Finance Basics
Secrets

The experts tell all!

Stuart Warner

Table of Contents

Cover Page

Title Page

Financial awareness is fundamental to business success

Introducing business finance

1.1 Know the different business entities

1.2 Find out how a business gets money

1.3 Find out how a business uses money

1.4 Appreciate the need for record-keeping

1.5 Know what a finance department does

1.6 Understand the key financial systems

1.7 Differentiate financial and management accounting

Accounting fundamentals

2.1 Make sense of the jargon

2.2 Discover why timing is essential

2.3 Know about doubleentry bookkeeping

2.4 See how accounting systems work

2.5 Understand the balance sheet

2.6 Understand the income statement

2.7 Understand the statement of cash flows

2.8 Watch out for non-cash costs

2.9 Be aware of accounting regulation

2.10 Know who uses financial statements

Making profit

3.1 Realize that not all ‘costs’ are the same

3.2 Know what is meant by ‘profit’

3.3 Differentiate mark-ups and margins

3.4 Consider the impact of discounting

3.5 Forecast costs, volumes and profit

3.6 Know when to use CVP analysis

3.7 Know how to manage profitability

3.8 Be aware of tax

Managing cash

4.1 Understand why cash is king

4.2 Avoid the overtrading trap

4.3 Understand the cash operating cycle

4.4 Measure the cash operating cycle

4.5 Improve cash flow – 1

4.6 Improve cash flow – 2

4.7 Collect cash from customers

4.8 Prepare regular cash flow forecasts

Budgeting

5.1 Understand budgets

5.2 Follow the steps forpreparing budgets

5.3 Choose the best way to budget

5.4 Understand participative budgeting

5.5 Calculate variances from budget

5.6 Monitor budgets effectively

Evaluating business opportunities

6.1 Focus on the relevant costs

6.2 Work out if an opportunity pays back

6.3 Calculate return on investment

6.4 Understand the time value of money

6.5 Use NPV and IRR toappraise investments

Measuring business performance

7.1 Evaluate a business using ratios

7.2 Measure profitability

7.3 Measure short-term solvency and liquidity

7.4 Measure long-term solvency and stability

7.5 Calculate investor ratios

7.6 Estimate the value of a business

Jargon buster

Further reading

About The Author

Copyright

About the Publisher

Financial awareness is fundamental to business success

Many business people, professionals and senior executives who may be experts in their field are sometimes less confident in finance. Quite often this is unfounded and can easily be overcome. In the business world the ability to understand finance and communicate financially is essential.

To date, I’ve spent almost two decades working in finance. I’ve spent a large proportion of this time teaching others. Early on, I found that learning finance was akin to learning a language. One of my own finance teachers told me, “It’s not the numbers, it’s the English you’ll find hard!” – and my own experience proves that this is certainly true. Accountants will often use several names for the same thing. Where possible I’ve tried to give alternative explanations when introducing a financial term. The Jargon Buster at the back of the book should also help you get to grips with some key financial terminology.

In this book I’ve picked 50 secrets that will help you get to grips with finance basics. I’ve divided the secrets into seven chapters which cover seven crucial areas every business person should understand.

Introducing business finance. Business owners, managers and employees need to have a basic level of financial awareness to help a business succeed.

Accounting fundamentals. Make sure you know basic financial terminology and concepts. Be familiar with the main financial statements produced by a business.

Making profit. Profit is the raison d’être for most businesses. Knowing how to make and increase profit is one of the key ingredients for business success.

Managing cash. “Profit is sanity but cash is reality.” Without cash a business cannot survive for long. Effective cash management will help a business to endure.

Budgeting. Many businessess invest considerable time in budgeting but few do it successfully. Some practical tips can improve the process.

Evaluating business opportunities. Businesses should use established techniques to help decide whether or not to commit time, resources and money on investment opportunities.

Measuring business performance. A successful business can be judged by the size of its market value. Its performance can be measured by using financial ratios.

From students who are interested in business finance to chief executives who want to know more, this book can help you get to grips with finance basics. You’ll even find it interesting and it can help you with your future business activities.

Financial knowledge is not just for accountants – it’s for everyone!

Introducing business finance

Owners, managers and employees need to be aware of the financial consequences of running their business. In this chapter I’ll explain the different types of business entities. I will show you where a business gets its money from and what it does with it. You’ll appreciate the need to record, analyse and summarize business transactions. I’ll also explain the essential difference between financial accountants and management accountants.

