Financial Intelligence for Leaders

7/18/2019 Financial Intelligence for Leaders

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FinancialIntelligence

for

Leaders9 practical

Finance ideasthat you

must know

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Vipin Khandelwal is anentrepreneur, a discoverer, a

voracious reader. He isconstantly evaluating ways toenable learning in innovativeways.

Previously, he was involved indoing business and financialanalysis and headed afinancial planning services firm.

Follow him on Twitter @vipinkh

AUTHOR

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YOUR FIRST STEP TO FINANCIAL INTELLIGENC

One of the key reasons a largenumber of organisations and theirleaders fail is their inability tounderstand and question thefinancial numbers?

They fail to understand a key aspecton which their organisationsperformance is measured.

INTRODUCTION

You cannot escape this fact that as a Leader you need tolearn the language. And that language is ofNumbers, of Finance.

Now to learn and talk this language, you don’t need to bean accountant or possess one of the famous finance

degrees.

You can know these secrets right now and add FinancialIntelligence as one of your key tools to enable you tonavigate.So, ready. Here we go!

It’s true for leaders of any organisation, for profit ones as wellas non profit ones. If you are an entrepreneur, it is all themore.









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.









The job of Accounting is to record these transactions usingrules of debits and credits. It is like scorekeeping in a cricketmatch.

Finance is about using the information and reportsproduced by accounting to evaluate and review business anduse them to make critical decisions.

Accounting or Finance

In a business transaction,there is a transfer of valuefrom one party to another inreturn for another item ofvalue, money, product or

service.

Image credit: Wikimedia

7

1









The first principles determine the way we treat ourbusiness 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 isso. Just that in business finance, matching refers to incomesand expenses.

All expenses should be matched to the incomes or productsthat cause them and also to the appropriate period (month,

year). This is important because we want to knowwhat was spent to earn that revenue.

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

Materiality literally meansimportance. A financial transactionor data could be materiallyimportant if it has the capability toinfluence the decisions one way orthe other.

Materiality changes from business tobusiness.

Example: One rupee inone million is not materialbut one rupee per unit fora million units is highlymaterial.

Principle 2: MATCHING

Principle 1: MATERIALITY

9

Source- dreamstime

Unit









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

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

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

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If you cannot measure it,

you cannot manage it." “

Accounting Period









3

So, what is the end result of all financialtransactions? How do we summarise the businessactivities in order to make sense of what happened?

The end result for any business organisation are 3 FinancialStatements:

The 3 Key Financial Statements

Profit &Loss

Statement

Balance

Sheet

Cash FlowStatement

11

3 KeyFinancial

Statements









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

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

The two important items in this statement are Incomes andExpenses.

The incomes for the period and all expenses for that sameperiod 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 ” andProfit/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 itsfinancial strength, how would you do it? How would youknow where the business stands today?

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

Essentially, the balance sheet shows what the businessowes (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 thebusiness obtained funds/capital, the sources and how did ituse those funds or the application.

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

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Net worth = Total Assets – All External Liabilities

What is the other way you could calculate Net Worth?

15

Infoedge India

Externalliabilities









Cash is the lifeblood of business.Ultimately, in any business activity, we sell a product orservice and receive cash payment against it or we hire orbuy 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 cashresources 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 incl

buying of raw

material, sales,

salaries, etc.

Cash from

Investment

Buying or selling ofassets, Loans,

investment in stock

markets, etc.

Cash from

Financing

Raising freshmoney 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 thebusiness made a profit or a loss. But how do we know whichitem would fall under income or expense and how should itbe treated?

Income and Expenses

An income is alsocalled revenue,

sales, turnover andis a result of thenormal business

activity whereinproducts or services

are provided inreturn for income.

An expense is anoutflow of moneyin return for a

product orservice. It is alsoknown as “cost ”.

Count expenses whichcontribute to theireconomic usefulness withinthe period of measurement(typically a year ).

Count incomes againstwhich value has beendelivered within theperiod, not advances.

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4









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

This results in what we are discussing here, Accrual.

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

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

World over, accounting is mostly done on the basis ofaccrual.

So, your vendor might sendyou a bill which has to be

paid after 30 days. In thatcase, cash will leave thebusiness only after 30 daysand hence it is an accruedexpense. It has becomedue but not paid.

Similarly, you might make asale for which the cash will

actually come in after 60days. You record thetransaction and it becomesan accrued income. Ithas become due but notreceived.

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The Concept of Accrual









In the Balance sheet section, you read that Assets are “whatthe business owns “ and Liabilities are “what the businessowes ”. 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 economicusefulness in business operations overseveral 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) orintangible (patents); movable (Cash) and immovable(Land)

19

5









Liability A Liability is an obligation whichprovides economic resources forrunning the business operations likebuying of equipment.

Important points about Liabilities

Liabilities can be long term (like bank loans, longterm deposits) and short term (working capitalborrowings, accrued expenses, creditors who soldgoods 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) isalso shown on the liabilities side since it is the amountthat the business has to pay back to theowners/shareholders.

