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Introduction to financial

management
Financial Management can be defined as:
The management of the finances of a business / organisation in order to
achieve financial objectivesTaking a commercial business as the most common
organisational structure, the key objectives of financial management would be to:
Create wealth for the business
Generate cash, and
Provide an adequate return on investment bearing in mind the risks that the
business is taking and the resources invested
There are three key elements to the process of financial management:
(1) Financial Planning
Management need to ensure that enough funding is available at the right time to
meet the needs of the business. In the short term, funding may be needed to invest
in equipment and stocks, pay employees and fund sales made on credit.
In the medium and long term, funding may be required for significant additions to
the productive capacity of the business or to make acquisitions.
(2) Financial Control
Financial control is a critically important activity to help the business ensure that the
business is meeting its objectives. Financial control addresses questions such as:
Are assets being used efficiently?
Are the businesses assets secure?
Do management act in the best interest of shareholders and in accordance with
business rules?
(3) Financial Decision-making
The key aspects of financial decision-making relate to investment, financing and
dividends:

Investments must be financed in some way however there are always financing
alternatives that can be considered. For example it is possible to raise finance from
selling new shares, borrowing from banks or taking credit from suppliers
A key financing decision is whether profits earned by the business should be
retained rather than distributed to shareholders via dividends. If dividends are too
high, the business may be starved of funding to reinvest in growing revenues and
profits further.

Corporate finance
Corporate finance is the area of finance dealing with monetary decisions that
business enterprises make and the tools and analysis used to make these decisions.
The primary goal of corporate finance is to maximizeshareholder value.[1] Although
it is in principle different from managerial finance which studies the financial
decisions of all firms, rather than corporations alone, the main concepts in the study
of corporate finance are applicable to the financial problems of all kinds of firms.
The discipline can be divided into long-term and short-term decisions and
techniques. Capital investment decisions are long-term choices about
which projects receive investment, whether to finance that investment
with equity or debt, and when or whether to pay dividends to
shareholders. On the other hand, short term decisions deal with the shortterm balance of current assets and current liabilities; the focus here is on
managing cash, inventories, and short-term borrowing and lending (such
as the terms on credit extended to customers)
The terms corporate finance and corporate financier are also associated with
investment banking. The typical role of an investment bank is to evaluate the
company's financial needs and raise the appropriate type of capital that best fits
those needs. Thus, the terms corporate finance and corporate financier may be
associated with transactions in which capital is raised in order to create, develop,
grow or acquire businesses.

capital investment decisions


Capital investment decisions[2] are long-term corporate finance decisions relating to
fixed assets and capital structure. Decisions are based on several inter-related
criteria. (1) Corporate management seeks to maximize the value of the firm by
investing in projects which yield a positive net present value when valued using an
appropriate discount rate in consideration of risk. (2) These projects must also be
financed appropriately. (3) If no such opportunities exist, maximizing shareholder
value dictates that management must return excess cash to shareholders (i.e.,
distribution via dividends). Capital investment decisions thus comprise an
investment decision, a financing decision, and a dividend decision.

The investment decision


Management must allocate limited resources between competing opportunities
(projects) in a process known as capital budgeting.[3] Making this investment, or
capital allocation, decision requires estimating the value of each opportunity or
project, which is a function of the size, timing and predictability of future cash flows.

Project valuation
Further information: Business valuation, stock valuation, and fundamental analysis .
In general, each project's value will be estimated using a discounted cash flow
(DCF) valuation, and the opportunity with the highest value, as measured by the
resultant net present value (NPV) will be selected (applied to Corporate Finance by
Joel Dean in 1951; see also Fisher separation theorem, John Burr Williams#Theory).
This requires estimating the size and timing of all of the incrementalcash flows
resulting from the project. Such future cash flows are then discounted to determine
their present value (see Time value of money). These present values are then
summed, and this sum net of the initial investment outlay is the NPV. See Financial
modeling.
The NPV is greatly affected by the discount rate. Thus, identifying the proper
discount rate often termed, the project "hurdle rate" [5] is critical to making an
appropriate decision. The hurdle rate is the minimum acceptable return on an
investmenti.e. the project appropriate discount rate. The hurdle rate should reflect
the riskiness of the investment, typically measured by volatility of cash flows, and
must take into account the project-relevant financing mix. Managers use models
such as the CAPM or the APT to estimate a discount rate appropriate for a particular
project, and use the weighted average cost of capital (WACC) to reflect the
financing mix selected. (A common error in choosing a discount rate for a project is
to apply a WACC that applies to the entire firm. Such an approach may not be
appropriate where the risk of a particular project differs markedly from that of the
firm's existing portfolio of assets.)
In conjunction with NPV, there are several other measures used as (secondary)
selection criteria in corporate finance. These are visible from the DCF and include
discounted payback period, IRR, Modified IRR, equivalent annuity, capital efficiency,
and ROI. Alternatives (complements) to NPV include Residual Income Valuation, MVA
/ EVA (Joel Stern, Stern Stewart & Co) and APV (Stewart Myers). See list of valuation
topics.

Valuing flexibility
Main articles: Real options analysis and decision tree
In many cases, for example R&D projects, a project may open (or close) various
paths of action to the company, but this reality will not (typically) be captured in a
strict NPV approach.[6] Management will therefore (sometimes) employ tools which

place an explicit value on these options. So, whereas in a DCF valuation the most
likely or average or scenario specific cash flows are discounted, here the flexible
and staged nature of the investment is modelled, and hence "all" potential payoffs
are considered. The difference between the two valuations is the "value of
flexibility" inherent in the project.
The two most common tools are Decision Tree Analysis (DTA)[7][8] and Real options
valuation (ROV);[9] they may often be used interchangeably:

DTA values flexibility by incorporating possible events (or states) and


consequent management decisions. (For example, a company would build a
factory given that demand for its product exceeded a certain level during the
pilot-phase, and outsource production otherwise. In turn, given further
demand, it would similarly expand the factory, and maintain it otherwise. In a
DCF model, by contrast, there is no "branching" each scenario must be
modelled separately.) In the decision tree, each management decision in
response to an "event" generates a "branch" or "path" which the company
could follow; the probabilities of each event are determined or specified by
management. Once the tree is constructed: (1) "all" possible events and their
resultant paths are visible to management; (2) given this knowledge of the
events that could follow, and assuming rational decision making,
management chooses the branches (i.e. actions) corresponding to the
highest value path probability weighted; (3) this path is then taken as
representative of project value. See Decision theory#Choice under
uncertainty.

