How to talk to your cfo with confidence eguide


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How to talk to your cfo with confidence eguide

  1. 1. How to talkconfidentlyto your CFO9 practical finance tips thatyou must know
  2. 2. Vipin Khandelwal is anentrepreneur, a discoverer, avoracious reader. He is constantlyevaluating ways to enablelearning in innovative ways.Before entrepreneurship, he wasinvolved in doing business andfinancial analysis and headed afinancial planning services firm.Follow him on Twitter @vipinkhAUTHORPublished by
  3. 3. Accounting vs Finance…………………….….…6The First Principles……………..………………..7The 3 Key Financial Statements……….…..10Income and Expenses…………….……….….16Assets and Liabilities...………….……….……18Is Profit = Cash?...………….……….…………20Did you Budget for it?…………………………25Cost marginally –>Break Even.……………28True Cost of Capital…..……………………….32TABLE OF CONTENTS:
  4. 4. If you’re interested in usingfinancial numbers to makeimpactful decisions, join theFinance 360 Degrees Coursefrom Learning Infinite.FINANCE 3600Click here to know more
  5. 5. What happens when you go to adifferent country, say China, andyou ask a local for directions?You hear some mumbling inChinese which you don’tunderstand and you are left allconfused.INTRODUCTIONTo manage business profitably, you need to measureand evaluate your business decisions effectively.For this you need to know the language. And thatlanguage is Finance.Now you don’t need to be an accountant or possess afamous finance degree to be smart and make sense ofall that your CFO talks to you.You can know these secrets right now and talkconfidently to your CFO. So, ready. Here we go!Now imagine you are in a meeting with the CEO and theCFO who are discussing with your division or unitsperformance with you. How do you feel there?Very similar to the China experience. Right?5
  6. 6. 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.1Accounting or FinanceIn a business transaction,there is a transfer of valuefrom one party to another inreturn for another item ofvalue, money, product orservice.Image credit: Wikimedia6
  7. 7. 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 Matching2The First Principles7Source: flickr
  8. 8. HOW TO TALK CONFIDENTLY TO YOUR CFOIt 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: MATCHINGPrinciple 1: MATERIALITY8Source: flickr
  9. 9. HOW TO TALK CONFIDENTLY TO YOUR CFOAccounting PeriodIt 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.9If you cannot measure it,you cannot manage it."
  10. 10. 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:3The 3 Key Financial Statements3 KeyFinancialStatementsProfit &LossStatementBalanceSheetCash FlowStatement10
  11. 11. HOW TO TALK CONFIDENTLY TO YOUR CFOAny 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 STATEMENT11
  12. 12. HOW TO TALK CONFIDENTLY TO YOUR CFO12Source: IncomeSAMPLE P & L – Infoedge India
  13. 13. HOW TO TALK CONFIDENTLY TO YOUR CFOIf 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 andApplication 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)BALANCE SHEET13
  14. 14. HOW TO TALK CONFIDENTLY TO YOUR CFONet worth = Total Assets – All External LiabilitiesWhat is the other way you could calculate Net Worth?14Infoedge IndiaExternalliabilities
  15. 15. HOW TO TALK CONFIDENTLY TO YOUR CFOCash 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 howcash 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 changesfrom 3 types of activities.Cash fromOperationThe day to dayoperations of thebusiness inclbuying of rawmaterial, sales,salaries, etc.Cash fromInvestmentBuying or sellingof assets, Loans,investment instock markets,etc.Cash fromFinancingRaising freshmoney throughstock markets orloans, paymentof dividends, etc.CASH FLOW STATEMENT15
  16. 16. 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?4Income and ExpensesAn income is alsocalled revenue, sales,turnover and is aresult of the normalbusiness activitywherein products orservices are providedin return for income.An expense is anoutflow of moneyin return for aproduct orservice. It is alsoknown as “cost”.Count expenses whichcontribute to their economicusefulness within the period ofmeasurement (typically a year).Count incomes against whichvalue has been deliveredwithin the period, notadvances.16
  17. 17. HOW TO TALK CONFIDENTLY TO YOUR CFOThe Concept of AccrualIf 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” ( 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 bepaid 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 willactually come in after 60days. You record thetransaction and it becomesan accrued income. Ithas become due but notreceived.17
  18. 18. 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?5Assets and LiabilitiesAssetAn Asset is an outlay, like a computerequipment, 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 exhaustedwithin 12 months Assets can also be tangible (Owned Office space) orintangible (patents); movable (Cash) and immovable (Land)18
  19. 19. HOW TO TALK CONFIDENTLY TO YOUR CFOLiabilityA Liability is an obligation whichprovides economic resources for runningthe business operations like buying ofequipment.Important points about Liabilities Liabilities can be long term (like bank loans, long termdeposits) 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 within12 months (creditors, expenses due but not paid) Shareholders money (share capital, owners equity) is alsoshown on the liabilities side since it is the amount that thebusiness has to pay back to the owners/shareholders.Required to run day to day businessoperations.= Current Assets – CurrentLiabilitiesWorkingCapital19
  20. 20. 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 productson 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.Note: Now as per the accrual rule, the sale is done andrecorded so it increases topline and bottomline, but not CASH.6Is Profit = Cash?PROFIT20
  21. 21. HOW TO TALK CONFIDENTLY TO YOUR CFOThere are several companies who showhuge profits but there is no cash with them.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)21
