trade creditors
Other creditors
Accruals

Non current liabilities

Total equity and liabilities
£
£


£
£
£
£

£ total

£
£


£
£
£

£

£ total
Non-current assets:
Tangible fixed assets
Intangible fixed assets

Current assets:
Inventory (stock)
Receivables (debtors)
Prepayments and accrued income
Cash

Total assets

Share capital
Retained earnings

Current liabilities:
Trade creditors
Other creditors
Accruals

Non current liabilities

Total equity and liabilities
£
£


£
£
£
£

£ total

£
£


£
£
£

£

£ total


Non-current assets include fixed assets and other receivables.

Fixed assets are assets which are expected to be used over an extended period of time.

tangible fixed assets :
land & buildings, vehicles, furniture, office equipment, computers, plant & machinery

intangible fixed assets :
brands, trademarks, licences, patents, copyrights, software

other receivables :
long-term debtors, rent deposits
Double-entry accounting
Debits and Credits
Income statement / P&L
Revenue and cost recognition
Cost of sales, gross profit / margin
Operating costs, operating profit / margin
Non-operating costs
Balance sheet
Net assets
Assets, liabilities and equity
Current vs non-current
Fixed and intangible assets
useful economic lives (UEL)
Depreciation, amortisation and impairment
Working capital
Historical cost and net realisable value
Let's return to Feisty Foods -
After a solid start, Anna has a fantastic second year in business.
Sales nearly treble, and she maintains her gross profit margin of 40%. In order to move into the business catering market, she hires extra staff, extra equipment, and buys a second, bigger van.
To fund this, she does have to borrow more, and invest money she inherited during the year, but the business makes a solid profit for the year, and the business now has net assets of £69,000 !
P&L
Sales

Costs of sales
Staff costs
Office costs
Marketing costs
Bad debts

Operating profit
Gross margin %
Operating profit %

BALANCE SHEET
Assets
Van
Equipment
Stock
Trade debtors
Prepayments
Cash

Liabilities
Trade creditors
Loan

Net assets

Share capital
Profit/(loss)

Equity and reserves
YEAR 1
70

(29)
(30)
(7)
(8)
(2)

(6)
41%
(9)%



10
5
2
15
2
11


(1)
(20)

24

30
(6)

24
YEAR 2
193

(80)
(50)
(12)
(15)
(1)

35
41%
18%



28
21
8
33
4
6


(1)
(30)

69

40
29

69













Change

18
16
6
18
2
(5)


-
(10)



10
35
Cashflow
YEAR 2
Profit for the year

non-cash items:
depreciation - vans
depreciation - equipment


Working capital cashflows:
incr debtors
incr stock
incr creditors
incr prepayments

Cash from operations:

Investing cashflows:
New van
New equipment

Financing cashflows:
Incr loan
Shares issued

Net cash movement:

Opening cash
Closing cash

Net cash movement:
YEAR 2

35


3
2
40


(18)
(6)
-
(2)

14


(21)
(18)


10
10

(5)

11
6

(5)
Anna is facing a very common problem - over-trading.

Business success entices her to invest for growth, and maybe lose focus on working capital.

If the business fails to continue growing, if some of her trade debtors avoid paying, or if the loans need repaying, disaster looms...
The benefit of high working capital is that it enables a company to run smoothly. Having ample stock on hand to meet demand, offering customers generous credit terms, paying suppliers early; all these make running a business easier.
But - this comes at a cost...
The disadvantage of high working capital is that costs money to purchase and to maintain, and can deteriorate over time, but is essentially unproductive.
Eg: keeping wider stock ranges will need more space to storage properly, and more time to manage. Generous credit terms will lead to high losses if a customer goes bust.
Imagine a business does £1.2 million of business with a supplier over the year. Invoices are settled on 60 days terms.
The business has just given away £200,000.
But in return the business has given away something valuable, too.
The 1% price discount is valuable - it means a saving of £12,000 pa.
As part of the annual contract renewal negotiations, the supplier offers a 1% price discount, if the business settles invoices immediately by direct debit.
The reduction in credit terms means that instead of permanently holding two month's worth of invoices unpaid, trade creditors are £ nil.
Three reasons why:
inflation - money tomorrow is worth less than today
risk - a loan made today may not be repaid tomorrow
opportunity cost - there are many competing uses for your money.
An educated investor will make judgements about inflation, risk, and competing uses for his money, in deciding what interest rate to demand in return for his funds.
Time is money !
A bank making a business loan will assess the risk of default, the period of repayment, and other competing uses for its cash, in order to set the interest rate it demands.
A company will be funded by a mix of shareholder equity, and external debt - the providers of both these sources of funds will recognise the time value of money.

An equity investor (shareholder) will do exactly the same.

If the business cannot generate profits greater that its weighted average cost of capital, it is in trouble.
Imagine a business does £1.2 million of business with a customer over the year. Normally, invoices are settled by the customer on 60 days terms.
Aware of the importance of working capital, the sales manager wants to reduce the level of outstanding unpaid invoices in his business. He is unable to change the customer credit terms, which are industry-standard. Instead, he decides to off the customer the option of receiving a prompt payment discount. If the customer pays outstanding invoices within 30 days, he will be entitled to a 1.5% discount.
If the customer moves all their transactions into this discount scheme, this will reduce working capital by £100,000. The discount will cost 1.5% x £1.2 million = £18,000.
The cost of this saving in working capital is 18%. It is has the same impact on the business as taking out a £100,000 loan at an interest rate of 18%.
Only in the most desperate of circumstances would this be sensible.
Once you know the weighted average cost of capital for your business, you can perform some simple yet effective evaluations of the present value of future cashflows.
Most business decisions consist of evaluating the risks and rewards of investments over time. For example;
the purchase of a new production machine in the hope of increasing output and reducing training and maintenance costs;
the acquisition of a business competitor in the hope of generating new market opportunities and reducing pricing pressure;
allowing a customer to buy himself out of a future contractual commitment;
terminating an unproductive employee, or hiring an additional member of staff;
Each of these decisions could be modeled in excel, as a series of cash inflows and outflows over time, with a discount factor (the WACC) applied to assess their net present value (NPV) today.

