Chapter 5 Financial Decisions Management: Commercial theory and practice.

Chapter 5Financial Decisions

Management:Commercial

theory and practice

Learning objectives

• Understand the nature and purpose of financial information

• Be aware of the main user groups and their financial information needs

• Understand the content and function of the primary financial statements

• Explain the nature and use of some basic accounting control systems

Commercial Management: theory and practice, First Edition. David Lowe.© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.

Learning objectives

• Be aware of how to use financial information to make short-term decisions

• Be aware of long-term investment appraisal techniques such as discounted cash flow, and understand how they are used in the creation of a business case


Introduction

• Financial information aids:

• the stewardship function of management

• to demonstrate how well business resources have been managed

• management planning, decision-making and control

• to provide useful and timely information to help managers make decisions


Introduction

• Demand side to assess whether a project:

• will generate a sufficient return on an investment

• is affordable in terms of the projected monthly/annual cost

• Supply side to monitor/assess:

• whether a project’s costs are running at the amounts estimated (and the amount of and reason for any significant differences)

• the level of return that the project is making on the investment (together with the ability of the project to make debt repayments when due)Commercial Management: theory and practice, First Edition.

David Lowe.© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.

Nature/purpose of financial information

• Generated by the accounting function in an enterprise or organisation

• The accounting process (providing useful financial information) involves:

• the classification and measurement of transactions

• summarising them for a period of time (a week, a month or a year)

• communicating and analysing that financial information



• A major function of accounting is the preparation of financial statements:

‘The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders and other creditors in making decisions in their capacity as capital providers. Information that is decision-useful to capital providers may also be useful to other users of financial reporting who are not capital providers.’ (IASB, 2008, Paragraph OB2)



• Components:

• balance sheet – the financial position of a business, frozen at a point in time

• income statement – a historical summary of performance over the past year

• cash flow statement

• Users of accounting information:

• investors, lenders, suppliers and other creditors, employees, customers, government and their agencies, the public, management



• Desirable qualities of financial information

‘Information provided by financial statements needs to be relevant and reliable and, if a choice exists between relevant and reliable approaches that are mutually exclusive, the approach chosen needs to be the one that results in the relevance of the information provided being maximised.’ (ASB, 1999)

• In addition, information needs to be:

• comparable (implies consistency and the need for adequate disclosure)

• understandableCommercial Management: theory and practice, First Edition. David Lowe.© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.


• Financial reports can be divided into:

• financial accounting reports – prepared for the purposes of supplying information to shareholders and other interested parties; must be prepared according to statutory and other regulatory requirements in terms of content and format

• management accounts – concerned with the production of information in order to facilitate planning, evaluation and control of commercial activities


Nature of financial reporting environment

• Varies depending on the way in which a business has been formed – e.g.:

• small unincorporated businesses and partnerships are usually subject to less regulation than

• larger incorporated enterprises, private or public limited liability companies – trading as a group (holding company and subsidiaries)


Relationship between parent company and subsidiaries

Extract from Vinci’s Annual Report 2011)


Nature of financial reporting environment

• Financial reporting (by companies) is governed by national and international regulatory frameworks

• These cover:

• content, formats and presentation of published financial statements, including extensive disclosures, permissible valuation methods for items such as buildings, inventory and financial instruments, and treatments of specific transactions

• requirements for directors and in relation to auditors and corporate governance

• The financial reporting environment is dynamic, and subject to constant change, as reporting issues have become more complex


Presentation of financial statements

• Financial reports include:

• the balance sheet

• the income statement

• the cash flow statement

• ad hoc reports prepared for special projects



• Balance sheet – indicates how a company, is funded as represented by the equation:

Assets − Liabilities = Equity

• assets – the rights or other access to future economic benefits controlled by a company as a result of past transactions or events (non-current and current assets)

• liabilities – the obligations of a company to transfer economic benefits as a result of past transactions or events (current and non-current liabilities)

• equity – the residual amount found by deducting all of the company’s liabilities from all of its assetsCommercial Management: theory and practice, First Edition.