  22. 22. HOW TO TALK CONFIDENTLY TO YOUR CFOSimilarly, there are companies who may have lot of cashwith them but they are not profitable? Depreciation or amortisation of assets charged to income, anon cash expense. Hence cash is available but there would below or no profit. A company which has raised capital (equity or debt) andhence has cash, but revenues are lower than expenses andhence no profit ________________________________(fill in a reason)22
  23. 23. HOW TO TALK CONFIDENTLY TO YOUR CFOThe Concept of DepreciationDepreciation literally means by which something reduces invalue.As per wikipedia, depreciation refers toThe allocation of the cost of the assets to periods inwhich the assets are used (depreciation with thematching principle)”Typically assets offer useful value over a period of time. Toensure that we match these uses of value with the rightperiod, we depreciate assets. Which means that for everyperiod the value of the usage is deducted.For example, if you have bought a computer for 45,000and it is going to be useful for 3 years, then you woulddepreciate it by 15,000 (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.23
  24. 24. HOW TO TALK CONFIDENTLY TO YOUR CFODepreciation vsAmortisationWhile depreciation is usedin reference to physical ortangible assets,amortisation is used forintangible ones likepatents.24EBITDAAlso, Operating profit or profit from coreoperations or operational profitabilityEBITDA = Income (minus) all expensesexcept Interest, Tax, Depreciation/Amortisation
  25. 25. 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.7Did you budget for it?25
  26. 26. HOW TO TALK CONFIDENTLY TO YOUR CFOA budget is a very important document for you and foryour organisation. It helps to put quantitative estimates to a set of intentions It helps in channelising the resources available to theorganisation in the right direction towards achievement ofdesired objectives When compared with actual results, it helps to evaluate andanalyse the performance of the division/unit/organisation When you perform better than the budgets, you getrewarded.Typically budgets are prepared on a yearlybasis.Budgets are a bottom up exercise, whereevery department (marketing, production,sales, IT HR) makes its budget and sends itto the central business planningdepartment which collates all of them tocreate a company wide budget.26
  27. 27. HOW TO TALK CONFIDENTLY TO YOUR CFOImportant points to keep inmind while making abudget to save pain in thefuture Ensure that youunderstand the businessobjectives to be achievedwith respect to yourdepartment or business unit.You will be able to defend yourbudget only in relation to thebusiness objectives andstrategy. Start to prepare inadvance. Generously useinputs from the team. Ensure that you plan for allpossible expenses, fixed andvariable. And after that,include a contingency reserveto provide for unexpectedexpenses that might come upincluding new initiatives. Be realistic in estimatingincome. Be actively involved inmaking your budget. Ifsomeone else makes yourbudget, it will be their budgetand not yours. Review your budgetperiodically. If there aresignificant changes in theassumptions or marketconditions from the time youmade your budget, you shouldadjust it to reflect the currentrealities.27
  28. 28. The Cost ofdoing 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 ourbusiness results.Let’s look briefly at the role of various costs.8Cost marginally - Break Even28
  29. 29. HOW TO TALK CONFIDENTLY TO YOUR CFOCosts are primarily of two typesFixed CostsThese costs areincurred irrespective ofwhether the businesshas any runningoperations or not.Examples: Rent ofoffice, permanentemployees and relatedcosts.Variable CostsCosts incurred as aresult of businessoperations. As businessoperations vary in sizeand scale, these costsvary too. You got theword, vary. Right!Examples: Rawmaterials, salescommission andcontract employees.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 andmarket demand.Manufacturing businessestend to have a high fixedcost structure. Think powerplants.Service businesses are lotmore flexible with respect tocost. Think Consultancy.29
  30. 30. HOW TO TALK CONFIDENTLY TO YOUR CFOB E Point is = Fixed Costs / Contribution MarginContributionMarginAlso, Marginal profit per unit of sale= Sales Price - Variable CostIf this is positive, it makes sense to takethat bulk order at a discounted price.Break EvenMarginThe point of business operations at whichincomes are equal to costs is known asthe break even point. It is useful inevaluating whether a new project makessense or not.30
  31. 31. HOW TO TALK CONFIDENTLY TO YOUR CFOAs Henry Ford once put it, Ifyou need a machine and dontbuy it, then you will ultimatelyfind that you have paid for it anddont have it. Thinking on amarginal basis can be very, verydangerous."- Clayton Christensen31
  32. 32. 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.9True Cost of Capital32
  33. 33. HOW TO TALK CONFIDENTLY TO YOUR CFOBusinesses raise money in the form of equity and debt.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 sharesprofit and/or losses in the business.33
  34. 34. HOW TO TALK CONFIDENTLY TO YOUR CFOEquity has a cost, definitely.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 and50% 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.34
  35. 35. HOW TO TALK CONFIDENTLY TO YOUR CFOCan you relate the concept of“true cost of capital” to“Return on Investment(ROI)” concept?ROI is used as one of the tools (alongwith payback period and Internal Rate ofReturn) to evaluate investmentopportunities.Scarce organisational resources aredirected towards opportunities whichhave the potential to provide themaximum return on investment.So, next time when you are proposing aninvestment to the company, read CFO,ensure that the ROI calculation is inplace.35
  36. 36. HOW TO TALK CONFIDENTLY TO YOUR CFOIf you really want toimpress your CFO,start talkingmetrics."36
  37. 37. If you’re interested in usingfinancial numbers to makeimpactful decisions, join theFinance 360 Degrees Coursefrom Learning Infinite.FINANCE 3600Click here to know more
  38. 38. COMING SOONHow to confidently talk to yourCFO – Advanced GuideWas this guide useful?Then Share it!