2. Accounting&Financialanalysis
1 The need for financial reporting
2 The balance sheet
3 The basic rules of accounting
4 The profit and loss account
5 The structure of a balance sheet
6 Financial flows
7 Key financial ratios
8 Different balance sheets
Basic principles of accounting & financial analysis
3. A learning Curve – Step by StepA learning Curve – Step by StepStepbystep
Knowledge in
accounting
Time
4. Theneedforfinancialreporting
1 Sources of information
2 Management reports
3 Financial and legal requirements
Basic principles of accounting & financial analysis
2
3
5. What are indicators that things are going, or not
going, as they should?
FinancialReporting Financial reporting
6. Sources of financial informationFinancialReporting
• Why do we need financial information?
• What could be the sources of financial
information?
• What might be the difference between management
accounts and statutory accounts, and who
needs them?
9. The need for financial reportingFinancialReporting
The speedometerThe speedometer = information that allows for
control :
• daily recording of activities
• the financial situation
• the financial activities
• the situation versus budget
Performance improvement depends on the use and
reliability of financial information:
10. Management requires control
Control requires knowing what
is happening
Knowing what is happening
requires reporting
Management reportsManagement reports
PERFORMANCE
MANAGEMENT
CONTROL
REPORTING
FinancialReporting
11. Financial and legal requirementsFinancialReporting
Statutory
• Annual
• After audit
• Legally defined
• Accurate
• Public record
Management
• Monthly
• Promptly after the end
of the period
• Suited to individual
needs
• Estimate / Provisions
• Internal Use
12. The four functions of management :
Manage1
MEMO : MOPC
2 Organise
3 Plan
4 CONTROL
FinancialReporting The need for financial reporting
13. What type of information do managers need ?
We really need various types of information:
Financial : % Gross Margin / Invested capital
Commercial : Total credit cards sold
Activities : Total calls made
FinancialReporting
14. The annual accounts do not provide real time information,
we need information reports which allow for timely controls
and allow for:
The comparison of results versus budget
Fast actions in order to improve performance
The assurance that the company is on the right track!
FinancialReporting What type of information do managers need ?
15. The three sources of financial information
There are 3 sources of financial information:
The balance sheet
shows what the company has and what it owes
The Profit and Loss Account or Income statement
shows what the company earns or looses (results)
The cash flow report
the source and application of funds
Basicprinciplesofaccounting
16. The three sources of financial information
The car dealer as a base for many examples.
Why? Simple process : purchase - show room (stock) –
sales
No production, we do not take into account the other
activities, such as maintenance.
Basicprinciplesofaccounting
17. The need for financial reportingFinancialReporting
A?A? A?A?
A?A?
A?A?
A?A?
ProfitProfit
A?A?
Profit Leaks
18. The concept of a balance sheetExercise1
What I HAVE What I OWE
19. Exercise1
What I HAVE What I OWE
House
Car
Furniture
Equipment
Savings
“Petty” Cash
Mortgage
Car loan
Equipment loan
Invoices
Overdraft
The concept of a balance sheet
20. Exercise1
What I HAVE What I OWE
House 100
Car 10
Furniture 30
Equipment 20
Savings 10
Petty Cash 5
Adding up 175
Mortgage 65
Car loan 5
Equipment loan 10
Invoices 5
Overdraft 10
Adding up 95
The concept of a balance sheet
21. Exercise1
What I HAVE What I OWE
House 100
Car 10
Furniture 30
Equipment 20
Savings 10
Petty Cash 5
Total 175
Net worth 80
Mortgage 65
Car loan 5
Equipment loan 10
Invoices 5
Overdraft 10
Total 175
The concept of a balance sheet
22. Exercise1
What I HAVE What I OWE
House at
purchase price 70
Car 10
Furniture 30
Equipment 20
Savings 10
Cash 5
Total 145
Net worth 50
Mortgage 65
Car loan 5
Equipment loan 10
Invoices 5
Overdraft 10
The difference is a matter of evaluation of the assets
The concept of a balance sheet
Total 145
23. Exercise1
What I HAVE What I OWE
House at expected sales
price 120
Car 10
Furniture 30
Equipment 20
Savings 10
Cash 5
Net Worth 100
Mortgage 65
Car loan 5
Equipment loan 10
Invoices 5
Overdraft 10
The difference is a matter of evaluation of the assets
The concept of a balance sheet
Total 195 Total 195
24. Exercise1
Asset Valuation What I OWE
How do we value an asset? The simple answer is the
original cost LESS the depreciation BUT the alternative
is :
• realisable value
• replacement value
• useable or economic value (i.e. cost,which
would be incurred in any event)
The concept of a balance sheet
25. Exercise1
What I HAVE What I OWE
All this does not tell us much about our income or
expenses during a given period of time
This would be shown in other reports, i.e.
• The Profit and Loss report or Income statement &
• The Cash flow report
The concept of a balance sheet
26. Accounting&Financialanalysis
1 The need for financial reporting
2 The balance sheet
3 The basic rules of accounting
4 The profit and loss account
5 The structure of a balance sheet
6 Financial flows
7 Key financial ratios
8 Different balance sheets
Basic principles of accounting & financial analysis
27. Accounting&Financialanalysis
The concept of a balance sheet
The key elements of a balance sheet
Facts of a balance sheet and
management decisions
Basic principles of accounting & financial analysis
1
2
3
28. The concept of a balance sheet
Assets = Have Liabilities = Owe
LONG TERM
ASSETS
SHORT TERM
ASSETS
OWN FUNDS
Assets – Liabilities to
third parties
LONG TERM
DEBT
SHORT TERM
DEBT
Thebalancesheet
29. Can we draw a conclusion as to the viability of a
company by looking at its balance sheet on any
given time?
Would a balance sheet be sufficient?
Why do we pay so much attention to balance
sheets?
Are there rules for a balance sheet structure?
Thebalancesheet The concept of a balance sheet
30. answers
a. The balance sheet is a picture at any given moment of
the company :
The balance sheet is subject to interpretation
The balance is only meaningful after
analysis:
- over various periods
- in line with balance sheets of the competition
- in function of sector
- in function of the economic cycle
The balance sheet shows the financial health of a
company and its capacity to borrow in order to finance
its assets!
Thebalancesheet The concept of a balance sheet
31. Fixed assets
Current assets
Equity
&
Reserves
LT debt
Current
debt
Workingcapital The key elements of a balance sheet
Fixed assets
Current assets
Equity & Res
LT debt
Current
debt
Our car dealer A bank
34. OWN FUNDS
Equity (F)
Reserves (D)
Revaluations (D)
Advance owners (D)
EQUITY = FACT
The amount invested by the
shareholder
RESERVES = DECISION
The retained earnings
REVALUATIONS
Based on expertise
• The shareholders can decide to
finance their company in current
account (or subordinate loans)
Balance block 1
Factsanddecisions Facts (F) and decisions (D)
F = a fact
D = a mgt decision
36. Most are facts, others such as
provisions are the result of an
assessment or future charges
(accruals)
OPS DEBT (F)
Suppliers (F)
Provisions (D)
ST Bank debt (F)
Balance block 3
Factsanddecisions Facts (F) and decisions (D)
37. The intangible assets are
subject to amortisation
The amount is a decision
INTANGIBLES FIXED
Goodwill (D)
Balance block 4
Factsanddecisions Facts (F) and decisions (D)
38. A building is put on the
books at a purchase value and is
amortised over a period of time
in function of the rhythm of
annual amortisation.
