your first step to financial intelligence

Your First

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Financial

Intelligence 9 practical Finance tips that you must know

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Vipin Khandelwal is an entrepreneur, a discoverer, a voracious reader. He is constantly evaluating ways to enable learning in innovative ways. Before entrepreneurship, he was involved in doing business and financial analysis and headed a financial planning services firm.

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YOUR FIRST STEP TO FINANCIAL INTELLIGENCE

Accounting vs Finance 7

The First Principles 8

The 3 Key Financial Statements 11

Income and Expenses 17

Assets and Liabilities 19

Is Profit = Cash? 21

Did you Budget for it? 26

Cost marginally –>Break Even 29

True Cost of Capital 33

TABLE OF CONTENTS:

Index Page No.







What happens when you go to a different country, say China, and you ask a local for directions?

You hear some mumbling in Chinese which you don’t understand and you are left all confused.

INTRODUCTION

To manage business profitably, you need to measure and evaluate your business decisions effectively.

For this you need to know the language. And that language is Finance.

Now you don’t need to be an accountant or possess a famous finance degree to be smart and make sense of all that your CFO talks to you.

You can know these secrets right now and take the first step to build your Financial Intelligence. So, ready. Here we go!

Now imagine you are in a meeting with the CEO and the CFO who are discussing with your division or units performance with you. How do you feel there?

Very similar to the China experience. Right?

6







The job of Accounting is to record these transactions using rules of debits and credits. It is like scorekeeping in a cricket match.

Finance is about using the information and reports produced by accounting to evaluate and review business and use them to make critical decisions.

Accounting or Finance

In a business transaction, there is a transfer of value from one party to another in return for another item of value, money, product or service.

Image credit: Wikimedia

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1







The first principles determine the way we treat our business and financial transactions and resultantly, how they can impact our decisions about business.

There are 2 important principles that you should know:

Materiality and

Matching

The First Principles

8

Source: flickr

2







It almost sounds like match making and in some ways it is so. Just that in business finance, matching refers to incomes and expenses.

All expenses should be matched to the incomes or products that cause them and also to the appropriate period (month, year). This is important because we want to know what was spent to earn that revenue.

Example: If a customer pays in March 2013 but the service is going to be delivered in June 2013, then you should count the sale /revenue only in the year pertaining to June 2013.

Materiality literally means importance. A financial transaction or data could be materially important if it has the capability to influence the decisions one way or the other.

Materiality changes from business to business.

Example: One rupee in one million is not material but one rupee per unit for a million units is highly material.

Principle 2: MATCHING

Principle 1: MATERIALITY

9

Source- dreamstime

Unit







It is usually a period of 12 months for which the accounts are prepared and balanced. At the end of this period, the financial statements are also prepared.

The accounting period is either from January to December or from April to March.

In India, either can be followed but for taxation purposes, the year is April to March.

10

If you cannot measure it, you cannot manage it."“

Accounting Period







3

So, what is the end result of all financial transactions? How do we summarise the business activities in order to make sense of what happened?

The end result for any business organisation are 3 Financial Statements:

The 3 Key Financial Statements

Profit &

Loss Statement

Balance Sheet

Cash Flow

Statement

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3 Key

Financial

Statements







Any business exists to make a profit. And it is important to measure it.

A profit and loss statement helps you know what is the result of the business operations. Note, it is made for a period of time, typically, quarterly, half yearly, yearly.

The two important items in this statement are Incomes and Expenses.

The incomes for the period and all expenses for that same period matched and the net result calculated.

If Revenues exceed expenses, there is a profit.

If Expenses exceed revenues, there is a loss.

Revenue in business parlance is also called “Topline” and Profit/Loss the “Bottomline”.

Incomes – Expenses = Profit / (Loss)

PROFIT AND LOSS STATEMENT

12







13

Source: Infoedge.co.in

Topline

Bottomline

Operating Income

SAMPLE P & L – Infoedge India







BALANCE SHEET

If you have to look at your business and evaluate its financial strength, how would you do it? How would you know where the business stands today?

Through a Balance Sheet! Like its name it provides the balances of your various accounts “as on a particular date or point of time”. Read the emphasis.

Essentially, the balance sheet shows what the business owes (liabilities) to others and what it owns (assets).

It is also called the Statement of Sources and Application of Funds as it tells you from where all the business obtained funds/capital, the sources and how did it use those funds or the application.

The balance sheet helps you understand and analyseimportant financial information about a business. (More about that in the next guide)

14







Net worth = Total Assets – All External Liabilities

What is the other way you could calculate Net Worth?

15

Infoedge India

External liabilities







Cash is the lifeblood of business.

Ultimately, in any business activity, we sell a product or service and receive cash payment against it or we hire or buy a product or service and pay cash for its use.

The Cash Flow statement therefore is a summary of how cash was received and in what ways it was sent out.

It is an important statement as it shows how and when cash resources will be available to carry out business operations.

A Cash Flow statement typically shows cash flow changes from 3 types of activities.

