Mastering Financial Management

Manjit graduated at the prestigious Aston Business School, the largest business school in Europe. His degree in Business Administration included a placement year with Deloitte Haskins & Sells, one of the top five Accountancy firms at the time.

He won the Ernst & Young prize for best Dissertation, based on his placement year.

He proceeded to continue his career with the newly merged firm Coopers & Lybrand Deloitte. His experience included auditing some of the top firms including National Grid, Barratt Homes and United Biscuits along with a number of local government institutions. He also spent some time in the insolvency and administrator department.

After 2 years with this firm he moved on to complete his CIMA accountancy qualification working for a number of firms including GRT Transport, Boots and Central & Carlton Television.

He spent 4 years in Edinburgh working for Lloyds TSB as a Business Implementation Manager and then went on to work for AMP UK Financial Services, the largest Insurance Company in Australia, as an internal management consultant.

He went on to work for Hays PLC as a Commercial Accountant, then finally decided to run his own business and get street experience, putting his entrepreneurial skills to the test. After selling his business at a young age, he now enjoys semi-retirement, working as a part-time lecturer, free-lance trainer, business consultant & Internet Marketing Coach.

Manjit has had extensive training in the Thompsett Project Management program, Quality Management Techniques and Customer care implementation. He delivers courses on all aspects of Accounting, Finance & Business including Finance for Non Finance Managers, Risk Anaylisis & Management, Forensic Accounting & Auditing, Corporance Governance.

The financial crisis brought turmoil to the world's financial markets and triggered a global recession that is only now showing tentative signs of abating in some of the major economies.Things have been tough for enterprises of all sizes and as the credit squeeze shows no immediate sign of easing it is likely to remain so for the foreseeable future. Some famous name companies have already gone out of business and no doubt there will continue to be high levels of business failures.

Lack of credit finance, fear of redundancies and loss of consumer confidence haveall been blamed for the demise of many companies across several business sectors. But research shows that in any economic climate a lack of essential business finance skills is a major factor in the failure of many businesses.And when things get tough it is these key financial skills that will sort out the winners from the losers.

So what do we mean by “essential business finance skills”?

First and foremost we mean the efficient control of working capital and cashflow. Cashflow is the “lifeblood” of business and many businesses fail due to lack of cash. If you do not understand how working capital affects cashflow then you are much more likely to run out of cash!

We mean making the right pricing decisions so that we not only achieve strong sales but also produce the strong gross margins we need to cover the fixed costs of the business and generate strong profit. When funds are hard to find it is profit that generatesthe vital cashflow neededto fuel the engine of business growth.

And fundamentally, we mean the ability to interpret the financial statements that give us the information we need to apply these business finance skills.

If you are running your own business, or are a senior manager in a large organisation,these finance skills are critical in making the right decisions that will help your business to survive and thrive in any economic climate.

Acquiring these financial skills is not as difficult as many people believe. Of course, finance has its own jargon, but the principles are not difficult to master and in the hands of an experienced manager these financial skills can provide the formidable competitive advantage that comes from superior business decision making.

This manual accompanies theMastering Financial Management course and has been designed and written to give you the essential business finance skills to help in the effective management of your business.

Paul Lower fcma

Key course topics

Understanding Financial Statements
Managing Working Capital
Gross Margin and Profit
Measuring Performance
Budgeting

There is a glossary of financial terms at the back of this manual. It is not exhaustive but covers some of the terms we will be using in the course.

Understanding Financial Statements

Fundamental requirement of financial statements

Show “true and fair view”
Prepared in accordance with:
Generally Accepted Accounting Principles
Financial Reporting Standards
Local FRS
International FRS

Four basic accounting concepts

Going concern concept
Assumes business will continue to trade for the foreseeable future.
Assets are valued based on the cost to the business rather than what they might fetch in a winding up sale
Accruals concept
Also referred to as the “matching concept”
All costs must be matched with sales in the period they were incurred
Regardless of when they were actually paid
Consistency concept
Things must be treated the same from one period to the next
Prudence concept
Profit is not realised until a sale has taken place
Provision is made for all known losses

Accounting policies

In addition to the basic accounting concepts a business will usually also have its own rules for treating certain items in the financial statements.

These “accounting policies” must be stated in the published company accounts and should be applied consistently from one period to the next.