ROV is usually used when the value of a project is contingent on the value of
some other asset or underlying variable. (For example, the viability of a
mining project is contingent on the price of gold; if the price is too low,
management will abandon the mining rights, if sufficiently high, management
will develop the ore body. Again, a DCF valuation would capture only one of
these outcomes.) Here: (1) using financial option theory as a framework, the
decision to be taken is identified as corresponding to either a call option or a
put option; (2) an appropriate valuation technique is then employed usually
a variant on the Binomial options model or a bespoke simulation model, while
Black Scholes type formulae are used less often; see Contingent claim
valuation. (3) The "true" value of the project is then the NPV of the "most
likely" scenario plus the option value. (Real options in corporate finance were
first discussed by Stewart Myers in 1977; viewing corporate strategy as a
series of options was originally per Timothy Luehrman, in the late 1990s.) See
also Option pricing approaches under Business valuation.

Quantifying uncertainty
Further information: Sensitivity analysis, Scenario planning, and Monte Carlo
methods in finance
Given the uncertainty inherent in project forecasting and valuation, [8][10] analysts will
wish to assess the sensitivity of project NPV to the various inputs (i.e. assumptions)

to the DCF model. In a typical sensitivity analysis the analyst will vary one key
factor while holding all other inputs constant, ceteris paribus. The sensitivity of NPV
to a change in that factor is then observed, and is calculated as a "slope": NPV /
factor. For example, the analyst will determine NPV at various growth rates in
annual revenue as specified (usually at set increments, e.g. -10%, -5%, 0%, 5%....),
and then determine the sensitivity using this formula. Often, several variables may
be of interest, and their various combinations produce a "value-surface",[11] (or even
a "value-space",) where NPV is then a function of several variables. See also Stress
testing.
Using a related technique, analysts also run scenario based forecasts of NPV. Here,
a scenario comprises a particular outcome for economy-wide, "global" factors
(demand for the product, exchange rates, commodity prices, etc...) as well as for
company-specific factors (unit costs, etc...). As an example, the analyst may specify
various revenue growth scenarios (e.g. 5% for "Worst Case", 10% for "Likely Case"
and 25% for "Best Case"), where all key inputs are adjusted so as to be consistent
with the growth assumptions, and calculate the NPV for each. Note that for scenario
based analysis, the various combinations of inputs must be internally consistent
(see discussion at Financial modeling), whereas for the sensitivity approach these
need not be so. An application of this methodology is to determine an "unbiased"
NPV, where management determines a (subjective) probability for each scenario
the NPV for the project is then the probability-weighted average of the various
scenarios. See First Chicago Method.
A further advancement is to construct stochastic[12] or probabilistic financial models
as opposed to the traditional static and deterministic models as above.[10] For this
purpose, the most common method is to use Monte Carlo simulation to analyze the
projects NPV. This method was introduced to finance by David B. Hertz in 1964,
although it has only recently become common: today analysts are even able to run
simulations in spreadsheet based DCF models, typically using a risk-analysis add-in,
such as @Risk or Crystal Ball. Here, the cash flow components that are (heavily)
impacted by uncertainty are simulated, mathematically reflecting their "random
characteristics". In contrast to the scenario approach above, the simulation
produces several thousandrandom but possible outcomes, or trials, "covering all
conceivable real world contingencies in proportion to their likelihood;" [13] see Monte
Carlo Simulation versus What If Scenarios. The output is then a histogram of
project NPV, and the average NPV of the potential investment as well as its
volatility and other sensitivities is then observed. This histogram provides
information not visible from the static DCF: for example, it allows for an estimate of
the probability that a project has a net present value greater than zero (or any other
value).
Continuing the above example: instead of assigning three discrete values to
revenue growth, and to the other relevant variables, the analyst would assign an
appropriate probability distribution to each variable (commonly triangular or beta),
and, where possible, specify the observed or supposed correlation between the
variables. These distributions would then be "sampled" repeatedly incorporating
this correlation so as to generate several thousand random but possible scenarios,
with corresponding valuations, which are then used to generate the NPV histogram.
The resultant statistics (average NPV and standard deviation of NPV) will be a more

accurate mirror of the project's "randomness" than the variance observed under the
scenario based approach. These are often used as estimates of the underlying "spot
price" and volatility for the real option valuation as above; see Real options
valuation: Valuation inputs. A more robust Monte Carlo model would include the
possible occurrence of risk events (e.g., a credit crunch) that drive variations in one
or more of the DCF model inputs.
The financing decision

Domestic credit to private sector in 2005.


Main article: Capital structure
Achieving the goals of corporate finance requires that any corporate investment be
financed appropriately.[14] The sources of financing are, generically, capital selfgenerated by the firm and capital from external funders, obtained by issuing new
debt and equity (and hybrid- or convertible securities). As above, since both hurdle
rate and cash flows (and hence the riskiness of the firm) will be affected, the
financing mix will impact the valuation of the firm (as well as the other long-term
financial management decisions). There are two interrelated considerations here:

Management must identify the "optimal mix" of financingthe capital


structure that results in maximum value.[15] (See Balance sheet, WACC, Fisher
separation theorem; but, see also the Modigliani-Miller theorem.) Financing a
project through debt results in a liability or obligation that must be serviced,
thus entailing cash flow implications independent of the project's degree of
success. Equity financing is less risky with respect to cash flow commitments,
but results in a dilution of share ownership, control and earnings. The cost of
equity is also typically higher than the cost of debt (see CAPM and WACC),
and so equity financing may result in an increased hurdle rate which may
offset any reduction in cash flow risk.[16]