The method of amortisation is a
matter of decision
TANGIBLES
FIXED
Land (F)
Buildings (F & D)
Equipment (F &D)
Balance block 4
Factsanddecisions Facts (F) and decisions (D)
39. STOCK is based on purchase
price or net sales price
-When the sales price is deemed
lower than the purchase price a
stock depreciation needs to be
recorded :
depreciation for stock with a
low rotation - It is a decision
CURRENT ASSETS
Stock (D)
Balance block 5
Factsanddecisions Facts (F) and decisions (D)
40. DEBTORS = FACT
However the principle of
prudence entails two
corrections for:
-past due debtors
-uncollectable
= Management decision
CURRENT ASSETS
Debtors
- past due (D)
Cash (F)
- investments (D)
- banks (F)
- cash account (F)
Balance block 5
Factsanddecisions Facts (F) and decisions (D)
41. The effect of an over-evaluation of current assets (with
unchanged liabilities)
The balance sheet …but in fact
Factsanddecisions The effect of a management decision
42. The over- or understatement of profits
Brand accounting
Changes in valuation methods
Changes in depreciation policy
Off balance sheet finance
Capitalisation of R & D
Factsanddecisions
43. Accounts over a long period, plus notes to the accounts, are
likely to provide the best basis for the analysis of the
financial position of a company
Accounting and financial analysis have their own
vocabulary
Key elements allow for ratio-analysis
Summary – Key points to rememberSummary – Key points to rememberThebalancesheet
44. Accounting&Financialanalysis
1 The need for financial reporting
2 The balance sheet
3 The basic rules of accounting
4 The profit and loss account
5 The structure of a balance sheet
6 Financial flows
7 Key financial ratios
8 Different balance sheets
Basic principles of accounting & financial analysis
46. A balance sheet must balance
What would the opening balance sheet look like?
HAVE = Assets OWE = Liabilities
Basicprinciplesofaccounting
47. Example :
The balance sheet of a newly founded company
Assets Liabilities
Current Asset Equity
A balance sheet must balanceBasicprinciplesofaccounting
57. EQUITY
The company re-sells the
equipment for 60 ! (without VAT)
CASH PROFIT & LOSS
DEBTORS
ASSETS LIABILITIES
EQUIPEMENT
The double entry conceptBasicprinciplesofaccounting
65. EQUITY
We take a depreciation of an asset into account for 10
P & L Account
EQUIPMENT
Cash and non cash entries
ASSETS LIABILITIES
CASH
Basicprinciplesofaccounting
66. EQUITY
P & L Account
EQUIPMENT
Cash and non cash entries
ASSETS LIABILITIES
CASH
Basicprinciplesofaccounting
We take a depreciation of an asset into account for 10
67. • Depreciation
A decrease in value of current assets
stock
- spare parts
- accessories
- debtors
• Amortisation
A decrease in value of fixed assets (long term assets)
fixed assets
- land and buildings
- plant and equipment
- renovation costs
Depreciation and AmortisationBasicprinciplesofaccounting
68. The influence of a depreciation is a decrease in
current assets & the equity and reserves (debts
remain unchanged)
Basicprinciplesofaccounting Depreciation and Amortisation
69. The influence of an amortisation is a decrease in
fixed assets AND the equity and reserves (debts
remain unchanged)
Basicprinciplesofaccounting Depreciation and Amortisation
70. Methods of amortisation
A fixed asset with a value of 100.000 at 10 % per year
A fixed asset with a value of 100.000 at 20% per year
LINEAR
Amortisation 10000 10000 10000 10000 10000 10000 10000 10000 10000 10000
Residual
Value 90000 80000 70000 60000 50000 40000 30000 20000 10000 0
DIGRESSIVE
Amortisation 20000 16000 12800 10240 10000 10000 10000 10000 960 0
Residual
Value 80000 64000 51200 40960 30960 20960 10960 960 0 0
Amortisation
72. Cash and non cash transactionsFinancialReporting
When Profit and Cash Differ
Difference
P&L expense, no cash
outflow
Cash outflow, no P&L
expense
P&L income, no cash inflow
Cash inflow, no P&L income
Example
Depreciation
Payment of Creditor
Sale on credit
Debtors settle account
73. The four principles of accounting
Accruals:
Each change needs to be recorded during the relevant period
Consistency:
The same logic needs to be followed over the periods of
accounting
Going Concern:
Accounting on the basis of a functioning company, in
opposition to a gone basis
Prudence
The financial situation has to be accurately and factually
represented
MEMO : ACGP
FinancialReporting
74. The significance of financial management
Financial management allows for the optimisation of the
use of working capital
It is a matter of management of the business cycle!
STOCKS
SALES
DEBTOR
S
TREASURY
SUPPLIERS
PURCHASE
Financialmanagement
75. Activity Ratios
The management of stock of spare parts
One of the management issues is the stock rotation, in this case we use
two ratios:
The definition of the two ratios
1. Stock turn
Annual sales of spare parts at cost
Stock spare parts
2. Stock turn in days 365
Stock turn
The utility of the ratio
This ratio indicates how often the stocks rotates on an annual basis
or alternatively how many days stock days the company has
Financialmanagement
76. The utility of the management of the working capital
Turn over parts 500.000
Gross margin 150.000
Stock 70.000
Stock rotation 500.000-150.000
70.000
5 times p.a.
Stock in days 70.000 x 365
350.000
73 days
Other computing method 365
5
= 73 days
Financialmanagement Activity Ratios
77. The purpose of the spare parts management by means of
Ratios
Factors influencing the stock:
- The need to match inventory with customer requests
- The express order surcharge
- Obsolescence
- The discounts on spare parts
Financialmanagement Activity Ratios
78. Outstanding debtors in days
Outstanding debtors x 365
Turnover « with » VAT
Outstanding suppliers in days
Outstanding suppliers x 365
Purchases « with » VAT
Financialmanagement Activity Ratios
The purpose of the debtors and suppliers management by
means of Ratios
79. Summary & key pointsSummary & key points
The source of working capital allows for a stable
base of financing
The management of the working capital allows for
the management of the activities’ cycle
The management of the rotation of stock, debtors
and suppliers will lead to improved results
The activity ratios allow for a trend analysis!
