What Every Manager Should Know 1
Are You Savvy About Finance? 2
1. Learning the Tools of the Trade 3
The Balance Sheet 3 Sample Corporate Balance Sheet 4
Assets 5 Liabilities and Equity 5
The Income Statement 5
Sample Income Statement 6
The Statement of Cash Flows 7
Sample Statement of Cash Flows 8
2. How the Financial Pros Use These Tools 10
Troubleshooting With Ratio Analysis 10
Ten Critical Ratios 10
Does your firm have enough cash to pay its bills? 12
To leverage or not to leverage? 12
How profitable is your firm? 12
Should you provide credit to a customer? 12
3. Answering Some Difficult Financial Questions 14
A Question of Profit Margins 14
A Question of Working Capital 15
RMA’s Annual Statement Studies 15
A Question of Returns 16
A Question of Asset Management 17
A Question of Debt Strategy 18
A Question of Purchasing 19
A Question of Stability 20
4. Profit From Your Budget 22
The Budgeting Process 22
Developing a Budget System That’s Right for You 22
Organizing a Budget Team 23
The Budget Committee 24
The Budget Chairman 24
Team Budgeting 24
A Look at Zero-Base Budgeting 25
What Not to Expect From a Budget 27
5. Should You Use a Fixed or Variable Budget? 29
Limitations of a Fixed Budget 29
How Rising Sales Can Affect a Fixed Budget 29
How Falling Sales Can Affect a Fixed Budget 30
Comparing Changes 30
Using a Variable Budget 30
The Need for Flexibility 30
Budgeting After the Fact 31
Getting What You Pay For 31
6. Producing an Effective Budget, Step by Step 32
Step 1: Develop a Sales Forecast 32
Step 2: Develop Measures of Activity 33
Step 3: Collect Historical Data 34
Step 4: Do Cost Analysis 34
Step 5: Determine Budget Allowances 35
Expense Budget, Year Ending Dec. 31: ABC Corporation 36
Step 6: Review Expense Budgets 37
Step 7: Estimate Profits 37
Using Your Budget 38
Remember to Follow Up 38
Revising Your Budget 38
7. Managing Your Cash 40
Making Cash-Flow Decisions 40
Using Your Cash Budget 41
Where to Obtain the Right Cash-Flow Information 42
Expense Budget: ABC Publishing Company 42
Cash Budget: ABC Publishing Company 43
Receipts and Disbursements Analysis 43
Receipts and Disbursements Analysis: ABC Publishing Company 45
Flow of Funds Analysis 45
Flow of Funds Analysis: ABC Publishing Company 46
Forecasting Your Cash Flow 47
Preparing a Short-Term Cash-Flow Forecast 48
Role of Cash-Flow Assumptions 48
Using a Long-Term Cash-Flow Forecast 49
Adapt Flow-of-Funds Analysis 49
Long-Term Cash Forecast: ABC Publishing Company 50
Keeping Cash Flow Under Control 51
The Cash-Flow Statement 51
Liquidity Report 51 Flow-of-Funds Statement 52
Making Your Cash Count 53
Managing a Financial Emergency 53
Priority List 54
8. Capital Investment Basics 56
How to Prepare a Capital Investment Proposal 56
Classifying Capital Spending Projects 56
Avoiding Common Pitfalls 57
Calculating Your True Capital Costs 58
Assessing the Cost of Debt 58
What Are Equity Costs? 58
Ways to Measure Your Expected Return 59
The Payback Method 59
Using Net Present Value to Measure Return 61
Understanding the Discounting Concept 61
Discounting to Find NPV 62
Table 1: Present Value Factors 63
Using Internal Rate of Return 63
Calculating Internal Rate of Return (IRR) 64
The Hurdle Point: Uses and Misuses 65
Determining Flexible Hurdle Rates 65
Analyzing Your Capital Investment Risks 66
Weighted-Risk Analysis 67
Adjusting for Probabilities 67
Alternate Scenarios Measure Risk 68
Probability Adjustment—ABC Company 68
9. How to Raise Money 69
Keep a Business Plan on Hand 69
Contents of a Business Plan 69
When a Shorter Proposal Will Do 70
Where to Look for Funds 71
Internal Financing 71
Customers Come First 71
Make Your Employees Owners 72
The ABCs of Bank Borrowing 72
Finding the Right Type of Loan 73
Score Your Loan Worthiness 75
The Loan Application 75
If Your Banker Turns You Down… 77
Loan Guarantees From the SBA 77
How PLP Works 78
Loans From Commercial Finance Companies 78
Using a Factor 79
Bond Financing 80
Raising Equity Capital 81
How to Attract a Venture Capitalist 81
Evaluating a Venture Capitalist 82
Dealing With an SBIC 82
The Role of the Private Investor 83
Regulation D Private Placement 84
Raising Capital Through a Public Stock Offering 85
Other Methods of Financing 86
A Look at Leasing 86
Don’t Forget Development Corporations 87
What Every Manager Should Know
No subject seems to pervade our lives as much as finance. Whether it’s wrestling with your family budget or seeing if your company qualifies for a bank loan, finance looms larger than any other technical subject on a daily basis.