Assets include:

• non-current assets – used on a long-term basis (that is, over the course of more than one year) to generate profits

• Examples are tangible items (land, buildings, machinery, motor vehicles, computers), intangible items (goodwill, leases) and investments

• current assets – assets that generate cash within 12 months of the balance sheet date

• Examples are inventory (stock), trade receivables (debtors), prepayments, cash and cash equivalents



Liabilities include:

• non-current liabilities – amounts payable more than 12 months after the balance sheet date

• Examples are borrowings, deferred tax liabilities, pension obligations and other provisions

• current liabilities – amounts payable within 12 months of the balance sheet date

• Examples are bank overdrafts, trade payables, accruals, current tax liabilities and proposed dividends



Equity (also known as capital and reserves or shareholders’ funds) includes:

• share capital

• share premium

• reserves (including retained profit)



• The income statement or statement of financial performance gives a summary of income less expenditure for the year

• revenue – the total sales or operating revenue of a company

• cost of sales –the value of materials and services (including labour and overheads) bought during the year in order to make the goods or to provide the services sold

• distribution costs – costs incurred after production of goods is completed

• administrative expenses – the additional costs incurred in running a company



• Cash flow statement – shows how cash has been managed during the period:

• net cash flow from operating activities – reconciles the operating profit figure with operating cash flow

• cash flows from investing activities:

• receipts resulting from ownership of investments or loans to other companies

• the sale or purchase of businesses, intangible or tangible non-current assets and to the sale or purchase of debt instruments of other companies

• cash flows from financing activities – payments to the providers of finance and long-term financing cash flows



• Difference between profit and cash

• In the income statement:

• Income is included when it is earned – when a sale is made, not when the cash is received

• Expenditure is matched with the income it helps to generate

• It can therefore be potentially misleading

• The cash flow statement (reporting the actual cash inflows and outflows of the company) is:

• seen to provide additional relevant and reliable information

• less open to manipulation than the income statementCommercial Management: theory and practice, First Edition. David Lowe.© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.


• Financial analysis

• Financial statements can be used to generate trends

• Enables providers of finance to monitor debt covenants

• A return on the investment can be calculated and compared with the target return

• Used to produce additional internal information comparing actual figures to those budgeted and planned for

• However, financial accounting information can be incomplete, or subject to creative accounting techniques

• Financial statements and their analysis can only act as a starting point for further investigation


Management accounting• Accounting information – individualised to meet the

needs of the specific users

• Emphasis on the context of the financial information and a sophisticated analysis of costs and cost behaviour

• Management accounting information contributes to:

• strategic planning

• investment appraisal

• budget/profit planning

• financial management

• communication of financial and operating information

• financial control Commercial Management: theory and practice, First Edition. David Lowe.© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.

Cost determination and cost behaviour• Costing information feeds into:

• planning decisions – use estimates of future costs, and include pricing and outsourcing decisions.

• control procedures are in place to maintain and improve the efficiency with which resources are employed

• providing timely and accurate feedback on the efficiency and effectiveness of operations

• Understanding cost behaviour is important for decision-making, with costs being categorised as:

• direct or indirect

• variable, fixed, semi-variable (mixed), or stepped Commercial Management: theory and practice, First Edition. David Lowe.© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.

Cost–volume–profit analysis• Break-even analysis – a useful way to predict costs

at different levels of activity

• Any product or service that can be sold for more than its variable cost is making a positive contribution to the fixed costs of the business

• contribution – the difference between the selling price and the variable cost of producing and selling that item

• profit per unit – the difference between the selling price and the cost of producing and selling that item

• unit contribution –equal to selling price less total variable cost per unit

• Contribution analysis is an important tool in management decision-making


Cost–volume–profit analysis

• Break-even point:

• volume of sales at which

• total contribution is equal to total fixed costs

• neither a profit nor a loss is made

• Break-even analysis – useful for short-term decision-making

• Graphical display can be provided and sensitivity analysis carried out

• Can be used only in certain (relatively straightforward) situations, and relies on several assumptions


Total cost to output relationship


Cost prediction• Techniques include:

• engineering methods based on direct estimation of required production inputs

• historical cost methods based on the information already in the accounting system – extrapolated to meet the new position

• statistical methods such as linear regression analysis

• Each method will yield different figures, and experience is needed to arrive at an appropriate conclusion

• Understanding cost behaviour will help management make better and more effective decisionsCommercial Management: theory and practice, First Edition.


Performance measurement• Budgets help managers plan for the future in a

controlled way

• A budget is:

• a formal financial and/or quantitative statement, prepared prior to a defined period of time, of the policy to be pursued during that period for the purpose of attaining a given objective

• the short-term projection of the long-term strategy for managing projects and project contracts, and will usually be set in terms of profit targets and a required return on capital

• Revenue, expenses, capital and cash budgets Commercial Management: theory and practice, First Edition. David Lowe.© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.