Management must attempt to match the long-term financing mix to the


assets being financed as closely as possible, in terms of both timing and cash
flows. Managing any potential asset liability mismatch or duration gap entails
matching the assets and liabilities according to maturity pattern ("Cashflow
matching") or duration ("immunization") respectively; managing this
relationship in the short-term is a major function of working capital
management, as discussed below. Other techniques, such as securitization,
or hedging using interest rate- or credit derivatives, are also common. See

Asset liability management; Treasury management; Credit risk; Interest rate


risk.
Much of the theory here, falls under the umbrella of the Trade-Off Theory in which
firms are assumed to trade-off the tax benefits of debt with the bankruptcy costs of
debt when making their decisions. However economists have developed a set of
alternative theories about financing decisions. One of the main alternative theories
of how firms make their financing decisions is the Pecking Order Theory (Stewart
Myers), which suggests that firms avoid external financing while they have internal
financing available and avoid new equity financing while they can engage in new
debt financing at reasonably low interest rates. Also, Capital structure substitution
theory hypothesizes that management manipulates the capital structure such that
earnings per share (EPS) are maximized. An emerging area in finance theory is
right-financing whereby investment banks and corporations can enhance
investment return and company value over time by determining the right
investment objectives, policy framework, institutional structure, source of financing
(debt or equity) and expenditure framework within a given economy and under
given market conditions. One of the more recent innovations in this are from a
theoretical point of view is the Market timing hypothesis. This hypothesis, inspired in
the behavioral finance literature, states that firms look for the cheaper type of
financing regardless of their current levels of internal resources, debt and equity.

The dividend decision


Main article: The Dividend Decision
Whether to issue dividends,[17] and what amount, is calculated mainly on the basis
of the company's unappropriatedprofit and its earning prospects for the coming
year. The amount is also often calculated based on expected free cash flows i.e.
cash remaining after all business expenses, and capital investment needs have
been met.
If there are no NPV positive opportunities, i.e. projects where returns exceed the
hurdle rate, then finance theory suggests management must return excess cash
to shareholders as dividends. This is the general case, however there are
exceptions. For example, shareholders of a "growth stock", expect that the company
will, almost by definition, retain earnings so as to fund growth internally. In other
cases, even though an opportunity is currently NPV negative, management may
consider investment flexibility / potential payoffs and decide to retain cash flows;
see above and Real options.
Management must also decide on the form of the dividend distribution, generally as
cash dividends or via a share buyback. Various factors may be taken into
consideration: where shareholders must pay tax on dividends, firms may elect to
retain earnings or to perform a stock buyback, in both cases increasing the value of
shares outstanding. Alternatively, some companies will pay "dividends" from stock
rather than in cash; see Corporate action. Today, it is generally accepted that
dividend policy is value neutral i.e. the value of the firm would be the same,

whether it issued cash dividends or repurchased its stock (see Modigliani-Miller


theorem).

Working capital management


Main article: Working capital
Decisions relating to working capital and short term financing are referred to as
working capital management.[18] These involve managing the relationship between a
firm's short-term assets and its short-term liabilities. In general this is as follows: As
above, the goal of Corporate Finance is the maximization of firm value. In the
context of long term, capital investment decisions, firm value is enhanced through
appropriately selecting and funding NPV positive investments. These investments,
in turn, have implications in terms of cash flow and cost of capital. The goal of
Working Capital (i.e. short term) management is therefore to ensure that the firm is
able to operate, and that it has sufficient cash flow to service long term debt, and to
satisfy both maturing short-term debt and upcoming operational expenses. In so
doing, firm value is enhanced when, and if, the return on capital exceeds the cost of
capital; See Economic value added (EVA).

Decision criteria
Working capital is the amount of capital which is readily available to an
organization. That is, working capital is the difference between resources in cash or
readily convertible into cash (Current Assets), and cash requirements (Current
Liabilities). As a result, the decisions relating to working capital are always capital
investment decisions in terms of discounting and profitability considerations; they
are also "reversible" to some extent. (Considerations as to Risk appetite and return
targets remain identical, although some constraints such as those imposed by
loan covenants may be more relevant here).
Working capital management decisions are therefore not taken on the same basis
as long term decisions, and working capital management applies different criteria in
decision making: the main considerations are (1) cash flow / liquidity and (2)
profitability / return on capital (of which cash flow is probably the most important).

The most widely used measure of cash flow is the net operating cycle, or
cash conversion cycle. This represents the time difference between cash
payment for raw materials and cash collection for sales. The cash conversion
cycle indicates the firm's ability to convert its resources into cash. Because
this number effectively corresponds to the time that the firm's cash is tied up
in operations and unavailable for other activities, management generally
aims at a low net count. (Another measure is gross operating cycle which is
the same as net operating cycle except that it does not take into account the
creditors deferral period.)

In this context, the most useful measure of profitability is Return on capital


(ROC). The result is shown as a percentage, determined by dividing relevant
income for the 12 months by capital employed; Return on equity (ROE) shows

this result for the firm's shareholders. As above, firm value is enhanced when,
and if, the return on capital, exceeds the cost of capital. ROC measures are
therefore useful as a management tool, in that they link short-term policy
with long-term decision making.

Management of working capital


Guided by the above criteria, management will use a combination of policies and
techniques for the management of working capital. [19] These policies aim at
managing the current assets (generally cash and cash equivalents, inventories and
debtors) and the short term financing, such that cash flows and returns are
acceptable.

Cash management. Identify the cash balance which allows for the business
to meet day to day expenses, but reduces cash holding costs.

Inventory management. Identify the level of inventory which allows for


uninterrupted production but reduces the investment in raw materials and
minimizes reordering costs and hence increases cash flow. (Note that
"inventory" is usually the realm of operations management: given the
potential impact on cash flow, and on the balance sheet in general, finance
typically "gets involved in an oversight or policing way". [20]:714) See Supply
chain management; Just In Time (JIT); Economic order quantity (EOQ);
Dynamic lot size model; Economic production quantity (EPQ); Economic Lot
Scheduling Problem; Inventory control problem; Safety stock.

