Generating and Evaluating Solutions

Finance for Non-Financial Managers

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Module ObjectsBy the end of this module you should be able to:Describe key financial termsIdentify elements of a balance sheet/income statementExplanation of EBITDAIdentify sources of savings

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UNDERSTANDING OF KEY FINANCIAL TERMS

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Accounting Terms and ConceptsAssets - Items that a person or business ownsLiabilities - Sums of money owed by a person or businessEquity - The net worth of a person or businessTotal Assets - Total Liabilities = Equity

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Current AssetsCurrent LiabilitiesLong-term (fixed) AssetsLong-term LiabilitiesAccounting Terms and Concepts

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Pg 5Current Assets - Describes those assets of the business that are most liquid and easily converted to cash., These are items usually sold or consumed within the accounting period (usually one year).Current Liabilities - Debt obligations whose liquidation is reasonably expected to require the use of current assets or the establishment of other current liabilities. Current liabilities include notes payable, accounts payable, income taxes payable, accrued liabilities and the current portion of ling-term debt due within one year from the beginning date of the current year.Long-term (fixed) Assets - Assets normally not consumed within a single accounting period and that, therefore, are useful to the business over a longer period of time. Examples include fixed assets (machinery and equipment, buildings, etc.), intangible assets (patents, goodwill).Long-term Liabilities - Amounts owed by the business but not payable within the next accounting period (normally a year) Examples include long-term borrowing, mortgages, etc. FinanceNotes:

Capital StockPaid-in-CapitalRetained Earnings (Deficit)Accounting Terms and Concepts

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Pg 6Capital Stock - The number of share of stock (certificates of ownership)/ which a company has issued multiplied times a stated value per share (par value).Paid in Capital - The difference between the par value for the shares issued and the amount actually paid/contributed to the company in exchange for these shares.Retained Earnings (Deficit) - The cumulative profits/(loss) of the company less any dividends paid to shareholders.FinanceNotes:

Financial Statements consists of:Balance SheetIncome StatementStatement of Changes in Financial PositionStatement of Shareholders EquityAccounting Terms and Concepts

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Pg 7Financial statements - Typical company financial statements consists of:

Balance Sheet - A key financial statement that presents assets, liabilities and net worth, each measured at a specified point in time.

Income Statement - A key financial statement which matches a companys sales against all the costs and outlays occurred in order to operate the company. The result is a net profit or a net loss for a stated period of time.

Statement of Changes in Financial Position - This statement, which is also sometimes called a fund statement, highlights the changes which have occurred in the balance sheet by showing major categories of transactions which have caused the changes in the balance sheet.

Statement of Shareholders Equity - This statement shows the major categories of transactions which have given rise to the changes in the equity section of the balance sheet.

FinanceNotes:

EXAMPLE #1Four individuals decide to set-up a small company to manufacture a better mouse trap.Investor A contributes$35,000 in cashInvestor B contributes$25,000 in cashInvestor C contributes$10,000 in cash and agrees to pay the company $10,000 more in 1 year plusinterest at 10%.Investor D contributes His patent on the mouse trap which he and the others agree is worth $30,000.The investors decide to make each share have a par value of $10.00 and to issue 1,000 shares divided by each owners respective interest. The company also borrows $100,000 from the local bank payable $20,000 per year with interest at 12%

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Accrual Basis of AccountingCash Basis of Accounting CapitalizationDepreciation/AmortizationExpenseAccounting Terms and Concepts

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Pg 10Accrual Basis of Accounting - A method used to determine income and expense under which items of income or expense are recognized when the obligation to receive or pay them is incurred.

Cash Basis of Accounting - The basis on which a personal income statement is normally prepared; only cash income and cash expenses are included on the income statement.

Capitalization - The accounting practice under which assets (machinery, equipment, buildings, patents, etc.) are recorded in long-term classifications and then depreciated or amortized over the estimated useful life of the asset.

Depreciation/Amortization - The accounting process under which a capitalized asset is written-off to expense (income statement) over the estimated useful life of the asset.

Expense - The accounting practice under which assets are charged to expense at the time of purchase. For example, Coopers policy is to charge to expense capital type assets which cost less then $200.

