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FINANCIAL GOVERNANCE
KWAME BOASIAKO OMANE-ANTWI
Tuesday, July 07, 2015
PROF. OMANE-ANTWI
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FINANCIAL GOVERNANCE
This course transforms financial and accounting
language and concepts into decision-making
tools that the non-financial director can use on a
daily basis.
Successful
Directors
must
be
able
to
communicate effectively with those who get
things done and those controlling the financial
aspects of the organisation.
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THE AIM OF THIS VERY PRACTICAL AND
PARTICIPATIVE COURSE IS TO:
 Develop their financial understanding.
 Understand how their decisions affect their organization's
financial performance.
 Improve their organization's financial performance.
 Communicate effectively with the financial executives and
staff.
 Measure the financial performance and stability of a
business.
 Appreciate the financial implications of decision making.
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AGENDA
To succeed as a non-financial
director knowledge of basic financial
principles and the budgeting process
is critical.
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YOU WILL LEARN HOW TO:
 Integrate financial concepts and policies into the
management decision and budgeting process
 Evaluate the meaning of profit and loss accounts
(Income Statement) and balance sheets (Statement of
Financial Position)
 Use
ratio
analysis
and
interpretation
of
key
performance indicators
 Understand terminology such as gearing and return on
capital employed
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YOU WILL LEARN HOW TO CONT.’
Employ cash flow analysis to assess business status
 Calculate the cost of business activities and price
effectively
 Use tools such as break-even analysis
 Manage working capital
 Control business operations through effective budget
management
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THE IMPORTANCE OF FINANCE
 Demystifying financial jargon
 Accounting Principles
 Accountability and responsibility for
financial information
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UNDERSTANDING THE PROFIT AND LOSS
ACCOUNT
(Income Statement)
Differentiating profit, operating and
capital expense items
 Measuring profit and business success
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ANALYSING THE BALANCE SHEET
(State of Financial Position)
 Evaluating the worth of an established business
 Distinguishing between fixed (non-current) and current
assets and liabilities
 Linking the profit and loss account to the balance sheet
 Shareholder equity: What is it and why does it matter?
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CASH FLOW
 Differentiating between cash flow, profit and net worth
 Connecting cash management to line management
 Credit and cash flow— maximizing benefits and minimizing
costs
 How much cash is enough?
 Generating unique information from cash flow statements
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BUDGETING
Managing effectively within budgeting constraints
 Making the budget work for you
 Comparing budget approaches
 Types of budgets
 Developing the budget
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BUDGETING CONT.’
 Budgeting as a planning and control tool
Controlling and evaluating the business
using the budget
 Budget process and coordination
 Forecasting sales revenues and expenses
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FINANCIAL MANAGEMENT
All too often, a manager’s performance is measured by
how effectively they oversee departmental budgets. Learn
to apply the fundamentals of finance to improve budget
management, increase potential profits, and assess the
financial viability of projects and transform financial and
accounting concepts into decision-making tools.
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THE CHANGING FOCUS OF FINANCIAL
MANAGEMENT
Changes in policy and structure have had a
significant impact on the focus of financial
management in industry/ commerce and
government
as
the
following
diagram
depicts.
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THE CHANGING FOCUS OF FINANCIAL MANAGEMENT
SHARED
SHARED
RESPONSIBILITY
RESPONSIBILITY
Decision
Support 10%
Controls
30%
Reporting
20%
Transaction
Processing 40%
Role Transformation
Process Redesign
Value Added Services
Integrated Systems &
Shared Services
Decision Support & Risk
Management 50%
Controls 10%
Reporting 20%
Transaction
Processing
20%
EFFICIENCY/EFFECTIVENESS
EFFICIENCY/EFFECTIVENESS
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CHANGING ENVIRONMENT
Within the global financial community of private and public
sectors, significant changes have and are continuing to
take place which have a major impact on the finance
function and the role of the CFO.
The increased use of technology and consequent access to
and availability of financial information have moved the
financial function away from a focus on transactional
activities to more strategic roles within the organization –
from a “control” role to a “planning & management” role.
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CHANGING ENVIRONMENT CONT.’
 Globally, we have also moved from tightly regulated national and
global financial markets to deregulated environments which
significantly increase the complexity for financial managers and
at the same time, enhance the opportunity for financial leaders
to create real economic value within organizations.
 Financial leaders are increasingly at the table, in
with
business
leaders,
developing
strategies,
partnership
considering
business initiatives and providing expertise on risk and cost
management to enable sound business decisions.
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FINANCIAL GOVERNANCE MODEL
Driving performance through growth and productivity and leadership development
CREDIT: BOEING MANAGEMNET MODEL
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FINANCIAL GOVERNANCE
THE BOTTOM LINE
 The link between good governance and business is
irrefutable
 Companies with weak governance systems are
significant investment risks
 Governance should be a key factor in analysts’
recommendations
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DRIVERS OF SUSTAINABILITY
Sustainability actions
(Strategy, plans & programmes, structure and systems)
Sustainability
performance
Corporate
and
business
unit
strategy
•
•
•
•
•
•
•
•
Work force diversity
Environmental impacts
Bribery/corruption
Community involvement
Ethical sourcing
Human rights
Product safety
Product usefulness
Source: Epstein and Roy (2001)
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Stakeholders
reaction
• Employees
• Community
• Customer
• Government
• Investors
• Financial
analysts
Long term
corporate
financial
performance
Feedback
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0
CORPORATE GOVERNANCE MOSAIC AND FINANCIAL
REPORTING QUALITY
Courts & Legal System
Financial Analyst
Legislators
Regulators
Stock Exchanges
Stockholders
Audit Committee
Internal Auditors
Board Directors
External Auditors
Management
Financial Reporting
Quality
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ACCEPTABLE BALANCE SHEET
Increase in Assets
Growth
 Profitability
 Success

Liabilities of Defined
Liabilities
Non satisfying
stakeholders Interest i.e.
Communities,
stakeholders, employees,
etc.
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CHALLENGES WHEN STRIVING FOR ACCEPTABLE
BALANCE SHEET
CHALLENGES
Clashes with politicians
and associates
 Not being with the
“crowd”
Strength to withstand
temptations
 Possible loss of position
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WHAT IS NEEDED
Strong values/Principles
Non acceptance of
mediocrity
Upholding utmost
professionalism
Integrity
Have God on your side
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IMPROVING FINANCIAL COMPLIANCE AND CONTROLS
ACCOUNTING
DRIVERS
ENVIRONMENTAL
DRIVERS
•
•
•
•
•
Political/Social
Market
Location
IT
Sector
Inform
Influence/Direct
•
•
•
•
Representation
Techniques
Regulation
Professionalization
FINANCIAL ACTIVITIES
STRATEGY & RISK
FUNDING
Management
and Control
Organizational
Activities
Accounting
Compliance
ORGANISATIONAL
DRIVERS
•
•
•
•
•
•
Ownership
Size
Structure
People
Culture
Routines
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PROPERTIES OF FINANCIAL ACCOUNTING REPORTS TO ENSURE
QUALITY REPORTING
 Financial Statements:
 Financial position ( Balance Sheet) Statement
Income Statement
 Cash flow statement
Notes to the Accounts
Mandatory Disclosures
 Corporate Governance Report
 Compliance with IAS/IFRS/Listing regulations
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PROPERTIES OF FINANCIAL ACCOUNTING REPORTS TO ENSURE
QUALITY REPORTING CONT.’
 Concept Statement:
 Recognition VRS Disclosure
Relevance and Reliability
Substance over Form
Verifiability and Timeliness
Accrual VRS Cash basis
Conservatism
Going Concern
Clarity of difficult-and-easy-to verify information
 Timely Loss recognition
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THE JOB DESCRIPTION OF A FINANCE DIRECTOR
ROLE:
The role of the finance director varies according to the size of the company
involved. However, in general, he or she oversees all financial aspects of
company strategy and is responsible for the flow of financial information to the
chief executive, the board and, where necessary, external parties such as
investors or financial institutions.
MAIN RESPONSIBILITIES:
• overall control of the company’s accounting function
• financial planning and related ongoing advice for the chief
executive and
senior management
• formulating financial targets and budgets in accordance with the strategy
determined by the board
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THE JOB DESCRIPTION OF A FINANCE
DIRECTOR CONT.’
MAIN RESPONSIBILITIES:
 Overall control of all financial transactions and accountancy
matters, including audit systems.
 Corporate finance: managing company policies regarding
capital requirements, debt, taxation, equity and
acquisitions, as appropriate.
 Preparing annual accounts
 Ensuring that the regulatory requirements of all statutory
bodies are met regarding all the company’s financial affairs.
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THE JOB DESCRIPTION OF A FINANCE
DIRECTOR CONT.’