CASH FLOW STATEMENT

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Cash from OperationThe day to day operations of the business inclbuying of raw material, sales, salaries, etc.

Cash from InvestmentBuying or selling of assets, Loans, investment in stock markets, etc.

Cash from FinancingRaising fresh money through stock markets or loans, payment of dividends, etc.







So, we now know that a Profit and Loss Account summarisesthe Incomes and Expenses so that we can figure out if the business made a profit or a loss. But how do we know which item would fall under income or expense and how should it be treated?

Income and Expenses

An income is also called revenue,

sales, turnover and is a result of the normal business activity wherein

products or services are provided in

return for income.An expense is an outflow of money in return for a product or service. It is also known as “cost”.

Count expenses which contribute to their economic usefulness within the period of measurement (typically a year).

Count incomes against which value has been delivered within the period, not advances.

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4







If you recall the matching principle, it says that we should match incomes and expenses to each other as also the period to which they actually belong.

This results in what we are discussing here, Accrual.

Put simply, Accrual is “an act or process of accumulating” (thefreedictionary.com).

In the world of finance, accrual reflects a recognition of an income or expense even before actual cash has been received or paid out. In other words, they are non-cash.

World over, accounting is mostly done on the basis of accrual.

So, your vendor might send you a bill which has to be paid after 30 days. In that case, cash will leave the business only after 30 days and hence it is an accrued expense. It has become due but not paid.

Similarly, you might make a sale for which the cash will actually come in after 60 days. You record the transaction and it becomes an accrued income. It has become due but not received.

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The Concept of Accrual







In the Balance sheet section, you read that Assets are “what the business owns “ and Liabilities are “what the business owes”. So, how do we know what is an asset or a liability?

Assets and Liabilities

Asset

An Asset is an outlay, like a computer equipment, which has economic usefulness in business operations over several years.

Important points about Assets

Assets can be Fixed assets (Plant & machinery, Computers, Land) and Current assets (Inventory, Stocks, Cash, Goods sold on credit or accounts receivables)

Current Assets are those the value of which is exhausted within 12 months

Assets can also be tangible (Owned Office space) or intangible (patents); movable (Cash) and immovable (Land)

19

5







LiabilityA Liability is an obligation which provides economic resources for running the business operations like buying of equipment.

Important points about Liabilities

Liabilities can be long term (like bank loans, long term deposits) and short term (working capital borrowings, accrued expenses, creditors who sold goods to us on credit, advance income).

Current Liabilities are those which have to be repaid within 12 months (creditors, expenses due but not paid)

Shareholders money (share capital, owners equity) is also shown on the liabilities side since it is the amount that the business has to pay back to the owners/shareholders.

Required to run day to day business operations. = Current Assets – CurrentLiabilities

Working Capital

20

Note:







So, you might wonder that for all the sales that you have brought into the company, when it is time for the bonus, you are told that there is no cash to pay. Why?

Because you got the sale, not the cash! You sold the products on 60 days credit. Means, your customer needs to pay only after 60 days. So the real cash arrives after 60 days. And that’s when you get your share of bonus.

Is Profit = Cash?

PROFIT

21

Now as per the accrual rule, the sale is done and recorded so it increases topline and bottomline, but not CASH.

Note:

6







The shareholders might feel cheated thinking that though the company has made record profits, why it is not declaring any dividends?

Can you figure out why would that be the case?

Let us see some of the reasons

Sales happening on credit - Income up, not cash

Advance payments made for equipment / software

________________________________(fill in a reason)

22

There are several companies who

show huge profits but there is no cash

with them.







Similarly, there are companies who may have lot of cash with them but they are not profitable?

Depreciation or amortisation of assets charged to income, a non cash expense. Hence cash is available but there would be low or no profit.

A company which has raised capital (equity or debt) and hence has cash, but revenues are lower than expenses and hence no profit

________________________________(fill in a reason)

23







Typically assets offer useful value over a period of time. To ensure that we match these uses of value with the right period, we depreciate assets. Which means that for every period the value of the usage is deducted.

For example,

if you have bought a computer for 45,000 and it is going to be useful for 3 years, then you would depreciate it by 15,000 (45,000 / 3 yrs) every year.

Remember, depreciation is a non cash expense, means there is no outflow of cash. This treatment is carried out in the Profit and Loss statement under the expenses side. The balance value of the asset (post depreciation) is shown under Assets in the Balance Sheet.

“

24

Depreciation literally means by which something reduces in value.

As per wikipedia,

depreciation refers to

The allocation of the cost of the assets to periods

in which the assets are used (depreciation with

the matching principle)”

The Concept of Depreciation







While depreciation is used in reference to physical or tangible assets, amortisation is used for intangible ones like patents.

25

EBITDA

Also, Operating profit or profit from core operations or operational profitability

EBITDA = Income (minus) all expenses except Interest, Tax, Depreciation /Amortisation

Depreciation vs Amortisation







You are the head of the department. And you finally come across this fabulous technology that will help the company achieve its objective.

You rush to the CFO and talk to her about getting it.

She listens to you patiently and asks, “Did you budget for it?”

