Finance for Non-Financial Managers

By Paramesh Alisetti, ACMA

Why it is important to understand Finance

Every activity that you do is connected with Finance . You will be at edge if you understand and assess the financial implications before you take a decisions.

It is the language that is discussed in the Board rooms. Hence, by knowing Finance you will at advantage in your career ahead.

Inside Edge – the more you know about finance, the more insights you will get about the Business.

You can understand better the accountant’s language when you deal with them day to day.

If you understand finance better, you can relate to your area of Business and question the sanctity of the numbers prepared by finance deptt.

When you know the drivers of financial performance, you will drive the respective Business activities in order to achieve better performance.

Outline Accounting is the language of business Key Financial statements- Income statement Analysis Key Financial statements -Balance sheet analysis Key Financial statements -Cash flow Analysis Financial Health check Reading Company annual report Key decisions of Financial Management Investment appraisal Working capital Management Cost Accounting for decision making PBF as a planning and controlling tool.

Accounting is the language of business

Business cycle

Performance

measurement

Policies LOA

SOPs

Documents flow

ACCRUAL ACCOUNTING

CASH BASED ACCOUNTING

ERP HAS ENABLED AUTOMATIC ACCOUNTING

REAL TIME MIS IS THE ORDER OF THE DAY

Income statement of Model Ltd

Rs mln Rs mln

Revenue from Operations 23 14,076 14,011

Other Income 24 63 59

Total Revenue 14,139 14,070

Expenses:

Land purchase cost 25 1,686 1,297

Material & Labour cost 26 5,010 6,700

Contribution 7,443 6,073

53% 43%

Employee benefit expense 27 1,267 1,035

Other expense 28 1,775 1,479

EBITDA 4,401 3,559

31% 25%

Finance costs 29 1,061 845

EBIT 3,340 2,714

24% 19%

Depreciation and Amortisation expense 30 387 278

PBT 2,953 2,436

21% 17%

Tax expense 31 944 611

PAT 2,009 1,824

14% 13%

EPS 20 19

Share price 320 284

P/E ratio 16 15

Particulars Notes 31.3.2012 31.3.2011

The balance sheet always balances

DebtInvAR A/PCash Equity

Assets = Liabilities + Equity + Reserves & surplus

Reveals the financial health of a company

Long term and short term balances

How can you increase the assets with out corresponding increase in liabilities ???

Balance sheet of Model Ltd

Rs.mln Rs.mln

Equity and Liabilities :

1. Shareholder's Fund

I. Share Capital 3 980 980

II. Reserves & Surplus 4 19,024 17,585

2. Share application Money pending Allotment 5 5 1

3. Non-current liabilities

I. Long-term borrowings 6 244 20

II. Trade payables 7 177 165

III. Deferred tax liability (net) 8 330 -

III. Long-term provisions 9 21 26

4. Current liabilities

I. Short-term borrowings 10 1,973 3,251

II. Trade payables 11 3,358 2,841

III. Other current liabilities 12 13,366 12,262

IV. Short-term provisions 13 1,236 904

Total Liabilities 40,714 38,035

Assets

1. Non Current assets

I. Fixed Assets 14

a. Tangiable Assets 2,740 1,366

b. Intangible Assets 58 6

C. Capital Work in progress 13 647

2,811 2,019

II. Non-current Investments 15 1,539 506

III. Deferred Tax Assets 16 - 74

IV. Long-term loans and advances 17 5,501 4,582

V. Other non current assets 18 144 104

2. Current assets

I. Current Investments 19 - 10

II. Inventories 21 14,352 9,707

III. Receivables 1,117 1,044

IV. Cash and Bank balances 22 533 217

V. Short-term loans and advances 23 12,573 16,943

VI. Other current assets 24 2,145 2,830

Total Assets 40,714 38,035

Particulars NotesAs at

31-Mar-12As at

31-Mar-11

Cash flow statement of Model Ltd S.No Particulars 31.3.2012 31.3.2011

Rs.mln Rs.mln

A. Cash Flow from operating Activites

Net Profit (loss) before Tax 2,952 2,436

Share of profit from investment in a partnership firm (73) (77)

Profit on sale of fixed assets (1) (3)

Depreciation & other writeoffs 388 278

Provision for doubtful debts & advances 94 0

Interest Expense 976 769

Interest Income (34) (16)

4,301 3,387

Changes in Working Capital:

Increase / Decrease in Current Liabilities / Provisions / Long-term liabilities 1,360 839

Increase / Decrease in Current Assets / Other long-term assets* 140 204

5,802 4,430

Less : Taxes Paid (net of refunds) (498) (299)

Net Cash flow from Operating Activities 5,303 4,131

B. Cash flow from Investing activities

Purchase of Fixed Assets (1,021) (218)

Proceeds from sale of fixed assets 2 5

Purchase of non-current investments (986)

Purchase of current investments (10)

Proceeds from sale of current investments 10

Investments in Bank deposits (141) (62)

Interest Received 34 16

Net Cash flow from Investing Activities (2,102) (268)

C. Cash flow from Financing activities

Proceeds from Long Term Borrowings 7,083 2,956

Repayment of Long Term Borrowings (6,657) (5,949)

Proceeds from Short Term Borrowings - 1,021

Repayment of Short Term Borrowings (1,278) (459)

Dividend paid on equity shares (294) (245)

Tax on equity dividend paid (48) (42)

Interst Paid (gross) (1,810) (1,732)

Net Cash flow from Financing Activities (3,004) (4,450)

NET INCREASE IN CASH & CASH EQUIVALENTS (A+B+C) 197 (587)

CASH & CASH EQUIVALENTS AT THE BEGINNING OF THE PERIOD 161 748

CASH & CASH EQUIVALENTS AT THE END OF THE PERIOD 358 161

Financial health checkup

ProfitabilitySales growth – price/volumeContribution Margin ratioEBITDA MarginOperating MarginNet profit margin All the above ratios are calculated on sales revenue.

Helps gauge the Margins that the Company is generating

SolvencyCurrent ratio = CA/CLQuick ratio = CA-INV/CLInterest cover = EBIT/Interest Exp

Gearing Ratio = Long term debt/Shareholders funds+Long term debt

Debt ratio = Long term debt/total assets

Helps understand the liquidity position and capital structuring

EfficiencyRevenue/ Total assetsInventory Turnover= Avg Inventory / COGS

ROCE = EBIT/ Capital employed

Avg Inventory holding days= Avg Inventory/COGS*365

Avg receivable days=Avg Receivables/Credit Sales*365

Payable days = Avg Payables/Credit purchases*365

Reading Company annual reportMain sections in an Annual reportChairman message to the shareholdersBusiness PortfolioBoard of DirectorsBoard CommitteesCorporate InformationDirectors reportCorporate GovernanceManagement discussion and analysisFinancial statementsAuditor’s reportNotes to accountsNotice of the AGMAny other details

Key decisions of Financial ManagementInvestment decisions- New projects / expansion- Acquisition of another entity- Investment in working capital

Financing decisions(Proper balance between equity & debt at lower cost )-Money Market for short term funds – CPs, BOE,CDS,Inter-company loans etc-Capital Market - IPO, rights issue- Debt – Bonds, Term loans from banks, - Bank term loans, Mezzanine finance, leasing, Hire purchase, venture capital etc - Reserves

Dividend decisions-Whether to pay dividend or retain for future growth- How much to be paid and how frequently.Retain when a Company has positive NPV projects and pay 100% dividend when they do not.

Risk and Return tradeoffTime value of money

Investment appraisalInvestment in an Annual Marketing programme

Cash Present RecoveryYear Flows Value Payback

0 (4,000,000) (4,000,000)1 1,200,000 1,081,081 (2,918,919) 2 1,100,000 892,785 (2,026,134) 3 1,000,000 731,191 (1,294,943) 4 900,000 592,858 (702,085) 5 800,000 474,761 (227,324)6 700,000 374,249 146,925 <= payback7 600,000 288,995 435,9208 500,000 216,963 652,8839 400,000 156,370 809,253

Net Present Value 809,253

Cost of capital 11.00% Net Present Value $809,253 IRR 17.10%Discounted Payback (years) 6.6

IRR rule : Choose a project if and only If the IRR > cost of capital

Capital rationing – select projects with highest NPV or higest profitability index

Working capital managementWorking Capital - (Current assets – Current liabilities) Exceeds current operating assets (Inventory+Receivables-Payables)The Company has a cash surplus usually represented by a Bank deposits and investments. Otherwise, it has a deficit usually represented by a bank loan and / or overdraft

Financing decision Conservative policy - Both non-current + permanent part of current assets +some portion of fluctuating current assets financed by long term finance Aggressive policy - short term financing for all fluctuating + some part of permanent portion of current assetsModerate policy – matches the short term finance to fluctuating current assets and long term finance for permanent portion of current assets