Accounting policies will usually cover things like:

Sales income recognition
Depreciation of fixed assets
Depreciation reduces the net asset value of fixed assets by an amount each year that reflects the reduction in value through its use.
Depreciation is charged as a cost in calculating profit.
Stocks and work in progress
There are different ways of valuing stocks, each of which produce quite different results in the Balance Sheet and Profit and Loss Account.
Research and development costs

Double entry bookkeeping

Each transaction shown by two entries
Two simple rules apply:
DEBIT the account of the RECEIVER of value
CREDIT the account of the GIVER of value

THE MEGA TOY COMPANY LIMITED

The Mega Toy Company Limited started trading on 1stJanuary 2007.

The company imports toys and sells them to UK toy wholesalers and retailers. The two business partners had considerable experience in the trade and their good connections meant they quickly had orders from some of the large toy wholesalers.

The following transactions took place in the first three months and you have been asked to prepare the accounts and financial statements at the end of this period.

The partners put £400,000 cash in to the business as share capital.
The company rented a warehouse for £60,000 per year of which £30,000 was payable by cheque on signature of the lease as a prepayment of rent.
Racking and office equipment was bought by cheque for £40,000.
Salaries in the first three months were £20,000 and other overheads £18,000; both of these were paid by cheque.
In January stock costing £200,000 was bought and paid for by cheque.
In March stock costing £75,000 was bought on 30 days credit.
Sales and cost of sales in the period were:

Sales £245,000sold on 60 days credit

Cost of stock sold£147,000

Freight costs£ 14,000

In March the company rented a stand at a major toy trade fair. Agreed rent was £17,000, but none of this had been paid or invoiced at 31st March.
Fixed assets are depreciated on a straight line basis over 5 years

Balance sheet

A snapshot of the company’s financial position
As at the balance sheet date
The balance sheet shows
What the company owns= assets
What the company owes= liabilities
How these are financed= capital employed

IFRS versus US terminology

If you use or have seen US financial statements you have probably noticed some different financial terms being used:

IFRSUS

Balance sheetStatement of financial position

Land and buildingsProperty (real estate)

StocksInventories

DebtorsReceivables

CreditorsPayables

Bank loans and overdraftsNotes payable

Called up share capitalCapital stock – common

GearingLeverage

MergerPooling of interests

Company Corporation

Profit and loss accountIncome statement

Turnover or salesNet sales or revenue

Profit after taxNet income or earnings

SAPHIRE SOFTWARE LIMITED

Simon Scott founded the company in 2006. Simon’s background was as a software developer and until 2006 he had worked for a large software company. After founding SapphireSoftware he continued to work for his former employee as a consultant in order to finance the development of an innovative software product.

At the end of 2009 the new software was completed, debugged and beta tested. The new software was unlike anything that was previously available;according to the trade press the product hadenormous potential. SapphireSoftware planned to start marketing the new product in the first quarter of 2010.

Until the end of 2009 the company had made small profits entirely from the consulting activities undertaken by SimonScott. The BalanceSheet is shown below.

Simon’s former employer had been disappointed when he left the company in 2006. They had established their own reputation by developing innovative new software products for more than 25 years. When they heard that SapphireSoftware had beaten them to developing a valuable new product they were very keen to acquire both the product and Simon Scott for themselves.

They offered Simon £750k to buy 95% of the shares in SapphireSoftware on condition that he took up the position as their Senior Software Developer.

How might SimonScott’s former employer have arrived at the valuation of £750k to buy 95% of the shares in SapphireSoftware?

What items not shown on the SapphireSoftware BalanceSheet might have been taken in to account in arriving at the offer price?

Profit and loss account

Technically part of the capital section of balance sheet
A statement of trading performance for the period
The profit and loss account shows
Sales
Cost of goods and services sold
Gross profit
Other costs of running the business
Profit

What is EBITDA?

ebitda is earnings (ie. profit) before interest, tax, depreciation and amortisation.

ebitda is the company’s operating profit excluding non-cash accounting charges reflecting the write-off of tangible (depreciation) and intangible (amortisation) assets.

It is used as an approximation to cashflow generated, although it does not take in to account the impact on cashflow of increases or reductions in net working capital.

Where net working capitalis relatively stable ebita is a very good indication of cash generated by the business and which can be used to pay:

the banks, in the form of interest,

the taxman and

the shareholders, in the form of dividends

Cashflow statement

A bridge between profit and loss account and balance sheet
The cashflow statement shows
Where funds have come from
How funds have been applied in the business
Cashflow in the period

BIG TREE BOOKS LIMITED

BigTreeBooks publishes children’s books and has been trading for several years.

The TrialBalance at 31stDecember2007 is shown below.