EDUCATION AND EXPERIENCE:
 Degree-level education
 Qualified member of an accountancy body or holder of an
equivalent qualification
 Significant experience in finance, with at least five years in
senior management. (This last requirement may be relaxed
for SMEs)
 Experience of managing professional staff
CREDIT: INSTITUTE OF DIRECTORS, UK
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STRATEGIC ROLE FOR CFO
Need “departmental” as well as overall CFO to
provide strategic advice to decision-makers
 Not “bean-counting”
 But must understand financial implications, know
what questions to ask and have ability to judge if
answer holds up.
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ROLE OF THE CFO: LEADER & STEWARD
Public Sector CFO MANAGEMENT FRAMEWORKTM
Leadership
Planning &
Resource
Management
Management
Advice &
Performance
Management
Stakeholder
Management
CFO
Organization
Management
Policy
Development
CFO
Financial
Accounting &
Reporting
Risk
Management
& Control
Stewardship
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KEY DRIVERS FOR SUCCESS
 Financial Management a priority for all levels of program
managers;
 Risk Management as part of day-to-day job;
 Clear governance/accountability;
 Integrated Financial Information System;
 Performance Management system;
 Linking Financial & Performance Information;
 Attract & retain skilled staff
 BUY-IN from political & civil service levels!!!
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THE CHANGING ROLE OF FINANCIAL MANAGEMENT
THE STATEMENT OF FINANCIAL POSITION
Today
Yesterday
Internal activities
• Working capital
• Capital budgeting
• Management information
systems
Focus
• Economy
• Efficiency
• Effectiveness
Focus: Raising funds
Operating and
financial matters
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External activities
• Mergers
• Acquisitions
• Reorganization
• Recapitalization
Legal matters
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THE MEANING OF FINANCIAL MANAGEMENT
Statement of Financial Position
Assets
Investors
Return on
assets
Cost of
financing
7%
10%
• How are we doing and is the business profitable?
• How much cash do we have on hand and can we pay our bills on time?
• What should we spend our funds on? Operating activities or non-current
assets?
• Where will our funds come from? From internal operations? From lenders?
From shareholders?
• How will our investors’ interests be protected? How much will it cost?
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WHO IS RESPONSIBLE FOR THE FINANCE FUNCTION?
TREASURER
CONTROLLER
•
•
•
•
•
•
•
•
•
•
•
•
•
•
General accounting
Cost accounting
Credit and collections
Management information
systems
Trade and other payables
Corporate accounting
Internal auditing
Budgets and analysis
Systems and procedures
Planning and controlling
Interpreting financial reports
Evaluation and consultation
Preparing reports for
government agencies
Reports on capital assets
•
•
•
•
•
Raising capital
Investor relations
Short-term borrowings
Dividends and interest payments
Insurance management
•
•
•
•
•
•
•
•
•
Analysis of investment securities
Retirement funds
Property funds
Property taxes
Investment portfolio
Cash flow requirements
Actuarial
Underwriting policy and manuals
Tax administration
All MANAGERS
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THE FOUR FINANCIAL OBJECTIVES
Efficiency
(Incubation)
Liquidity
(Cash shortage: must rely on
credit)
R.O.R
R.O.A
R.O.I
R.O.E
%
Current assets
$
Less: current liabilities
$
Net working capital
$
• Revenue
Growth
• Working capital
(Financial insolvency = inaction)
• Non-current assets
• Profit for the year
Stability
(Total insolvency: debt is out of
proportion)
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Equity
%
Debt
%
Assets
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RETURN ON REVENUE OBJECTIVE
Non-current assets
$3,000 or
Internal use
$0.03
(retained earnings)
$5,000 or
$0.05
Current assets
$2,000 or
Return on
revenue
$0.02
$8,000 or
$0.08
Dividends
$2,000 or
External use
$0.02
$3,000 or
$0.03
Debt reduction
$1,000 or
$0.01
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TYPES OF BUSINESS DECISIONS
Statement of Financial Position
Investing
Decisions
Managers
Non-current assets
Current assets
Operating
Decisions
Managers
Financing
Decisions
CEO/CFO/Treasurer
Statement of Income
Equity
Revenue
• Share capital
Cost of sales
• Retained earnings
Gross profit
Operating expenses
Liabilities
Profit before taxes
• Long-term
Income tax expense
• Short-term
Profit for the year
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OPERATING DECISIONS
Statement of
Financial
Position
Working Capital Management
• Inventories
• Trade receivables
• Trade and other payables
• Cash
• Demassing
• Planned downsizing
Statement
of Income
• Productivity indicators
• Rewarding simplification
• Cutting back useless activities
• Rewarding quality work
• Empowering workers
• Zero-based budgeting
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FINANCING DECISIONS
 The matching principle
 Sources and forms of financing
 Cost of borrowed funds
 Financing mix
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INVESTING DECISIONS
Capital Assets
 Research and development
 Expansions
 New plants
 Modernizations
 Acquisitions
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CORPORATE TRANSPARENCY AND
ACCOUNTABILITY
 Government Legislation
(most recent Act,
Sarbanes-Oxley in 2002).
 Corporate Governance
(a push towards transparency,
integrity and ethical behaviour).
 Corporate Culture
(emphasis on shared values and
beliefs).
 Global Accounting and Financial
Statements (creation of the International Accounting
Standards Committee (IASC), the International Financial Reporting
Interpretations Committee (IFRIC) and the development of the
International Financial Reporting Standards (IFRS).
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FINANCIAL MANAGEMENT INCLUDES
Bookkeeping
Accounting
FINANCIAL STATEMENTS
Analysis
Decision-Making
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BOOKKEEPING
As a rule, when all accounts are closed at the end of an accounting period,
the asset and expense accounts have debit balances and the equity,
liability and revenue accounts have credit balances.
Debit
Statement of Financial Position Accounts
Assets
Credit
Equity
Liabilities
Debit
Statement of Income Accounts
Expenses
Credit
Revenue
Transfer (profit for the year) is made at the end of the
accounting period
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THE ACCOUNTING EQUATION
Statement of Financial Position
A
=
Debit
Increases
Credit
Decreases
E
+
Decreases
Increases
Statement of Income
R
L
Decreases
Increases
-
Decreases
E
Increases
Increases
Decreases
Profit for the year
Ends with the Trial Balance
Profit
Debits = Credits
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Statement of changes
in equity
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THE ACCOUNTING CYCLE
Business
Business
Activity is
recorded in
Transaction
Document
takes place
is prepared
Journals
Activity is
transferred to
Ledgers
Statement of Financial Position
1. Cash account
3. House
2. Inventories
4. Car
Statement of Income
1. Salary
3. Rent
2. Food
4. Clothing
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THE TRIAL BALANCE (ABC INC. DEC. 31, 2010)
Revenue
Prepaid expenses
Finance costs
Costs of sales
Short-term borrowings
Retained earnings (beginning of year)
Trade receivables
Accrued expenses
Distribution costs
Income tax expense
Current income taxes payable
Future income taxes payable (deferred taxes)
Long-term borrowings
Inventories
Trade and other payables
500,000
SFP
20,000
SI
10,000
SI
300,000
SFP
50,000
135,000 SCE
100,000
SFP
15,000SFP
50,000SI
25,000SI
2,000SFP
3,000 SFP
200,000 SFP
200,000 SFP
100,000
Total
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SFP
20,000 SFP
Current portion of long-term debt
Administrative expenses
Non-current asset (at cost)
Depreciation
Accumulated depreciation
Dividends
Shared capital
Credit ($)
IS
Cash and equivalents
Debit ($)
25,000 SFP
50,000 SI
500,000 SFP
25,000SI
100,000
SFP
20,000 SCE
200,000 SFP
1,325,000
PROF. OMANE-ANTWI
1,325,000
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FINANCIAL STATEMENTS
To determine the value or wealth of a business, look at the STATEMENT OF
FINANCIAL POSITION (also known as the balance sheet) since it gives a
reading of its financial position at a given point in time; it’s like a snapshot or
an X-Ray.
To determine the flow or wealth of a business, look at the STATEMENT OF
INCOME (also known as the earnings statement, the statement of operations
and the profit and loss statement) since it shows the infusion of revenue and
expenses between two accounting periods.
To determine the accumulated wealth of a business, look at the STATEMENT
OF CHANGES IN EQUITY (statement of retained earnings section) since it
shows the amount paid to the shareholders and the amount retained in the
business.
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PROF. OMANE-ANTWI
FINANCIAL STATEMENTS - STRUCTURE AND CONTENTS
Statement of Retained Earnings
Statement of Income
Revenue
Retained earnings (beginning)
$900,000
Cost of sales
Earnings for the year
$100,000
Gross profit
$ (20,000)
Less: dividends
Other income/expenses
Profit for the year
Retained earnings (ending)
$100,000
Statement of Financial Position
Equity
Assets
$80,000
• Non-current $230,000 Liabilities
• Long-term
• Current
$25,000
• Current
$150,000
$25,000
$980,000
Statement of Cash Flows
• Sources of funds
(Where they come from)
$100,000
Profit
$25,000
CL
$150,000
LT
• Uses of funds
(Where they went)
$20,000
Div.