Financialmanagement
80. Accounting&Financialanalysis
1 The need for financial reporting
2 The balance sheet
3 The basic rules of accounting
4 The profit and loss account
5 The structure of a balance sheet
6 Financial flows
7 Key financial ratios
8 Different balance sheets
Basic principles of accounting & financial analysis
81. TheP&LAccount
Expenses and profits
Key elements of a P & L
Direct and variable expenses
The concept of profit centres
Basic principles of accounting
1
2
3
4
82. Expenses and profits
A turnover generates expenses:
Fixed expenses are the result of the activity of the company.
For example:
Salaries
Rental
Training
Advertising
TheP&LAccount
83. The benefits of profits
Profits:
• reward shareholders with dividends
• reward shareholders with capital growth
• pay interest on loans
• provide protection for future business
• provide funding for additional fixed assets
• provide funding for additional working capital
• provide customer confidence
• protect the employment of the employees
TheP&LAccount
84. Profits do not necessarily mean cash!
There is often a time lag between earnings and cash
inflows. Indeed :
Stock may be purchased on payment conditions and may
be sold and replaced before paying the supplier
Stock may be sold, the earnings accounted for, but the
payment is made at a much later date
A spare part has been sold but had been paid to the
supplier already a long time ago
TheP&LAccount The benefits of profits
85. P & L N-1 EURO N
Turnover (1)
Purchased goods
- Inventory
= Cost of goods sold (2)
Gross margin (3)=(1)-(2)
+ Other business related income
= Income from operations (4)
- Goods and services (5)
= Added Value (6)=(4)-(5)
- Personnel expense
- Other operational expenses
= Gross operating income
+ Financial revenues
+ Exceptional results
= Gross total revenue (EBITDA)
- Amort., provisions, depreciations
= EBIT
- Financial expenses
- Taxes
= NET PROFIT
ExceptionalExceptional
OperationsOperations
InvestmentsInvestments
FinancingFinancing
Key elements of a P & LTheP&LAccount
86. N-1 EURO N
Net Result
+ Amortisation and provisions
= Cash Flow
- Paid dividends (Shareholders)
- Repayment LT debt
= Net self-financing margin
cash flowTheP&LAccount
87. The charges to the P & L
Net Result
TheP&LAccount
Other
operation
al income
Gross
margin
Added
Value
Gross ops
profit
Profit before
taxes
Goods
& services
Personnel
-expense
Other ops
expenses
Amortisa
tion
EBIT
Financial
expenses
Taxes
Result of
Operations
Financial
Income &
exceptional
Gross
Profit
Other
income
88. Fixed and variable expenses
There are two types of expenses:
The fixed expenses
these expenses are incurred irrespective of the activities
or production process
Variable expenses
fluctuate in function of the volume of production
TheP&LAccount
89. The break-even point
There will be a point where production covers both
fixed and variable cost
This crucial point is called break-even and is the
point as of which profit is being earned
TheP&LAccount
92. The concept of a profit centreTheP&LAccount
SalesSales
Gross ProfitGross Profit
Variable ExpensesVariable Expenses
Direct ExpensesDirect Expenses
Department ProfitDepartment Profit
SalesSales
Gross ProfitGross Profit
Direct ExpensesDirect Expenses
Department ProfitDepartment Profit
SalesSales
Gross ProfitGross Profit
Direct ExpensesDirect Expenses
Department ProfitDepartment Profit
Sales Service Parts
Total Departmental ProfitTotal Departmental Profit
Indirect ExpensesIndirect Expenses
Operating ProfitOperating Profit
Other Income (Expenses)Other Income (Expenses)
Total Company Net ProfitTotal Company Net Profit
93. Reflects the structure of
the organisation
Allows for a specific
reporting per profit centre
Allows for educated
decisions
Adequate measures for
performance improvement
Allows for a better
allocation of resources
Could inhibit an overall
approach
Could encourage
independence
Could encourage internal
competition
Could encourage the
pursuit of department
proper goals
ADVANTAGES DISADVANTAGES
The P & L per profit centreTheP&LAccount
94. BALANCE
Fixed assets
Assets
Current assets
Reserves
LT Debt
ST Debt
P & L
Amortisation
Turn over
Depreciation
Profit
Financial charges
Financial charges
The link between the balance sheet and the profit and
loss account
Basicprinciplesofaccounting
95. Accounting&Financialanalysis
1 The need for financial reporting
2 The balance sheet
3 The basic rules of accounting
4 The profit and loss account
5 The structure of a balance sheet
6 Financial flows
7 Key financial ratios
8 Different balance sheets
Basic principles of accounting & financial analysis
96. The key elements of a balance sheet
Fixed Assets
Land & Buildings
Plant & Equipment
Fixtures & Fittings
Company Vehicles
Intangible assets
Current Assets
Stocks
Debtors
Work in Progress
Prepayments
Cash
Equity & Reserves
Share Capital
Revenue Reserves
Capital Reserves
Long Term Liabilities
Long Term Loans
Mortgages
Thebalancesheet
Current Liabilities
Bank Overdraft
Creditors (inc Tax & VAT)
Accruals
Short Term Loans
97. Norms
There are certain basic
principles such as:
LT Assets > LT Liabilities
ST Assets > ST Liabilities
LT Liabilities should finance:
- 100% LT assets
- the permanent ST Assets
LT
ASSET
S
N.W.
LT
DEBT
ST
ASSETS
ST
DEBT
Thebalancesheet
Long
term
The concept of a balance sheet
100. (2) Use of
Working capital
(3) Treasury
(1)Source of
Working capital
Working capital management
Fixed assets
Source of
working capital
Shares & Reserves
LT debt
Stock
Debtors
ST debt
Use of working
capital
ST Bank debt
Cash
Treasury
Workingcapitalmanagement
101. The structure of a balance sheet
Fixed assets
Own funds
LT debt
Inventory
Debtors
Use of
working capital
ST Debt
Workingcapitalmanagement
103. The definition of the working capital
The origin of the working capital
= the difference between equity & l.t. debt and l.t.assets
The use of working capital
= is the difference between current assets and current
liabilities
Treasury
= the difference between the origin of working capital and
the use of working capital
Theworkingcapital
104. The Net Worth
The difference between assets and liabilities towards third
parties :
Ownership interest (permanent capital)
Capital + retained earnings (losses)
The difference between ownership and liabilities is of great
practical importance. Normally claims which belong to the
owners will only be paid directly to them if the organisation
ceases trading.
Theworkingcapital
105. SummaryThestructureofabalancesheet
1. Quite a large number of elements of the balance sheet
are subject to judgement.
2. The source of working capital and the use of working
capital relate to each other and determine the level of
the treasury
3. Net worth (equity and reserves) can be over- or
undertstated.