Please use the pro forma statements on the following pages to prepare:

The Balance Sheet as at 31stDecember 2007

The Profit and Loss Account for the year ending 31st December 2007

The Cashflow Statement for the year ending 31st December 2007

Managing Working Capital

Working capital is the circulating cash in the business

People say that cashflow is the lifeblood of the business

That’s a good way to think about working capital

THE KOSI-KNIT SWEATER COMPANY

Kosi-Knit Sweaters has been in business for several years selling hand knitted sweaters to the UK clothing retail trade. In the two years to the end of 2006 sales had been declining;a significant number of the company's traditional small retail customers had suffered in recent years under competition from the major chain stores. However, it was thought that the sales decline was also due in part to the fact that many of the company's knitwear designs were old fashioned.

In 2007 the company employed a young new designeradded some new and fashionable designs to the product range.

The company also opened new accounts with several large fashion chain stores, albeit on longer payment terms than the 30 days allowed to their traditional accounts.

As a result of these measures sales increased in 2007.

Until 2007 all of the sweaters had been manufactured in Eastern Europe. Delivery from this supplier takes 4-5 weeks from order and stock is invoiced on shipment. Payment terms are 60 days on invoice.

In 2007 several batches of sweaters were imported from China in an effort to reduce costs and improve gross margins. These sweaters were paid for by 50% cash transfer on order and 50% paid in cash before shipment. Delivery from the Far East usually takes 14-15 weeks from the order being placed.

In January 2008 the company was ready to place and order for £500,000 worth of new spring stock from China but found itself without the cash to pay the deposit.

The Profit & Loss Account for the most recent two years is shown below.

Please comment on sales and profit performance for the most recent year.

The Balance Sheet as at the end of the last two years is also shown below.

Please comment on any significant changes in the balance sheet.

How would you describe Kosi-Knit’s cash position?

What factors might have resulted in changes to the balance sheet?

QUICK BYTE COMPUTERS

Quick Byte Computersmakes desktop and laptop computers. In July 2008 the company gets great news: the Sales Manager has negotiated a deal to supply a major retail chain with their new laptop.The sales value of the order is £600,000.

The company’s gross margin on this order will be 25%. This is less than the 40% margin theynormally make but there is spare production capacity and the computers can be built without incurring any additional labour costs. This will guarantee a profit of £150,000 on the deal.

The customer wants the whole of the order to be ready to ship in the first week of September but has said it will probably have them delivered in three equal monthly batchesstarting from September 2008

QuickByte will invoice the customer on delivery of the laptops. Payment terms are 60 days after the end of the month in which the invoice is submitted.

The components for the laptops are imported from Eastern Europe. Delivery takes 3 days and the supplier’s payment terms are 30 days after the end of the month in which the components have been delivered.

It will take 30 working days (6 weeks elapsed time) to build the computers.

Quick Byte’s most recent profit and loss account and balance sheet is attached.

Please use the pro forma below to prepare the cashflow statement for the year ending 30th June 2008

Comment on the financial performance of the company in 2007 and 2008

Comment on the financial strength of the company at 30thJune2008

Estimate how much QuickByteComputers will need to fund the deal for each of the next six months.

How might Quick Byte Computers fund this working capital requirement?

Would you recommend that the company sign the deal in its present form?

If so, why?

If not, why not?

Gross Margin and Profit

RECESSION, WHAT RECESSION?

The UK is suffering its deepest and longest recession

for many years; there have already been many

business failures and no doubt there will be more

before we see economic recovery. But not all sectors

have suffered to the same extent.

Come boom or bust the barrow boys always do well;

they never seem to be short of cash and still take their

foreign holidays. How do they do it?

The barrow boy is the master of the essential business finance skills – but you

never see him reading a computer report. So why are they so successful?

Here are ten reasons why these businesses perform consistently well. The same principles could be applied to many other businesses with the similar results.

TOP 10 BARROW BOY BUSINESS SECRETS

Barrow boys understand business cashflow and deal in cash whenever possible
They maintain short supply chains and can accurately estimate daily demand
All or most stock is sold on the day and little unsold stock has to be funded
Barrow boys don’t give credit to their customers
They know the gross margin on every item in their small product range
Barrow boys know exactly where their break-even point is and use ‘dynamic pricing’ to maximise their cashflow and profit
Their businesses have flat management structures and few decision makers
Salary costs are kept low
Other business overhead is kept low: fixed costs are kept to a minimum
They have clear objectives; they know which market they are in and they understand how to satisfy their customers’ needs

THE BRIGHT SPARK ELECTRONICS COMPANY