1.1 Know the different business entities

A useful starting point to understanding business finance is to appreciate the different ways of trading. There are three main categories: sole traders, partnerships and limited companies. Each offers advantages and disadvantages in relation to legal issues, taxation and the personal liability of its owners.

1 Sole traders. A sole trader or proprietorship is a business with 1 one owner, who has unlimited personal liability. If the business becomes insolvent, the proprietor is personally liable for any unpaid debts. Examples can include shopkeepers, tradesmen (e.g. electricians), hairdressers and florists.

2 Partnerships. A partnership is a business with multiple owners, who share profits or losses. The partners can share unlimited personal liability or can take limited liability status. Examples tend to include doctors, dentists, lawyers and accountants.

“A friendship founded on business is better than a business founded on friendship” John D. Rockefeller, industrialist

3 Limited companies. A limited company is a business incorporated by law. Its owners are ‘shareholders’ who have the benefit of limited liability. If the business becomes insolvent the shareholders are only liable for the amount they invested in the company. Limited liability is a key advantage of turning a business into a limited company and can help to attract potential investors. In practice, however, banks may require personal guarantees from shareholders of small owner-managed businesses for loans or overdrafts. There is also an increased administrative and financial burden, in comparison to sole traders.

A limited company can be ‘private’ or ‘public’. Most companies, especially small ones, are private and are owned by a small number of shareholders. In the UK, private limited company names end with the suffix ‘Limited’ or ‘Ltd’. The directors of a private limited company are also likely to be the majority shareholders.

Public companies are usually much larger than private compa-companies. Their shares can be sold and purchased on a public stock exchange. In the UK public company names end with the suffix ‘Public Limited Company’ – or ‘PLC’.

This book will be useful to all entities and in particular limited companies which experience the most regulation.

Limited liability is a key advantage for limited companies.

1.2 Find out how a business gets money

The majority of businesses need money to get started. The ability to raise finance is essential to the initial and ongoing success of a business. A lack of finance is one of the main ways that businesses fail.

Imagine you about to start a new business that requires $1 million initial investment. Let’s say this money is needed for premises, a motor vehicle, computer equipment and goods to sell. If you don’t have $1 million, where can you get the money from?

Most entrepreneurs will initially invest their own money when starting a new business. This is known as ‘share capital’ and for limited companies the owners are called ‘shareholders’. ‘Share capital’ is sometimes referred to as ‘equity finance’.

If more money is needed, there are three main options:

1 Raise further equity finance. Ask existing shareholders for more money or find investors who wish to become joint owners/shareholders of the business and contribute to the share capital. As these investors will become joint owners of the business, they will have a say in the running of the business. They will also expect returns on their investment in the form of dividends.

“Never spend your money before you have earned it” Thomas Jefferson, 19th-century American President

2 Borrow money. Typically from a bank or family and friends. This is known as ‘loan finance’ or ‘debt finance’. It is a common route for shareholders who don’t want to share ownership of their business. Equity finance does not have to be repaid, and dividends to shareholders are discretionary. Loan finance, on the other hand, needs to be repaid and will incur interest costs.

3 Use surplus cash generated from operating activities. See Secret 4.5 for more on this. The surplus cash must not have been paid as dividends to shareholders or committed elewhere in the business.

There are many other alternative sources of finance for a business. Examples include leasing assets (as opposed to purchasing assets outright), government grants and even sponsorship. Reading a company’s financial statements should reveal where they have got their money from (Secret 2.5).

A successful financing strategy is just as important as a successful business strategy.

1.3 Find out how a business uses money

If the first thing a business does is raise finance, the next thing it does is to spend it, usually on assets. These are resources owned or controlled by a business and are used to generate money. Assets are generally the biggest investments made by businesses. Both long-term and short-term assets are essential for most businesses.

There are four main categories of assets, as follows:

1 Fixed assets. The term ‘fixed assets’ refers to assets that are a ‘fixed’ item within a business, usually for more than a year (and hence long-term assets). Fixed assets are also referred to as ‘property, plant and equipment’ and sometimes as ‘non-current assets’. They are for continuous use in the business and are essentially used to make money. There are many different types of fixed assets found in businesses. The most common types are land, buildings, machinery, fixtures and fittings, office equipment, computers and motor vehicles.

2 Intangible assets. Intangible assets are also long-term assets. They are non-physical resources and rights owned by a business that offer a competitive advantage or add value to the business. Examples of intangible assets include brands, trademarks and patents.

3 Investments. Many businesses spend their money on investments, which they intend to ‘hold’ for the future and hence are also long-term assets. Investments include assets such as shares held in other companies and rental property.

