Prelims/The Finance Manual 28/6/02 11:57 am Page i. The Finance Manual for Non-Financial Managers

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2 Prelims/The Fiace Maual 28/6/02 11:57 am Page i The Fiace Maual for No-Fiacial Maagers

3 Prelims/The Fiace Maual 28/6/02 11:57 am Page ii About the Authors PAUL MCKOEN is a Fellow of the Chartered Istitute of Maagemet Accoutats. After readig a fiace degree, he joied Ford Motor Compay where he spet eleve years i a variety of roles. Now Fiace Director of Vertex, the Busiess Process Outsourcig compay created by Uited Utilities, he is based i Cheshire. This is his first book ad is ispired by all those marketig, operatioal ad egieerig maagers who have patietly shared their techical expertise i exchage for help with fiacial issues. LEO GOUGH is a fiacial jouralist. His other books iclude How the Stock Market Really Works ad Offshore Ivestmet. The Istitute of Maagemet (IM) is at the forefrot of maagemet developmet ad best maagemet practice. The Istitute embraces all levels of maagemet from studets to chief executives. It provides a uique portfolio of services for all maagers, eablig them to develop skills ad achieve maagemet excellece. If you would like to hear more about the beefits of membership, please write to Departmet P, Istitute of Maagemet, Cottigham Road, Corby NN17 1TT. This series is commissioed by the Istitute of Maagemet Foudatio.

4 Prelims/The Fiace Maual 28/6/02 11:57 am Page iii SMARTER SOLUTIONS The fiace pack The Fiace Maual for No-Fiacial Maagers The power to make cofidet fiacial decisios PAUL McKOEN ad LEO GOUGH Lodo New York Toroto Sydey Tokyo Sigapore Madrid Mexico City Muich Paris

5 Prelims/The Fiace Maual 28/6/02 11:57 am Page iv PEARSON EDUCATION LIMITED Head Office: Ediburgh Gate Harlow CM20 2JE Tel: +44 (0) Fax: +44 (0) Lodo Office: 128 Log Acre Lodo WC2E 9AN Tel: +44 (0) Fax: +44 (0) First published i Great Britai 1997 Pearso Educatio Limited 2000 The right of Paul McKoe ad Leo Gough to be idetified as Authors of this Work has bee asserted by them i accordace with the Copyright, Desigs, ad Patets Act ISBN British Library Cataloguig i Publicatio Data A CIP catalogue record for this book ca be obtaied from the British Library. All rights reserved; o part of this publicatio may be reproduced, stored i a retrieval system, or trasmitted i ay form or by ay meas, electroic, mechaical, photocopyig, recordig, or otherwise without either the prior writte permissio of the Publishers or a licece permittig restricted copyig i the Uited Kigdom issued by the Copyright Licesig Agecy Ltd, 90 Totteham Court Road, Lodo W1P 0LP. This book may ot be let, resold, hired out or otherwise disposed of by way of trade i ay form of bidig or cover other tha that i which it is published, without the prior coset of the Publishers Typeset by Norther Phototypesettig Co. Ltd, Bolto Prited ad boud i Great Britai by Bookcraft, Midsomer Norto The Publishers policy is to use paper maufactured from sustaiable forests.

6 Prelims/The Fiace Maual 28/6/02 11:57 am Page v Cotets 1 Reportig to the outside world 1 Compay backgroud 1 The framework 3 The report 5 The fiacial statemets 6 The profit ad loss accout 8 The balace sheet 13 The cash flow statemet 19 Published accouts ad the stock market 21 2 Aalysig accouts 27 Aalysig compay accouts 27 Ratio aalysis 28 Applyig ratios i credit cotrol 36 Corporate goverace 40 Auditors 43 3 The basics of accoutig 51 Double etry bookkeepig the debits ad the credits 51 Accoutig records 54 Basic priciples 60 v

7 Prelims/The Fiace Maual 28/6/02 11:57 am Page vi CONTENTS 4 Accoutig withi the orgaisatio 63 Iteral versus exteral accouts 63 The cotrol cycle 66 Structurig the pla 68 Makig budgets effective 69 Cost cetres 73 Profit cetres 74 Measurig performace 78 5 Costig 87 Itroductio 87 Cost some defiitios 88 Traditioal (absorptio) costig 92 Stadard costig 94 Activity based costig 98 Sales versus ivetory 101 Accoutig for throughput 102 Costig some geeral thoughts Pricig 105 Itroductio 105 Competitive positio 107 Product revisios 109 Retur o sales 110 The Special Value Programme (SVP) 114 Geeral poits o pricig Project aalysis 119 What is project aalysis? 119 The basic tools 122 Payback 122 Iteral Rate of Retur (IRR) ad Discouted Cash Flow (DCF) 124 Some more advaced cosideratios 131 vi

8 Prelims/The Fiace Maual 28/6/02 11:57 am Page vii CONTENTS WACC the Weighted Average Cost of Capital 134 Cashflows i perpetuity Orgaisatioal cotrol 139 Itroductio 139 Iteral cotrol 142 Fraud a geeral profile 144 Orgaisatioal cotrol whose resposibility? Corporate taxatio 151 Tax a strategy 152 The mai taxes o compaies 154 Capital allowaces 160 The taxatio of multiatioals 160 Double taxatio treaties 161 Trasfer pricig 162 Usig offshore cetres ad tax haves 168 Holdig compaies i Hollad 176 Compay structure 179 Summary Fiacig 185 The balace sheet 186 The cash flow cycle 188 Forms of fiacig 190 Overdrafts ad loas 191 Bods 194 Credit terms 198 Fiacig of specific assets 200 Equity fiacig 203 vii