106. Accounting&Financialanalysis
1 The need for financial reporting
2 The balance sheet
3 The basic rules of accounting
4 The profit and loss account
5 Financial flows
6 The structure of a balance sheet
7 Key financial ratios
8 Different balance sheets
Basic principles of accounting
108. Business Growth
Business growth can take three basic forms:
• Increased profitability on current volume
• Increased volume on current profitability
• Increased profitability on increased volume
Accounting&FinancialanalysisAccounting&Financialanalysis
109. To cover the effects of inflation and/or growth
we need extra funds to:
The Need For Extra Funding
• Carry more stock
• Support more debtors
• Update/add to fixed assets
• Pay more staff
Accounting&Financialanalysis
110. ... but where will it come from?
Growth Will Require More of This...
Accounting&Financialanalysis
111. Sources of Funding
Internal
• Share Capital
• Reserves
External
• Long Term Loans
• Stocking Loans
• Bank Overdrafts
• Working Capital Loan
• Venture Capital
Accounting&Financialanalysis
112. The financial flows underline the significance of the
profitability of the operations and the financial management
of the company
The company should generate enough cash to:
Finance the investments :
repayment of loans and the financial charges
Finance the use of working capital
Pay out dividends and taxes :
Shareholders dividends
State taxes
Financialflows The financial flows
113. Accounting&Financialanalysis
1 The need for financial reporting
2 The balance sheet
3 The basic rules of accounting
4 The profit and loss account
5 The structure of a balance sheet
6 Financial flows
7 Key financial ratios
8 Different balance sheets
Basic principles of accounting & financial analysis
115. Accounting&Financialanalysis Basic principles of accounting & financial analysis
The analysis of a company financial statements is indertaken for
the purpose of extracting information related to:
•The company’s activities
•Profitability
•Efficiency
•Degree of risk
118. Financial ratios
The concept of a ratio
A ratio is a fraction
Accounting&Financialanalysis
+
119. The financial ratios
Examples of key performance ratios
Profitability ratios
Return on capital
Return on sales
Efficiency ratios
Sales / Fixed assets
Stock / Total assets
Risk ratios
Current ratio
Debt to equity
Stock market
Price to earnings
Asset value per share
Accounting&Financialanalysis
120. Keyratios Return on capital employed
The definition of the ratio
Operating profit
Capital employed
The meaning of the ratio
° Capital employed is defined as fixed assets plus current
assets
° Gives an indication of the profitability of the company
= A high profitability could be the result of a high mark-up
on goods sold and/or an efficient usage of assets
121. Keyratios Return on sales
The definition of the ratio
Operating profit
Sales
The meaning of the ratio
° Gives an indication of the profitability of the company
= A high profitability could be the result of an efficient
production or distribution process
122. Keyratios Sales on fixed assets
The definition of the ratio
Sales
Fixed Assets
The meaning of the ratio
° Provides an assessment on the efficiency of management
in using the company’s assets
123. Keyratios Stock on total assets
The definition of the ratio
Stock
Total Assets
The meaning of the ratio
° The ratio assess the degree of stability in the stock figure
throughout the years.
124. Keyratios Current ratio
The definition of the ratio
Current Assets
Current Liabilities
The meaning of the ratio
° Assess short-term liquidity and examines the ability of
the company to meet its short-term commitments.
125. Keyratios Debt to equity
The definition of the ratio
Long-term debt
Shareholders’ equity
The meaning of the ratio
° This ratio is used to assess the company’s ability to meet
both interest and principal repayments on loans as they fall
due.
126. Keyratios Price to earnings ratio (P/E)
The definition of the ratio
Current market Price
Earnings per share
The meaning of the ratio
° This ratio gives the number of years’ earnings
represented by the current price
° The P/E ratio is a mixture of current price reflecting
expectations about the future and historic profit for the
most recent accounting period.
127. Keyratios Asset value per share
The definition of the ratio
Net assets attributable to ordinary shareholders
Number of shares issued
The meaning of the ratio
° The result of this fraction is often compared with the
market value to see to what extend the current price is
supported or backed by assets
129. A series of key ratios provide us a good indication of the
structure of the balance sheet, of the profit and loss account
and about the trend of the company’s performance
Ratios show either positive or negative correlations
The trend analysis allows for timely decisions and the
comparison of the company’s performance versus a peer
group
Ratios allow for standard deviations and the evaluation of
the relative performance of the company
SummarySummaryKeyratios
Editor's Notes
This slide shows you how the course is structured It is a classical structure So we will see the following subjects 1 TO 8 The most difficult part is 6 the financial flows and I have therefore turned that part into an exercise that we can solve together step by step Three days should give us ample time to go through above modules and related exercises
As stated make sure you follow step by step as the course is a cornerstone for further knowledge and most concepts depend upon the previous ones
Before going into the accounting principles let us have a look at the necessity of management reports and legal requirements
Before we do that let us take a minute to think about what information is needed when managing business…. and of primary importance what could be an indication that things are not going the way they should. What would be an indication? bills that we can not pay, so lack of liquidity (the difference as we are going to see later between the current assets and the current liabilities) Files which are out of order Customers who are complaining Failure to attract new customers Errors Slack morale Late or wrong reporting … and so on SO WE NEED INFORMATION OF ALL SORTS TO HELP US IN MANAGING THE BUSINESS and this information needs to be accurate, usuful and timely so that we can take action when required and before it is too late
So the key questions about information and sources of information are in front of you Before we give an answer to these question let us make a parallel between the driver of a car and the business manager
You are the driver of a car and quite familiar with this picture Let us replace CAR with BUSINESS how would you change the other words? So instead of driver we would have MANAGER Instead of SPEED we would have RESULTS and make the difference between actual results and expected or budgetted results We could replace control by reports or information Finally we could replace the accelerator, the gear and the brake by KEY PERFORMANCE INDICATORS
As you can see there is a tremendous difference between statutory reporting and management reporting The course concentrates on statutory reporting as we will see the principles of accounting
We are going to concentrate on CONTROL by means of accounting reports