4 Current assets. The term ‘current assets’ refers to assets that help on a short-term basis, usually for less than a year. These are assets which are traded e.g. inventory, or by their nature ‘liquid’, e.g. cash. Money owed by customers is also a current asset because it is a ‘future benefit’. The customer will pay cash in the future. Money owed by customers is also referred to as ‘debtors’, ‘accounts receivable’, trade receivables’ or more simply ‘receivables’.

Reading a company’s financial statements should reveal what they have spent their money on (Secret 2.5).

Investing money in both long-term and short-term assets is essential for most businesses.

1.4 Appreciate the need for record-keeping

Successful businesses know that accurate record-keeping is not only essential for accounting but also provides infor m ation that can be a key source of competitive advantage.

 Accounting and bookkeeping. ‘Accounting’ can be defined as the provision of financial information concerning the results of a business over a period of time. A business needs to ‘account’ for what it has done and accounting is a process of recording, analysing and summarizing commercial transactions. The term ‘bookkeeping’ generally refers to just the recording of transactions.

case study Tom runs a computer services company and understands the benefits of recording, analysing and summarizing all business transactions. The list opposite shows the information about customers that Tom finds useful to record. It is a list that millions of other companies around the world also compile about their customers:

 Key contact information

 Sales to date

 Forecasted sales

 Credit rating

 Money owed by date

 Distribution costs

 Discounts offered and taken

 Separate legal entity. A fundamental principle of accounting is that a business is a separate entity from its owner. For ‘limited’ companies the concept of separate entity is a legal distinction. As such, business transactions should never be mixed with the personal transactions of the owners, which is also advisable for other business entities. In addition, for ‘limited’ companies there is a statutory requirement to maintain proper accounting records.

 Management and financial accounting. Once transactions are recorded they need to be analysed and summarized. ‘Management accounting’ is the use of this data within a business for management information, planning, decision making, and control purposes. ‘Financial accounting’ is the use of this data to report financial results and the latest position of a business to a number of interested parties, for a number of different purposes. See Secret 1.7 for more detail on the differences between financial and management accounting. See Secret 2.9 for more information on the users of accounts.

 Users of financial information. All users of financial information require quality information which is both relevant and reliable. Therefore it essential that the transactions which underpin this information are properly recorded, analysed and summarized.

Keeping accurate records of business transactions is valuable in many ways.

1.5 Know what a finance department does

A finance department manages the financial operations of a business and provides information and advice to the rest of the business. All areas of a business will have some contact with the finance department. You should understand how a typical finance department operates, and who does what in it.

The four key responsibilities of a finance department are:

 Ensuring that a business has sufficient money

 Recording and controlling transactions within a business

 Providing information internally to managers to help with planning, decision-making and control

 Reporting information externally to stakeholders such as shareholders and tax authorities

 The finance director. The finance department is usually headed up by a finance director (FD) or chief financial officer (CFO) who, as a board member, is responsible for ‘financing and investment strategy’ and making sure it supports the ‘business strategy’.

“My money goes to my agent, then to my accountant and from him to the tax man” Glenda Jackson, English actress

The FD also runs the finance department, which may include the following roles, depending upon the size and complexity of the business:

 The financial controller. This person has responsibility for recording, analysing and summarizing financial transactions. In particular the financial controller will produce the financial statements. The financial controller may manage a number of accounting staff who look after areas such as sales invoicing; debt collection; purchases; making payments; payroll; fixed assets; and taxation.

 The management accountant. He or she assists management with planning, decision making and control. The management accountant will prepare both regular and ad-hoc reports. These reports will include ‘key performance indicators’ (KPIs) which measure the performance of individuals, departments and other critical areas of the business. In particular the management accountant will manage the budgeting process.

 The treasurer. Found in larger businesses, the treasurer has responsibility for financing the business and implementing the financing and investment strategy. In particular the treasurer will liaise with banks, manage cash flow and deal with foreign currency exchange.

The finance department is a key function which should contribute to the success of the business.

1.6 Understand the key financial systems

Irrespective of size, businesses need financial systems to record and control business transactions, especially where money comes in or goes out of the business. System controls should prevent, or detect and correct errors as well as minimize the risk of fraud. You need systems for sales, purchases, payroll and, especially, for cash transactions.

 Credit sales to customers. There should be a clear link between credit limits, orders, issues from stock, delivery, invoicing and collecting debts. Supporting documents should be matched at each stage, so customers receive what they order, are correctly invoiced and ultimately pay. The system should keep track of what is owed by each customer and when they are expected to pay.

