The subject and language of finance are often viewed as difficult and bewildering especially to those managers not schooled in the dark art of accountancy. They need not be.
It is imperative to understand the subject and language of finance if managers are to communicate with authority within a business. After all, finance is the language used in the board room. Without a grasp of some basic financial concepts, it can be easy to take what appears to be a wise decision, but one that nevertheless is ill informed and one that adversely affects the financial health of the business. These unintentional own goals happen every day in every business and at every level. Own goals are usually career limiting.
Those not comfortable with finance and the appropriate use of its language invariably find themselves struggling to operate as effectively as they could. In contrast, those that do:
Whilst finance is not rocket science, it is nevertheless a challenge for many managers especially those who perceive themselves not to be good at maths. However, as with any life skill, finance can be learned. All it takes is a willingness to try and a good tutor.
At a fundamental level, there are two types of accounting information:
Financial accounts are geared towards external users of accounting information (i.e. investors, industry commentators and government agencies), whereas management accounts are geared towards internal users of accounting information.
Companies that are incorporated under the Companies Act 1989 are required by law to prepare and publish financial accounts. Financial accounts describe the performance of a business as a whole (i.e. at the level of the legal entity), rather than analysing the component parts of a company. Financial accounts are prepared for a specific period of time, typically a year. The specific period is referred to as the 'trading period', and the period end date as the 'balance sheet date'. Financial accounts have three key statements:
Financial accounts are historic, and most of the information that is provided, is financial in nature.
In contrast, management accounts are used to help management record, plan and control the activities of a business and to assist in the decision-making and decision-taking processes. They can be prepared for any period of time such as daily, weekly, monthly or yearly. Reports can be both forward looking or historic or a mix of both. Whilst there is no legal requirement to prepare management accounts, few businesses could expect to survive or thrive without them. Management accounts are prepared to meet the specific needs of the user and typically include both financial and non financial information. There are an infinite number of potential management reports a business could choose and examples include:
A company's financial accounts are mostly used by people outside the company. They can be used to analyse its performance over time, to compare its performance with other companies operating in the same industry and help actual and potential investors determine whether the company is an attractive investment prospect.
When analysing a company's financial accounts, there are numerous possibilities. These include:
When analysing or comparing companies, it is important to compare apples with apples and remove distortions such as depreciation, amortisation of goodwill and non-reoccurring one-off costs or gains (known as exceptional items). Furthermore, it is important to remember that balance sheets are prepared on the basis of historic costs rather than current market valuations. This distinction can be the source of considerable variance between companies. For example, one company might own the land of a site it purchased 100 years ago whereas another might own the land of a site it purchased 5 years ago. At market values, the 100 year old site might be worth more than the 5 year old site, but on the balance sheet, the 5 year old site might have a significantly higher net book value (NBV) than the 100 year old site. Likewise, another company, may not own a site at all, instead choosing to lease one. If these three companies were competitors, any comparison of return on sales % (i.e. profit after tax divided by revenue) or return on capital employed % (i.e. profit after tax divided by net book value of capital employed), both of which are commonly used comparatives, would be prone to considerable misinterpretation. Nevertheless, despite the difficulties that arise due to technical accounting differences, it is still possible to gain deep insights into the relative performance and strengths and weaknesses of competing companies.
One such approach is to undertake a DuPont pyramid of ratios analysis, named after the DuPont Corporation which pioneered this form of performance analysis in the 1920's. This type of analysis is best done over a period of time, say 5 years, and will often unlock many important insights that would otherwise remain buried deep within the accounts.
The pyramid of ratio's can also be used to analyse the performance of different business units within the same company.
Other commonly used comparative measures of company performance include:
When evaluating the financial health of a company, there are also a number of other commonly used ratios to access the liquidity and the solvency of a company. These are:
Liquidity is directly related to cash flows and accesses whether a company has sufficient cash to meet its working capital requirements. In contrast, solvency is a measure of a company's ability to meet its financial obligations as they become due, whether they are suppliers' invoices, tax payments, dividend payments or interest or loan repayments. To illustrate the difference between liquidity and solvency, consider an individual who has £1m invested in shares, but not enough cash to buy a train ticket. The individual is solvent, but far from being liquid. Many a solvent company has gone out of business due to it becoming illiquid and running out of cash. Good cash flow management is therefore a vital competence for every company and every business unit.