All your hopes suddenly fall flat on the ground. You had not provided for this new technology in the budget.

Did you budget for it?

26

7







A budget is a very important document for you and for your organisation.

It helps to put quantitative estimates to a set of intentions

It helps in channelising the resources available to the organisation in the right direction towards achievement of desired objectives

When compared with actual results, it helps to evaluate and analyse the performance of the division/unit/organisation

When you perform better than the budgets, you get rewarded.

Typically budgets are prepared on a yearly basis.

Budgets are a bottom up exercise, where every department (marketing, production, sales, IT HR) makes its budget and sends it to the central business planning department which collates all of them to create a company wide budget.

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28

Important points to keep in mind while making a budget to save pain in the future

Ensure that you understand the business objectives to be achieved with respect to your department or business unit. You will be able to defend your budget only in relation to the business objectives and strategy.

Start to prepare in advance. Generously use inputs from the team.

Ensure that you plan for all possible expenses, fixed and variable. And after that, include a contingency reserve to provide for unexpected expenses that might come up including new initiatives.

Be realistic in estimating income.

Be actively involved in making your budget. If someone else makes your budget, it will be their budget and not yours.

Review your budget periodically. If there are significant changes in the assumptions or market conditions from the time you made your budget, you should adjust it to reflect the current realities.







The Cost of doing nothing

is everything.”

It is a given that there is a cost to produce and deliver a product or service.

The way we structure our costs can significantly impact our business results.

Let’s look briefly at the role of various costs.

Cost Marginally - Break Even

“

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8







Costs are primarily of two types

Fixed CostsThese costs are incurred irrespective of whether the business has any running operations or not.

Examples: Rent of office, permanent employees and related costs.

Variable CostsCosts incurred as a result of business operations. As business operations vary in size and scale, these costs vary too. You got the word, vary. Right! Examples: Raw materials, sales commission and contract employees.

Fixed costs also do not change with the change in the output and hence put pressure on the business to perform specially in not so good market scenarios.

Variable costs change with the change in output. They allow for suitable adjustments based on business climate and market demand.

Manufacturing businesses tend to have a high fixed cost structure. Think power plants.

Service businesses are lot more flexible with respect to cost. Think Consultancy.

30







B E Point is = Fixed Costs / Contribution Margin

Contribution Margin

Also, Marginal profit per unit of sale

= Sales Price - Variable Cost

If this is positive, it makes sense to take that bulk order at a discounted price.

Break Even

MarginThe point of business operations at which incomes are equal to costs is known as the break even point. It is useful in evaluating whether a new project makes sense or not.

31







32

As Henry Ford once put it,

If you need a machine and don't buy it, then you will ultimately find that you have paid for it and don't have it.' Thinking on a marginal basis can be very, very dangerous."

- Clayton Christensen

“







When you take a business loan from the bank at 15%, you know the cost of the loan, that is, 15% per year.

Now to be profitable, you have to deploy this money so as to be able to earn more than 15%.

For example, if you earn 20%, then you make a profit of 5% or a margin of 33% (5% / 15%).

Remember: A business exists to make a profit.

True Cost of Capital

33

9







There are various forms and structure of equity and debt but for the purpose of this ebook, we will stick to the simpler definition.

On the previous page, we went over an example where you borrowed debt at a defined fixed rate of interest.

The question now is “What is the cost of owner’s capital or equity”?

Now if you are thinking there is no cost to equity (since there are no fixed returns), I am sorry to break the bad news. You are mistaken !

Debtis money borrowed from third parties like banks, individuals and other financing institutions. The returns are fixed and assured to the one who provides debt/loans.

Equityalso known as the owner’s money, represents of the ownership in the business. It is a risk capital in the sense that there is no fixed return and shares profit and/or losses in the business.

34

Businesses raise money in the form of equity and debt.







It is important to ascertain this for it will help us understand what returns do we need to target to have a profitable business.

How do we do it? Now think for a while, that the owner has a choice to lend her money at a fixed rate of interest than give it to the business.

Assuming that the owner is able to give away a loan at 15% (same as our debt example).

To this we would have to add a premium for the fact that the owner is taking a risk. Why? She is not going to get fixed returns and so she needs to be compensated for this uncertainty.

For example sake again, the cost of equity capital would be, say 20% (a 5% additional return for the risk premium).

Now assuming 50% of the money comes through debt and 50% through owner’s equity, the true cost of capital would be (50% x 15%) + (50% x 20%) = 17.5% (weighted cost)

The business will have to earn more than 17.5% to be truly profitable. Else the owner is better off giving a loan for a fixed return.

35

Equity has a cost, definitely.







ROI is used as one of the tools (along with payback period and Internal Rate of Return) to evaluate investment opportunities.

Scarce organisational resources are directed towards opportunities which have the potential to provide the maximum return on investment.

So, next time when you are proposing an investment to the company, read CFO, ensure that the ROI calculation is in place.

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Can you relate the concept of “true cost of capital” to “Return on Investment (ROI)” concept?







If you really want to impress your CFO, start talking metrics.”“

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