 Non-credit sales to customers. Non-credit sales will often follow the same system and controls, with instant payment recorded against the invoice.

 Cash transactions. Although the term ‘cash’ is widely used in finance, very few businesses actually handle cash. Even retailers have a large proportion of customers using payment cards. For many businesses the only cash will be petty cash. Nevertheless, wherever cash is involved, there should be tight controls and links to authorized supporting documents.

 Purchases of goods for resale and stock management. There should be tight controls over purchases, including a clear link to authorized orders and checks that goods or services have actually been received, before any payments are authorized. There should also be links to a stock management system, where applicable. There should be additional controls that purchases are made from approved suppliers at agreed prices. Purchasing systems should monitor payment due dates so businesses can take full advantage of supplier credit.

 Payments for expenses and capital expenditure. The same system and controls will often be used for expenses such as rent and utility bills. High-value capital expenditure will have additional authorization controls.

 Payroll. Payroll is typically the largest and most frequent expense and should have tight controls and segregation of duties. There should be links back to personnel records, authorized pay rates and, where applicable, timesheets. As an additional control the payroll system is often separate to the other systems.

You must record and control business transactions and maintain clear links back to authorized documentation.

1.7 Differentiate financial and management accounting

There are different types of financial information and reports produced by the finance team, which generally fall under two categories: financial accounting and management accounting.

Financial accounts

 Purpose. Financial accounts are used to report the financial results of a business. They are produced at least annually, mainly for the benefit of external users, such as shareholders.

 Focus. The historical financial results of a business.

 Scope. The financial results of the whole business.

 Frequency. Prepared at least annually, although some companies prepare ‘interim’ financial reports every six months.

 Requirement. Financial accounts are a legal requirement for regis-tered companies.

 Format. There are financial accounting standards which govern the format and contents of financial accounts.

 Accuracy. Financial accounts are required to show a ‘true and fair’ view. For practical purposes this means that they should be as accurate as possible and not misleading. ‘Accuracy’ will depend upon the size of a business.

Management accounts

 Purpose. Management accounts provide financial and non-financial information and are used to help managers make informed business decisions. They are usually confidential and not released outside the organization.

 Focus. Use past and present information to make decisions about the future.

 Scope. Can report on products, customers, departments, divisions or the whole business.

 Frequency. Produced whenever required – usually at least monthly.

 Requirement. There are no legal requirements for management accounts. Although, in practice, some external investors, such as banks, may insist on regular management accounts as a condition of funding.

 Format. There are no standard formats or rules for management accounts but some popular established techniques are used, for example, the calculation of profit margins and other financial ratios.

 Accuracy. Management accounts are required to be as accurate as possible as they are used to make critical business decisions. At the same time, as management accounts are used to predict an uncertain future, they can include reasonable approximations.

Financial accounts report historical data. Management accounts help managers make critical decisions.

Accounting fundamentals

You have to walk before you can run. This chapter explains the basic accounting fundamentals which are essential knowledge for anyone in business. The first step is to understand the language of finance used by accountants. Accountancy is notorious for jargon and I will start the chapter by explaining some of the more commonly used terms. I will then move on to some of the most basic financial concepts.

2.1 Make sense of the jargon

Those new to finance can take a while to get used to the terminology used by accountants. Here are some of the common terms used. You can also refer to the ‘jargon buster’ at the back of the book at any time.

Financial statements and accounting principles

 Financial statements. The collection of formal financial records of a business’s activity (namely the balance sheet, income statement, statement of recognized income and expense, and statement of cash flows).

 Matching (or accruals) concept. Costs are accounted for when incurred, and income when earned.

 Going concern. An assumption that the business will continue in operation for the foreseeable future, which provides the basis for the valuation of business assets.

 Prudence. Revenues and profits should only be recognized once their realization is reasonably certain. Conversely, liabilities are accounted for when they are foreseen.

 Materiality. Amount above which an item’s omission or mis-statement would affect the view taken by a reasonable user of financial statements.

“People want to learn about finance because they want to know what accountants are talking about” Anonymous

Revenue, capital and assets

 Asset. An item of value owned or controlled by a business that will generate a future benefit. Examples include buildings and inventory.

 Capital expenditure. Payments to purchase or improve long-term assets such as property and equipment.

 Revenue expenditure. Expenses incurred in running a business, which do not specifically increase the value of long-term assets.

 Receivables (debtors). Amounts owed by customers paying on credit.