Debtors management. There are two inter-related roles here: Identify the
appropriate credit policy, i.e. credit terms which will attract customers, such
that any impact on cash flows and the cash conversion cycle will be offset by
increased revenue and hence Return on Capital (or vice versa); see Discounts
and allowances. Implement appropriate Credit scoring policies and
techniques such that the risk of default on any new business is acceptable
given these criteria.

Short term financing. Identify the appropriate source of financing, given


the cash conversion cycle: the inventory is ideally financed by credit granted
by the supplier; however, it may be necessary to utilize a bank loan (or
overdraft), or to "convert debtors to cash" through "factoring".

Relationship with other areas in finance


Investment banking
Use of the term corporate finance varies considerably across the world. In the
United States it is used, as above, to describe activities, decisions and techniques
that deal with many aspects of a companys finances and capital. In the United
Kingdom and Commonwealth countries, the terms corporate finance and
corporate financier tend to be associated with investment banking i.e. with
transactions in which capital is raised for the corporation. [21] These may include

Raising seed, start-up, development or expansion capital

Mergers, demergers, acquisitions or the sale of private companies

Mergers, demergers and takeovers of public companies, including public-toprivate deals

Management buy-out, buy-in or similar of companies, divisions or subsidiaries


typically backed by private equity

Equity issues by companies, including the flotation of companies on a


recognised stock exchange in order to raise capital for development and/or to
restructure ownership

Raising capital via the issue of other forms of equity, debt and related
securities for the refinancing and restructuring of businesses

Financing joint ventures, project finance, infrastructure finance, public-private


partnerships and privatisations

Secondary equity issues, whether by means of private placing or further


issues on a stock market, especially where linked to one of the transactions
listed above.

Raising debt and restructuring debt, especially when linked to the types of
transactions listed above

Financial risk management


Main article: Financial risk management
See also: Credit risk; Default (finance); Financial risk; Interest rate risk;
Liquidity risk; Operational risk; Settlement risk; Value at Risk; Volatility risk.
Risk management is the process of measuring risk and then developing and
implementing strategies to manage ("hedge") that risk. Financial risk management,
typically, is focused on the impact on corporate value due to adverse changes in
commodity prices, interest rates, foreign exchange rates and stock prices (market
risk). It will also play an important role in short term cash- and treasury
management; see above. It is common for large corporations to have risk
management teams; often these overlap with the internal audit function. While it is
impractical for small firms to have a formal risk management function, many still
apply risk management informally. See also Enterprise risk management.
The discipline typically focuses on risks that can be hedged using traded financial
instruments, typically derivatives; see Cash flow hedge, Foreign exchange hedge,
Financial engineering. Because company specific, "over the counter" (OTC)
contracts tend to be costly to create and monitor, derivatives that trade on wellestablished financial markets or exchanges are often preferred. These standard
derivative instruments include options, futures contracts, forward contracts, and

swaps; the "second generation" exotic derivatives usually trade OTC. Note that
hedging-related transactions will attract their own accounting treatment: see Hedge
accounting, Mark-to-market accounting, FASB 133, IAS 39.
This area is related to corporate finance in two ways. Firstly, firm exposure to
business and market risk is a direct result of previous Investment and Financing
decisions. Secondly, both disciplines share the goal of enhancing, or preserving,
firm value. There is a fundamental debaterelating to "Risk Management" and
shareholder value: in question is the shareholder's desire to optimize risk versus
taking exposure to pure risk (a risk event that only has a negative side, such as loss
of life or limb). The debate links the value of risk management in a market to the
cost of bankruptcy in that market. See Fisher separation theorem.

Personal and public finance


Corporate finance utilizes tools from almost all areas of finance. Some of the tools
developed by and for corporations have broad application to entities other than
corporations, for example, to partnerships, sole proprietorships, not-for-profit
organizations, governments, mutual funds, and personal wealth management. But
in other cases their application is very limited outside of the corporate finance
arena. Because corporations deal in quantities of money much greater than
individuals, the analysis has developed into a discipline of its own. It can be
differentiated from personal finance and public finance.

Alternate Approaches
A standard assumption in Corporate finance is that shareholders are the residual
claimants and that the primary goal of executives should be to
maximizeshareholder value. Recently, however, legal scholars (e.g. Lynn Stout[23])
have questioned this assumption, implying that the assumed goal of maximizing
shareholder value is inappropriate for a public corporation. This criticism in turn
brings into question the advice of corporate finance, particularly related to stock
buybacks made purportedly to "return value to shareholders," which is predicated
on a legally erroneous assumption.

INCOME STATEMENT
Income statement (overview)
The income statement is a historical record of the trading of a business over
a specific period (normally one year). It shows the profit or loss made by the
business which is the difference between the firms total income and its
total costs.
The income statement serves several important purposes:

Allows shareholders/owners to see how the business has performed and


whether it has made an acceptable profit (return)

Helps identify whether the profit earned by the business is sustainable


(profit quality)

Enables comparison with other similar businesses (e.g. competitors) and the
industry as a whole

Allows providers of finance to see whether the business is able to generate


sufficient profits to remain viable (in conjunction with the cash flow
statement)

Allows the directors of a company to satisfy their legal requirements to report


on the financial record of the business

The structure and format of a typical income statement is illustrated below:

Boston Learning Systems plc

Income Statement

2011

2010

Year Ended 31 December

'000

'000

Revenue

21,450

19,780

Cost of sales

13,465

12,680

Gross profit

7,985

7,100

Distribution costs

3,210

2,985

Administration expenses

2,180

1,905

2,595

2,210

156

120

2,439

2,090

746

580

1,693

1,510

Operating profit

Finance costs

Profit before tax

Tax expense

Profit attributable to shareholders

The lines in the income statement can be briefly described as follows:


Category
Explanation

Revenue

The revenues (sales) during the period are recorded here.