Companies make use of several different measures of profit, and each company will have its own preference. It is important to understand this preference, because as the well-known adage goes, 'you get what you measure'. This is especially the case when bonuses are contingent on achieving a particular year end profit target. Commonly used profit measures include:
Cash and profit are not the same. A loss making company can survive as long as it has cash. A profitable company cannot survive without cash. In business, cash is king.
A profit occurs whenever revenue exceeds expenses within a period. However,
Furthermore, the profit and loss account is drawn up on an accruals basis with revenues being recorded when they are earned (i.e. the invoice date) and costs recorded when they are incurred. The actual receipts and payments of cash may be several weeks or months after the invoice dates depending on the terms of business negotiated with customers and suppliers. Similarly, corporation tax for the trading period does not usually become due for payment until 9 months after the period end date.
Cash flow is the life blood of all companies and it is important for every business to understand and actively manage its cash flows. A company's cash flow is made up of three main constituents:
Free cash flow is the cash that is free (i.e. available) to the investors who are the providers of a company's finance. Free cash flow is the cash flow from its operating activities less the cash flow from its investing activities.
It is also important that a company understands and actively manages its working capital cycle. This is because company's that go out of business usually do so because they run out of cash. Even a highly profitable company will go bust if it runs out of cash.
Working capital is the cash needed to finance the day to day operations of the business and to:
The working capital cycle or cash cycle is measured in days. It is calculated in three parts:
The cash cycle is the calculated by adding the number of receivables (debtors) days to the number of inventory and work in progress days and then subtracting the number of payables (creditors) days. The larger the number of days in the cash cycle, the more cash that is 'tied-up' financing a company's day to day operations. Companies generally aim to shorten their cash cycle to free up cash for other uses i.e. to finance additional investment or to reduce borrowings. The cash cycle can be reduced by:
More important than making a profit, is the ability of a company to convert profit into cash. This requires a business to actively manage its working capital. This is especially the case when undergoing periods of rapid expansion or contraction, both of which can put a severe strain on a company's management and cash flow.
Different industries adopt different methods for determining the costs of their products and services. Commonly used costing methodologies include:
Whichever costing method is used, it is important that managers understand:
Value engineering is the process by which a company analyses the individual components of cost within a product or service in order to determine whether it can re-engineer the product's cost base in order to improve the value to the customer.
The start point for value engineering is to understand the relationship between each individual cost component and the value to the customer associated with each individual component of cost. Consider the example of Comfort fabric conditioner.
The components of cost divide into four segments:
The win win from value engineering is to increase the customer perceived value whilst reducing the total cost.
Whilst often overlooked, pricing is the single most important part of value engineering. This is because:
Whilst pricing is a business critical decision, few managers are skilled at pricing. This is hardly surprising given that pricing is a difficult decision involving complex inter-relationships between price, margin and volume. In the worst case, this can mean pricing is:
Neither situation is satisfactory as it results in a company failing to capture the true economic value of its products and services and consequently the company underperforms.
When considering the pricing decision, it is critical to appreciate that customers buy benefits rather than products or services (i.e. a hole in the wall rather than a drill) and that they buy on value not price per se. Furthermore, not all customers are homogeneous. This means different customers will value the same product or service differently and are therefore prepared to pay different prices.
Whenever the customer value increases, a company will gain market share and whenever the customer value diminishes, it will lose market share. In order to improve the value to the customer, a company can do one of two things. It can:
Customers always buy the product or service they perceive to represent best value. The customer's perception of value is therefore always relative to the competition.
Adding more or new benefits to a product or service enables a company to increase its prices providing these additional benefits are relevant and motivating to the target market customer. Adding benefits need not however necessarily lead to an increase in costs if value engineering is executed effectively.