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$ 80,000
$230,000
NCA
PROF. OMANE-ANTWI
$25,000
CA
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STATEMENT OF FINANCIAL POSITION
(FINANCIAL STRUCTURE)
Non-Current Assets
Equity
Long-term borrowings
 Financial leverage
 Capital budgeting
 Cost of financing
 Cost of capital
Current Assets
Current Liabilities
Working capital
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FINANCIAL ANALYSIS
 Horizontal analysis
 Vertical analysis
 Statement of cash flows
 Ratio analysis
 Break-even analysis
 Leverage analysis
 Risk analysis
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DECISION-MAKING
 Financing decisions
 Working capital decisions
 Capital budgeting decisions
 Growth decisions
 Capital structure decisions
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DECISION-MAKING CONT.’
 Lease or buy decisions
 Pricing decisions
 Operating budgeting decisions
 Valuation decisions
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FINANCIAL STATEMENTS–GAAP versus IFRS
GAAP
IFRS
Income Statement
Statement of Income and Statement of
Comprehensive Income
Sales revenue
Cost of sales
1 Gross profit
Operating expenses
Selling expenses
Administrative expenses
2
Total operating expenses
Cost of sales
1 Gross profit
Other income
Distribution costs
Administrative expenses
Finance costs
Total
Operating income (EBIT)
Other income
Other expenses
3
Revenue
Extraordinary expenses
Income before taxes
4 Income taxes
Net income
2 Profit before taxes
Income tax expense
3 Profit for the year
Total other comprehensive income/(loss) for
the year
4 Total comprehensive income
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FINANCIAL STATEMENTS – GAAP versus IFRS
GAAP
IFRS
Balance Sheet
Statement of Financial Position
Assets
Assets
Current assets
Non-current assets
Capital assets
Intangible assets
Intangible assets
Current assets
Total assets
Total assets
Liabilities
Equity
Current liabilities
Long-term debts
Liabilities
Total liabilities
Non-current liabilities
Current liabilities
Shareholders’ equity
Total liabilities
Total liabilities and equity
Total equity and liabilities
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FINANCIAL STATEMENTS – GAAP versus IFRS
GAAP
IFRS
Statement of Changes in Equity
Share capital
Statement of Changes in Equity
Share capital
• Preferred shares
• Preferred shares
• Common shares
• Common shares
• Contributed surplus
• Contributed surplus
• Retained earnings
• Retained earnings
• Total other comprehensive
Total shareholders’ equity
income/(loss) for the year
Total shareholders’ equity
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IMPORTANCE OF MANAGING CASH FLOW
$75,000 or 75%
Managers
Profit for the year
Internal
inflow
Investing
Depreciation
Operating activities
Outflow
$100,000
Activities
Working capital
Financing activities
Equity
External
inflow
Debt
Leasing
Contributions
Investors
$25,000 or 25%
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CASH FLOW ANALYSIS
Statements of Financial
2010
Position
2009
Inflows
Outflows
$150,000
$130,000
$ 20,000
217,000
200,000
----
5,000
15,000
10,000
Automobile
20,000
10,000
----
Visa account
1,000
2,000
Inventories
28,000
25,000
----
3,000
Savings account 3,000
2,000
----
1,000
Mortgage
House
Term deposits
$ 31,000
Total
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1,000
PROF. OMANE-ANTWI
---$ 17,000
---10,000
----
$ 31,000
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RULES TO IDENTIFY INFLOWS AND OUTFLOWS OF CASH
Inflows of
cash
Outflows
of cash
Asset accounts
Equity accounts
Liability accounts
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STATEMENT OF CASH FLOWS
B. Omane Consult.
Statement of Cash Flows
For the Year Ended December 31, 2010
Operating Activities
1.
Profit for the year
Depreciation
$97,500 SI
40,000
SI or SFP
Adjustments in non-cash
working capital
SFP
(11,000)
TOTAL
2.
$126,500
Financing Activities
Payment of dividends
$(47,500) SRE
Long-term borrowings
200,000
SFP
15,000
SFP
Share capital
$167,500
TOTAL
3.
Investing Activities
Purchase of non-current assets
Increase in cash
290,000
$ 4,000
Cash at beginning of year
18,000
Cash at end of year
22,000
Tuesday, July 07, 2015
SFP
($290,000)
SFP
($4,000)
60
PROF. OMANE-ANTWI
WHY ANALYZE FINANCIAL STATEMENTS?
1. Ensure liquidity
2. Maintain solvency
3. Improve productivity of assets
4. Maximize return
5. Secure long-term prosperity
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61
B. OMANE CONSULT – HORIZONTAL ANALYSIS
2010 ($)
2009 ($)
Revenue
2,500,000
2,300,000
Cost of sales
(1,400,000)
(1,334,000)
Gross profit
1,100,000
Amount of
change ($)
% of change
200,000
8.69
66,000
4.95
966,000
134,000
13.87
(820,000)
(763,600)
56,400
7.38
Salaries
(20,000)
(18,000)
2,000
11.10
Lease payments
(50,000)
(30,000)
20,000
66.67
Depreciation
(50,000)
(48,000)
2,000
4.17
(940,000)
(859,600)
80,400
9.35
Profit before taxes
160,000
106,400
53,600
50.37
Income tax expense
(80,000)
(53,200)
26,800
50.37
80,000
53,200
26,800
50.37
Operating expenses
Other expenses
Total operating
expenses
Profit for the year
Tuesday, July 07, 2015
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62
FINANCIAL RATIOS
Statement of financial position
Statement of Income
Equity
Non-current assets
Revenue
Cost of sales
Current assets
Non-current liabilities
Gross profit
Operating expenses
Current liabilities
1. Statement of financial position ratios
2. Statement of income ratios
Profit for the year
Liquidity ratios
Debt/coverage ratios
3. Combined ratios
Asset-management ratios
4. Vertical analysis
Profitability ratios
5. Horizontal analysis
Market-value ratios
Tuesday, July 07, 2015
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63
B. OMANE CONSULT – STATEMENT OF FINANCIAL POSITION
AS AT DECEMBER 31, 2010
Non-current assets
Equity
Property, plant & equipment
$ 900,000
Share capital
Accumulated depreciation
(100,000)
Retained earnings
Total non-current assets
$ 800,000
Trade receivables
$ 400,000
Total equity
$ 150,000
190,000
$ 500,000
Mortgage
Long-term borrowings
Marketable securities
10,000
Total non-current liabilities
Cash
50,000
Current liabilities
Total current assets
Total assets
300,000
Non-current liabilities
Current assets
Inventories
$ 100,000
$ 400,000
$ 1,200,000
Trade and other payables
100,000
$ 600,000
$ 100,000
Notes payable
80,000
Accruals
20,000
Total current liabilities
$ 200,000
Total equity & liabilities
$ 1,200,000
Tuesday, July 07, 2015
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64
CATEGORIES OF FINANCIAL RATIOS
Liquidity ratios
Indicate a company’s ability to meet its
short-term obligations.
 short-term lenders
suppliers
employees
Measure the extent to which a business can
be financed by debt.
ratios
Debt
coverage
Investors (shareholders &
long-term lenders)
ratios
Assetmanagement
Show how effectively management utilizes
the assets of a business.
 managers
Profitability ratios
 everybody
Tuesday, July 07, 2015
Indicate the management’s overall
effectiveness and efficiencies as measured
by return on revenue, on assets, on equity.
PROF. OMANE-ANTWI
65
COMMONLY USED FINANCIAL RATIOS
Liquidity
1.
Current ratio (times)
ratios
2.
Quick or acid test ratio (times)
Debt/coverage
3.
Debt-to-total assets (percent)
ratios
4.
Times-interest-earned (times)
5.
Fixed-charges coverage (times)
Asset/management
6.
Average collection period (days)
ratios
7.
Inventory turnover (times)
8.
Capital assets turnover (times)
9.
Total assets turnover (times)
Profitability
ratios
10. Profit margin on revenue (percent)
11. Return on total assets (percent)
12. Return on equity (percent)
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66
CURRENT RATIO
To give a general indication of the ability of a business (borrower) to
meet its current obligations.
Purpose
• collateral
Current assets
Current liabilities
• growth
$ 400,000
= $ 200,000
Current assets
Inventories
Trade receivables
$ 150,000
190,000
10,000
Cash
50,000
Tuesday, July 07, 2015
= 2.0 times
Current liabilities
Marketable securities
Total current assets
• cushion
$ 400,000
Trade and other payables
$ 100,000
Notes payable
80,000
Accruals
20,000
Total current liabilities
PROF. OMANE-ANTWI
$ 200,000
67
QUICK RATIO OR ACID TEST RATIO
Purpose
To supplement the current ratio in measuring liquidity, this ratio
places more emphasis on liquid assets which can be quickly
converted into cash.