Finally we do it all to avoid unnecessary expenses and boost performance Accounting and financial analysis are thus tools, means to an end which is to boost profitability or in other words a satisfactory return on invested capital After this introduction Let us have a go at it, ladies and gentlemen Here comes the first exercise The purpose of the exercise is to show that a balance sheet is just a statement of what an entity, a physical or moral person, has at the one hand and owes at the other hand The exercise should be given in steps A_ what do you as a person have and what do you owe B_ do not add figures just a list C_just add figures (imaginary figures is ok) and make the sum D_ the sum on both sides is not the same E_ the difference between the sum of both sides is called NET WORTH or EQUITY F_the net worth will be positive if you have more than you owe and is said to be negative if you owe more than what you have G_the difference is added at one side so that the total on both sides are the same IT IS THE PRINCIPLE OF BALANCE of the balance sheet THE NET WORTH IS JUST THE DIFFERENCE BETWEEN WHAT YOU HAVE AND WHAT YOU OWE IT IS ALSO CALLED EQUITY OR THE LIABILITY OF THE COMPANY VERSUS THE SHAREHOLDERS PLEASE NOTE THE SIGNIFICANCE OF EVALUATION OF THE ASSETS A DEBT IS USUALLY QUITE CLEAR HOWEVER HOW DO YOU EVALUATE YOUR HOUSE SAY AT 1 THE PURCHASE PRICE AT 2 THE MARKET PRICE AT 3 THE SALES PRICE AT 4 THE FORCES SALES PRICE AT 5 THE HYPOTHETICAL SALES PRICES IN THE FUTURE ????? Accounting rules and standards are there to make sure accounting relfects the TRUE VALUE THINK OF ENRON WHERE THEY BOOKED THEIR CONTRACTS AT MARKET VALUE AND BOOKED PROFITS WHEREBY IN FACT THEY WERE MAKING LOSSES DOWN THE ROAD
The following slides are an illustration of what was stated in relation to the EVALUATION OF ASSETS and the impact on the NET WORTH
When going to the tax inspector I would probably take a forced sales value for the house AND make the statement that life is tough When going to the bank I would probably take the expected sales value for the house AND make the statement that life is nice but that I need some more money to finance something When discussing with my partner in case you fully trust him you might wish to use the TRUE VALUE Accounting and fiscal rules are there to make sure figures reflect the true value and that the NET WORTH is indeed representing the TRUE share of the investors or shareholders HAVE A LOOK AT THE ENRON FILM IT IS PROBABLY THE BEST « LIFE » illustration of what was said so far
Learn to see the balance sheet as proportions As stated the NET WORTH = OWN FUNDS or the difference between the long term assets + short term assets AND the long term liabilities and short term liabilities The difference between short term and long term is a matter of definition and will be covered later The proportions of the balance sheet in front of you are not a coincidence However this is not a typical balance sheet of a bank but rather of our car dealer we are going to study later Notice that his long term assets are financed by long term liabilities (like you financed your house with a mortgage loan) and that short term assets are financed by short term liabilities Also notice that the company (or the individual who has such a structure) has some excess short term assets AND that a portion of his own funds + his long term debt is financing both long term assets and a fraction of the short term assets Indeed although the car in the dealer’s show room is a short term asset as soon as it is sold it is replaced with another car and can THEREFORE BE SEEN AS THE PERMANENT PART OF THE SHORT TERM ASSETS WE DEFINE SHORT TERM ASSETS MINUS SHORT TERM LIABILITIES AS WORKING CAPITAL USE YOUR IMAGINATION IN CASE THIS WOULD BE THE BALANCE SHEET OF AN INDIVIDUAL WHAT WOULD BE THE PROFILE OF THIS PERSON? Is he 30 or 60 years old (according to statistical observation) ? Is he an entrepreneur or an employee ? Is he successful ? In case you would be in charge of a direct marketing campaign would you send him an invitation? In case you would be in charge of selling investment products what type of investment would you propose? ANSWER He is 30 years old as he still has quite a lot of long term liabilities He is in all likelihood an entrepreneur as he has quite a lot of short term assets in has asset column He is successful as his own funds represent already one third of his total liabilities He has already a credit card or two so sending him a folder would be a waste of money, really He would in all likelihood be interested in a semi agressive investment product say a 40/40/20 (40% shares, 40% bonds and 20% short term investments such as a certificate of deposit, the latter being a saleable deposit) ALSO NOTICE THAT A BALANCE SHEET IS IN FACT A SUM OF ASSETS FINANCED BY LIABILITIES THE BALANCE SHEET OF A VERY WEALTHY PERSON WOULD ONLY HAVE ASSETS AT THE ONE SIDE AND OWN FUNDS AT THE OTHER SIDE NO LONG TERM DEBT OR SHORT DEBT TO THIRD PARTIES
As you can see a balance sheet tells us a lot but it is JUST A PICTURE AT ANY GIVEN TIME AND SHOULD BE SEEN OVER THE YEARS Also it does not say anything on income of flows of funds IT IS JUST A STATIC PICTURE So we need MORE: an income statement and a cash flow statement and IF WE HAVE THAT FOR A FEW YEARS WE MIGHT HAVE A PRETY GOOD IDEA WHERE THE HOLDER OF THE BALANCE SHEET IS GOING Why do we pays so much attention? Most of us and most companies need credit, have suppliers, customers who all look for information when dealing with them
Spot the difference A steel company would be the oppositie of a bank, the net worth would represent a much larger portion of the liability side What determines the choice? COST IS THE ANSWER THE ASSETS ARE FINANCED BY LIABILITIES AND WHEN A COMPANY IS QUOTED THE SHAREHOLDERS EXPECT A LARGE RETURN ON THEIR INVESTMENT THEREFORE EQUITY IS EXPENSIVE MORE EXPENSIVE THAN LONG TERM FINANCING !
We often show the balance sheet like this to allow for comparison over the years As you can see it is quite easy to determine that equity and reserves increased during the last three years and long term debt decreased WHAT DOES IT MEAN? It means that the company increasingly finances itself with own funds rather than with third party funds, is does less dependant upon credit A GOOD TREND REALLY This is one of the features of financial analysis IT PROVIDES YOU WITH A TREND ANALYSIS AND TELLS YOU WHERE A COMPANY IS GOING
The slides which follow introduce the key elements of a balance sheet and the place where elements are put Remember this is a result of the way it is done YOU COULD ALSO SHOW A BALANCE SHEET QUITE DIFFERENTLY AS WE ARE GOING TO SEE LATER ALSO NOTICE THAT SOME ELEMENTS ARE JUST PLAIN FACTS _ FOR INSTANCE THE BANK DEBT_ WHEREAS OTHER ELEMENTS ARE A RESULT OF A MANAGEMENT DECISION THE WAY YOU AVALUATE THINGS IS OFTEN THE RESULT OF A MANAGEMENT DECISION (also prescribed by law or by fiscal administrations)
This picture shows you what we have already seen at the very beginning : an overvaluation (HOUSE) results in an overstatement of the NET WORTH in case of same liabilities The balance sheet looks great and net worth represents on third of the liability side whereas in fact ASSETS ARE WORTH FAR LESS AND THE EQUITY DOES NOT EVEN REPRESENT IN FIFTH OF THE TOTAL BALANCE SHEET
Brand accounting : what is the value of MICROSOFT? Not really the buildings and computers but the BRAINS who work there: in other words Intangibles Assets; what is their value? Anyway putting their value in the balance sheet will result in an increased NET WORTH An approximation of the Brand equity might be the difference between the value of 1 share such as computed by the accountant of the company and the value of 1 share such as quoted by the market, in case we talk about a quoted company We all know COCA-COLA; at one point in time the value of the name or brand was evaluated in billions of USD We will come back on depreciation and amortisation We talk about depreciation when dealing with current assets in opposition to amortisation which is related to fixed assets Finally expenses such as R& D expenses can be capitalised WHICH MEANS PUT ON THE BALANCE SHEET AS ASSET SUBJECT TO AMORTISATION Not doing it would unduly affect the income statement of a given period – Example: the pharmaceutical industry