Sometimes referred to as the top line revenue shows the
total value of sales made to customers

Cost of sales

The direct costs of generating the recorded revenues go into


cost of sales. This would include the cost of raw materials,
components, goods bought for resale and the direct labour costs
of production.

Gross profit

The difference between revenue and cost of sales. A simple but


very useful measure of how much profit is generated from every
1 of revenue before overheads and other expenses are taken
into account. Is used to calculate the gross profit margin (%)

Distribution & Operating costs and expenses that are not directly related to
administration producing the goods or services are recorded here. These would
expenses
include distribution costs (e.g. marketing, transport) and the
wide range of administrative expenses or overheads that a
business incurs.

Operating
profit

A key measure of profit. Operating profit records how much


profit has been made in total from the trading activities of the
business before any account is taken of how the business is
financed.

Finance
expenses

Interest paid on bank and other borrowings, less interest income


received on cash balances, is shown here. A useful figure for
shareholders to assess how much profit is being used up by the

funding structure of the business.

Profit before
tax

Calculated as operating profit less finance expenses

Tax

An estimate of the amount of corporation tax that is likely to


be payable on the recorded profit before tax

Profit
The amount of profit that is left after the tax has been accounted
attributable to for. The shareholders then decide how much of this is paid out
shareholders
to them in dividends and how much is left in the business
(retained earnings in the equity section of the balance sheet)

BALANCE SHEET
Balance Sheet (overview)
A balance sheet is a statement of the total assets and liabilities of an
organisationat a particular date - usually the last date of an accounting period.
The balance sheet is split into two parts:

(1) A statement of fixed assets, current assets and the liabilities (sometimes
referred to as "Net Assets")
(2) A statement showing how the Net Assets have been financed, for example
through share capital and retained profits.
The Companies Act requires the balance sheet to be included in the published
financial accounts of all limited companies. In reality, all other organisations that
need to prepare accounting information for external users (e.g. charities, clubs,
partnerships) will also product a balance sheet since it is an important statement of
the financial affairs of the organisation.
A balance sheet does not necessary "value" a company, since assets and liabilities
are shown at "historical cost" and some intangible assets (e.g. brands, quality of
management, market leadership) are not included.
Example Balance Sheet
The structure of a typical balance sheet is illustrated below:
Boston Learning Systems plc
Balance Sheet at 31
December

2009

2008

'000

'000

150

150

2,450

2,100

2,600

2,250

Inventories

1,325

1,475

Trade and other receivables

4,030

3,800

250

190

1,340

780

ASSETS
Non-current assets
Goodwill and other intangible
assets
Property, plant & equipment

Current assets

Short-term investments
Cash and cash equivalents

6,945

6,245

2,310

2,225

Short-term borrowings

350

550

Current tax liabilities

800

650

Provisions

290

255

3,750

3,680

3,195

2,565

1,200

1,450

140

140

1,340

1,590

4,455

3,225

500

500

3,955

2,725

Current liabilities
Trade and other payables

Net current assets

Non-current liabilities
Borrowings
Provisions

NET ASSETS

EQUITY
Share capital
Retained earnings

TOTAL EQUITY

4,455

3,225

An asset is any right or thing that is owned by a business. Assets include land,
buildings, equipment and anything else a business owns that can be given a value
in money terms for the purpose of financial reporting.

Definition of Liabilities
To acquire its assets, a business may have to obtain money from various sources in
addition to its owners (shareholders) or from retained profits. The various amounts
of money owed by a business are called its liabilities.
Long-term and Current
To provide additional information to the user, assets and liabilities are usually
classified in the balance sheet as:
- Current: those due to be repaid or converted into cash within 12 months of the
balance sheet date;
- Long-term: those due to be repaid or converted into cash more than 12 months
after the balance sheet date;
Fixed Assets
A further classification other than long-term or current is also used for assets. A
"fixed asset" is an asset which is intended to be of a permanent nature and which is
used by the business to provide the capability to conduct its trade. Examples of
"tangible fixed assets" include plant & machinery, land & buildings and motor
vehicles. "Intangible fixed assets" may include goodwill, patents, trademarks
and brands - although they may only be included if they have been "acquired".
Investments in other companies which are intended to be held for the long-term can
also be shown under the fixed asset heading.
Definition of Capital
As well as borrowing from banks and other sources, all companies receive finance
from their owners. This money is generally available for the life of the business and
is normally only repaid when the company is "wound up". To distinguish between
the liabilities owed to third parties and to the business owners, the latter is referred
to as the "capital" or "equity capital" of the company.
In addition, undistributed profits are re-invested in company assets (such as stocks,
equipment and the bank balance). Although these "retained profits" may be
available for distribution to shareholders - and may be paid out as dividends as a

future date - they are added to the equity capital of the business in arriving at the
total "equity shareholders' funds".
At any time, therefore, the capital of a business is equal to the assets (usually cash)
received from the shareholders plus any profits made by the company through
trading that remain undistributed.

CURRENT ASSETS
Current assets
This section of the balance sheet shows the assets a business owns which are either
cash, cash equivalents, or are expected to be turned into cash during the next
twelve months.
Current assets are, therefore, very important to cash flow management and
forecasting, because they are the assets that a business uses to pay its bills, repay
borrowings, pay dividends and so on,
Current assets are listed in order of their liquidity or in other words, how
easy it is to turn each category of current asset into cash.
The main elements of current assets are:
Inventories
Inventories (often also called stocks) are the least liquid
kind of current asset. Inventories include holdings of raw
materials, components, finished products ready to sell and also
the cost of work-in-progress as it passes through the
production process.
For the balance sheet, a business will value its inventories at
cost. A profit is only earned and recorded once inventories
have been sold.
Not all inventories can eventually be sold. A common problem
is stock obsolescence where inventories have to be sold
for less than their cost (or thrown away) perhaps because they
are damaged or customers no longer demand them. For these
inventories, the balance sheet value should be the amount that
can be recovered if the stocks can finally be sold.