Current assets – Inventories
Current liabilities
$250,000
$200,000
=
Current assets
Inventories
Trade receivables
Current liabilities
----$ 190,000
Marketable securities
10,000
Cash
50,000
Total current assets
= 1.25 times
$ 250,000
Trade and other payables
$ 100,000
Notes payable
80,000
Accruals
20,000
Total current liabilities
Tuesday, July 07, 2015
$ 200,000
PROF. OMANE-ANTWI
68
DEBT-TO-TOTAL ASSETS
Purpose
Measures the proportion of “all” debts provided by lenders to
finance “all” assets.
It is also called the debt ratio.
Total liabilities
Total assets
Non-current assets
Current assets
Total assets
Tuesday, July 07, 2015
=
$800,000
$1,200,000
$ 800,000
400,000
$ 1,200,000
= 67 percent
Equity
$ 400,000
Non-current liabilities
600,000
Current liabilities
200,000
Total liabilities
800,000
Total equity & liabilities
PROF. OMANE-ANTWI
$ 1,200,000
69
INVENTORY TURNOVER
Purpose
Shows how long it takes for inventories to turn around or
how fast it moves.
Cost of sales
Average inventories
$1,400,000
= $150,000
Statement of Income
=
9.3 times
Statement of Financial Position
Revenue
$ 2,500,000
Current assets
Cost of sales
1,400,000
Inventories
Gross profit
$ 1,100,000
Total current assets
Tuesday, July 07, 2015
----$ 150,000
$ 400,000
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70
CAPITAL ASSETS TURNOVER
Measures how intensively a firm’s non-current assets such as property, plant, and
equipment are working.
Purpose
Revenue
Non-current assets
$2,500,000
= $800,000
Statement of Income
Revenue
Cost of sales
Gross profit
Other income
3.1 times
Statement of Financial Position
$ 2,500,000
(1,400,000)
1,100,000
80,000
Total distribution costs
(355,000)
Total administrative expenses
(590,000)
Finance costs
(75,000)
Profit before taxes
160,000
Income tax expense
(80,000)
Profit for the year
=
Non-current assets
$ 800,000
Current assets
$ 400,000
Total assets
$ 1,200,000
$ 80,000
Tuesday, July 07, 2015
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71
TOTAL ASSETS TURNOVER
Measures the intensity by which all assets, that is, current and non-current assets are used
to generate revenue.
Purpose
Revenue
Total assets
=
$2,500,000
$1,200,000
Statement of Income
$ 2,500,000
Cost of sales
(1,400,000)
Gross profit
1,100,000
80,000
Total distribution costs
(355,000)
Total administrative expenses
(590,000)
Finance costs
(75,000)
Profit before taxes
160,000
Income tax expense
(80,000)
Profit for the year
2.1 times
Statement of Financial Position
Revenue
Other income
=
Non-current assets
$ 800,000
Current assets
$ 400,000
Total assets
$ 1,200,000
$ 80,000
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72
PROFIT MARGIN ON REVENUE
Purpose
Shows the efficiency of a business.
Operating profit
Revenue
=
$155,000
$2,500,000
= 6.2 percent
Vertical analysis
Statement of Income
Revenue
$ 2,500,000
Cost of sales
(1,400,000)
Gross profit
1,100,000
Total distribution costs
(355,000)
Total administrative expenses
(590,000)
Operating profit
155,000
Other income & finance costs
44.0
6.2
5,000
Profit before taxes
160,000
Income tax expense
(80,000)
Profit for the year
100.0
3.2
$ 80,000
Tuesday, July 07, 2015
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73
RETURN ON TOTAL ASSETS
Purpose
Measures the return on funds invested in the business by both the
owners and the lenders.
Profit for the year
Total assets
=
$ 80,000
$ 1,200,000
STATEMENT OF INCOME
STATEMENT OF FINANCIAL POSITION
Revenue
$ 2,500,000
Cost of sales
(1,400,000)
Gross profit
Other income
1,100,000
Non-current assets
$ 800,000
Current assets
$ 400,000
80,000
Total distribution costs
(355,000)
Total administrative expenses
(590,000)
Finance costs
(75,000)
Profit before taxes
160,000
Income tax expense
(80,000)
Profit for the year
$ 80,000
Tuesday, July 07, 2015
= 6.7 percent
Total assets
PROF. OMANE-ANTWI
$ 1,200,000
74
RETURN ON EQUITY
Purpose
Shows how profitable a business is to its owners.
Profit for the year
Equity
$80,000
=
$400,000
STATEMENT OF INCOME
STATEMENT OF FINANCIAL POSITION
Revenue
$ 2,500,000
Cost of sales
(1,400,000)
Gross profit
Other income
Equity
$
400,000
1,100,000
80,000
Total distribution costs
(355,000)
Total administrative expenses
(590,000)
Finance costs
(75,000)
Profit before taxes
160,000
Income tax expense
(80,000)
Profit for the year
$ 80,000
Tuesday, July 07, 2015
= 20.0 percent
Non-current liabilities
600,000
Current liabilities
200,000
Total liabilities
800,000
Total equity & liabilities
PROF. OMANE-ANTWI
$ 1,200,000
7
5
SUPPLEMENTARY FINANCIAL AND
MARKET RATIOS
Liquidity ratios
1.
Cash ratio (times)
2.
Working capital ratio (times)
Debt/coverage 3.
ratios
Asset/management
ratios
Profitability
ratios
Debt-to-equity (times)
4.
Trade receivables turnover (times)
5.
Day’s sales to inventories (days)
6.
Profit for the year to revenue (percent)
7.
Gross profit on revenue (percent)
8.
Return on invested capital (percent)
9.
Earnings per share (dollars)
10. Cash flow per share (dollars)
Market
ratios 11. Return per share (percent)
12. Price/earnings ratio (times)
Tuesday, July 07, 2015
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76
FINANCIAL BENCHMARKS
B. OMANE
CONSULT
Liquidity
ratios
1.
Current ratio (times)
2.00
1.50
2.
Quick or acid test ratio (times)
1.25
1.00
Debt-to-total assets (percent)
67.00
55.00
Times-interest-earned (times)
3.10
5.00
Fixed-charges coverage (times)
2.70
5.00
Average collection period (days)
27.70
35.00
Inventory turnover (times)
9.30
8.00
8.
Capital assets turnover (times)
3.10
4.50
9.
Total assets turnover (times)
2.10
3.5
10. Profit margin on revenue (percent)
6.20
5.50
11. Return on total assets (percent)
6.70
5.50
20.00
15.00
Debt/coverage 3.
ratios
4.
5.
Asset/management 6.
ratios 7.
Profitability
ratios
12. Return on equity (percent)
Tuesday, July 07, 2015
BENCHMARKS
PROF. OMANE-ANTWI
77
LIMITATIONS OF FINANCIAL RATIOS
To make ratios meaningful, you should …
1.
Look at trends
2.
Compare your financial performance with other businesses or industry
The caveats of financial ratios
• They only give signals – they do not answer questions relating to why, what, or how.
• When comparing ratios with other businesses, make sure that the closing dates of the
financial statements are the same.
• Make sure that the numbers used are similar.
• The size of the business may make a difference.
• The nature of the operations may also be different (new plant versus worn-out plant).
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78
RELEVANCE OF BREAK-EVEN ANALYSIS
Break-even analysis helps to:
1. Price existing or new products and services.
2. Decide whether to introduce a new product or service, open
a new plant, hire a sales representative, open a new sales
office, launch an advertising program.
3. Modernize or automate an existing plant.
4. Expand an existing plant.
5. Change the cost structure (fixed versus variable).
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FIXED AND VARIABLE COSTS
Standby costs
Variable costs
Direct costs
Out-of-pocket costs
Volume costs
Characteristic
Characteristic
Fixed costs
Period costs
Constant costs
Element of fixedness and must be paid
with passage of time.
Rent, interest, insurance, property taxes,
office salaries, depreciation, telephone
Tuesday, July 07, 2015
Vary almost automatically with volume.
Sales commission, direct labour, packing
material, electricity, overtime premiums,
equipment rental, truck expenses
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80
THE CONTRIBUTION MARGIN
Revenue
$ 1,000,000
Less variable costs:
Direct material
Direct labour
($ 500,000)
PV Ratio
(250,000)
Total variable costs
(750,000)
$250,000
Contribution margin
250,000
Less fixed costs:
Manufacturing
(150,000)
Administration
(50,000)
Total fixed costs
Operating profit
$1,000,000
.25
(200,000)
$ 50,000
PV ratio
Tuesday, July 07, 2015
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81
BREAK-EVEN POINT CALCULATION
B.E.P.