There are five fundamental pricing relationships to understand. These are:
There are a number of commonly used pricing strategies. These include;
Many managers and directors get confused by depreciation. In everyday language, the term is used to mean a reduction in the market value or worth of an asset. For example, a car that is said to have depreciated by £2,000 in a year, is commonly understood to be worth £2,000 less today than if it were sold a year earlier. Unfortunately, this is not what an accountant means by the term depreciation.
When an asset is purchased by a company, the accountants make an estimate for the asset's useful life. If it were a computer, the useful life might be three years, whereas if the asset were a new production line, the useful life might be deemed to be 10 years. A company is free to choose whatever depreciation policy it prefers and consequently, different companies purchasing identical assets will often have different depreciation policies. Furthermore, the useful life as defined by the accountants may or may not reflect the actual life of an asset.
If an asset were purchased for £10m and its useful life deemed to be 10 years, most companies would depreciate the asset on a straight-line basis over the 10 years i.e. the net book value (NBV) of the asset on the balance sheet would be reduced by £1m per annum for each of the 10 years and a depreciation cost of £1m per annum would be charged to the profit and loss for each of the 10 years. After 5 years, the NBV of the asset would be £5m and after 10 years, the NBV of the asset would be £0m. However, it is important to understand that the NBV is an accounting book value and one that does not necessarily reflect the market value of the asset, which may be more or less than the NBV at any point in time. Furthermore, whilst a depreciation cost of £1m per annum is being charged to the profit and loss for 10 successive years, this does not mean £1m cash leaves the company in each of those 10 years. This is because the £10m cost of the asset would have been paid to the supplier or suppliers as per the terms agreed when purchasing the asset.
When a company acquires another company, the difference between the purchase price and the NBV of the acquired company is called goodwill. Goodwill is included as an intangible asset on the balance sheet and can be considered to reflect the value of the intangible assets acquired. These intangible assets might include brands, trade marks, patents, intellectual property and the value of customer relationships, all of which are not easy and subjective to value other than at times of an acquisition. When a company makes an acquisition and pays a premium over the NBV of the company, this premium or goodwill, is normally written off on a straight-line basis over the expected useful life. This is normally not more than 20 years. For example, if the goodwill on acquisition were £60m and written off over 20 years, the NBV of goodwill on the balance sheet would be reduced by £3m for each of the next 20 years and an amortisation of goodwill cost of £3m would be charged to the profit and loss for each of the next 20 years. As with depreciation, amortisation of goodwill is a subjective, non cash cost. Indeed, it could be argued that when managed effectively, the value of the purchased intangible assets could increase substantially rather diminish. Thus, it is important to remember what the accounts represent and what they do not represent.
One of the most important decisions for any business is investment of which there are two general types:
When considering an investment decision, a company will undertake an investment appraisal which will consider:
Most companies start by estimating the impact of the investment on current and future cash flows and compare the with investment situation to a without investment base case. The incremental cash flows associated with the investment (i.e. the cash flows over and above the base case) are discounted by the company's average weighted cost of capital (WACC*) to produce a single figure that values the cash flows in today's money. This is called the net present value (NPV) of the investment. If the NPV is positive, the project will yield a return greater than the company's WACC and will therefore create value, whereas if the NPV is negative, the investment would yield less than WACC and thereby destroy value. As with any set of estimates, garbage in generates garbage out. Consequently, any robust investment appraisal will also assess the impact of changes in assumptions on the projected cash flows and thus the NPV associated with the investment. This is called sensitivity analysis.
In addition, a company will also calculate the internal rate of return (IRR) and payback period associated with the investment. The internal rate of return is the discount rate that would result in a zero NPV, and the higher the IRR, the more attractive the investment. Payback on an investment is the period of time (projected or actual) that it takes for the incremental discounted cash flows associated with the investment to payback the initial capital investment. If the initial investment where £10m, and payback achieved in year 3, more than £10m of incremental cash would need to be generated from the investment in order to achieve payback. This is because cash today is worth less than the same amount of cash yesterday and more than the same amount of cash tomorrow.