Performance measurementThe budget is used to evaluate actual performance

• achieved through a system of budgetary control, which uses budget data to monitor and control progress

Variance analysis – compares the difference between a budget estimate and an actual result

• Investigation and explanation of variances form part of the process of management control

Flexed budgets adjust the original budget to reflect actual levels of activity

• identify separately differences arising from changes in activity and differences arising for other reasons


Performance measurement• Effective budgeting improves efficiency

• It demands the following requirements:

• careful planning and the provision of information/data for management

• the participation of both managers and other employees

• coordination and cooperation

• a sound accounting system


Performance measurement• Effective budgeting improves efficiency

• It can deliver the following benefits:

• new trends and inefficiencies are detected at an early stage of the planning and control process

• the delegation of duties/authority

• control by responsibility

• management by exception

• a sound evaluation system for comparing/reporting on budgeted and actual results

• the motivation of employees

• good clear communications

• corrective action by management to remedy adverse conditionsCommercial Management: theory and practice, First Edition. David Lowe.© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.

Performance measurementMost companies experience

difficulties in implementing the budgeting process

Management must take care over the way in which the budgetary control system is operated to avoid sub-optimal problems

• Some of the limitations:

• Staff regard the techniques as pressure instruments

• Motivation may be misplaced

• Checking of estimates may be difficult, and conditions may change once budgets have been agreed

• Management may not be willing to cooperate, or support may be inadequate

• The accounting system may not be effective to ensure adequate control

• There may be deficiencies in the organisational structures of the business


Cash flow management

• More businesses go bankrupt through lack of cash than for any other reason

• Cash flow forecast includes elements of capital and revenue income and expenditure to help forecast the cash needed to keep the business solvent

• Cash flow management is closely related to working capital control


Cash flow management

• Cash flow management is particularly important for implementing commercial project pricing strategies based on determining monthly charges to customers

• Ideal strategy will involve a large cash payment at the start of the project to cover the capital and start-up costs, followed by monthly rental to cover ongoing personnel and maintenance costs

• Any unrecovered up-front charges will be built into finance charges

• Different exit strategies will also affect cash flow Commercial Management: theory and practice, First Edition. David Lowe.© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.

Capital investment decisions• Four main methods of investment appraisal:

• accounting rate of return (ARR) – calculates the percentage value of the average annual operating profit divided by the average investment over the life of the project, and compares it with a target percentage rate

• payback period – calculates the amount of time it takes to recover, or pay back, the initial investment

• net present value (NPV) – compares the present value of cash inflows (benefits) with the present value of cash outflows (costs)

• internal rate of return (IRR) – calculates the interest (discount) rate whereby NPV equals zero


Capital investment decisions

• Major disadvantage with ARR and payback period – both ignore the time value of money

• Both NPV and IRR take the time value of money into account – but IRR demonstrates pitfalls:

• It ignores the scale of the investment, focusing instead on the percentage return

• The IRR rule may disagree with the NPV rule if the project profile shows cash inflows first, followed by cash outflows at a later date

• It is possible for a project to show multiple IRRs, if for example project cash flows change signs over time Commercial Management: theory and practice, First Edition.


Capital investment decisions

• NPV is the only investment appraisal measure that ensures the maximisation of shareholder value

• technique usually used for the preparation of business cases

• A further consideration for companies undertaking capital investment is how to finance that investment


Summary• Commercial managers need a working understanding

of financial reporting

• to ensure that projects are being properly run

• Management accounting information helps commercial managers to plan and control costs, and make informed business decisions

• Income and costs can be estimated and combined to produce budgets (revenue or capital), as part of an overall strategy for achieving business targets

• often expressed a percentage return on investment or a percentage profit on sale


Summary

• Cash flow forecasts can be modelled

• to assist with estimating borrowing requirements, setting pricing strategies, or for use in NPV projections

• Performance evaluation can be undertaken to:

• determine areas of good and poor performance

• identify where and when management action should be taken

• Good quality financial information – and some understanding of how it is produced – underpins effective decision-making


Recommended readingISBN-10: 1-4051-24687ISBN-13: 978-1-4051-24683

Chapter 5

Additional readingISBN-10: 1-4051-2450-4ISBN-13: 978-1-4051-2450-8

Chapters 5 and 18

Chapter 5 Financial Decisions Management: Commercial theory and practice.

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Transcript of Chapter 5 Financial Decisions Management: Commercial theory and practice.