9 Prelims/The Fiace Maual 28/6/02 11:57 am Page viii CONTENTS 11 Acquisitios 211 Itroductio 211 Acquisitios the strategic view 212 What makes compaies vulerable to bids? 214 Accoutig implicatios 218 Accoutig policies 224 Bids ad the stock market Risk ad risk maagemet 235 Risk aalysis 235 Evirometal/strategic risk 236 Fiacial risk 239 The forward cotract 242 Derivatives 246 Fiacial futures hedgig versus speculatio 248 Other fiacial risks 249 Loger-term risk 250 The risk/reward relatioship ad the stock market 251 The equity risk of a listed compay 252 Coclusio 255 Appedix A Fiacial cotrols who, where, whe ad how 257 Appedix B Some umerical tools 269 Appedix C The Greebury report 285 Appedix D Preset value tables 289 Glossary 291 Idex 299 viii

10 Prelims/The Fiace Maual 28/6/02 11:57 am Page ix The MCI Middle If you are studyig for oe of the NVQs o which the MCI stadards are based, this book ca help. Here s how some of the topics i this book relate to particular uits. Middle Maagemet Stadards Uit 1 Iitiate ad implemet chage ad improvemet i services, products ad systems Chapter 4. Accoutig withi the orgaisatio 63 Chapter 8. Orgaisatioal cotrol 139 Elemet 1.1 Idetify opportuities for improvemets i services, products ad systems Chapter 4. Accoutig withi the orgaisatio 63 Chapter 7. Project aalysis 119 Elemet 1.2 Evaluate proposed chages for beefits ad disadvatages Chapter 7. Project aalysis 119 Appedix B. Some umerical tools 269 Uit 2 Moitor, maitai ad improve service ad product delivery Elemet 2.1 departmet Establish ad maitai the supply of resources ito the orgaisatio/ Chapter 5. Costig 87 Elemet 2.2 Establish ad agree customer requiremets Chapter 6. Pricig 105 ix

11 Prelims/The Fiace Maual 28/6/02 11:57 am Page x THE MCI MIDDLE AND SENIOR MANAGEMENT STANDARDS Uit 3 Moitor ad cotrol the use of resources Elemet 3.1 Elemet 3.2 Cotrol costs ad ehace value Chapter 4. Accoutig withi the orgaisatio 63 Chapter 5. Costig 87 Moitor ad cotrol activities agaist budgets Chapter 4. Accoutig withi the orgaisatio 63 Chapter 10. Fiacig 185 Appedix A. Fiacial cotrols who, where, whe ad how 257 Uit 4 Elemet 4.1 Elemet 4.2 Uit 9 Elemet 9.1 Elemet 9.2 Secure effective resource allocatio for activities ad projects Justify proposals for expediture o projects Chapter 7. Project aalysis 119 Chapter 9. Corporate taxatio 151 Chapter 10. Fiacig 185 Negotiate ad agree budgets Chapter 4. Accoutig withi the orgaisatio 63 Seek, evaluate ad orgaise iformatio for actio Obtai ad evaluate iformatio to aid decisio makig Chapter 4. Accoutig withi the orgaisatio 63 Chapter 7. Orgaisatioal cotrol 119 Appedix B. Some umerical tools 269 Forecast treds ad developmets which affect objectives Chapter 7. Project aalysis 119 Chapter 12. Risk ad risk maagemet 235 Appedix B. Some umerical tools 269 x

12 Prelims/The Fiace Maual 28/6/02 11:57 am Page xi THE MCI MIDDLE AND SENIOR MANAGEMENT STANDARDS Seior Maagemet Stadards Uit A2 Iteral stregths ad weakesses Elemet A2.1 Product ad service audit Chapter 5. Costig 87 Chapter 6. Pricig 105 Appedix C. The Greebury report 285 Uit C1 Programmes, projects ad plas Elemet C1.1 Preparig ad submittig proposals Chapter 4. Accoutig withi the orgaisatio 63 Chapter 7. Project aalysis 119 Chapter 10. Fiacig 185 Chapter 11. Acquisitios 211 Chapter 12. Risk ad risk maagemet 235 Elemet C1.2 Evaluatig proposals Chapter 7. Project aalysis 119 Chapter 12. Risk ad risk maagemet 235 Appedix B. Some umerical tools 269 Elemet C1.5 Obtaiig agreemet Chapter 4. Accoutig withi the orgaisatio 63 Uit C2 Delegatio ad actio Elemet C2.3 Targets Chapter 4. Accoutig withi the orgaisatio 63 Uit C4 Moitorig Elemet C4.1 Key idicators Chapter 1. Reportig to the outside world 1 Chapter 2. Aalysig accouts 27 Chapter 4. Accoutig withi the orgaisatio 63 Chapter 7. Project aalysis 119 Chapter 10. Fiacig 185 Chapter 12 Risk ad risk maagemet 235 xi