Most companies are often confronted with a choice of investment projects and only limited funds available. In such circumstances, the company has to choose between competing projects. Over and above conducting an investment appraisal on each individual project, a company can also compare the NPV of each project per £1m invested. The resulting measure is helpful for assessing which value creating investment (i.e. those with a NPV greater than zero, or an IRR greater than the WACC) is the most efficient. The amount of capital invested is also a measure of risk and thus a company may prefer a portfolio of several lower yielding, 'less risky' investment projects than one more attractive, 'higher risk' big roll of the dice. Efficiency investments are generally considered to be lower risk than growth investments. This is because there are more knowns with the former and consequently, future cash flow projections should be more robust. Nevertheless, empirical studies show that growth investments have a much greater effect on creating value than efficiency investments.
Furthermore, when considering investments decisions, it is also important to remember that not all investments are capitalised on the balance sheet. For example, investments in:
are usually charged to the profit and loss account rather than capitalised on the balance sheet. This is because most accountants consider these costs to be margin reducing expenses rather than investments per se. Nevertheless, irrespective of the accounting treatment, an investment is an investment and cash is cash. All investments of cash need rigorous appraisal, and not just those capitalised on the balance sheet by the accountants.
*When investors entrust their money to a company, they expect to receive a return by way of compensation. For lenders, compensation is in the form of interest and for shareholders, compensation is in the form of dividends and share price appreciation. The minimum rate of return required by investors is called the 'opportunity cost of capital' and represents the rate of return foregone by not investing in an alternative investment with the same level of risk. The weighted average cost of capital (WACC) for a company is the opportunity cost of capital for each investor type (i.e. lenders and shareholders) weighted by the amount of funds provided by each investor type. The WACC represents the minimum return on investment required to create value.
In economics, the value of a company is known as its enterprise value and is the net present value (NPV) of the company's future free cash flows discounted by its weighted average opportunity cost of capital (WACC). Value is said to be created whenever a company's enterprise value increases and value is said to be destroyed whenever the enterprise value of the company decreases. Investments with a positive NPV, or an IRR greater than a company's WACC, create value whereas investments with a negative NPV, or an IRR less than a company's WACC, destroy value.
It is, however, incorrect to conclude that a company that increases its profit in any given year has created value, or that a company where profitability has decreased, has destroyed value. This is because profit in any given year is a single period measure whereas the enterprise value of a company is determined by its future free cash flow performance. Indeed, a company that increases its profitability in one year may in fact be destroying value. Such a situation could arise if the company were either making insufficient investments to retain its competitiveness or has made a misguided value destroying investment decision. Similarly, a company where profitability decreased in any given year, may be creating value by virtue of it improving its ability to compete or because it has made a number of value creating investment decisions whose financial benefits have yet to materialise in the current year's profit and loss account.
Accounting profit suffers from several limitations. These include:
Economic Profit (EP), sometimes mistakenly called Economic Value Added (EVA), is a measure of profitability that has become increasingly popular in the last 10-20 years, especially amongst complex multi-divisional or multi-national companies with stock market listings. The great beauty of EP is that it produces a single number which captures elements from both the profit and loss account and the balance sheet.
EP measures the surplus earned by a business after the deduction of all its operating costs including its liability to pay corporation tax and the opportunity cost of using investor's capital employed in the company.
Consider a company with a profit before tax of £10m, capital employed of £25m and a WACC of 12%. At its simplest, economic profit is calculated as follows:
|Profit before tax||£10.0m|
|Corporation tax liability (£10m x 26% tax rate)||(£2.6m)|
|Charge on capital employed **||(£3.0m)|
**Capital employed x WACC in this example £25m x 12%
EP often provides powerful insights. Some business units and activities which have previously been thought to be good performers generating healthy accounting profits can sometimes be shown to be 'economically unprofitable' once the costs of tax and capital employed are taken into account. Nevertheless, reading too much into a single year's EP performance can be misleading. As with traditional accounting measures, EP is a single period measure, and thus susceptible to manipulation by management. For example, a positive EP may have been achieved by cutting back on research and development, training and or marketing expenditure, all of which are likely to impact adversely upon a company's enterprise value by impairing its future economic performance. Likewise, a negative EP may be the result of a significant capital investment in preceding years, which even if projected to be value creative, will have an adverse effect on near-term EP. It is therefore important to consider the future flows of EPs over time rather than EP in any one single period.
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