The operating cycle in a typical mfg industry Raw material days + Time taken to produce the goods + the time goods remain in the finished inventory + the time taken by the customers to pay for the goods- the period of credit taken from the customers -Reduce RM stock holding, obtain more finance from suppliers, reduce WIP & FG, reduce customer credit

Cost accounting for decision makingThe purpose of Cost Accounting - strictly for insiders (That’s way it’s also called Management Accounting- a tool of every CEO of a Company)

Product costing and calculating COGS and protecting the GROSS MARGIN while maintaining the quality of the product or service levels at acceptable level is the subject of Cost accounting. (allocate costs between COGS and Inventory)

Many companies don’t really know whether or not they’re making a gross profit on many of the products they sell.

Segregation of costs into variable & fixed -All costs are fixed in the short term and all costs are variable in the long term.

Controllable and uncontrollable costs - All costs are uncontrollable in the short term; all costs are controllable in the long term

Costing Techniques - Relevant costing, Standard costing , Marginal costing and break even analysis, Activity Based Costing, target costing, life cycle costing, Pricing decisions and profitability analysis.

Decision MakingRelevant costing (Incremental cashflows)Special pricing orders (below the Market prices) – Proposed price less than the order cost. Study of the cost estimates reveals that in the next qtr there are some overheads which will not change irrespective of this order, hence those costs are not relevant for calculating the profit.

Product Mix decisions when capacity constraint exists- Limiting factor (raw materials, machine hrs, labour Hrs, market etc) – In this case, produce those products which contribute more per limiting factor.

Replacement of equipment – The irrelance of past/ sunk costs

Outsourcing and make or buy decisions – At first instance it appears that the component be outsourced since the pruchase price is less than cost of Mfg.However, the unit costs include some costs that will be unchnaged. These are not relevant costs.

Discontinue decisions – if the incremental costs are more than incremental revenues shutdown.

Break even analysis.Model speciality PensNo.of sales 9,259 18,519 27,778 37,073 Unit sale price 27 27 27 27 Variable cost /Pen 19 19 19 19 Contribution/Pen 8 8 8 8 Fixed costs 80,000 80,000 80,000 80,000 Profit (2,502) 75,004 152,502 230,301

Break even pointFixed costs/ Contribution 9,558 Pens

PBF as a planning and controlling toolStrategic plan A type of business plan designed to define the overall vision and mission of a business, its strategy and long-term objectives. It does not contain lot of details about implementation.

Operating plan A detailed description of what the company will do to pursue the objectives of its strategic plan for the next operating period, usually one year. It will contain enough detail that the operating managers of the company can use it to guide their daily and monthly activities.

Exercise budgetary control Once the budgets are prepared and approved by the CEO, then the monthly actual results will be compared with the budgets and necessary actions will be taken based on variance analysis.

Monthly & quarterly forecasts to capture the downsides and upsides of the budget, a monthly/quarterly estimates will be prepared to know how the year is going to end .

The myths of Business planningThe Myth The Reality

1. Planning is a lot of Planning actually saves work and time, bywork; busy managers helping managers to avoid doing more workdon’t have time for than is necessary to reach their goals.still another task.

2. Plans are obsolete as Plans are dynamic and ever evolving as thesoon as they’re done. business evolves. The best ones get

reviewed and modified regularly.

3. Plans must always be Plans need not be any more detailed thanlong and detailed to the company needs to guide its activities.be of any value. Some very focused plans for small business

will fit on a single page.

4. Business moves too The speed of business is a big reason whyfast to be held back plans are important, because we can go veryby a plan. far off the mark in a short time. Plans don’t

hold managers back; rather, they guidemanagers’ forward movement.

5. Planning is not as Planning makes what we do more productiveimportant or valuable by enabling us to avoid doing things thatas doing something don’t contribute to our productivity asproductive. measured by end results.

6. We should leave the Plans done without the substantialplanning to the planners involvement of the managers who areand let the managers making the decisions are largely useless,do their work. because they don’t reflect reality.

• Mission and Objectives

• Corporate Appraisal

• Position Audit

• Environmental Analysis

• Strategic Option Generation

• Strategy Evaluation and Choice

• Review and Control

• Strategy Implementation

• Rational Model of Strategy

Strategic Planning

Any questions

Thank you