13 Prelims/The Fiace Maual 28/6/02 11:57 am Page xii THE MCI MIDDLE AND SENIOR MANAGEMENT STANDARDS Elemet C4.2 Performace review Chapter 8. Orgaisatioal cotrol 139 Elemet C4.3 Future performace Chapter 8. Orgaisatioal cotrol 139 Chapter 12. Risk ad risk maagemet 235 Elemet A2.2 Orgaisatioal structures Chapter 8. Orgaisatioal cotrol 139 Chapter 9. Corporate taxatio 151 Chapter 10. Fiacig 185 Appedix A. Fiacial cotrols who, where, whe ad how 257 Elemet A2.5 Fiacial resources Chapter 2. Aalysig accouts 27 Chapter 4. Accoutig withi the orgaisatio 63 Chapter 7. Project aalysis 119 Chapter 10. Fiacig 185 Chapter 12. Risk ad risk maagemet 235 Appedix B. Some umerical tools 269 Uit A3 Stakeholders Elemet A3.1 Stakeholders iterests Chapter 1. Reportig to the outside world 1 Chapter 2. Aalysig accouts 27 Chapter 11. Acquisitios 211 Appedix C. The Greebury report 285 Elemet A3.2 Stakeholders impact Chapter 1. Reportig to the outside world 1 Chapter 2. Aalysig accouts 27 Chapter 11. Acquisitios 211 Appedix C. The Greebury report 285 xii

14 Prelims/The Fiace Maual 28/6/02 11:57 am Page xiii THE MCI MIDDLE AND SENIOR MANAGEMENT STANDARDS Uit B1 Settig the strategy ad gaiig commitmet Elemet B1.2 Objectives ad strategies Chapter 2. Aalysig accouts 27 Chapter 4. Accoutig withi the orgaisatio 63 Chapter 7. Project aalysis 119 Chapter 10. Fiacig 185 Chapter 12. Risk ad risk maagemet 235 Appedix B. Some umerical tools 269 Uit D1 Evaluatig ad improvig performace Elemet D1.1 Measures ad criteria Chapter 1. Reportig to the outside world 1 Chapter 2. Aalysig accouts 27 Chapter 4. Accoutig withi the orgaisatio 63 Chapter 12 Risk ad risk maagemet 235 xiii

15 Prelims/The Fiace Maual 28/6/02 11:57 am Page xiv Ackowledgemet Thaks to Steve Morris of the Burto Morris Cosultacy for his iitial support ad ecouragemet. xiv

16 Prelims/The Fiace Maual 28/6/02 11:57 am Page xv Key to margi symbols! Key thoughts for the sectio Example / case study Checklist A exercise A referece to aother relevat sectio of the book A book referece xv

17 Prelims/The Fiace Maual 28/6/02 11:57 am Page xvi This book is aimed at givig the o-fiacial maager a isight ito the complexities of fiace, busiess law, ad best practice. We have tried to simplify ad clarify the issues ad preset them i a cocise fashio to allow the maager i a o-fiace disciplie a geeral uderstadig of the more importat ad most commo issues which may be ecoutered but either the accuracy or the completeess of the iformatio cotaied ca be guarateed. This book aims to provide geeral iformatio oly it caot deal with all possible issues which may arise i ay particular situatio ad should ot be relied upo by maagers i makig fiacial decisios. It is sold with the uderstadig that either the authors or the publishers are egaged i rederig legal, ivestmet or other professioal advice. If assistace is required the reader should seek expert professioal advice. No resposibility for ay loss resultig from actios take or refraied from actig as a result of ay part of this publicatio will be accepted by the authors or the publisher.

18 Chap1/The Fiace Maual.1 28/6/02 11:48 am Page 1 CHAPTER ONE Reportig to the outside world Compay backgroud The framework The report The fiacial statemets The profit ad loss accout The balace sheet The cash flow statemet Published accouts ad the stock market Compay backgroud I this chapter we will look at the fiacial iterface of a compay with the outside world, which is its reportig of fiacial results. These are typically referred to as aual reports, with listed compaies filig iterim half-year reports as well. Compaies aual reports are prepared to the ed of that compay s fiacial year, which is ot ecessarily either the caledar year or the April to March fiscal year. To uderstad the cotext of this reportig we must explore some of the backgroud ad history, sice it is easy today to take the cocepts etirely for grated. The term compay is ow used to describe a compay registered uder the 1

19 Chap1/The Fiace Maual.1 28/6/02 11:48 am Page 2 THE FINANCE MANUAL FOR NON-FINANCIAL MANAGERS Compaies Act. Today s Compaies Acts, revised ad updated by Parliamet, cotiue to refie the laws relatig to compaies. The fudametal priciples that follow from icorporatio ad registratio of a limited compay, are that: the compay has its ow distict legal existece, separate from that of its owers, ad the owers are protected by the cocept of limited liability, which meas that i the evet of the compay failig, they stad to lose oly their ivestmet i that compay, ad ot ay other assets which they may ow. Historically, the first Compaies Act allowed busiess people to create compaies istead of tradig as a sole trader or partership, with the beefits metioed above. I the ladmark case of Salomo vs. Salomo Ltd 1897, the courts upheld the legal distictio betwee the compay Salomo Ltd ad Mr Salomo, cofirmig the separate legal existece of the Limited Compay. Additioally, the cocept of shares ad shareholders allowed stakes i such compaies to be traded freely betwee idividuals. The quid pro quo for these commercial beefits was the stipulatio of certai requiremets ad restrictios o the compay i the form of: registratio with Compaies House, the maiteace at Compaies House of up-to-date records, icludig particulars of directors, ad the filig of aual reports of the fiacial affairs of the busiess. Probably desiged origially simply to protect existig ad potetial shareholders ad creditors of the compay, the law ad best practice has sice shifted to recogise the cocept of a stakeholder i a compay. A stakeholder is defied as someoe with a iterest or stake i the future of the compay, ad icludes the followig: shareholders these ca be private idividuals, other compaies, pesio fuds or other fiacial istitutios creditors of the compay (those to whom the compay owes moey) those tradig sigificatly with the compay employees of the compay the public at large. 2