Such work cannot provide a complete answer to the business decision - there will be other non-financial factors to consider - but it will distil the problem, by quantifying the result and by identifying the most critical variables to consider.

If you combine the percentage interest rate on the company's loans, with the percentage return demanded by the company's equity shareholders, weighted for the relative proportions of debt and equity financing, you get the company's weighted average cost of capital (WACC).
In the same way that a loan increases over time with the accumulation of interest (and interest on the interest), we can apply this in reverse to reduce future cash inflows and outflows to a net present value (NPV).
The maths of this is not straight-forward (see separate example) but the application of the WACC to a series of future cashflows will convert these into discounted cash flows (DCF). Add these up and get the NPV. You will find a simple formula in excel which can do this for you.
Alternatively, instead of using a discount rate to identify the NPV, we can reverse this and use a formula to identify the discount rate at which the NPV of the future cashflows is zero - the project's internal rate of return (IRR). Once again, excel can do this for you.
With these tools, we can look at a project over time, and identify either the value of the project in today's terms (the NPV) or the percentage return the project delivers (the IRR).
Cashflow statement
Working capital
The time value of money
WACC
NPV
DCF
IRR
Financial control - protecting the business from -
bad decisions;
bad financial management;
theft;
fraud
Bureaucracy can be frustrating, and sometimes financial processes attract criticism for slowing the business down. We are always open to challenge, but financial control across a large international group requires process, the same as any other area of the business.
This presentation has shown a number of ways in which cash and accounting profits can differ -
in the stone mason example, we saw that assets are valued at cost, not what they are worth or what it would cost to replace them;
in the Feisty Foods example, we saw how easily a profitable business can go bust through failing to manage cash;
looking at revenue and cost recognition, and asset valuation, we saw that accounting profits make assumptions which impact how we record financial transactions.
When evaluating a project, it is important to evaluate cashflows only; non-cash accounting items (most commonly depreciation) are not relevant.
Financial controls exist across the Group to ensure that the financial data we all share can satisfy both our need to make sound financial decisions, and to satisfy our external reporting obligations.
Fraud (internal and external) is an ever-present threat.
Examples I have seen personally (Synergy and elsewhere) -
purchasing frauds (supplier payment details, cheque refunds, illegitimate ordering);
expenses fraud;
financial reporting fraud;
petty cash fraud;
Dishonesty can be contagious; need a culture of honesty, openness and control. In some environments, fraud can prosper (basketball game example)
As a UK publicly listed company, we must be compliant - there are serious financial and criminal sanctions to punish failure
The UK has taken a stand against bribery, for ethical and commercial branding reasons.
A training programme has been delivered across the business, and much of this available on our external website plus on our internal portal.
If you feel you need either general advice on this area, or on a specific issue, there are a number of routes you can follow -
Tim Mason/ Roger Pierce
Whistleblower telephone line (audit committee)
Double-entry accounting
Debits and Credits
Income statement / P&L
Revenue and cost recognition
Cost of sales, gross profit / margin
Operating costs, operating profit / margin
Non-operating costs
Balance sheet
Net assets
Assets, liabilities and equity
Current vs non-current
Fixed and intangible assets
useful economic lives (UEL)
Depreciation, amortisation and impairment
Working capital
Historical cost and net realisable value
Cashflow statement
Working capital
The time value of money
WACC
NPV
DCF
IRR

Key ratios:
ROCE
Asset turn
ROS
Working capital
Cash is King - but cash does not equal profit...
Finance are here to help !
An overview of Financial terms and concepts
Working capital - the Cash Cycle
Working capital - the Cash Cycle
To a large degree the cash cycle will be determined by the industry a company operates within, or the business model which it adopts within that industry..
Within these constraints, there are many opportunities to re-design a business to improve the cash cycle
For example, compare:
Tesco plc - retail
Wimpey plc - housebuilding
A wheat farmer
Alternatively, compare:
Waterstones, with physical locations full of stock
Amazon - warehouses full of stock but lower holdings overall
Amazon Kindle - digital distribution
Worked example - WACC
Feisty Foods Limited has two sources of long-term funding - a loan for £30,000 and Anna's equity investment in the company of £40,000.
Therefore Feisty Food's WACC is (30/70 x 5%) + (40/70 x 15%) = 10.7%
If Feisty Foods is generating profit margins of less than 10.7%, it is not exceeding its cost of capital; this will mean an unhappy shareholder (since the loan will be repaid first), or in the worst case, default on the bank loan.
The business loan carries a low rate of interest of 5% - it was obtained from a generous relative. Anna has invested her own money in the business - to compensate her for the risk of losing her savings, and for missing out on other investments she could have made, she expects to receive a 15% return.
Where do these costs sit in our P&L ?
product packaging
the electricity costs for the admin office
training courses
road tax for the delivery lorry
stock purchased for resale
roof repairs
staff costs
legal fees
interest costs for paying an invoice late
customer discounts
Full transcript