With downsizing of companies and staffs, managers at every level are having to face financial matters in ever-greater proportions today. If you haven’t yet been asked to scale down inventories or set up financing for departmental projects, chances are you will be soon.
In today’s corporate environment, nonfinancial managers are expected to make financial decisions fast. In fact, your decision often was due “yesterday.” If that’s not enough pressure, the arrival of computers and cyberspace has given your competition access to more financial facts, in greater detail and more promptly, than ever before. The need to make financial decisions quickly is vital to your success.
There’s no time for an in-depth study of financial concepts and their meaning when your boss or your employees are expecting a yes or no answer right away.
This report is meant to strip away the fear and confusion you may experience about finance. It explains expense and capital budgets, financial analysis and cash management, and tells you how to go about raising money—all in language that’s easy to understand.
We explain jargon where we have to use it—and where we think that a picture would be worth a thousand words, you’ll find an example or an illustration. Unlike most publications on finance, we give you not just the how but also the why of the financial process. Our goal: to bring you up to speed fast on the financial tools you need to succeed in business today.
Learning the Tools of the Trade
To get the big picture of the role finances play in your company, think about any major decision you or others within your company make. The decisions to hire, fire, buy, sell, start up or close down—all are financial nature. Almost any question that makes its way to your desk, and that requires a decision by you, can be put into financial terms.
In the strictest sense, the financial pro or officer in your company is still the one charged with making sure the company uses its assets to bring the greatest possible return on the money invested. To accomplish that, he or she must manage those assets, measure the need for additional assets, obtain funds to finance expansion and repay borrowed funds from profits that the assets have generated. In short, the financial officer rides herd on incoming and outgoing dollars. But, in fact, every manager has at least part of that responsibility.
It should come as no surprise to you, then, that the basic tools of the trade used to carry out these tasks begin and end in dollar signs. They are called the balance sheet, the income statement and the statement of cash flows.
These financial statements are prepared by your accounting department or accountant on the accrual basis of accounting. According to the accrual accounting method, revenues are recorded when realized and expenses when incurred, regardless of the date when cash is actually received or disbursed.
For many nonfinancial managers, the accrual concept is confusing because most of us manage our personal finances on a cash basis. Similarly, other business financial concepts create frustration and embarrassment for managers who, often unknowingly, attempt to “simplify” things by applying personal financial practices.
For instance, most of us regard our annual income on a gross basis.
Rarely do we consider depreciating personal items, such as a car for wear and tear, or amortizing less tangible goods. An examination of the balance sheet, income statement and statement of cash flows will reveal the importance of understanding the difference between business and personal finance.
The Balance Sheet
The balance sheet is a comprehensive statement of the financial picture of your company on a given date. Virtually every business prepares a balance sheet at the close of its fiscal or tax year. Many also prepare semiannual or quarterly balance sheets, and most should do so.
There are two primary sections on the balance sheet: The first one (the left side, if the two sections are shown side by side) lists your company’s assets, or what it owns. The second section (right-hand side) lists liabilities, or debts, and the owner’s equity in the company. Total liabilities are claims against total assets.
The sum of these liabilities and equity always equals total assets (assets = liabilities + equity): hence, the name “balance sheet.” The simplified balance sheet that appears on page 4 might be prepared by any manufacturing company. Other companies would have similar statements.
Following is a description of each of the basic balance-sheet items listed, many of which will be used to construct the various financial ratios explained in Section 2.
Current assets: All cash held (primarily in bank balances or money market funds); assets that will be converted to cash in the normal course of business within one business year (trade accounts, notes receivable and inventories); plus other assets that could or will be converted within a year (marketable short-term securities, nontrade debts or debt installments owed to the company within a year). Other than cash and equivalents, current assets include inventories (in various stages of completion) and prepaid expenses (any rent, interest, insurance or taxes paid in advance).