20 Chap1/The Fiace Maual.1 28/6/02 11:48 am Page 3 REPORTING TO THE OUTSIDE WORLD! With the growth i size of compaies to the poit where some of today s compaies are substatially larger ad arguably more powerful tha may smaller atios, there has bee a discerible shift toward more ope maagemet of compaies. This is geerally referred to as corporate goverace. A marked icrease i the amout of iformatio required i the aual reports, maily of listed compaies, has bee oe result of this tred. Icreased legal resposibility of compay directors has bee aother (see pages ). So all compaies have the requiremet to make aual returs to Compaies House ad to circulate these to shareholders. This book will assume that you work for a listed UK compay, but much of the iformatio will be useful if you work i a private compay. Most listed compaies recogise that the aual report is ot just a routie filig of fiacial iformatio, but also the opportuity to iform shareholders of geeral iformatio about the compay s affairs ad prospects, ad so to icrease the feel-good factor amog private shareholders.! Icreasigly, the best corporate practice is to dissemiate at least a summary of the aual report to all the employees of the compay. Do you have a copy of your compay s aual report? If ot, do obtai oe; as we work through this sectio it will be very useful to refer to your orgaisatio s report. If you have a copy but do t uderstad it, you ve bought the right book. The fu starts here! 3

21 Chap1/The Fiace Maual.1 28/6/02 11:48 am Page 4 THE FINANCE MANUAL FOR NON-FINANCIAL MANAGERS The framework The cotets of the aual report follow a pre-set patter that is similar for all compaies. This is ot a coicidece. The cotets of the aual report are prescribed i some detail i the Compaies Acts. The acts set out the requiremets for directors reports, which must iclude a fair review of the compay s activities throughout the year ad of its positio at the year ed. Additioally, detailed formats are provided for the fiacial iformatio which must be supplied. Further detail as to the preparatio of compay accouts i geeral, ad the aual report, are icluded i FRSs, or Fiacial Reportig Stadards (previously SSAPs, Stadard Statemets of Accoutig Practice). These are developed ad issued by the ASB (Accoutig Stadards Board) ad cover areas which are developig, or which require additioal clarificatio ad stadardisatio withi the professio i order to esure that the accoutig treatmet of certai areas is cosistet betwee compaies. The ASB has bee authorised by the Secretary of State for the purpose of issuig such stadards, ad these statemets become Accoutig Stadards as referred to i the Compaies Acts. There is geerally substatial cosultatio withi the accoutacy professio before a ew stadard is issued. The combied effect of the legislatio, the stadards ad curret best practice is, of course, eormously detailed, ad way beyod the scope of this book. I the sectios that follow, we will be describig the basic priciples of reportig to the outside world, which takes place i the aual report. Directors are resposible Although i practice o-fiacial maagers ad directors leave the preparatio ad filig of fiacial reports to their fiace directors, if you are a director you have a duty to esure that appropriate accoutig records are maitaied, prepared ad submitted. As a director you caot leave or delegate this resposibility to your Fiace Director, you are joitly liable. If you are a director, I ca recommed the Coopers & Lybrad publicatio Beig a Director as a excellet user friedly guide to the resposibilities of the post.! If you re a seior maager, particularly i a smaller compay, ask yourself Do I act as a director? If so, the law might treat you as oe! Cosider takig professioal advice. 4

22 Chap1/The Fiace Maual.1 28/6/02 11:48 am Page 5 REPORTING TO THE OUTSIDE WORLD The report Havig discussed the framework which stipulates the cotets of the report, let s look at the report itself. Every report will cotai: a directors report a statemet by the auditors the fiacial statemets. We will take a brief look at the first two before examiig the fiacial statemets i more depth. Read through the aual report ad accouts of your compay you ll fid the report of the chairma/directors cotais a full review of the year ad some descriptio of the curret positio ad outlook. There ll be a sectio o directors cotracts, corporate goverace, ad dissemiatio of the report to employees. All this iformatio is required.! Ofte compaies add to the reports i order to produce a documet that will impress potetial ivestors ad/or customers, but you ll fid that much of the cotet is madatory. The picture of the chairma smilig cofidetly i frot of his ewest most glamorous product will also feature i your compay s report. This is t madatory, but might as well be! There will also be a report of the auditors sayig that i our opiio the accouts give a true ad fair view. There is curretly a iterestig debate o the role of auditors, ad the extet of their liability whe they miss somethig. I a etirely ucoected developmet(!), some of the big audit firms either have, or are cosiderig, movig to limited liability compaies from their curret status as ulimited liability parterships. I the real world, a audit ca ever check the validity of every trasactio i every part of the largest compaies, ad hece the terms used i the auditor s report: reasoable assurace ad material mis-statemet. The audit ca oly ever provide a high-level review of the compay s policies ad cotrols together with more detailed spot-check reviews of ew ad/or more critical operatios. Ideed the resposibility for maagig iteral cotrols remais with the directors. 5