FinanceNotes:

Income StatementsRevenue/Sales/Other IncomeCost of Sales and other CostsIncome Taxes

Accounting Terms and Concepts

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Pg 11Income statements - are normally divided into three major sections:

Revenue/Sales/Other income - The sums generated by the business activities of the company. These can include sales of a product, rental of a product, sale of a service, etc.

Cost of sales and other costs - The sums incurred by the company with respect to its business activities. These can include the cost of the products or services sold or rented; marketing and administrative costs and other costs associated with running the business. Also included is depreciation and amortization expense, etc.

Income taxes - Taxes based upon income. Often include both Federal Taxes and State and Local taxes. FinanceNotes:

BETTER MOUSE TRAP CO.The company bought machinery and equipment, a small building and land for $40,000.00They manufactured 15,000 mouse traps and sold 12,000 of which 10,000 are paid for and 2,000 are still to be paid. Each mouse trap cost $1.25 to manufacture and was sold for $2.25.The company spent the following:manufacturing wages$15,000utilities 1,500operating supplies 250materials 4,167other miscellaneous 500 10% of the materials purchased were still on hand at the end of the year.

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BETTER MOUSE TRAP CO.In order to develop the cost of what was sold and the value of what remains on hand and without becoming terribly complicated we need to decide which costs will make-up the direct cost of our product because they vary with the value of the product and which will be attributed to the passage of time. For this example, we decided on:Material and wages as the direct costsUtilities and supplies as period costsOther miscellaneous as other cost of operations.

As a result of this decision, inventory would be costed as followsLabor per mouse trap = 15,000 / 15,000 traps = $1.00 eachMaterial per mouse trap = (4,167-417)/15,000 traps = $.25 eachTotaling $1.25

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FinanceNotes:

Better Mouse Trap Company Annual Income StatementSales (12,000 x $2.25)$27,000Interest on investor note 1,000Cost of Sales (12,000 x $1.25)15,000Production period costs 1,750Other miscellaneous costs 50017.250Depreciation on Bldg & M&E 2,500Interest Expense12,000Amortization of Patent (10 years) 3, 000Total costs and expenses 34,750Loss from operations before tax (6,750)Income Tax -Net Income(loss) (6,750)

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Mouse Traps Fixed AssetCost of Fixed AssetsLand$ 5,000Building 25,000Machinery and Equipment 10,000 40,000Estimated Life for Depreciable Assets:Building - 16 2/3 YrsMachinery & Equipment - 10 Yrs

Calculation of Depreciation:Building = 25,000 / 16,667 = $ 1,500M&E = 10,000/ 10 = 1,000TOTAL$ 2,500

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Better Mouse Trap Company Balance Sheet Cash$131,083Note Receivable from Investor plus Interest 11,000Accounts Receivables 4,500Inventory 4,167TOTAL Current Assets 150,750Fixed Assets (Net) 37,500Patent (Net) 27,000TOTAL Assets $215,250Current Portion of Bank Loan and Interest $ 32,000TOTAL Current Liabilities 32,000Long-Term Note Payable to Bank 80,000TOTAL Liabilities 112,000

Shareholders EquityCommon Stock 10,000Paid-in-Capital 100,000Retained Deficit (6,750)TOTAL LIABILITIES AND SHAREHOLDERS EQUITY$215,250

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A Better Mouse Trap Company Funds StatementWorking Capital Provided by (Used by) OperationsIncome$ (6,750)Income not requiring cashDepreciation and Amortization 5,500Working Capital Used by Operations (1,250)Purchase of Fixed Assets (40,000)Decrease in Working Capital (41,250)Increase/(Decrease) in Current AssetsCash$(38,917)Note Receivable 1,000Accounts Receivable 4,500Inventory 4,167$(29,250)(Increase)/Decrease in Current Liabilities (12,000) (12,000)Decrease in Working Capital$(41,250)

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Methods of Capturing CostActual CostEach element of cost is specifically identified to the item produced.

Example - In producing mouse traps there is a piece of wood, if an employee receiving $10.000 per hours produced 100 pieces of wood per hour, then each one would cost $.10. If however another employee receives $15.00 per hours for the same production, then the cost changes to $.15. If per hour production varies (90, 100, 105) we have a variance in the labor portion of the wood cost.

Actual cost rapidly becomes complicated and difficult to track.