=
Fixed costs
Price per unit sold – Variable cost per unit or unit contribution
In Units
B.E.P.
$200,000
$15.00 - $10.00
=
= 40,000 units
X $15.00
$ 600,000
Step 1:
PV =
In Revenue
Step 2:
B.E.P. =
Tuesday, July 07, 2015
Find the PV ratio
Unit contribution
Unit selling price
=
$5.00
$15.00
= .333
Find the revenue break-even point
Fixed costs
PV
=
PROF. OMANE-ANTWI
$200, 000
.333
=
$600,000
82
PROFIT BREAK-EVEN
Fixed costs + Profit objective
Price per unit sold – Variable cost per unit
In
Units
In
revenue
Tuesday, July 07, 2015
$200,000 + $20,000
$15.00 - $10.00
=
$220,000
= 44,000 units
$5.00
Fixed costs + Profit objective = $220,000 = $660,000
PV
.333
PROF. OMANE-ANTWI
83
SENSITIVITY ANALYSIS
Base case
Break-even
Break-even
in units
in revenue
40,000
$600,000
50,000
$750,000
36,364
$563,642
34,782
$521,730
Change in
Fixed costs
(increased by $50,000 to $250,000)
Selling price
(increased by $0.50 to $15.50)
Variable costs
(decreased by $0.75 to $9.25)
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84
WHERE BREAK-EVEN ANALYSIS
CAN BE USED
 Company-wide
 Advertising program
 Trucking operation
 Department store
 Plant
 Travel agency
Direct mail advertising
 Product/division
District or sales
 Hotel business
territory
 Taxi business
 Retail store
 Movie theatre
 Production centre
 Service centre
 Restaurant business
 Machine operation
 Book publishing
 Airline business
Tuesday, July 07, 2015
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85
OTHER COST CONCEPTS
Committed costs:
Costs that must be incurred in order to operate a
business.
Discretionary fixed costs: Costs that can be controlled by managers.
Controllable costs:
Costs that operating managers are accountable for.
Non-controllable costs:
Costs that are not under the direct control of
managers.
Direct costs:
Materials and labour expenses that are directly
incurred when making a product or providing a service.
Indirect costs:
Costs that are necessary in the production cycle but that
cannot be clearly allocated to specific products or services.
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86
MEANING OF WORKING CAPITAL
Working capital management involves the management of individual current assets,
current liabilities, and interrelationships that link current assets with current liabilities
and with other statement of financial position accounts.
Working Capital
Current liabilities
Current assets
Inventories
Trade receivables
Notes receivable
Prepaid expenses
Marketable securities
Cash
$ 70,000
30,000
5,000
3,000
10,000
10,000
Total current assets
$128,000
Trade and other payables
Notes payables
$56,000
20,000
Accrued expenses
4,000
Taxes payable
8,000
Total current liabilities
$ 88,000
Net working capital is defined as current assets minus current liabilities.
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87
CASH CONVERSION CYCLE
Existing
209 days
Target
160 days
Reduction
Cash
Deposit
Purchase
decision and
order
49 days
5
Processing
payment
Payment by
customer
Payment to
suppliers
5
12
19
Credit
decision
60
10
- 30
8
4
7
Billing
5
Inventory of
finished goods
60
9
Shipment
Tuesday, July 07, 2015
Purchase of raw
materials
15
Delivery of raw
materials
Inventory of raw
materials
Manufacturing
PROF. OMANE-ANTWI
88
DAYS OF WORKING CAPITAL (DWC)
Using B. Omane Consult (Transparencies 3.5 & 3.6)
Purpose
Measures the amount of days in working capital a
business holds in order to meet its average daily sales
requirements.
(Inventories + Trade receivables) - Trade payables
Revenue ÷ 365
($218,000 + $300,000) - $195,000
$2,500,000 ÷ 365
=
=
$323,000
$6,940
Tuesday, July 07, 2015
=
PROF. OMANE-ANTWI
47.2 days
89
MANAGING INVENTORIES
The goal of inventory management is to replenish stocking points in such a way
as to minimize the total of all associated costs, and thereby enhance profitability
of the business.
Types of inventories:
1. Raw Materials (i.e., lumber, steel, rubber, plastics, chemicals, paint
and other fishing substances, also includes supplies and parts).
2.
Work-in-Progress (i.e., partially assembled or partially
processed, not yet completed).
3.
Finished Goods (i.e., goods completed and ready to be sold for
resale by wholesaling and retailing firms).
Tuesday, July 07, 2015
PROF. OMANE-ANTWI
90
INVENTORY DECISIONS
Typical Costs of Ordering And Holding Inventory
Order and set-up costs
Holding costs
Transportation costs
 Storage costs
Clerical costs of making
orders
 Fire insurance
Cost of placing goods in
storage
Downtime on equipment
Quantity discounts
Tuesday, July 07, 2015
 Property taxes
 Spoilage and deterioration
 Cost of borrowing
 Rent of facilities
 Obsolescence
PROF. OMANE-ANTWI
91
MANAGING TRADE RECEIVABLES
The goal of trade receivables management is to set credit terms, grant
credit to customers, monitor payment patterns, and apply necessary
collection procedures so as to increase profitability.
Credit policy consists of choosing the appropriate credit terms to offer to customers
(present and future). Terms differ from product to product and industry to industry.
Example: Selling price
$120.00
Cost of product
Cost of capital
$ 90.00
10%
Should the company grant 2/10, net 30 days?
$90.00 x 10% x
60-day delay
= $1.48
365 days
Effective price
Cost of product
Credit costs
Finance costs
Profit
Tuesday, July 07, 2015
10-day payment
117.60
-$ _________
90.00
_________
_________
.25
1.61
+ _________
28.96
$ _________
60-day payment
-$ _________
120.00
90.00
_________
_________
1.48
+ _________
--$ _________
28.52
PROF. OMANE-ANTWI
92
GRANT CREDIT TO CUSTOMERS(Credit report)
Summary
Report
Information
Payments
Classification code for line of business, year business
started, rating, principal executives (owners).
Payments, sales, worth, number of employees, trends.
How business pays its bills (i.e., amounts owing,
amounts past due, terms of sale, manner of payment,
and supplier comments).
Finance
Financial conditions and trend of business (balance
sheet and income statement analysis).
History
Names, birth dates and past business experience of the
principals or owners, affiliation, ownership, outside
interest of the principal owners.
Banking
Operations
Tuesday, July 07, 2015
Outstanding loans.
Nature of the premises, neighbourhood, size of floor
space, production facilities.
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93
MANAGING CASH
The goal of cash management is to reduce the amount of cash that
is being used within the firm so as to increase profitability, but
without reducing business activities or exposing the firm to undue
risk in its financial obligations.
$20,000 x 12% X
20 days late for payment
365 days
= $131.51
Cash flows in connection with credit serve to introduce the concept
FLOAT
of _________
which is the time lag or delay between the moment of
disbursement of funds on the part of the customer and the moment
of receipt of funds on the part of the seller (i.e., mail time,
processing time, and clearing time with the banking system).
Tuesday, July 07, 2015
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94
WAYS TO IMPROVE COLLECTION OF CASH
A. Changing customer paying habits
1. Letters, telephone calls, or personal visits
2. Economic incentive for paying bills faster; offer
discounts (i.e., 2/10, N/30)
B.
Improve the Delivery system (reduce the negative float)
1.
Regional banking (customers pay bills to banks since they
can transfer funds more quickly than mail order delivery).
2.
Lockbox collection system (firm rents a post office box in
a particular city and the bank monitors the lockbox
periodically).
3.
Electronic communications (i.e., data-phone wire
systems).
C. Bypass the problem (Factoring of trade receivables).
Tuesday, July 07, 2015
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MANAGING CURRENT LIABILITIES
 Trade and other payables
 Accruals
 Salaries and wages payable
 Taxes payable
 Working capital loans
Tuesday, July 07, 2015
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96
PLANNING, BUDGETING, FINANCIAL PROJECTIONS
AND CONTROLLING
Planning
Budgeting
Business Plans &
Financial
Projections
Controlling
A. Planning
assumptions
Corporate
level
B.
D.
SWOT
analysis
Divisional
level
C.
SWOT
analysis
E.
• Mission
• Value goals
• Corporate
priorities
• Strategic goals
and plans
• Operational
priorities
• Tactical and
operational goals
• Tactical and
operational plans
F.
•Consolidated
budget
• Capital
budget
• Cash budget
G.
H.
•Consolidated
business plan
• Financial
projections
I.
Operating
budgets
• sales
• manufacturing
• staff
Tuesday, July 07, 2015
J.
Results and
monitoring
corporate
performance
K.