23 Chap1/The Fiace Maual.1 28/6/02 11:48 am Page 6 THE FINANCE MANUAL FOR NON-FINANCIAL MANAGERS The fiacial statemets Let s ow move o to look at the fiacial statemets of the compay. These are broke dow ito three mai statemets as follows: profit ad loss accout balace sheets cash flow statemet. Most large compaies are ow actually groups of compaies, ad their glossy aual report will cover the top compay, or ultimate holdig compay of the group. The profit ad loss accout ad cash flow statemet will be for the group as a whole, while the balace sheet is provided for the cosolidated group ad for the holdig compay aloe. For the purposes of this descriptio I will igore the holdig compay balace sheet, ad cocetrate o the cosolidated statemets. The first thig to ote is that the profit ad loss ad cash flow will state for the year eded, while the balace sheet will state as at (the year ed). Profits ad cash are eared throughout the year, whereas the balace sheet is a sapshot at the poit i time which is the year ed. profit ad loss/cash flow balace sheet profit ad loss/cash flow (Year 1) (Year 2) Cosolidatio (group accouts) Note that a group of compaies will probably iclude some compaies which are ot wholly owed. The method of cosolidatio of these compaies depeds o whether they are maaged or cotrolled by the group. The basic test here is whether the owership ad/or cotrol is over 50 per cet. The stadards are actually quite complicated i this area, ad are full of ati-avoidace measures. What follows is, therefore, a simplificatio. 6

24 Chap1/The Fiace Maual.1 28/6/02 11:48 am Page 7 REPORTING TO THE OUTSIDE WORLD The basics are as follows: Subsidiary whe a group ows a majority of the rights of aother compay, or exercises domiat cotrol, the compay is deemed to be a subsidiary of the group. Normally if 50 per cet+ of the shares of the compay is owed by aother compay, the former is a subsidiary of the latter. Associate whe a group ows a participatig iterest with a sigificat ifluece, the compay is a associate. Normally if per cet of the shares of a compay is owed by aother compay, the former is a associate. Ivestmet at less tha 20 per cet of shares, the holdig would be treated simply as a ivestmet. I the case of associates ad ivestmets, cosolidatio is simply show by recordig the group s share of profits ad assets as oe-liers o the profit ad loss accout ad balace sheet. Subsidiaries are dealt with by icludig the whole of the subsidiary s results i the group accouts, ad the excludig the miority iterests separately. Example For example, the results for a simple paret compay with oe 75 per cet owed subsidiary would be as follows: Paret Subsidiary Group Sales Profit less miority iterests (25) Total Group profit 175! NOTE: sales ad profits are show gross, with the profits due to miority shareholders show ear the bottom of the profit ad loss accout. Now let s cosider the shape ad cotet of aual reports, startig with the profit ad loss accout. 7

25 Chap1/The Fiace Maual.1 28/6/02 11:48 am Page 8 THE FINANCE MANUAL FOR NON-FINANCIAL MANAGERS The profit ad loss accout Coceptually the most readily uderstood, the profit ad loss is the statemet of profits or losses i the year, or other stated period. The layout is prescribed i FRS3. Profit is the surplus of reveue over costs attributable for that period. It is ot cash flow. Profit ca ad ofte is eared despite strogly egative cash flow, particularly i fast-growig compaies. The treatmet of stocks (or ivetories) ad capital ivestmets ca illustrate the geeratio of profit data. Example: Stocks A compay sells 50 pieces of machiery, but has maufactured 100 i the year. Costs each Total (50,000) Sales each Total 37,500 So the cash impact o the tradig compay is 50,000 out ad oly 37,500 i, or a cash outflow of 12,500. What is the profit? At the ed of the year the compay still has 50 uits of stock i had, ad may eve have orders for delivery i the followig year, so it has a asset worth at least the replacemet cost of the uits, or 25,000. The accoutig profit for the period would be developed by lookig at the sales figures, ad the deductig the cost of those sales. This is kow as matchig, ad would be as follows: Sales each 37,500 Cost of sales each (25,000) Profit for the period 12,500! NOTE: the differece betwee the cash outflow (top) of 12,500 ad the profit of 12,500 is 25,000, which just happes to be the replacemet value of the stocks at the year ed. Look at your ow compay s accouts ad fid the ote that is called recociliatio of tradig profit to cash flow. Fid the lie that reads icrease/decrease i stocks. 8

26 Chap1/The Fiace Maual.1 28/6/02 11:48 am Page 9 REPORTING TO THE OUTSIDE WORLD Example: Capital Ivestmet ad depreciatio A compay purchases a capital asset for 1 millio with a estimated useful life of 10 years. I pure cash terms, it is dow 1 millio assumig outright purchase (i.e. ot leased). What is the effect o profits? As you might expect, there is a techique to spread the cost of the asset, or, to be more accurate, to spread the charge to the profit ad loss accout, over the useful life of the asset. I that way you might thik that you would take the cost of the asset, divide it by its useful life to give a aual amout, ad charge this agaist each year s profits. This is called depreciatio. There are two mai kids: straight lie depreciatio which is very commo, ad decliig balace where a percetage of the remaiig value is charged. What is your compay s depreciatio policy? Look at your compay s aual report for the aswer. Try ote 1, accoutig policies if you re stuck. For a asset with a three-year life, the charges would be as follows (decliig balace assumes 50 per cet write off): Straight lie Decliig balace Purchase 300, ,000 Year 1 (100,000) (150,000) Year 2 (100,000) (75,000) Year 3 (fial) (100,000) (75,000) Which method is right or wrog depeds very much o the type of asset, the idustry sector, whether there is a residual or scrap value at the ed of the period, ad o other variables. Other depreciatio techiques also exist, but you ll fid these two are the most commo. You ca see why you might wat to depreciate differet assets differet ways by cosiderig the causes of depreciatio: Obsolescece. Your compay may have a substatial amout of high-tech equipmet. This may have may years of workig life left i it, but if ew equipmet comes out which works better, or ca do more, the compay will have to replace its old equipmet i order to stay competitive. Compaies i the media, for example, are costatly havig to purchase ew techology because of the rapid pace of improvemets. 9