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Methods of Capturing CostMoving Average CostEach item is costed based on an average of costs necessary to produce the item.Example - If I buy wood for my traps on two different dates I would proceed as follows:First Purchase - Cost of wood for 100 traps = $25.00 ($.25/trap)

Purchase $25.00 / 100 = $.25Issue to Product 12.50 = 50 x $.25Balance12.50 = 50 x $.25Purchase20.00 / 100 = $.20Average32.50 / 150 = $.2167Issue to Product 10.84 = 50 x .2167Balance21.66 = 100 x .2167

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Methods of Capturing CostStandard Cost, VarianceStandard Cost - The actual cost to produce an item is estimated and then fixed for some period of time based on the estimate.

Variance - The difference between the estimated cost and the actual cost.Example - If during the first month of producing mouse traps we spend $1,250 to produce 1,000 traps, each cost $1.25 compared to a standard of $1.00. There is then a variance of $.25 per trap or $250.00 in total.

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DEBITCREDITASSETSIncreaseDecreaseLIABILITIESDecreaseIncreaseEQUITYDecreaseIncreaseINCOMEDecreaseIncreaseEXPENSEIncreaseDecrease Rules of Thumb

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EBITDA - WHAT IS IT?

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What is EBITDA?(pronounced e-bit-da)What doesit mean?EBITDA is a acronym that stands for Earnings Before Interest, Taxes, Depreciation and Amortization

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What does it really mean?In otherwords . . .EBITDA =Revenues minus ExpensesEBITDA is a simple measure of earnings that indicatesthe amount of sales the company makes before subtractingfinancing costs for capital expenditures, acquisitionsand payments made in company stock, such as stockincentives, are calculated.

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Calculating EBITDA

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Why isnt it just called cash flow?Cash flow is the cash that company collects each month minus the cash the company sends out each month. Sales are seldom paid for in cash and in some companies, the cash for the invoiced sales are not usually collected for approximately 90-120 days. Therefore, sales and cash flow are not the same thing.Because EBITDA is not the same as cash flow.. It is a simplified earnings measurement.

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Why isnt it just called net income?The term EBITDA came into use during the leveraged buyoutmania of the 1980s. This measurement is useful when you want to see the earnings that could be net income if the company didnt owe money for investments such as acquisitions or large expenditures like building new plants or purchasing new equipment. EBITDA is a good measure of what net income -- could be -- in the future, when debts are paid off. It also is a helpful measure to use when comparing earnings for divisions of the company. Because EBITDA is not the same as net income.. It is a simplified earnings measurement.

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Why is EBITDA used?The term EBITDA came into use during the leveraged buyoutmania of the 1980s. This measurement is useful when you want to see the earnings that could be net income if the company didnt owe money for investments such as acquisitions or large expenditures like building new plants or purchasing new equipment. It also is a helpful measure to use when comparing earnings among the business units of the company. EBITDA is a good measure of earnings without the debt from investments.

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EBITDA is a meaningless financial indicator that seriously distorts and misrepresents a businesss earnings. Warren Buffett

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Margins, Inventory Turns, DSOs

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Standard Margin vs Contribution MarginThis yearNext yearProduct Price$100.00$100.00Standard Cost 48.00 50.00Standard Margin 52.00 50.00Variance 2.00 0.00Other Costs (warrantyscrap, etc) 5.00 5.00Contribution Margin 45.00 45.00 45% 45%

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Pg 31Lets say we have a part that sells for $100.00. The standard cost this year is $48.00. This calculates to a standard margin of $52.00 with a variance of $2.00.We then need to consider other costs such as warranty, scrap, etc. This now gives us the contribution margin.

We can keep the price the same, raise the standard cost and still have the same contribution margin. The opportunity is the work on the other cost line which we have control over to increase and/or maintain the contribution margin. FinanceNotes:

Possible Sources of Savings

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Period Cost SavingsPeriod cost savings is defined as a reduction of headcount or spending in the period cost area.

Period cost savings can be the result of multiple factors:Reduced cycle time or increased throughputReduced ExpensesProperly assigning human resources qualifications to jobs.