• Divisional
business plans
• Financial
projections
Results and
monitoring
operational
performance
PROF. OMANE-ANTWI
97
THE PLANNING PROCESS
ACTIVITIES
DECISIONS
SWOT
What have we achieved so far and what are our strengths,
weaknesses, opportunities and threats?
Goals
What do we want to accomplish and what impact will these
goals have on the profile of our financial statements?
Planning
Implementation
Controlling
Tuesday, July 07, 2015
How and when are we going to implement our plans? Who
is going to implement them? How much will these plans
cost and what are the financial benefits?
What should we do to ensure that we will be on course and
that the goals and plans will materialize as planned?
Did we reach our goals and implement our plans? Are the
financial results in line with our financial projections?
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WHY PLANNING IS IMPORTANT
1. Creative, innovative, resourceful.
2. Goal congruence.
3. Sense of purpose and direction.
4. Cope with change.
5. Simplifies managerial control.
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HIERARCHY OF PLANS
1. Strategic plans
2. Tactical plans
3. Operational plans
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PERFORMANCE INDICATORS
High
Efficiency
(good use of
resources and
doing things right)
Low
Pursuing the
wrong goals but
not wasting
resources
Pursuing the right
goals and not
wasting resources
Pursuing the
wrong goals
and wasting
resources
Pursuing the right
goals but wasting
resources
Low
High
Effectiveness
(goal achievement and
doing the right things)
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SWOT ANALYSIS AND PLANNING
ASSUMPTIONS
SWOT
analysis
Planning
assumptions
Goals
and
Plans
What are our
strengths,
weaknesses,
opportunities
and threats?
What are the
boundaries
within which
we should set
our priorities,
goals and
plans?
What should we
try to
accomplish
(goals) and how
should we
implement them
(plans)?
Operating
budgets
and
consolidated
budgets
How much
does it cost
to realize our
goals and
implement
our plans?
Projected
statement of
income and
statement of
financial position
How will the
planning
assumptions
impact on our
revenue,
expense,
asset, equity
and liability
accounts?
102
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BUDGETING AND FINANCIAL PROJECTIONS
Projected
statements
Financial
projections
Investment
plan
Cash
budget
Financing
plan
Staff
budget
Manufacturing
budget
Sales
budget
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Operating
budgets
103
TYPES OF BUDGETS
Operating
budgets
• Sales budgets
• Flexible budgets
• Overhead unit budgets
Complementary
budgets
•
•
•
•
Comprehensive
budgets
• Projected financial
statements
Capital
budgets
• New plants
• Expansion/modernization
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Product budgets
Program budgets
Item-of-expenditure budgets
Cash budgets
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RULES FOR SOUND BUDGETING
1. Pinpoints authority
the organization's
2. Integrates all
needs
planning activities
3. Insists on sufficient
7. Communicates
budget guidelines and
and accurate
planning
information
assumptions
4. Encourages
8. Relates costs to
participation
benefits
5. Links budgeting to
monitoring
for all units
6. Tailors budgeting to
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9. Establishes standards
10. Be flexible
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THE BUSINESS PLAN
What it is
A business plan is a document that gives a complete
picture about an organization’s goals, plans, operating
activities, financial needs and financing requirements.
Benefits - for the company
 Shows how management intends to implement
plans.
 Forces managers to be realistic.
 Helps managers to monitor plans.
 Helps to pinpoint how resources should be deployed.
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THE BUSINESS PLAN CONT.’
Benefits - for the investors

Provides base for judging the company.
 Assures that managers are aware of the
opportunities and threats (external environment).
 Shows the ability of the business to repay its debt.
 Helps to analyze all components related to the
company (internal and external).
 Identifies the timing and nature of future cash
requirements.
 Helps to assess management’s ability.
 Indicates funding requirements and sources.
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CONTENTS OF THE BUSINESS PLAN
 Cover sheet
 Executive summary
 Company and ownership
 External environment
 Mission, statement of purpose and strategy
 statements
 Products and services
 Management team
 Operations
 Financial projections
 Appendixes
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THE SUSTAINABLE GROWTH RATE
Increase
profit on sales
New debt
GROWTH
FUNDS
New equity
Finance costs
Cost of goods
sales
Administrative
expenses
Pay less
dividends
Invest in
less assets
Inventories
Distribution
costs
SALES
Trade and
other payables
Non-current
assets
Depreciation
Trade
receivable
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THE CONTROL PROCESS
1.
Design the
subsystem
Planning
 Objectives
 Plans
6.
2.
3.
Performance
indicators
Performance
standards
4.
5.
Corrective
action
Analyze
variations
NO
Measure
performance
YES
There is no
need to do
anything
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TYPES OF CONTROLS
Start
Action
Finish
Preventive
controls
Plans
Results
Screening
controls
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Feedback
controls
111
FINDING FUNDING:
TEN-STEP PROCESS
2
1
Know
your
numbers
Identify
financial
needs
3
4
5
Pinpoint
sources of
cash
Identify
financing
sources
Identify
financing
requirements
6
7
8
9
10
Identify
forms of
financing
Seek
financing
synergy
Become
creditworthy
Prepare the
investment
proposal
Meet
investors
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SOURCES AND FORMS OF FINANCING
FINANCIAL NEEDS
FINANCING REQUIREMENTS
Current assets
Current liabilities
 Inventories
 Suppliers
 Trade receivables
 Factoring companies
 Cash
 Commercial banks
 Inventory financing
 Term loans
 Conditional sales contracts
Non-current assets
Leasing
 Land
Equity
 Share capital
 Retained earnings
 Contributions
Non-current liabilities
 Mortgages
 Bonds
 Buildings
 Equipment
 Machinery
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INTERNAL VERSUS EXTERNAL FINANCING
Internal financing
1. Cash flow from the operations
Profit for the year
Add back: depreciation
Total funds generated by the business
2. Working capital
- inventories
- trade receivables
External financing
1. Shareholders
2. Lenders (long- and short-term)
3. Leasing
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EQUITY FINANCING
Shareholders
Funds can be obtained from common shareholders and
preferred shareholders. Shareholders benefit from collective
and specific rights.
Risk capital financing
Risk capital investors typically seek returns ranging from a
minimum of 25% to 40% per year. The required return on
equity relates to the percentage or share ownership. Risk
capital can be provided by angels, private investors,
institutional investors, government-backed corporations and
corporate strategic investors.
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LONG-TERM CONVENTIONAL FINANCING
TERM LOAN
Amount of the term loan financing depends on what can be
offered as security and is determined by the lender (i.e., bank,
trust companies, insurance companies and pension funds). If
suitable security is not offered, chances for obtaining a term
loan are reduced.
CONDITIONAL SALES CONTRACT
This is an agreement made between a buyer and a seller
regarding the purchase of an asset (e.g., truck).
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LONG-TERM CONVENTIONAL
FINANCING CONT.’
Bonds
These are loans that could be secured or unsecured (20 to 30
years) for which a firm agrees to make payments of interest
and principal, usually semi-annually, to the holder of the bond
contract.
Mortgages
Mortgages finance real property, land and buildings. Lenders
base the amount of the mortgage on the market value of the
property (50% of the market value is a common assessment).
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LONG-TERM RISK CAPITAL FINANCING
Subordinated Debt
These investors accept a higher level of risk compared with
conventional sources and ask coupon interest rates typically
ranging from 8% to 12%.
The overall rate of return to the investor is higher because
participation features at the time of exit increase the rate of return
– the minimum expected return is between 12% to 25% per year.
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SHORT-TERM CONVENTIONAL FINANCING
Supplier Credit
Cash discounts should be taken when offered by suppliers, even if
a loan has to be borrowed from a bank. This also depends on the
size of the discount and the cost of funds (interest rate) on the
bank line of credit.
Bank Line of Credit
Banks may finance 75% of trade receivables, 50% of inventories
and 90% of marketable securities (these margins are indicative
only). Types of short-term financing include line of credit, selfliquidating loans, revolving credit, interim financing.
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SHORT-TERM RISK CAPITAL FINANCING
Factoring
Financing can be obtained from a factoring company
“the factor” who purchases receivables as they occur.
Asset-based Financing
Similar to a bank line of credit; it is subject to a “ceiling”
borrowing amount based on receivable and inventory
margins and also involves a security pledge on these
assets.
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LEASE FINANCING
Lease financing is an alternative to the more
traditional financing for the acquisition of any asset
and it takes place when a lessee pays a lessor for
the use of an asset.
There are two broad categories of leases:
1. Operating lease (maintenance lease)
2. Financial leases
 Direct lease
 Sale and leaseback
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ADVANTAGES TO LEASING
It is a good source of financing for obtaining assets for firms
that have limited capital funds.
Leases are quoted at fixed rates (the company avoids the risk
of having to refinance at a higher interest rate).
The business may conserve existing sources of credit for other
uses and usually does not restrict a firm’s borrowing capacity.
Leases provide 100% financing as compared to say 75%
through conventional financing.