27 Chap1/The Fiace Maual.1 28/6/02 11:48 am Page 10 THE FINANCE MANUAL FOR NON-FINANCIAL MANAGERS Wear ad tear. Assets wear out whe they are used, but are also affected by the eviromet. Equipmet located i harsh coditios overseas may well wear out faster tha equipmet at home. Copyrights, patets ad leases are all assets, but they have a fixed life which is set either by law or by cotract. This makes their remaiig life predictable. This kid of depreciatio is called amortisatio. Growth. If a compay icreases i size, some of its assets may o loger be useful. Suppose it operates ski-lifts i a resort which suddely becomes popular it will have to istall ew, improved ski-lifts which ca carry more people ad, perhaps, are more comfortable. The old ski-lifts may have to be scrapped if the compay ca t fid a buyer for them. Here are two importat poits about depreciatio: 1 2 Depreciatio looks as if it is just a paper trasactio. You do t actually pay out cash whe you depreciate, although it reduces the profit figure. Oe day, though, the compay s machies ad other fixed assets are goig to wear out ad will have to be replaced. At that poit, the compay will have to pay out for ew machies, so if it has t prepared itself by depreciatig, it will have a upleasat surprise. This might lead you to thik that it is sesible to depreciate assets as quickly as possible that way, the assets will have years of useful life left i them after they have bee depreciated to othig. The trouble with this is that it makes the percetage retur o the capital you are usig i the busiess look better tha it really is. The same thig happes if you fail to revalue assets that have actually icreased i value. A salutary example of this took place i the 60s ad 70s, whe may old-fashioed compaies had the value of their buildigs o their books at the price they were purchased at may years before; a compay i this situatio might thik it was gettig a retur of, say, 16 per cet o its assets whe, if the property had bee revalued, it would really be gettig a retur of, say, 8 per cet. 10

28 Chap1/The Fiace Maual.1 28/6/02 11:48 am Page 11 REPORTING TO THE OUTSIDE WORLD Let s look ow at the stadard format of the profit ad loss accout i the aual report. The stadard profit ad loss accout statemet shows turover, or total sales, gross profits, et profits, ad other items. Turover is show as it reached the compay, i.e. after deductio of all discouts, etc. ad after deductio of sales taxes such as VAT. A iterestig issue o turover arises from log-term cotracts. The classic example is the shipbuilder whose bespoke product may take several years to build. Sales receipts may ot reflect the progress of the ship. Here the accoutig stadards allow turover to be recogised either o a sales-based or cost-based approach. This would allow oe-third of the total turover to be recogised if oe-third of the ship had bee completed, eve if ot all of these amouts had bee received or were due. You will ote that turover is split betwee cotiuig operatios, acquisitios, ad disposals. This is to allow for year-o-year aalysis i the compay which has bought ad sold part of its busiesses durig the year. Cost of sales is the deducted to show gross profit. This is the gross profitability of the busiess before admiistratio, fiacig, etc. ad is importat for tred ad margi aalysis, of which more later. The ext category is operatig profit, which is the et profit of the busiess after admiistratio costs but before fiacig charges. Like turover this must be split by operatios showig cotiuig operatios, acquisitios, ad disposals. Icome from holdigs i associate compaies is the show. (See Cosolidatio above.) The compay s iterest charge or icome is show separately, to give PBT or Profits Before Tax. The tax charge for the year is show, followed by PAT or Profits After Tax. Note that typically the charge for the year is a estimate sice the completio of a compay s tax affairs for the year is geerally ot fialised util log after the report is filed. Oly the is the miority iterest removed from the group s profits. (See Cosolidatio above). Divideds are the show, leavig a retaied profit for the year. This represets the amout of PAT retaied i the busiess to support future growth. EPS or earigs per share is the show (this will be discussed later). 11

29 Chap1/The Fiace Maual.1 28/6/02 11:48 am Page 12 THE FINANCE MANUAL FOR NON-FINANCIAL MANAGERS Example Here is a example of a profit ad loss statemet: XYZ plc Profit ad Loss Accout for the year edig 20 mp Turover Cotiuig operatios 70)p Acquisitios 20)p Disposals 10)p Total 100)p Cost of sales (50)p Gross profit 50)p Sellig ad distributio costs Admiistrative expeses (12)p (8)p Total (20)p Operatig profit 30)p Iterest receivable 2)p Profit o ordiary activities before taxatio (PBT) 32)p Tax 10)p Profit o ordiary activities after taxatio (PAT) 22)p Miority iterest (2)p Profit for the fiacial year 20)p Proposed divided 8)p Amout trasferred to reserves 3)p Retaied profits carried to ext year 9)p Earigs per ordiary share 7p) 12

30 Chap1/The Fiace Maual.1 28/6/02 11:48 am Page 13 REPORTING TO THE OUTSIDE WORLD It is importat to get a uderstadig of what a profit ad loss statemet does t tell you. For example, it does t tell you: how, exactly, your compay s costs relate to sales there is o detailed breakdow of profits betwee differet products ad services, how much capital is ivested i the busiess, or what the retur o that capital is, whether there were losses i previous years, how much cash you have available right ow, what expediture you must make i the future, ad the tred of profits over a period of years. To discover the aswers to these questios, we will eed to examie the balace sheet ad cash flow statemet, to compare them with previous years, to apply ratio calculatios to the figures ad also to have access to other iteral accouts. People outside the compay, such as ivestors ad bakers, will ot have access to ay iteral iformatio, but will have to rely o the published accouts. The balace sheet As discussed above, the balace sheet is coceptually differet from the profit ad loss accout ad the cash flow statemet i that it represets a sapshot at a poit i time, rather tha the tradig picture over a period of time. It shows, at the balace sheet date, the assets ad liabilities of the compay. Sice the et assets of a compay are effectively owed or due to the shareholders, or owers, of the busiess, the the et assets of a compay must always be equal to the shareholders stakeholdig, ad the statemet must always balace, i.e. et assets equal shareholders assets equals the amout due by the compay to shareholders. Because these amouts must always balace, it is kow as the balace sheet. 13