As stated previously there is no logic in what will follow; it is a matter of mutual convention; it is the way it is done Confusion comes from the fact we are used to the banker’s terminology HOWEVER DO NOT FORGET YOUR ASSET IS THE BANKER ’S LIABILITY AND VICE VERSA!!! WE SHALL REVERT ON THAT DIFFERENCE BUT IT CREATES AN UNDERSTANDEABLE CONFUSION Listen carefully to what will follow as it is THE BASIS for accounting
We are going to see the following basic principles
Remember we saw that a balance sheet balances The total assets will always match the total liabilities
Say we put 100 on the table to start a NEW COMPANY without taking into account notary expenses and other expenses we would have 100 as an asset of the newly founded company and 100 as a liability towards the shareholders The asset total would be 100 and the liability total would be 100 In other words the asset of the company is 100% financed by the shareholders A share is a portion of the capital Say we would be 10 shareholders of the new company with an incorporated capital of 100 it would mean that each shareholder would hold 1/10 or 10 As soon as the company starts his life the assets and the liabilities will vary and the net worth (the difference between the assets and the liabilities) will move upwards or downwards
THIS IS THE WAY IT IS DONE WHEN A ASSET ITEM INCREASES IT MEANS A DEBIT Say you get a 500 bill that you have to put into your « petty cash » (cash on hand – it is always an asset item in opposition to treasury which is a broader concept and can be either positive or negative) – this would mean an accounting entry which would start as DEBIT PETTY CASH 500 CREDIT….. 500 What you HAVE is an ASSET and when it INCREASES we talk about a DEBIT
What we OWE is a LIABILITY and when it INCREASES we talk about a CREDIT Debits and credits are conventions and allow for the double entry concept and for the balance of a balance sheet Example : My telephone bill of 150 comes in – this means that I have A LIABILITY which INCREASES this means that the accounting entry will be DEBIT …… 150 CREDIT ELECTRICITY SUPPLIER 150 We will see later what we credit and debit and how As stated there is often a confusion due to the bank terminology whereby the bank considers that your asset is its liability So when YOUR MONEY IN YOUR BANK ACCOUNT INCREASES IT MEANS AN INCREASE OF THE LIABILITY OF THE BANK TOWARDS YOURSELF AND THEREFORE THE BANK TALKS ABOUT THE FACT THAT YOUR EXTRA MONEY MEANS FOR THEM A CREDIT TO YOUR ACCOUNT HELD WITH THEM But let us forget about banks for now and think like an entrepreneur or a private citizen Summary When an asset account increases the convention is that we DEBIT Wen a liability account increases the convention is that we CREDIT IN fact, the only thing you need to remember is the first sentence and the fact it is the opposite for the liability accounts It is therefore essential to know if an account is a asset or liability account We have general agreed standards for that like in Belgium we habe a Belgian Accounting Plan or a GAAP general accepted accounting practice and each account has a specific number For instance the 1… accounts are for equity and reserves,; the 6 ….. Accounts are for charges and the 7….. For revenues and so on The balance sheet of the EIB is based on the IFRS schedule or the International Financial Reporting Standards Those standards gain universal acceptance and even the USA is leaning towards the use of these standards It is not an academic issue as the companies quoted on various stock exchanges have to publish their balance sheet according to different schedules which represent quite an expense The need for a universal lay out and structure is quite obvious
The first accounting entry for a new company would be (not taking into account expenses, notary cost) DEBIT PETTY CASH or BANK ACCOUNT 100 CREDIT EQUITY or DUE TO SHAREHOLDERS 100 It balances and we have a debit and a credit You will notice that you always need the two (a debit AND a credit) and that it is ESSENTIAL to ask yourself if you deal with an ASSET ACCOUNT or a LIABILITY ACCOUNT which is increasing or decreasing Let us look at a few examples and after that we will have an exercise or two to get it into the fingers
This slide is a summary of all what has been stated previously
This slide explains BEFORE the example and the exercise that it is a CONVENTION FOR THE REVENUE ACCOUNT OR ALSO CALLED THE PROFIT AND LOSS ACCOUNT TO DEBIT FOR A CHARGE CREDIT FOR A REVENUE Example – the payment of a telephone bill would be considered as a charge and would mean a DEBIT to the P&L Account Example – the payment by a customer you invoiced would be considered as an income and would mean a CREDIT to the P&L Account
This is a one slide summary that the participants should keep in front of them for the rest of the module & exercise
This is an illustration of what has been said The class should fill in the accounts BUT IN TWO PHASES First phase WE RECORD THAT WE HAVE A NEW MACHINE AND AN INVOICE OF THE SUPPLIER Second phase WE PAY THE MACHING TO THE SUPPLIER THROUGH THE PETTY CASH
The company records that it has a new equipment An equipment is an ASSET THAT INCREASES SO IT IS A DEBIT The invoice of the supplier is a LIABILITY THAT INCREASES SO IT IS A CREDIT The accounting entry would be DEBIT EQUIPMENT 50 CREDIT SUPPLIER 50
We pay the supplier CASH IS DECREASING; IT IS AN ASSET ACCOUNT THAT IS DECREASING SO IT IS A CREDIT SUPPLIER IS DECREASING IT IS A LIABILITY ACCOUNT THAT IS DECREASING SO IT IS A DEBIT The accounting entry would be DEBIT SUPPLIER 50 CREDIT CASH 50
Let us do a second example The company sells the equipment for 60 (i.e.purchase price of 50 + a profit of 10 or 60 in total) AGAIN IN 2 PHASES: we shall record that we have sold the machine and later on we shall record that we received the payment The company is going to dispose of the equipment, therefore it is an asset account which drecrease so we talk about a credit At the other hand we have a debtor who owes us money it is an asset account which increases so we talk about a debit DEBIT DEBTOR …………60 CREDIT EQUIPMENT ….50 The entry does not balances yet; we also have to show that we made a profit of ten Remeber the rule is that we credit the Revenues ( Profit and Loss) account for revenues and debit the revenues account for charges In this case we would have CREDIT P&L………………10 As can be seen in the following slide
Second phase the purchasor or debtor is going to pay for the machine which means that we shall have a cash entry of 60, i.e. an asset account which increases by 60 and we will record that the supplier has paid 60 DEBIT CASH ……….60 CREDIT DEBTOR …60 You will have noticed that we record a profit although the profit is only realised when the debtor effectively pays the company At the time of the accounting entry it was A NON CASH ENTRY There are thus CASH and NON CASH entries! As we are going to see later: a depreciation (a decrease in value of, for instance, a car) would be a charge the profit and loss account BUT WITHOUT MOVEMENT OF CASH
Above shows the fact the debtor is effectively paying for the equipment he purchased and we sold for 60 Petty cash is an asset account and it increases as cash comes in: DEBIT CASH ………60 And the debtors is an asset account which decreases so it is a credi CREDIT DEBTORS ….60 Summary DEBIT CASH 60 CREDIT DEBTORS 60 It balances Please note that we were dealing with two asset accounts
