Your First Step to Financial Intelligence

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Finance is the language of business. To make effective business decisions, you have to understand and speak the terms in which business is measured. Top management decides on the basis of numbers. So, …

Finance is the language of business. To make effective business decisions, you have to understand and speak the terms in which business is measured. Top management decides on the basis of numbers. So, do you have a choice but to make the effort to start talking numbers confidently. This FREE eguide helps you take the first steps to financial intelligence.

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  • 1. Your First Step to Financial Intelligence 9 practical Finance tips that you must know
  • 2. AUTHOR 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. Follow him on Twitter @vipinkh Published by
  • 3. If you’re interested in using financial numbers to make impactful business decisions, join the Finance 360 Degrees Course from Learning Infinite. FINANCE 3600 Click here to know more
  • 4. YOUR FIRST STEP TO FINANCIAL INTELLIGENCE TABLE OF CONTENTS: Index Page No. 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
  • 5. YOUR FIRST STEP TO FINANCIAL INTELLIGENCE INTRODUCTION 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. 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? 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! 6
  • 6. YOUR FIRST STEP TO FINANCIAL INTELLIGENCE 1 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 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. 7
  • 7. YOUR FIRST STEP TO FINANCIAL INTELLIGENCE 2 The First Principles Source: flickr 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 8
  • 8. YOUR FIRST STEP TO FINANCIAL INTELLIGENCE Principle 1: MATERIALITY Materiality literally means importance. A financial transaction or data could be materially Unit important if it has the capability to influence the decisions one way or Example: One rupee in the other. Materiality changes from business to one million is not material but one rupee per unit for business. Source- dreamstime a million units is highly material. Principle 2: MATCHING 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. 9
  • 9. YOUR FIRST STEP TO FINANCIAL INTELLIGENCE Accounting Period 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. “ If you cannot measure it, you cannot manage it." 10
  • 10. YOUR FIRST STEP TO FINANCIAL INTELLIGENCE 3 The 3 Key Financial Statements 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: Balance Sheet Profit & Loss Statement Cash Flow Statement 3 Key Financial Statements 11
  • 11. YOUR FIRST STEP TO FINANCIAL INTELLIGENCE PROFIT AND LOSS STATEMENT 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. Incomes – Expenses = Profit / (Loss) 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”. 12
  • 12. YOUR FIRST STEP TO FINANCIAL INTELLIGENCE SAMPLE P & L – Infoedge India Topline Operating Income Bottomline Source: Infoedge.co.in 13
  • 13. YOUR FIRST STEP TO FINANCIAL INTELLIGENCE 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 analyse important financial information about a business. (More about that in the next guide) 14
  • 14. YOUR FIRST STEP TO FINANCIAL INTELLIGENCE Infoedge India External liabilities Net worth = Total Assets – All External Liabilities What is the other way you could calculate Net Worth? 15
  • 15. YOUR FIRST STEP TO FINANCIAL INTELLIGENCE CASH FLOW STATEMENT 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 from Operation Cash from Investment Cash from Financing The day to day operations of the business incl buying of raw material, sales, salaries, etc. Buying or selling of assets, Loans, investment in stock markets, etc. Raising fresh money through stock markets or loans, payment of dividends, etc. 16
  • 16. YOUR FIRST STEP TO FINANCIAL INTELLIGENCE 4 Income and Expenses So, we now know that a Profit and Loss Account summarises the 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? Count incomes against which value has been delivered within the period, not advances. 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. Count expenses which contribute to their economic usefulness within the period of measurement (typically a year). 17 An expense is an outflow of money in return for a product or service. It is also known as “cost”.
  • 17. YOUR FIRST STEP TO FINANCIAL INTELLIGENCE The Concept of Accrual 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. 18
  • 18. YOUR FIRST STEP TO FINANCIAL INTELLIGENCE 5 Assets and Liabilities 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? 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
  • 19. YOUR FIRST STEP TO FINANCIAL INTELLIGENCE 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. Liability A Liability is an obligation which provides economic resources for running the business operations like buying of equipment. Note: Working Capital Required to run day to day business operations. = Current Assets – Current Liabilities 20
  • 20. YOUR FIRST STEP TO FINANCIAL INTELLIGENCE 6 Is Profit = Cash? PROFIT 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. Note: Now as per the accrual rule, the sale is done and recorded so it increases topline and bottomline, but not CASH. 21
  • 21. YOUR FIRST STEP TO FINANCIAL INTELLIGENCE There are several companies who show huge profits but there is no cash with them. 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
  • 22. YOUR FIRST STEP TO FINANCIAL INTELLIGENCE 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
  • 23. YOUR FIRST STEP TO FINANCIAL INTELLIGENCE The Concept of Depreciation 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)” 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
  • 24. YOUR FIRST STEP TO FINANCIAL INTELLIGENCE Depreciation vs Amortisation While depreciation is used in reference to physical or tangible assets, amortisation is used for intangible ones like patents. EBITDA Also, Operating profit or profit from core operations or operational profitability EBITDA = Income (minus) all expenses except Interest, Tax, Depreciation /Amortisation 25
  • 25. YOUR FIRST STEP TO FINANCIAL INTELLIGENCE 7 Did you budget for it? 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. 26
  • 26. YOUR FIRST STEP TO FINANCIAL INTELLIGENCE 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. 27
  • 27. YOUR FIRST STEP TO FINANCIAL INTELLIGENCE 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. 28
  • 28. YOUR FIRST STEP TO FINANCIAL INTELLIGENCE 8 Cost Marginally - Break Even “ 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. 29
  • 29. YOUR FIRST STEP TO FINANCIAL INTELLIGENCE Costs are primarily of two types Fixed Costs These costs are incurred irrespective of whether the business has any running operations or not. Variable Costs Costs 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. Examples: Rent of office, permanent employees and related costs. 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
  • 30. YOUR FIRST STEP TO FINANCIAL INTELLIGENCE Break Even Margin The 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. 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. 31
  • 31. YOUR FIRST STEP TO FINANCIAL INTELLIGENCE “ 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 32
  • 32. YOUR FIRST STEP TO FINANCIAL INTELLIGENCE 9 True Cost of Capital 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. 33
  • 33. YOUR FIRST STEP TO FINANCIAL INTELLIGENCE Businesses raise money in the form of equity and debt. Equity Debt also 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. is 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. 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 ! 34
  • 34. YOUR FIRST STEP TO FINANCIAL INTELLIGENCE Equity has a cost, definitely. 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
  • 35. YOUR FIRST STEP TO FINANCIAL INTELLIGENCE Can you relate the concept of “true cost of capital” to “Return on Investment (ROI)” concept? 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. 36
  • 36. YOUR FIRST STEP TO FINANCIAL INTELLIGENCE “ If you really want to impress your CFO, start talking metrics.” 37
  • 37. What is your Financial Intelligence? How good are you at making impactful decisions based on numbers. Take this FREE assessment “What’s your financial intelligence?” NOW! A free assessment Click here to know yours
  • 38. Help Spread Knowledge! Share this guide now! Take your Second Step Now! With a few Challenges – Finance 360 Degrees. Know more.