31 Chap1/The Fiace Maual.1 28/6/02 11:48 am Page 14 THE FINANCE MANUAL FOR NON-FINANCIAL MANAGERS Example Let s use a simple example: a ivestor starts a compay by subscribig 100 i share capital: Assets cash 100 Share capital 100 It balaces! The compay trades ad ears 10 profit. Assets cash 110 Share capital 100 Profit ad loss accout 10 Total shareholders fuds 110 It declares a divided to be payable after the year ed. Assets cash 110 Divided payable,,,,,(5) Net assets 105 Share capital 100 Profit ad loss accout,,,(,(5) Total shareholders fuds 105 We ll examie some of the mechaics of this i more detail i Chapter 2, but for ow, accept that the et assets of the compay always equal the shareholders fuds. Let s ow look at the balace sheet items i detail. Agai the format is prescribed i legislatio ad stadards, so your compay s balace sheet should look very much like this oe. See the sectio o cosolidatio (page 6) for details of the treatmet of subsidiaries. 14

32 Chap1/The Fiace Maual.1 28/6/02 11:48 am Page 15 REPORTING TO THE OUTSIDE WORLD Fixed assets These are those assets which a compay uses to provide goods ad services they are ot traded routiely by the compay. Itagible assets these might iclude goodwill arisig o the acquisitio of aother compay (see Acquisitios later). Amouts spet o developig specific products or patets ca be capitalised, i.e. treated as expediture o a asset istead of writte off to profit i the curret year. This has previously bee a dagerous practice for some compaies, ad there are substatial restrictios o it. Tagible assets buildigs, machiery, etc. Show i the balace sheet after deductig the charge for depreciatio. The details are i the otes. Ivestmets this might iclude details of ay ivestmet properties together with the value of o-cosolidated smaller holdigs i other compaies. Curret assets Stocks the ivetory curretly beig carried by the compay. These will iclude raw materials as well as fiished goods. Also icluded here is the valuatio of ay part-fiished log-term cotracts (discussed o page 57). Agai, check ote 1, accoutig policies for the valuatio method used i assessig stocks. Debtors (or receivables) are the amouts due ito the compay from other parties. This, primarily, will reflect those sales made for which paymet is still outstadig. Cash is the fial curret asset. You will also see cash equivalets described. These are ormally liquid ivestmets used by corporate treasurers to icrease iterest icome o cash holdigs. It is worth otig here that the effect of the sales process, i balace sheet terms, is to reduce stocks as the goods leave the factory, ad to icrease debtors or cash by the amout o the sales ivoice. We ll describe the detail of this process i Chapter 2. Next o the balace sheet is curret liabilities. These are amouts due to third parties i the 12 moths from the balace sheet date. You the fid a sub-total et curret assets, which is also kow as workig capital. Fallig after this are the log-term creditors, due more tha 12 moths after the balace sheet date, ad provisios. Log-term creditors are typically fiacig loas from baks ad others while provisios are those amouts set aside to cover potetial future claims ad losses which are reasoably foreseeable. 15

33 Chap1/The Fiace Maual.1 28/6/02 11:48 am Page 16 THE FINANCE MANUAL FOR NON-FINANCIAL MANAGERS The fial total is called et assets. Let s simplify all this: Fixed assets (e.g. premises, factory buildigs ad equipmet) plus Workig capital (et curret assets icludig stocks ad cash) less Fudig ad provisios equals Net assets The et assets of the compay must also be equal to the shareholders stake i the compay, because ultimately the shareholders ow the compay. Shareholders fuds They cosist of: Called up share capital this is the omial amout of the shares i issue. All shares carry a omial value, ofte 1, ad this is the amout described here. Share premium accout shares are ofte issued at a premium, that is a compay may issue additioal shares after establishig a tradig record ad sell shares with a omial value of 10,000 for 100,000. I this case, the called up share capital would icrease by 10,000, ad the share premium accout would icrease by 90,000. Revaluatio reserve is created whe assets are revalued because their market worth has icreased. 16

34 Chap1/The Fiace Maual.1 28/6/02 11:48 am Page 17 REPORTING TO THE OUTSIDE WORLD Example Let us ow start a example. A compay issues shares with a omial value of 1, as above. The balace sheet is as follows: Barkig Traders Ltd Balace Sheet 31st December 1996 Fixed assets 0 Curret assets cash 100,000 Net curret assets 100,000 Net assets 100,000 Shareholders fuds called up share capital 10,000 share premium accout 90,000 Shareholders fuds 100,000 The compay trades successfully for a moth, edig the moth with profits of 10,000 ad some stocks. The compay also buys a buildig for 50,000. The balace sheet is as follows: Barkig Traders Ltd Balace Sheet 31st Jauary 1997 Fixed assets 50,000 Curret assets stocks 50,000 cash 10,000 Net curret assets 60,000 Net assets 110,000 Shareholders fuds called up share capital 10,000 share premium accout 90,000 profit ad loss accout 10,000 Shareholders fuds 110,000 17