Trade and
other
receivables

Trade debtors are usually the main part of this category. A


trade debtor is created when a customer is allowed to buys
goods or services on credit. The sale is recognised as revenue
(income statement) when the transaction takes place and the

amount owed is added to trade debtors in the balance sheet.


At some stage in the future, when the customer settles the
invoice, the trade debtor balance converts into cash!
Most businesses operate with a reasonably significant amount
owed by trade debtors at any one time. It is not unusual for
customers to take between 60-90 days to pay amounts owed,
although the average payment period varies by industry. Of
course some customer debts are not eventually paid the
customer becomes insolvent, leaving the business with debtor
balances that it cannot recover.
When a business is doubtful whether a customer will settle its
debts it needs to make an allowance for this in the balance
sheet. This is done by making a provision for bad and
doubtful debts which effectively reduces the value of trade
debtors to the total amount that the business reasonably
expects to receive in the future.

Short-term
investments

A business with positive cash balances can either hold them in


the bank or invest them for short periods perhaps by placing
them on short-term deposit. Such investments would be
shown in this category.

Cash and cash


equivalents

The most liquid form of current assets = the actual cash


balances that the business has! The bank account balance
would be the main item in this category.

CURRENT LIABILITIES
Current liabilities
Current liabilities represent amounts that are owed by the business and which
are due to be paid within the next twelve months. Current liabilities are normally
settled from the amounts available in current assets.
The main elements of current liabilities are:
Trade and other
payables
The main element of this is normally trade creditors
amounts owed by a business to its suppliers for goods and
services supplied. A trade creditor is the reverse of a trade
debtor. A business buys from a supplier and then pays for
those goods and services some time later the period depends
on the length and amount of credit the supplier allows.

Short-term
borrowings

Amounts in this category represent the amounts that need to


be repaid on outstanding borrowings in the next year. For
example, a business may have a bank loan of 2million of
which 250,000 is due to be repaid six months after the
balance sheet date. In the balance sheet, the bank loan would
be split into two categories: 250,000 as short-term borrowings
and the remainder (1,750,000) in the borrowings figure in
non-current liabilities.

Current tax
liabilities

This category shows the tax liabilities that the business is still
to pay to the government. This will mainly comprise
corporation tax, income tax and VAT.

Provisions

This is a category that can contain a variety of amounts due.


For example, it would include any dividends due to be paid to
shareholders. More importantly, it will also include any
estimates of potential costs which the business might incur in
relation to known disputes or other issues. For example, if the
business is subject to legal claims or is planning to make
redundancies in the near future then the likely costs of these
issues needs to be provided for in the balance sheet

Non-current liabilities
This category shows the longer-term liabilities that a business has. By longer-

term, we mean liabilities that need to be settled in more than one years time.
This would include bank loans which are not yet due for repayment.

RATIO ANALYSIS
Study Notes: Business Finance & Accounting
Main ratios (introduction)
In our introduction to interpreting financial information we identified five main areas
for investigation of accounting information. The use of ratio analysis in each of
these areas is introduced below:
Profitability Ratios
These ratios tell us whether a business is making profits - and if so whether at an
acceptable rate. The key ratios are:
Ratio

Calculation

Comments

Gross
Profit
Margin

[Gross Profit /
Revenue] x 100
(expressed as a
percentage

This ratio tells us something about the business's


ability consistently to control its production costs or
to manage the margins its makes on products its
buys and sells. Whilst sales value and volumes may
move up and down significantly, the gross profit
margin is usually quite stable (in percentage terms).
However, a small increase (or decrease) in profit
margin, however caused can produce a substantial
change in overall profits.

Operati
ng
Profit
Margin

[Operating Profit /
Revenue] x 100
(expressed as a
percentage)

Assuming a constant gross profit margin, the


operating profit margin tells us something about a
company's ability to control its other operating costs
or overheads.

Return
on
capital
employ
ed

Net profit before


ROCE is sometimes referred to as the "primary
tax, interest and
ratio"; it tells us what returns management has
dividends ("EBIT") / made on the resources made available to them
total assets (or
before making any distribution of those returns.
total assets less

("ROCE" current liabilities


)

Efficiency ratios
These ratios give us an insight into how efficiently the business is employing those
resources invested in fixed assets and working capital.
Ratio
Calculation
Sales
Sales / Capital
/Capital employed
Employe
d

Comments
A measure of total asset utilisation. Helps to answer
the question - what sales are being generated by
each pound's worth of assets invested in the
business. Note, when combined with the return on
sales (see above) it generates the primary ratio ROCE.
Sales or Sales or profit /
This ratio is about fixed asset capacity. A reducing
Profit /
Fixed Assets
sales or profit being generated from each pound
Fixed
invested in fixed assets may indicate overcapacity or
Assets
poorer-performing equipment.
Stock
Cost of Sales /
Stock turnover helps answer questions such as "have
Turnover Average Stock
we got too much money tied up in inventory"?. An
Value
increasing stock turnover figure or one which is
much larger than the "average" for an industry, may
indicate poor stock management.
Credit
(Trade debtors
The "debtor days" ratio indicates whether debtors
Given /
(average, if
are being allowed excessive credit. A high figure
"Debtor possible) / (Sales)) (more than the industry average) may suggest
Days"
x 365
general problems with debt collection or the financial
position of major customers.
Credit
((Trade creditors + A similar calculation to that for debtors, giving an
taken /
accruals) / (cost of insight into whether a business is taking full
"Creditor sales + other
advantage of trade credit available to it.
Days"
purchases)) x 365
Liquidity Ratios
Liquidity ratios indicate how capable a business is of meeting its short-term
obligations as they fall due:
Ratio
Current
Ratio

Calculation
Current Assets /
Current Liabilities

Comments
A simple measure that estimates whether the
business can pay debts due within one year from
assets that it expects to turn into cash within that
year. A ratio of less than one is often a cause for
concern, particularly if it persists for any length of

time.