Although the term doesn’t appear in most balance sheets, the following items make up non- current assets.
Fixed assets: All property, plants and equipment (buildings, real estate, machines, transportation equipment, office equipment, furniture, etc.) used in the business. The accumulated depreciation on these items is deducted where applicable in standard accounting practice.
Other assets: All long-term investments, such as securities (stocks, bonds, mortgages), and intangible assets, such as goodwill, patents, trademarks and other paper assets, which may be assigned a value for determining the total sale price of the business. Intangible assets can have a significant impact on a business’s ability to generate income. However, unlike a plant or equip- ment, they are often concepts or legal entitlements.
Total assets: The sum of the current, fixed and other assets listed above.
Liabilities and Equity
Current liabilities: Outstanding trade debts and obligations (trade accounts payable, short-term notes and loans payable, current installments due on long-term debts, etc.) that will fall due in the course of normal business within one year, plus accrued business expenses payable and accrued federal income taxes payable.
Long-term liabilities or debt: All business debts and liabilities (long-term loans, bonds, mort- gages, etc.) payable more than one year beyond the date of the balance sheet.
Total liabilities: The sum of the above items.
Shareholders’ equity (net worth): The par value of the corporation’s common and preferred stock, plus any paid-in or accumulated capital surplus over this par value, plus any retained earn- ings for use in business. Retained earnings of the business represent the total income earned by the firm over its life less any dividends paid out to the owners. (Equity = book value of outstanding stock + capital surplus + retained earnings)
Total liabilities and equity: The sum of the above two groups, which by definition is also equal to the total assets of the business.
The Income Statement
The income statement (also called the earnings report or profit-and-loss statement) reflects the results of operation over a period of time, in contrast to the balance sheet’s snapshot view of the company’s financial condition at a given instant.
Again, every business must prepare an annual income statement for tax, legal and other purposes; nevertheless, semiannual, quarterly or even monthly statements can be extremely useful.
The items included in the simplified income statement on page 6 will often be needed to create the financial ratios used in your analysis and covered in the next section. Briefly, here is a description of the items contained in a company’s income statement:
Gross sales or revenues: The actual total dollars billed for goods sold or services provided, before returns, discounts and allowances granted. Sales income and accounts receivable determine this first line item.
Net sales or revenues: Gross sales minus returns, discounts and allowances.
Cost of goods sold: The amounts paid for the purchased materials, components and finished products; direct payroll, operating overhead; and other costs of acquiring or producing the products or services and making them available for sale. This line item often appears as less cost of goods sold.
Gross profit: The difference between net sales or revenues and the cost of the products or services sold. This represents the amount of money left to sell the product and perform the day- to-day operations of the business.
Selling and administrative costs: Selling costs include salespersons’ salaries and commissions, travel and entertainment expenses, sales promotion and advertising costs. Administrative costs include office salaries and expenses, executive salaries and other current support expenses that can’t be allocated to production or sales departments.
Depreciation: The costs of plant assets (or fixed assets: property, plant and equipment) are written off as expenses over their anticipated useful life. Not all fixed assets are depreciated, however. For instance, the value of land tends to appreciate in value because it does not typically wear out.
There are various depreciation techniques an accountant can use. The simplest and most commonly used method in U.S. businesses is called the straight-line method of depreciation, which allows you to depreciate the same amount of expense each year of the estimated useful life of the asset.
For example, an asset with a value of $10,000 and a useful life of 10 years will have an annual $1,000 depreciation expense each year.
Net operating profit: Gross profit, less selling costs and administrative overhead. This line item represents the profit generated by the normal operations of the business.
Nonoperating income: Interest and dividends received on investments, gains on the disposition of capital assets, etc.
Nonoperating expenses: Interest paid on long-term debts, losses on sales of capital assets, etc.
Net profit before taxes: Net operating profit, plus any nonoperating income and minus any nonoperating expenses.
Provision for federal income taxes: The estimated amount to be paid on operating earnings for the period, not the amount of taxes paid during the period.
Net profit (or income) after taxes: The final “bottom line” profit cleared by the business from all sources during the period covered by the statement. Using this vital figure, stockholders can evaluate management, investors can decide on whether to purchase the company’s stock, and creditors can measure the riskiness of a loan.