Same exercise but with VAT Although we do not want to enter into details of the VAT issue The basic rule is as follows IF YOU INVOICE TO A CUSTOMER YOU HAVE TO ADD VAT WHICH IS DUE TO THE STATE THAT AMOUNT IS A LIABILITY IF YOU RECEIVE AN INVOICE FROM A SUPPLIERS YOU CAN COMPENSATE THE VAT WHICH IS TO BE RECEIVED FROM THE STATE THAT AMOUNT IS AN ASSET COMPENSATION OF VAT PAYABLE AND VAT RECEIVABLE IS AUTORISED _ It functions like a current account of which the difference is settled periodically
The first entry would be DEBIT EQUIPMENT …………40 DEBIT VAT RECEIVABLE…..10 CREDIT SUPPLIER……………50 The second entry would be DEBIT SUPPLIER……………..50 CREDIT CASH…………………50
Please note that the Debtors show an amount of 50, indeed they need to pay 50 BUT for the TURNOVER (SALES) only 40 is shown as the other 10 represent VAT PAYABLE IN CASE OF RATIO CALCULATION THIS WILL HAVE TO BE TAKEN INTO ACCOUNT AND SALES ADJUSTED TO INCLUDE VAT For instance when calculating the Outstanding debtors/Sales ratio
The invoice is being paid CASH IS COMING IN Cash or rather « Petty Cash » is an asset account that increases so we talk about a DEBIT
A depreciation is the recognition that an asset is worth less than recorded As one of the accounting principles is that one reflects the reality, an accounting adjustment needs to be effected Say an equipment has been used and is no longer in as good a shape as a brand new equipment We will account for that fact with an accounting entry We talk about a NON CASH ENTRY as it has no influence on the treasury and there is NO MOVEMENT OF CASH The entry would be the following: DEBIT P & L (charge) …….10 CREDIT EQUIPMENT ………10 You can see that in case you over-do it this would reduce the year end profit and hence the taxes payable on your profit !!! You can see why tax authorities and authorities in general have a heavy hand in the definition of what can be done in accounting terms and how it can be done For instance in Belgium, a restaurant bill of 100 is only considered an expense by the tax authorities up to 69%
There is usually little doubt as to the magnitude of a liability However the value of an asset is a different story Above, you see that with same liabilities if the value of current assets is overstated the net worth looks great However a closer look – everything else unchanged – would show that current asset are not that great and that the company has a much smaller net worth than at first glance – IN OTHER WORDS THE COMPANY IS MUCH MORE SENSITIVE TO THIRD PARTY CREDIT THE BALANCE SHEET AT THE LEFT SIDE CAN BE COMPARED WITH A BALANCE SHEET OF A BANK IN GENERAL AS FAR AS THE NET WORTH VERSUS TOTAL LIABILITIES IS CONCERNED
Same picture as the previous slide but with an overstatement of fixed assets, i.e. buildings for instance ( a road is being build along your house or company)
As we talk about depreciation and amortisation this is how it can be done There are two methods which once chosen for a given asset need to be followed What method would you choose in case of a business which is generating good profits and who would like to decrease its « taxes payable » if possible? What method would you choose in the opposite case with weak profits?
Same as slide we just saw but in graph form The linear depreciation is a straight line whereas the digressive depreciation is a curved line
We mentioned during this module more than once the difference between cash entries and non cash entries as well as the relationship between the balance sheet and the P & L account
This slide summarises the 4 key principles of accounting The next slide introduces another concept, i.e. the business cycle
The measurement of the business cycle is important as it is a very useful tool in « FINANCIAL MANAGEMENT » In this case for a car dealer who is also selling spare parts – how long are they laying on the shelves Recall that they are sale-able assets which should be sold and stay in the inventory (or stock to use a US term) and even worse become obsolete so that they can no longer be sold
Same thinking goes for all the sale-able assets or assets which need to be « turned-over » into cash A debtor who is not paying boils down to the fact you are playing his banker and hence loose the interest on that money
As you can see the Income statement also called the Profit & Loss Account is structured in 4 parts to show income and charges as a result of Operations Exceptional items (for instance head quarters have been sold) The results (positive or negative) of the investments made by the company The financial cost and taxes The purpose to structure a P & L that way is to make comparison possible and show if the money is coming from operations or anything else As you can see the P & L has its own vocabulary Turnover – cost of goods sold = GROS MARGIN GROS MARGIN + OTHER BUSINESS RELATED INCOME = INCOME FROM OPERATIONS INCOME FROM OPERATIONS – GOODS AND SERVICES = ADDED VALUE ADDED VALUE – PERSONNEL EXPENSE & OTHER OPERATIONAL EXPENSES = GROS OPERATION INCOME GROS OPERATING INCOME +/- EXCEPTIONAL ITEMS = EBITDA (Earnings before interest and taxes and before depreciation and amortisation) EBITDA – AMORTISATION & DEPRECIATIONS & PROVISIONS = EBIT (Earnings before interest and taxes) EBIT – INTEREST AND TAXES = NET PROFIT You have to get used to both the terminology and the lay-out
Finishing on the terminology, cash flow is often – ON THE CONTINENT- referred to as the NET PROFIT + AMORTISATION & PROVISIONS THE NET FINANCING MARGIN (MONEY LEFT OVER TO FINANCE THE EXPANSION OF THE COMPANY) = CASH FLOW – DIVIDENDS & REPAYMENT LONG TERM DEBT In the UK Cash flow means what is generally understood by it, i.e. Cash coming in and cash going out Example the payment of an electricity bill means a cash outflow
This is quite a remarkable slide It shows the P & L statement in a different manner Look at all this hard work and what is finally left over after taxes FOR OUR DEALER LESS THAN 1% OF HIS TURNOVER IS LEFT FOR HIM Now we should really company to what is left over with his initial investment The return on investment for our car dealer is about 12 to 15 %, in other words it is still worth being a car dealer Below 7% he better puts his money to fruition somewhere else and enjoy himself rather than working as hard as he is doing
This slide is a combination of curves The first curve the flat curve of fixed cost shows you that you have fixed expenses whatever the volume of sales Our car distributor has to heat and light up his showroom irrespective of the fact he is selling cars or not The next curve is the variable cost which starts above the fixed cost curve and is related to sales For our dealer this would mean for instance the cleaning cost of a new car that needs to be delivered Those cost are only incured if and when a car is sold The combination of these two curves show us clearly that a certain amount of cars need to be sold before there is even the possibility to make a profit That very point called the break-even point shows how many cars need to be sold in order to cover the fixed expenses AND taking into account the variable expenses
This slide is a combination of curves The first curve the flat curve of fixed cost shows you that you have fixed expenses whatever the volume of sales Our car distributor has to heat and light up his showroom irrespective of the fact he is selling cars or not The next curve is the variable cost which starts above the fixed cost curve and is related to sales For our dealer this would mean for instance the cleaning cost of a new car that needs to be delivered Those cost are only incured if and when a car is sold The combination of these two curves show us clearly that a certain amount of cars need to be sold before there is even the possibility to make a profit That very point called the break-even point shows how many cars need to be sold in order to cover the fixed expenses AND taking into account the variable expenses