Required to run day to day businessoperations.= Current Assets – Current Liabilities

Working

Capital

20

Note:









So, you might wonder that for all the sales that you havebrought into the company, when it is time for the bonus, youare 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 onlyafter 60 days. So the real cash arrives after 60 days. Andthat’s when you get your share of bonus.

Is Profit = Cash?

PROFIT

21

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

Note:

6









The shareholders might feel cheated thinking that though thecompany has made record profits, why it is not declaring anydividends?

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 severalcompanies whoshow huge profits

but there is no cash

with them.









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

Depreciation or amortisation of assets charged toincome, a non cash expense. Hence cash is available butthere would be low or no profit.

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

________________________________(fill in a reason )

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Typically assets offer useful value over a period of time. Toensure that we match these uses of value with the right

period, we depreciate assets. Which means that for everyperiod the value of the usage is deducted.

For example,

if you have bought a computer for 45,000 and it is goingto be useful for 3 years, then you would depreciate it by15,000 (45,000 / 3 yrs) every year.

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

“

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Depreciation literally means by which somethingreduces in value.

As per wikipedia,

depreciation refers to

The allocation of the cost of the assets to periodsin which the assets are used (depreciation with

the matching principle)”

The Concept of Depreciation









While depreciation isused in reference tophysical or tangible

assets, amortisation isused for intangible oneslike patents.

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EBITDA

Also, Operating profit or profit from core

operations or operational profitabilityEBITDA = Income (minus) all expensesexcept Interest, Tax, Depreciation/ Amortisation

Depreciation vs Amortisation









You are the head of the department. And you finally comeacross this fabulous technology that will help the companyachieve 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 notprovided for this new technology in the budget.

Did you budget for it?

26

7









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

It helps to put quantitative estimates to a set ofintentions

It helps in channelising the resources available to theorganisation in the right direction towards achievement of

desired objectives

When compared with actual results, it helps to evaluateand analyse the performance of thedivision/unit/organisation

When you perform better than the budgets, you getrewarded.

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 businessplanning department which collates all of them tocreate a company wide budget.

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Important points to keep in mind while

making a budget to save pain in the future

Ensure that you understand the businessobjectives to be achieved with respect to yourdepartment or business unit. You will be able to defendyour budget only in relation to the business objectives

and strategy.Start to prepare in advance. Generously use inputsfrom the team.

Ensure that you plan for all possible expenses,fixed and variable. And after that, include a

contingency reserve to provide for unexpectedexpenses that might come up including newinitiatives.

Be realistic in estimating income.

Be actively involved in making your budget. If

someone else makes your budget, it will be theirbudget and not yours.

Review your budget periodically. If there aresignificant changes in the assumptions or marketconditions from the time you made your budget, youshould adjust it to reflect the current realities.









The Cost of doing nothingis everything.”

It is a given that there is a cost to produce and deliver aproduct 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 incurredirrespective of whetherthe business has anyrunning operations ornot.

Examples : Rent of office,permanent employeesand related costs.

Variable CostsCosts incurred as a resultof business operations. As business operationsvary in size and scale,these costs vary too. You

got the word, vary.Right! Examples : Rawmaterials, salescommission and contractemployees.

Fixed costs also do notchange with the change inthe output and hence putpressure on the business toperform specially in not sogood market scenarios.

Variable costs change withthe change in output. Theyallow for suitableadjustments based onbusiness climate and marketdemand.

Manufacturing businessestend to have a high fixedcost structure. Think powerplants.

Service businesses are lotmore flexible with respect tocost. Think Consultancy.

30









B E Point is = Fixed Costs / Contribution Margin

ContributionMargin

Also, Marginal profit per unit of sale

= Sales Price - Variable Cost

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

BreakEven

MarginThe point of business operations at whichincomes are equal to costs is known as

the break even point. It is useful inevaluating whether a new project makessense or not.

31









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As Henry Ford once put it,

If you need a machine and don'tbuy it, then you will ultimatelyfind that you have paid for it anddon't have it.' Thinking on amarginal basis can be very, very

dangerous."

- Clayton Christensen

“









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

Now to be profitable, you have to deploy this money so as tobe 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 forthe purpose of this ebook, we will stick to the simpler definition.

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

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

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

Debtis money borrowed from third parties likebanks, individuals and other financinginstitutions. The returns are fixed andassured to the one who providesdebt/loans.

Equityalso known as the owner’s money,represents of the ownership in thebusiness. It is a risk capital in the sensethat 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 understandwhat returns do we need to target to have a profitablebusiness.

How do we do it? Now think for a while, that the owner hasa choice to lend her money at a fixed rate of interest than giveit 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 theowner is taking a risk. Why? She is not going to get fixedreturns and so she needs to be compensated for thisuncertainty.

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 wouldbe (50% x 15%) + (50% x 20%) = 17.5% (weighted cost )

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

35

Equity has a cost, definitely.









ROI is used as one of the tools (along with payback periodand Internal Rate of Return) to evaluate investmentopportunities.

Scarce organisational resources are directed towardsopportunities which have the potential to provide the

maximum return on investment.

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

36

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.” “

37








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