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Pg 33Period cost savings can be the result of multiple factors:Reduced cycle time or increased throughput. A reduction in the processing cycle of a task/activity results in available time or increased capacity. The increase of throughput yield results in the reduction of output errors and controlled processes that otherwise would have resulted in having to spend more time fixing those errors. With this simple explanation we would look at the following scenarios: Increased capacity but no additional workload to allocate that capacity. This will result in a possible reduction of headcount. If this is the goal of the project and agreed by management, then it becomes EBITDA savings. The formula here will be Headcount # to be reduced times salaries and fringes. If the headcount reduction is an alternative or an indirect result of the project, then it will be managements decision to determine what to do. In the mean time it will be considered potential savings. The same formula applies.Increased capacity to reduce backlog of current activity or even handle more activity over backlog level. If the extra capacity results in being able to process more of that activity and become current or being able to handle more, then you will have to consider how many days/hours or any other unit of the average backlog exist at any given time. By knowing the extent of that average backlog it will be possible then to determine how many people or hours of people would have been needed to reduce that backlog to a current position using the original cycle time of that activity or task. The result will be considered EBITDA savings resulting from the avoided expense of an increase in headcount.Reduced expenses. Reducing the expenses of a department is another way to reduce period costs. Like T&E expenses or office supplies.Reduced cost on T & E or supplies could be a source of EBITDA savings. To achieve it, will require a significant reduction in those types of expenses. For example, these savings can be achieved through better-negotiated prices or through economies of scale. Reduction in errors can also result in a period cost reduction when resources are better-utilized and additional expenditures avoided.Reduction in paid overtime.Properly assigning human resources qualifications to jobs. It might be possible to realize savings by better utilizing the human resources available. This will result in proper pay scales to the appropriate job functions. An example could be a project that simplifies tasks such that a lower ranked engineer could perform work, which previously required the effort of a lead engineer.

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Contribution MarginSavings in the contribution margin category are based on the reduction of manufacturing costs. Standard costsManufacturing variancesMaterial (price, usage, substitution, etc)Labor (spending, alternate routing, setup, etc)Subcontract (premiums, etc)Warranty expenseConcessionsScrap Rework

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MaterialsMaterial savings can be accomplished through:Better pricing agreementsSubstitutionsReduction of scrap

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Pg 35In some companies products, materials (raw, semi-finished or finished and commercial) constitute the greatest percentage of product cost (75% on average). Material savings can be accomplished through:

Better pricing agreements: from actual material cost negotiated reductions, to more efficient ways of packing, transporting and/or handling those materials that could result in lower spending.Substitutions: of current materials for other that are cheaper, better or simply are readily available.Reduction of scrap. In this case it affects the material usage variancesFinanceNotes:

Labor and OverheadWhen a project contemplates a reduction in direct labor hours , three assumptions are available:To reduce direct labor hours (touch time) without a formal decision of what to do with the new available hours.To increase output making use of the new available capacity.A combination of the two options above.

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Pg 36For Six Sigma purposes when a project contemplates a reduction in direct labor hours, three assumptions will be available:To reduce direct labor hours (touch time) without a formal decision of what to do with the new available hours. Savings will be the numbers of hours reduced, times the direct labor hourly rate. This will be considered as EBITDA Savings through spending reduction. Unless specific targets are given in the reduction of overhead spending, the only savings that are allowed are the direct labor savings. If a case is built to demonstrate the reduction of the overhead spending then those savings could be claimed.To increase output making use of the new available capacity. Savings will be the number of hours utilized in the increase of output times the labor & overhead rate less the increment in overhead spending as a result of the utilization of more operating supplies, indirect labor hours (like inspection), maintenance, etc. This will be considered EBITDA Savings achieved through volume. A combination of the two options above. We can have the labor savings as EBITDA and the overhead less the increment as potential EBITDA. Granted that you will specify that the use of capacity for activity X is subject to management approval. If at a later time management decides to utilize the extra capacity the savings will be reclassified accordingly.

FinanceNotes:

Warranty and ConcessionsAnother source of contribution margin savings:Effectively eliminating the source of the warranty call.Reducing the cost of warranty per warranty call.Lost revenues due to having to respond to warranty calls.