Essential is to know where money is made and where it is spent Therefore data are often grouped per profit centre, which means that one allocates revenues and expenses where they occur in order to obtain a clear picture of the various activities and allocate common expenses to the company Our car dealer is a good example; in the case he also provides an after sales service, say maintenance, and sells spare parts and accessories, he would like to know where he is actually making money and if that type of activity is worth the effort You will have guessed that maintenance is more profitable than selling cars and even more so that the profit margin of selling spare parts is much more profitable than selling cars
Profit centre P & L accounting has both advantages and disadvantages but it should be pointed out that the inconvenience is more related to very large companies where the tendency is to work in what is called silos with too little cross-communication
This last slide shows you the difference impact of accounting entries on both the balance sheet and the profit and loss account Looking at the first line: fixed assets will be amortised it will entail an entry to the balance sheet at the one hand (an asset accounts which decreases) and an entry in the P & L statement at the other hand (a charge) Line 2: increase in assets is usually the result of an increase in turnover or vice versa Line 3 Current assets are depreciated and have the same impact as the amortisation, they entail a charge in the profit and loss account Line 4 : Reserves which are booked in the Net Worth are the result of profits realised by the company and retained in the company Line 5 : Long term debt requires the payment of interest to the banker, it will mean a financial charge or a debit in the profit and loss account Line 6 : Idem So most of the movements in the balance sheet will have a correlation with the profit and loss account
This module and the following are usually considered as difficult by the participants They module is a compromise between UK accounting and continental accounting It finishes the pure technical accounting part to gradually switch to the analytical part of the course
I guess every participant is familiar with this picture by now We have stated at the beginning of this seminar that the ideal situation for our car dealer would be that EQUITY AND RESERVES + LONG TERM LIABILITIES SHOULD FINANCE FIXED ASSETS AND THE PERMANENT PART OF THE CURRENT ASSETS The « permanent part » of the current assets is this car which is always in the showroom, so to speak of It is not the same car all year round but it is always a car, an asset, that needs to be financed There are other points which earmark a well balanced balance sheet such as the amount of fixed assets and the financing thereof by means of long term liabilities, same goes for current assets financed by current liabilities Another point is the fact that it is much more comfortable to have more current assets than current liabilities – in that case we say that the company has a positive WORKING CAPITAL THE WORKING CAPITAL IS THE DIFFERENCE BETWEEN CURRENT ASSETS AND CURRENT LIABILITIES Note that prepayments can be on both side of the balance sheet because the company can prepay or a customer can prepay What would be the accounting entry of the fact you prepaid 1000 for a machine through your bank account? DEBIT PREPAID MACHINE CREDIT BANK ACCOUNT Accruals are liabilities which are to be recorded over the period where those expenses occur
On the continent we are used to classify the asset as to the degree of liquidity Land owned by the company is less easy to sell than the company car, i.e. land is less liquid Fixed assets are less liquid than current assets Another way to look and classify the assets is as to the degree of permanence Stock is less permanent than the office building We split the current assets into operating assets and treasury Please not that you can have a positive or negative treasury Operating assets are split into 2 broad categories stocks or inventory and debtors Finally if you have cash it will be listed under broad title « cash » However cash can mean « petty cash » or bank accounts If you are in red at the bank, in technical terms, if you are overdrawn, your bank account should no longer be considered as an asset but obviously as a liability In layman terms we say that you have a negative cash position Better would be to say that you have a negative TREASURY
What we have seen for the asset column is also valid for the liability column Liabilities are classified as to their liquidity which means the speed with which they need to be honoured Likewise liabilities are classified as to the degree of permanence Operating liabilities mainly represent suppliers You will notice that treasury can be negative in other words represent a short term debt rather than a short term asset Also note that a banker can, in case of bad performance, call (= ask reimbursement of) a short term loan much easier that a long term loan THE BANKER WILL USUALLY PUT FINANCIAL CONVENANTS IN THE LOAN AGREEMENT ALLOWING HIM TO CALL THE LOAN IN CASE OF A SERIOUS DETERIORATION OF THE FINANCIAL CONDITION OF THE COMPANY
This representation introduces the equilibrium needed in a balance sheet It introduces 3 concepts: 1° The source of working capital (in French Source de Fonds de Roulement, in Dutch Bedrijfskapitaal) 2° The use of working capital (In French Besoin de Fonds de Roulement, in Dutch Nodig Bedrijfskapitaal) 3° Treasury which is the difference between Source of working capital and the Use of working capital The treasury which is a « difference » will be positive only IF THE SOURCE OF WORKING CAPITAL IS HIGHER THAN THE USE OF WORKING CAPITAL An explanation in French: FR = FP + LT – IMM Fonds de Roulement = Fonds propres + Les dettes à long terme - Immobilisés BFR = ST + CL – FO Besoin de Fonds de Roulement = Stock + Clients - Fournisseurs T = FR – BFR Trésorerie = Fonds de Roulement – Besoins de Fonds de Roulement T = FP + LT – IMM – (ST + CL – FO) Trésorerie = Fonds propres + Dettes à long terme – Immobilisé – (Stocks + Clients – Fournisseurs) T = FP + LT – IMM – ST- CL + FO Trésorerie = Fonds propres + Long terme – Immobilisé – Stocks – Clients + Fournisseurs
This slide shows the same concept as the previous slide In a well structured balance sheet the Own Funds + Long term debt should finance the Fixed assets and the permanent part of the current asset
The purpose of asset and liability management is obviously to Maximise the Source of working capital (own funds and long term debt – long term assets) and minimise the use of working capital (stock and debtors – suppliers) The goal is to have a positive treasury whereby the Source of working capital is higher than the Use of working capital
The same principles in words However, a picture speaks a thousand words
Participants should not be too concerned if the terminology is confusing It is quite normal As the course is also an introduction to financial analysis what matters is the fact that it is clear that the balance sheet has a structure and that the assets are being financed by liabilities in structured way Besides management will always try to finance the assets as cheaply as possible A bank overdraft is much more expensive than a long term loan! Financing cost often eat up, in smaller companies, a great portion of the profits therefore a sound management is of importance For instance for our car dealer it is important for his treasury position that his customers pay him as quickly as possible if possible even before he has to pay the supplier himself If he is successful in doing that he is financing his business with the suppliers’ money Auchan, Cactus the large retailers in Luxembourg are doing just that!