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ADVANTAGES TO LEASING CONT.’
All costs, sales taxes, acquisition costs, delivery and
installation charges related to the acquisition may be
included in the lease payment.
The lease-payment is tax deductible.
It is a good way of trying machinery and equipment before
committing oneself to the purchase.
It provides a way to meet seasonal production.
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RETURN ON ASSETS AND COST
OF CAPITAL
Statement of Financial Position
Non-current assets
Equity
Non-current liabilities
Current assets
ROA
Current liabilities
12%
Cost of financing
11%
Spread
New non-current assets
New capital (financing)
Capital budget (IRR) 14%
Cost of capital
12%
EVA
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INTERDEPENDENCE OF THE MAJOR AREAS OF FINANCE
Capital
structure
…or the composition of
the sources of funds…
…to determine the
financial attractiveness of
capital projects
Cost of
capital
…determines the
discount rate used…
Capital
Budgeting
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COST OF CAPITAL AND THE LEVERAGE CONCEPT
Cost of capital Represents a company’s composite rate of return _________
expected or even
demanded by investors.
___________
Amounts of
Percentage
Cost of
Proportion
Sources of capital
capital
of total
capital
of cost
Personal
$50,000
0.50
x
9.0%
=
4.5%
Source A
$20,000
0.20
x
10.0%
=
2.0%
Source B
$20,000
0.20
x
12.0%
=
2.4%
Source C
$10,000
0.10
x
14.0%
=
1.4%
$100,000
1.00
10.3%
Leverage
Determines the cost structure (fixed versus variable costs) and
financing structure (debt versus equity) that will amplify the most, profit
performance for the business (EVA) and the wealth to the shareholders
(MVA).
i.e. A 10% increase in revenue produces an 18% increase in EBIT.
A 10% increase in EBIT produces a 22% increase in ROE.
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FINANCIAL STRUCTURE VERSUS
CAPITAL STRUCTURE
FINANCIAL
STRUCTURE
CAPITAL
STRUCTURE
Refers to the way the firm’s assets are financed
by equity and all debts (long- and short-term).
Represents the permanent forms of financing
such as common shares, preferred shares,
retained earnings and long-term borrowings
(ignores short-term credit or current liabilities).
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LEVERAGE
Leverage consists of determining the most
DEFINITION appropriate cost structure, at both the operating
and financial levels, that will optimize the
profitability of a business.
OPERATING
LEVERAGE
Deals with the cost behaviour of an operating unit
(fixed and variable costs) and excludes finance
costs
FINANCIAL
LEVERAGE
Deals with the capital structure of a business, the one
that will generate the greatest financial benefits to
the shareholders (capital share versus debt).
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FINANCIAL MARKETS
Deal with businesses, individual and government institutions
including procedures involved in the buying and selling of
financial assets.
Types of markets
 Money markets
 Capital markets
 Primary markets
 Secondary markets
 Spot and future markets
 Mortgage markets
 Consumer credit markets
 Physical asset markets
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STOCK MARKET
Net of exchanges, brokers, and investors that trade securities
(e.g., TSX).
1. Stock exchange
2. Types of companies:

Privately held companies

Publicly trade companies
3. Prospectus
4. Initial Public Offering
5. Listed company
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DIVIDEND THEORIES
Dividend Irrelevance Theory
Dividend payment has little effect to share price because if
earnings are retained in the business for growth purposes,
the incremental re-invested cash may cause the business to
become more profitable and/or grow faster in the future.
Dividend Preference Theory
Investors prefer receiving dividends now compared to not
receiving any due to the uncertainty factor.
Dividend Aversion Theory
Investors prefer not to receive dividends now in order to
enhance share prices in the future.
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WHY MONEY HAS A TIME VALUE
Money has a time value because of the
existence of interest
A dollar earned today will be worth more tomorrow
This is called compounding.
$1,000
$1,100
A dollar earned tomorrow is worth less today
This is called discounting.
$1,000
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$1,100
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INVESTMENT DECISIONS IN CAPITAL BUDGETING
TIME
CASH
CASH INFLOWS (RECEIPTS)
CASH OUTFLOWS
(DISBURSEMENTS)
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TOOLS FOR SOLVING TIME-VALUE-OF-MONEY
PROBLEMS
 Algebraic Notations
 Interest Tables
 Financial Calculators and Spreadsheets
 Time Lines
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WHY CAPITAL PROJECTS ARE IMPORTANT
Size of the cash
outlay
Nature of
commitment
Accounting
treatment
Cash turnover
Financial impact
of commitment
Effect on financial
structure
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Capital
investments
Large
Expense
investments
Small
Durable
Impermanent
Capitalized
Expensed
Recurrent and spread
over many years
One time and
immediate
Significant
Minimal
Minimal to sizeable
None
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CAPITAL BUDGETING PROCESS
Step 1
Step 6
Project approval
and
implementation
Environmental
 Corporate priorities
 Strategic goals
 Operational goals
Step 2
Formulation of
plans and capital
expenditure
projects
Scanning
Step 5
Determining the
hurdle rate
Step 4
Step 3
Cost of capital:
Capital expenditure
ranking on basis of:
 internal financing
 priorities/goals
 external financing
 operations/functions
 return/risk
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ACCOUNTING METHODS
What they are:
What they do:
Also referred to as “traditional yardsticks”, the “financial
statement method”, the “accountant’s method” and the
“book value rate of return” make use of data presented on
financial statements to express the economic results of a
capital project.
They give a rate of return on a capital project at a particular
point in time (year) based on book profit and book
investment.
A. Based on investment
How they work:
1. Return on original investment
2. Return on average investment
3. Return on depreciated investment
B. Based on capital employed
C. Based on average profit
D. Based on equity
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THE PAYBACK PERIOD
What it is:
Also known as the “cash recovery period”, the “payoff method”
or the “payout method” measures the period of time it takes
for the cash outflow of a project to be totally recovered by the
anticipated cash inflows; it measures how soon the initial funds
disbursed are recovered by the project.
What it does:
It appraises time risk (not risk conditions or uncertainties).
How it works:
Years Annual net cash flows
0
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($1,500,000)
Cumulative cash flows
($1,500,000)
1
50,000
(1,450,000)
2
150,000
(1,300,000)
3
550,000
(750,000)
4
650,000
(100,000)
5
1,600,000
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$1,500,000
138
NET PRESENT VALUE
What it is:
Measures the difference between the sum of all cash inflows discounted at
a pre-determined interest rate (the hurdle rate), which sometimes reflects
the company’s weighted cost of capital, and all cash outflows.
What it does:
How it works:
Shows whether or not the use of borrowed funds for a project has greater
financial merit than the cost of borrowing.
Years
0
Annual Net
Cash Flows
($1,500.0)
10%
Discount Factors
1.000
Present Value
($1,500.0)
1
50.0
0.909
45.4
2
150.0
0.826
123.9
3
550.0
0.751
413.1
4
650.0
0.683
444.0
5
$ 1,600.0
0.621
993.6
2,020.0
Net present value (NPV)
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$ 520.0
139
INTERNAL RATE OF RETURN
What it is:
Also known as the “discounted cash flow”, the “true yield”, or the “investor’s method” can
be described as the specific interest rate used to discount all future cash inflows, so that
their present value equals the initial cash outflows.
What it does:
How it works:
Shows the economic merits of independent projects, and of mutually exclusive ones, and
compares their returns to other financial indicators, such as the weighted cost of capital
and the company’s weighted rate of return.
Years Cash flows
0
($1,500.0)
1
50.0
2
3
4
5
150.0
550.0
650.0
$1,600.0
17%
($1,500.0)
42.7
109.6
343.4
346.8
$729.8
Net present value (NPV) $72.3
18%
($1,500.0)
42.4
19%
($1,500.0)
107.7
334.7
335.3
$699.4
42.0
105.9
326.4
324.1
$670.4
$19.5
($31.2)
IRR 18.4%
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THE PROFITABILITY INDEX
What it is:
Also known as the present value index, or benefitcost ratio, shows the ratio of the present value of
cash inflow to the present value of the cash
outflow, discounted at a predetermined rate of
interest.
Helps to rank capital projects by the ratio of the
What it does: net present value for each dollar to the cash
outflow and to select the projects with the highest
index until the budget is depleted.
Present value of
How it works:
cash inflows
Cash outflow
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= $ 2,020.0
=
1.347
$ 1,500.0
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SENSITIVITY ANALYSIS
Involves the identification of profitability variations as a result of one or more
What it is:
changes in the base case regarding certain key elements of a project, such as
the purchase of land, buildings, equipment, sales volume, selling price, cost of
materials, or labour and even the length of the economic life of a project.
What it does: Gives a range of results based on patterns of variation on the use of one single
set of factors generating the best possible results.