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Pg 37Warranty and Concession costs constitute another source of Contribution Margin savings. Some of the warranty savings can be derived from:Effectively eliminating the source of the warranty call. When this is the case, savings will be calculated based on the average cost of warranty generated by that specific problem during the past 12 months. This number will the be multiplied by the number of units that will still be covered by warranty in the next 12 months (that constitute a potential warranty call) plus the forecast of units to be delivered in the next 12 months.Reducing the cost of warranty per warranty call. This is the difference between the average of the past 12 months of cost of responding and solving a warranty call and the new projected cost per call based on improvements times the projected number of calls in the next 12 months.Lost revenues due to having to respond to warranty calls. For example: When service revenue is foregone because personnel are attending warranty calls instead of generating new revenue. The savings will be a measure of what the time spent on warranty calls would have generated if applied to new jobs to generate new revenue. This is usually measured by the EBITDA generated per day by this type of service. These savings should be included in the revenue growth section. They could be EBITDA or Potential EBITDA depending on the demand for the service that is executed by the service personnel

Concessions will be discussed on a case by case basis.

FinanceNotes:

Revenue GrowthINCREASE SALES!!!!!

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Pg 38These savings are achieved only one way, and that is to increase sales. Market growth, market penetration or diversification that will result in new sales to achieve that goal. Another source of saving is the acknowledgement of lost revenues that result from having inefficient systems, capacity constraints, quality problems, etc.To account for the increased revenue savings we will have to determine what is the EBITDA impact of those incremental sales. We would be calling them incremental sales since they will be an increment over pre-established guidelines, like the budget for the year. But it will have to be a significant achievement over those guidelines to be attributable to the Six Sigma efforts. Saying that Six Sigma will result in a 0.5 % increase in sales is not a realistic source of savings. But to say that a 10% increase will result from the improvements is more credible and it does make a difference. As a rule of thumb we should require the Sales & Marketing department to provide probabilities of success on the established goal. That way the favorable probability will be accounted for as EBITDA savings, and the unfavorable as potential EBITDA.

FinanceNotes:

Increased Sales ExamplesWhen calculating the EBITDA or potential EBITDA impact we will analyze two scenarios:Increased sales, same contribution margin, same period costExample: Original Sales20New sales 40Increment20Cont. Mrg.10Cont. Mrg.20Increment10Period Cost05Period Cost05Increment 0EBITDA05EBITDA15Increment10To the 10 units of Incremental EBITDA we will apply the probability determined by S&M and the result will be the EBITDA and potential EBITDA.

Increased sales, same contribution margin, higher period costExample: Original Sales20New sales 40Increment20Cont. Mrg10Cont. Mrg.20Increment10Period Cost05Period Cost10Increment05EBITDA05EBITDA10Increment05

To the 5 units of incremental EBITDA we will apply the probability determined by S&M and the result will be the EBITDA and potential EBITDA. In this example we take the hit of the period cost in the incremental revenue category to avoid placing negative savings on the period cost category of EBITDA.

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Working CapitalInventory: Reducing cycle time increases the turns of inventory.Days Sales Outstanding: Average Daily Sales = Previous quarter sales annualized (multiplied times 4) divided by 360 daysSavings = Averaged daily sales x Days of improvement

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FinanceNotes:

Sheet1BETTER MOUSE TRAP COMPANYBALANCE SHEETCash$170,000.00Note Receivealbe From Investor C10,000.00Current AssetTOTAL CURRENT ASSTS180,000.00Mouse Trap Patent30,000.00Long-Term AssetTotal Assets$210,000.00Current Portion of Bank Loan$20,000.00Current LiabiliesTotal Current Liabilities$20,000.00Long-Term Note Payable to Bank80,000.00Long-Term LiabilitiesTOTAL LIABILITIES100,000.00Shareholders' Equity:Common Stock10,000.00Paid-In Capital100,000.00EquityTotal Equity110,000.00Total Liabilities and Shareholders' Equity$210,000.00

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Sheet3

RevenuesSales value of items shipped to customer or service performed + other income items (agent commissions, property disposals)

Cost of Sale at

Standard MarginStandard costs (updated once each year) of components and service connected to each revenue item.

Standard MarginRevenues minus cost of sales at Standard

Variances from

StandardCosts that fall higher or lower than standard margin costs recognized on revenue items

Other Variance

Manufacturing

CostsOther costs associated with sales that are considered part of standard costs (warranty, import duty, scrap)

Contribution MarginStandard Margin minus variances and other variance manufacturing costs

Period CostsOverhead spending (spending not involved in production)

Other ExpensesMiscellaneous items such as foreign currency exchange revaluation costs

EBITDAContribution Margin minus period costs other expense

(this periods contribution of profit)