Quick
Ratio (or
"Acid
Test"

Cash and near


cash (short-term
investments +
trade debtors)

Not all assets can be turned into cash quickly or


easily. Some - notably raw materials and other
stocks - must first be turned into final product, then
sold and the cash collected from debtors. The Quick
Ratio therefore adjusts the Current Ratio to eliminate
all assets that are not already in cash (or "nearcash") form. Once again, a ratio of less than one
would start to send out danger signals.

Stability Ratios
These ratios concentrate on the long-term health of a business - particularly the
effect of the capital/finance structure on the business:
Ratio

Calculation

Comments

Gearing

Borrowing (all
Gearing (otherwise known as "leverage") measures
long-term debts + the proportion of assets invested in a business that
normal
are financed by borrowing. In theory, the higher the
overdraft) / Net
level of borrowing (gearing) the higher are the risks
Assets (or
to a business, since the payment of interest and
Shareholders'
repayment of debts are not "optional" in the same
Funds)
way as dividends. However, gearing can be a
financially sound part of a business's capital
structure particularly if the business has strong,
predictable cash flows.

Interest
cover

Operating profit
before interest /
Interest

This measures the ability of the business to "service"


its debt. Are profits sufficient to be able to pay
interest and other finance costs?

Investor Ratios
There are several ratios commonly used by investors to assess the performance of a
business as an investment:
Ratio

Calculation

Comments

Earnings
per
share
("EPS")

Earnings (profits)
attributable to
ordinary
shareholders /
Weighted average
ordinary shares in
issue during the
year

A requirement of the London Stock Exchange - an


important ratio. EPS measures the overall profit
generated for each share in existence over a
particular period.

PriceMarket price of
Earnings share / Earnings
Ratio
per Share
("P/E
Ratio")

At any time, the P/E ratio is an indication of how


highly the market "rates" or "values" a business. A
P/E ratio is best viewed in the context of a sector or
market average to get a feel for relative value and
stock market pricing.

Dividend (Latest dividend


Yield
per ordinary share
/ current market
price of share) x
100

This is known as the "payout ratio". It provides a


guide as to the ability of a business to maintain a
dividend payment. It also measures the proportion
of earnings that are being retained by the business
rather than distributed as dividends.

Introduction to ratio analysis


Financial information is always prepared to satisfy in some way the needs of various
interested parties (the "users of accounts"). Stakeholders in the business
(whether they are internal or external to the business) seek information to find out
three fundamental questions:
(1) How is the business trading?
(2) How strong is the financial position?
(3) What are the future prospects for the business?
For outsiders, published financial accounts are an important source of information to
enable them to answer the above questions.
To some degree or other, all interested parties will want to ask questions about
financial information which is likely to fall into one or other of the following
categories, and be about:
Performance Area
Key Issues

Profitability

Is the business making a profit?


How efficient is the business at turning revenues into profit?
Is it enough to finance reinvestment?
Is it growing?
Is it sustainable (high quality)?

How does it compare with the rest of the industry?

Financial
efficiency

Is the business making best use of its resources?


Is it generating adequate returns from its investments?
Is it managing its working capital properly?

Liquidity and
gearing

Is the business able to meet its short-term debts as they fall


due?
Is the business generating enough cash?
Does the business need to raise further finance?
How risky is the finance structure of the business?

Shareholder
return

What returns are owners gaining from their investment in


the business?
How does this compare with similar, alternative investments
in other businesses?

Using financial statements to assess business performance


The balance sheet and income statement provide much useful information for a
user of accounts to better understand how the business is doing. Some useful
analytical tasks would include:

Comparing performance over time:


A danger with just looking at one years results is that the numbers can hide a
longer term issue in the business.
By looking at data over several years, it is possible to see whether a trend is
emerging. Public companies in the UK are required to publish a five-year summary
of the income statement to help shareholders assess trends.

Comparing performance against competitors or the industry as a whole:

Assuming that the detailed information is available, a comparison against


competitors provides a useful way for management and shareholders to assess
relative performance.
Has the business revenues grown as fast as close competitors? How has the
business performed compared with the market as a whole?
Benchmarking against best-in-class businesses:
Comparison against other businesses who are not direct competitors can also be
useful particularly if they help set the standard that the business aims to achieve.
Care has to be taken with this, though. The benchmark business might operate in a
very different industry, with significantly different profit margins and balance sheet
norms.
Potential weaknesses in using published financial information to assess
performance
It is worth remembering some of the potential problems that can arise when using
the income statement and balance sheet to assess performance. Two in particular:

Valuing some assets and liabilities on the balance sheet involves subjective
judgment. For example, management has some discretion about what
provisions they need to make for trade debtors that may not pay or for
obsolete stocks.

Accounts are largely descriptive about what has occurred in the past rather
than explaining why. Publicly quoted companies are required to provide
much more detailed commentary on the financial statements in the Annual
Report. However, the vast majority of companies are not publicly quoted!

http://bizfinance.about.com/od/financialratios/f/Gross_Profit_Margin.
htm

What is the Gross Profit Margin?


The gross profit margin is a margin ratio. In order to calculate gross profit
margin, you have to look at your company's income statement.
Gross Profit = Sales Revenue - Cost of Goods Sold
In order to understand gross profit, you have to understand fixed and
variable costs. Variable costs are those that the company incurs as a result of
producing its product. They are, essentially, cost of goods sold. So, the gross
profit equation can be restated as:
Gross Profit = Sales Revenue - Variable Costs
Gross profit is expressed on the income statement as a dollar amount. Gross
profit margin is expressed as a percentage:
Gross Profit/Sales Revenue = Gross Profit Margin ______%
Gross profit is what you have left over after you pay all your variable costs or
costs associated with producing your product or service. It is important to
track the gross profit margin in order to track profitability.