 Prepayment. A payment for goods or services before they have been received. Examples include advance payment of insurance and rent.

Liabilities

 Liability. Money owed by a business. A commitment to transfer economic benefit in the future. Examples include payables and loans.

 Payables (or creditors). Amounts owed to suppliers who have offered credit.

 Accrual. Goods or services received but not yet invoiced by the supplier. Examples include certain goods for resale and utility bills.

 Provision. An amount set aside for a known liability whose extent and timing cannot be precisely determined, e.g. restructuring costs.

 Contingent liability. A liability where the amount and/or likelihood of payment are uncertain. As such, no specific provision is made.

Be aware of common financial terms.

2.2 Discover why timing is essential

The timing of cash receipts and payments may not be the same as the sales and purchases recorded in financial statements. At the end of an accounting period, a business should make sure that everything has been accounted for, when it should be accounted for.

 The importance of timing. Imagine you are shopping in January and make all your purchases using a credit card. Although, you’ve effectively ‘spent’ money (or ‘incurred’ expenditure) in January, you won’t actually pay any cash until you pay your credit card bill, perhaps during February. Therefore, the cash cost of the shopping in January is zero.

case study Aaron, a salesperson, would argue that he has made a sale when his customer has placed an order. Helena, a lawyer, would argue that she has made a sale when her client signs a contract. Others may argue it’s when goods are delivered, a service is performed, or a customer has paid. However, using the matching concept, Brian, the accountant who works for Aaron, Helena and other businesses, only recognizes a sale when it has been ‘earned’. Similarly, Brian recognizes a purchase made by Aaron and Helena only when their suppliers have ‘earned’ the revenue, not when an order is placed, a contract signed, goods received, or a payment made. Revenue and expense recognition is a complex area for Brian.

Now using a business example – imagine a credit sale made in March, where the customer pays in cash during April. Although the business has effectively ‘earned’ a sale in March, the cash receipts from that customer during March are zero.

These examples highlight the importance of timing in accounting. Expenses can be incurred at different times to the associated cash paid. Likewise, income can be earned at different times to the associated cash received.

 The matching (or accruals) concept. Financial statements ‘match’ income and expenses to the periods in which they are earned and incurred to show a true and fair view to the users of those statements. This concept is a fundamental accounting concept used by the majority of businesses.

 The benefits. Matching income and expenditure to the periods in which they are earned and incurred enables more accurate and realistic performance measurement. Ultimately this leads to more efficient business management. The timing of cash receipts and payments is still important and businesses will monitor this separately.

Costs are accounted for when incurred and income when earned, as opposed to when cash is received or paid.

2.3 Know about doubleentry bookkeeping

Accountants use an established system of recording financial transactions, called double entry bookkeeping. The globally used system has hardly changed since it was developed in 1494 by Renaissance scholar Luca Pacioli.

Pacioli’s principle is that every transaction has a dual effect. For example, if you get paid for work, then the first effect is that you’ve earned income and the second effect is that you now have more money. If you go clothes shopping, the first effect is that you have more clothes. The second, more unfortunate effect, is that you have less money.

case study Be careful not to confuse the words ‘debit’ and ‘credit’. For Brian and other accountants, a ‘debit’ represents an asset and a ‘credit’ a liability. A ‘debit’ will increase the value of an asset and a ‘credit’ will reduce its value. For example, a bank receipt, which increases cash (and hence is a business asset) is a debit. Similarly, a bank payment, which reduces cash, is a credit. This is the opposite way around for banks. For example: The Little Socks Company has $1,000 in the bank and therefore has an asset of $1,000 which is a ‘debit’ in The Little Socks accounts. The bank holds the $1,000 but owes it back to The Little Socks, as it is not the bank’s money. The bank has a liability to The Little Socks of $1,000 which is therefore a ‘credit’ in the bank’s accounts. The bank tells The Little Socks: “You are in credit for $1,000”.

“Never call an accountant a credit to his profession; a good accountant is a debit to his profession”

Sir Charles Lyell, British lawyer and geologist

Likewise, when a business makes a purchase, it (i) incurs an expense and (ii) has less cash. Similarly, when it makes a cash sale it has (i) more income and (ii) more cash. The system is called double entry bookkeeping because every transaction is effectively recorded twice.

 Debits and credits. The two equal and corresponding effects (recordings) of each transaction are termed ‘debits’ and ‘credits’. As this rule is consistently applied, the total amount of debits will always equal the total amount of credits. As such, accounts should always balance.

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