How it works:
Factors
% variation in factor
Base case
------
Selling price
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Internal rate of return
18.4%
-10%
14.2%
Cost of construction +5%
17.3%
Sales volume
16.6%
-10%
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BOOK VALUE VERSUS MARKET VALUE
STATEMENT OF FINANCIAL POSITION
(BASED ON BOOK VALUE)
HOUSE
Original cost
$ 200,000
Accumulated
depreciation
Book value
(100,000)
$ 100,000
New mortgage
$ 200,000
STATEMENT OF FINANCIAL POSITION
(BASED ON MARKET VALUE)
HOUSE
Market value
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$ 400,000
New mortgage
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$ 200,000
143
VALUATION MODELS
 Book value
 Market value
 Liquidation value
 Industry multipliers
 DCF method
 Going concern value
Economic value
 Replacement value
 Assessed value
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SCANNING THE ENVIRONMENT
This is a method used during the planning
process to pin down planning assumptions
or premises.
Scanning the
environment
(SWOT analysis)
General
Documenting
the planning
assumptions
 Statement
 Past
of income
 Present
Industry
Restating the
financial
statements
 Future
 Statement
of financial
position
Pricetagging
the
business
Examples of planning assumptions: GNP, labour rates, market
demand, supply capability, unemployment, interest rate, price for raw
materials, competitive climate, consumer profile, etc.
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DEVELOPING YOUR FINANCIAL
LEADERSHIP
 Create and maintain a culture of
accountability
 Develop skills and understanding in
financial area
 Advocate clear and appropriate roles and
responsibilities
 Build your financial leadership team
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BUDGET LEADERSHIP
 Set the tone and commitment to the process
 Maintain connection to mission and strategic plan
 Incorporate board into budget process
 Support the budget culture – scarcity or opportunity
 Facilitate choices among alternatives
 Communicate throughout the organization
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USING FINANCIAL INFORMATION
 Produce accurate financial reports
 Understand financial information
 Analyze information
 Interpret financial information
 Use information for monitoring & decisions
 Communicate financial information
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INSTITUTIONALIZING ACCOUNTABILITY
 Share honest and realistic information about activities,
decisions and major changes
 Conflict of interest policy for board & staff
 Conflict of interest practices
 Audit committee
 Offer information and context – don’t wait to be asked
 Walk the walk
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ORGANIZATIONAL VALUES
 Financial matters touch all areas
 All values have financial aspect
 Different levels of understanding,
comfort, and cultural lens in financial
area
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FINANCIAL INTEGRITY
Mission, Values and Culture
Board Adopted
Policies
Procedures and
Systems
Internal
Controls
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LEAD WITH AN UNDERSTANDING OF
 Financial health as component of mission
 Commitment to integrity in all activities
 Importance of organizational culture and
communications
 Support of financial management function
Integration of financial decisions in all
planning
 Responsibility for information & decisions
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INTERNAL AUDIT
The
function
of
the
internal
auditors
is
complementary to, but different from, that of the
outside auditors. We regard it as good practice for
companies to establish internal audit functions to
undertake regular monitoring of key controls and
procedures. Such regular monitoring is an integral
part of a company’s system of internal control and
helps to ensure its effectiveness.
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INTERNAL AUDIT CONT.’
An internal audit function is well placed to undertake
investigations on behalf of the audit committee and
to follow up any suspicion of fraud. It is essential
that heads of internal audit should have unrestricted
access to the chairman of the aud‘it committee in
order to ensure the independence of their position.
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FINANCIAL REPORTS
A basic weakness in the current system of financial
reporting is the possibility
of different accounting
treatments being applied to essentially the same
facts, with the consequence that different results or
financial positions could be reported, each apparently
complying with the overriding requirement to show a
true and fair view.
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FINANCIAL REPORTS CONT.’
Regardless of how far the market can understand the
implications of alternative accounting treatments or see
through presentational techniques designed to show a
company’s figures in the most flattering light, there are
advantages to investors, analysts, other accounts users
and ultimately to the company itself in financial reporting
rules
which
limit
the
scope
for
uncertainty
and
manipulation.
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FINANCIAL REPORTS CONT.’
The lifeblood of markets is information and
barriers to the flow of relevant information
represent imperfections in the market. The need
to sift and correct the information put out by
companies adds cost and uncertainty to the
market’s transparent, the more accurately will
their securities be valued.
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FINANCIAL REPORTS CONT.’
What shareholders (and others) need from the report and
accounts is a coherent narrative, supported by the
figures, of the company’s performance and prospects. We
recommend that boards should pay particular attention
to their duty to present a balance,: and understandable
assessment of their company’s position. Balance requires
that setbacks should be dealt with as well as successes,
while the need for the report to be readily understood
emphasises that words are as important as figures.
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FINANCIAL REPORTS CONT.’
The cardinal principle of financial reporting is that the
view presented should be true and fair. Further
principles are that boards should aim for the highest
level of disclosure consonant with presenting reports
which are understandable and with avoiding damage
to their competitive position. They should also aim to
ensure the integrity and consistency of their reports
and they should meet the spirit as well as the letter
of reporting standards.
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IMPORTANCE OF AUDIT
The annual audit is one of the cornerstones of
corporate governance. Given the separation of
ownership from management, the directors are
required to report on their stewardship by
means
of
annual
report
and
financial
statements sent to the shareholders.
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IMPORTANCE OF AUDIT CONT.’
The audit provides an external and objective check
on the way in which the financial statements have
been prepared and presented, and it is an essential
part of the checks and balances required. The
question is not whether there should be an audit,
but
how
to
ensure
its
objectivity
and
effectiveness.
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IMPORTANCE OF AUDIT CONT.’
Audits are a reassurance to all who have a
financial interest in companies, quite apart from
their value to boards of directors. The most
direct method of ensuring that companies are
accountable for their actions is through open
disclosure by boards through audits carried out
against strict accounting standards.
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ROTATION OF AUDITORS
Another proposal was that some form of compulsory rotation
of audit firms should be introduced, to prevent relationships
between management and auditors becoming to comfortable.
The committee felt that any advantages which this could bring
would be more than outweighed by the loss of the trust and
experience which are built up when the relations are sound,
an d by the risk to audit effectiveness at the changeover. The
committee agreed, however, that in the case of listed
companies a periodic change of audit partners should be
arranged to bring a fresh approach to the audit.
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ROTATION OF AUDITORS CONT.’
We
recommended
in
our
draft
report
that
the
accountancy profession should draw up appropriate
guidelines and we support the steps which it is now
taking to do so. We would expect the guidelines to allow
a measure of flexibility over timing to take account of the
incidence of other changes in senior personnel, both in
the audit team and in the client company, which have
helped to keep a distinction in relationships between
client and auditor.
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REPORTING AND CONTROLS
It is the board’s duty to present a balanced and
understandable assessment of the company’s position.
The
board
should
ensure
that
an
objective
and
professional relationship is maintained with the auditors.
The board should establish an audit committee of at least
three non-executive directors with written terms of
reference which deal clearly with its authority and duties.
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REPORTING AND CONTROLS CONT.’
The directors should explain their responsibility for
preparing the accounts next to a statement by the
auditors about their reporting responsibilities.
The directors should report on the effectiveness of
the company’s system of internal control.
The directors should report that the business is a
going concern, with supporting assumptions or
qualifications as necessary.
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AUDIT COMMITTEES
If they operate effectively, audit committees can bring significant
benefits. In particular, they have the potential to:
a)
Improve the quality of financial reporting, by reviewing the
financial statements on behalf of the Boar;
b)
Create a climate of discipline and control which will reduce the
opportunity for fraud;
c)
Enable the non-executive directors to contribute an independent
judgement and play a positive role;
d)
Help the finance director, by providing a forum in which he can
raise issues of concern, and which he can use to get things
done which might otherwise be difficult;
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AUDIT COMMITTEES CONT.’
e) Strengthen the position of the external auditor, by providing
a channel of communication and forum for issues of concern;
f) Provide a framework within which the external auditor can
assert his independence in the event of a dispute with
management;
g) Strengthen the position of the internal audit function, by
providing
a
greater
degree
of
independence
from
management;
h) Increase public confidence in the credibility and objectivity of
financial statements.
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CONCLUSION
The main aim of the course is to create an awareness of what
constitutes financial governance within the good corporate
governance structure:
- How to achieve it
- The threads to achieving it and
- The role of accountants and auditors
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THE END
THANK YOU
Prof.
Kwame Boasiako
Omane-Antwi
PhD, MBA, MA, ITP (HARVARD)
AMP(OXON),FCCA, FRSA(UK),
FBI(Hon), FIOD(UK),
FIOD(GH), FCIM, MCIPD,
MIMIS
Professor of Accounting &
Vice Rector
Pentecost University
College
Sowutuom
Tel 0244-320448/0202011775
E-mail:
[email protected]
[email protected]
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