How to Increase Your Gross Profit Margin


Small business owners are always looking to improve their gross profit
margins. In other words, they want to decrease their cost of goods sold or
variable costs while increasing their sales revenues. Typically, there are two
ways to do this.
First, you can increase the price of your product. You have to be careful about
doing this, particularly in a poor business climate. If you make a mistake and
increase your prices too much, your sales can drop. In order to increase your
prices successfully, you have to gauge the economic environment, your
competition, and the supply and demand for your product, along with your
customer base.
Second, you can decrease the cost of making your product or your variable
costs. This is just as tricky as increasing the price of your product. You can
make the product more efficiently. This might involve decreasing your labor
costs. That may involve layoffs or otherwise impacting employee goodwill. If

you decrease your labor costs in this way, it could affect the quality of your
product.
You can also decrease your manufacturing costs with regard to materials. You
may want to try to find a supplier for materials that offers them at a less
expensive price. You can also try to negotiate volume discounts with your
current supplier. If you buy materials in bulk, the supplier may give you a
discount. When you are looking for a supplier offering materials for a cheaper
price, never lose sight of quality. You don't want to compromise the quality of
your product.
Fixed and Variable Costs
The Types of Expenses you Incur when you Start a Small Business

When you start a small business, you will have two types of expenses. Fixed
expenses do not change with sales volume. Variable costs, however, do
change with the volume of the product you sell. It is important to understand
the relationship between your fixed and variable expenses, your sales
volume, and your expected net profit. First, you have to understand your
costs or expenses.
Fixed Costs

Fixed costs are the costs associated with the product that have to be paid
regardless of the volume you sell. No matter how much you sell or don't sell,
you have to pay your fixed costs.
An example of a fixed cost is overhead. Overhead may include rent for the
space your company occupies such as your office space. It may also include
your weekly payroll. Another fixed expense may be the depreciation you
incur on your equipment. Those are just a few examples of expenses you
have to pay no matter what your sales volume is.
Variable Costs

Variable costs are directly related to sales. In fact, variable costs change with
sales. As sales go up, so do variable costs. As sales go down, variable costs
go down. Variable costs are costs of labor or materials that change with
sales. One way for a company to save money is to reduce its variable costs.
Sometimes, calculating variable costs is as simple as looking at your costs of
goods sold on your income statement.

Examples of variable costs are the raw materials that go into creating the
company's product and the labor the company uses. Other examples are
costs of goods sold, sales commissions, delivery charges, shipping charges,
wages and numbers of temporary or part-time employees, and bonuses to
employees. If sales decline, all of these variable costs can decline and
probably will decline.
Semi-variable costs

Some costs have components that are fixed and some that are variable. One
example is wages for your sales force. A portion of the wage for a
salesperson may be a fixed salary and the rest may be sales commission.
When calculating your fixed and variable costs, you should allocate the fixed
portion to fixed costs and the variable portion to variable costs.
Costs, Sales Volume, and Profit

A change in any of your costs can drastically affect your net profit. A change
in sales volume can also affect your net profit. Another variable that is
important is the price of your product which interacts with volume and costs.
Breakeven analysis shows the relationship between the price of the product
you sell, the volume of the product you sell, and your costs or expenses. One
of the variables you use in breakeven analysis, price, can be determined by
further dividing up fixed and variable costs in direct and indirect costs
Direct and Indirect Costs and Their Effect on Pricing your Product
How to Include Direct and Indirect Costs When Pricing your Product

Part of the process of pricing your product is including the costs of producing
that product. Those costs include the direct and indirect costs associated
with producing your product.
Direct Costs

Direct costs are costs that can be easily traced to a particular object (also
called a cost object), such as a product, the raw materials used to
manufacture a product, or the labor associated with the work to produce the
product. If your company produces a widget and a production manager is
hired to oversee production of that widget, then the production manager's
salary is a direct cost. If you own a carpet cleaning business, which is a
service organization, and you hire workers just to clean carpets, their wages
are direct costs.

Direct costs are often, but not always, variable costs. Variable costs increase
as more units of the product are manufactured. As a result, raw materials are
variable and direct costs. But, if there is a supervisor overseeing the
manufacturing of this particular product, their salary is probably the same
regardless of how much of the product is manufactured, so it is a fixed cost.
Direct Materials and Direct Labor

The most common direct costs are direct materials and direct labor. Direct
materials are the materials that can be specifically identified with the
product. If you are a furniture maker, your direct materials would be the
wood that goes into making your furniture along with the nails, varnish, and
other products that you apply specifically to making the furniture. But, you
wouldn't count the gasoline that the loggers use to drive the trucks to get to
the forest to cut down the trees as direct materials.
A method of tracking the direct cost of materials has to be chosen, generally
LIFO or FIFO.
Direct materials are all the materials required to produce a product such as
raw materials. Direct materials costs are assignable to that particular
product, such as the cost of each raw material.
Indirect Costs

Indirect costs are those which affect the entire company, not just one
product. They are costs like advertising, depreciation, general supplies for
your firm, accounting services, etc. They are services, and costs, for your
entire firm, not just one product. Indirect costs are usually called overhead.
Overhead is the ongoing cost of operating a business that can't be
associated with just one product or service.
Indirect costs can be fixed or variable costs. Often, they are fixed costs with
an example being the rent you pay on your building. Sometimes, they are
variable. An example would be your electricity or water bill which can change
monthly.
Indirect Materials and Indirect Labor

Materials such as tools, cleaning supplies, and office supplies make


production of a company's products possible but can't be assigned to just
one product. These are classified as indirect materials or the overhead

portion of the material your company uses. Indirect materials costs are
usually variable because materials are based on the level of production.
Labor costs that make production of a product or products possible but can't
be assigned to one particular product are classified as indirect costs. An
example of an indirect labor cost would be the salary of a manager as that
manager would manage the entire operation and not just one product line.
The next issue is whether indirect labor costs are fixed or variable costs. In
this case, if the salary is a monthly or annual salary and does not change
based on production, it is a fixed cost. If it is based on production, it is a
variable cost.
It is important for a business owner to correctly classify direct and indirect
costs. One reason is because overhead, your indirect costs, are taxdeductible items. Some of the overhead expenses will be in be included in
cost of goods sold, business deductions, inventory, and other categories.

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