35 Chap1/The Fiace Maual.1 28/6/02 11:48 am Page 18 THE FINANCE MANUAL FOR NON-FINANCIAL MANAGERS The profits show are those that are realised or achieved. That is they relate to goods which have bee sold. (The exceptio here relates to log-term cotracts, which were discussed above.) Notice how the profit is added to shareholders fuds ad reflects the icrease i value of the firm as a whole. Let us ow suppose that the compay s buildig icreases i value by 25,000, to 75,000. I order to give a true ad fair view of the assets of the compay, the balace sheet value should be icreased to reflect the icrease i value of the buildig. But where should the correspodig balacig etry go? Had the buildig bee sold, it would ideed be recogised as profit. I this case, however, there is o itetio to sell the buildig, it remais as a fixed asset of the compay. We therefore create a revaluatio reserve ad the balace sheet looks as follows: Barkig Traders Ltd Balace Sheet 31st Jauary 1997 Fixed assets 75,000 Curret assets stocks 50,000 cash 10,000 Net curret assets 60,000 Net assets 135,000 Shareholders fuds called up share capital 10,000 share premium accout 90,000 revaluatio reserve 25,000 profit ad loss accout 10,000 Shareholders fuds 135,000 Iformatio o the revaluatio of fixed assets i this way must always be disclosed i the otes to the accouts. 18

36 Chap1/The Fiace Maual.1 28/6/02 11:48 am Page 19 REPORTING TO THE OUTSIDE WORLD! NOTE: of the shareholders fuds, oly the profit lie is distributable as divided. Compaies may ot pay divideds out of capital, revaluatio or other reserves, without applyig to the court for a capital reductio, which is rather uusual. Goig back to the early history of compay law, the amout of ower s capital that is locked i the busiess is importat for the protectio of the compay s creditors. The cash flow statemet The mai purpose of the cash flow statemet is to eable iterested parties to judge the reasos for a rise or fall i the amout of cash i the busiess durig the relevat period. This sheds light o the iformatio cotaied i the balace sheet ad profit ad loss accout. For example, the statemet serves as a check o whether the compay is actually collectig its debts ad whether the compay s cash is beig absorbed i replacig fixed assets either of which actios are revealed by the profit ad loss accout. There are strict rules about the categories that must be used i the cash flow statemet, but before we look at these, let s examie the way that cash comes i ad out of a compay: If a busiess is tradig at a profit, the amout of cash i the busiess might be expected to rise over the year. Equally, if it is makig a loss, the amout of cash might be expected to fall. (See Chapter 10, page 190 o overtradig, though.) If a compay buys a fixed asset, such as machiery or a buildig, the amout of cash it has will fall. Coversely, if it sells a fixed asset, cash will come ito the busiess. If the amout of stock a compay holds is fallig, its cash should icrease, sice it is ot buyig so much. If it buys more stock tha ormal, its cash holdig will decrease. The same priciple applies to debtors of the compay. If you were suddely able to force your customers to pay oly i cash, for example, you would get much more cash i tha ormal, ad if you suddely gave all your customers 90 days credit istead of the ormal 30 days, you would have less cash tha ormal. 19

37 Chap1/The Fiace Maual.1 28/6/02 11:48 am Page 20 THE FINANCE MANUAL FOR NON-FINANCIAL MANAGERS If shareholders decide to ivest more moey ito the busiess, the amout of cash will icrease, ad if they take moey out by way of directors drawigs or shareholders divideds the cash i the compay will decrease. If the compay borrows moey, its cash will icrease; whe it pays the moey back the cash will decrease. If the compay orders more goods o credit tha ormal its cash will icrease if it sells the goods before it pays for them, ad if it reduces its debts to its creditors its cash will decrease. Now let s look at the categories that actually appear i cash flow statemets: Operatig activities cash geerated i the ormal course of tradig. This is ot the same as profits, ad a recociliatio of this category to the profit ad loss accout follows the cash flow statemet. The sigle largest items are the addback of depreciatio, together with chages i workig capital. The addback of depreciatio ofte cofuses put simply, the profit ad loss accout is charged a share of the usage of fixed assets (see above). As this is a o-cash item that does ot affect cash it is reversed i the recociliatio. Returs o ivestmets ad servicig of fiace this shows divideds received together with iterest paid ad received. Taxatio paymets ad repaymets of taxes o sales reveue ad capital gais are show here, but ot VAT, which comes uder the Operatig Activities headig. Ivestig activities show here are the amouts of ivestmet i fixed assets, icludig ay disposals ad the acquisitio of subsidiaries (of which more later). Curret asset ivestmets, such as cash held at a bak, are also icluded, as are loas to ad from compaies i the same group. Net effect the amout is the sub-totalled to show the et effect of all activities i the year before ay additioal fiacig has bee raised. Fiacig the amout of ew moey borrowed to fiace the busiess is show separately here. Oly the receipt ad repaymets of the pricipal sum borrowed are icluded the iterest paymets go uder the Returs o ivestmet ad servicig of fiace headig. Cash flow relatig to shares, bods ad other types of corporate fiacig are all recorded here. 20

38 Chap1/The Fiace Maual.1 28/6/02 11:48 am Page 21 REPORTING TO THE OUTSIDE WORLD The fial total shows the absolute chage i cash levels betwee the two balace sheet dates. This wo t tally with the cash levels show i the balace sheet because: a) the short-term creditors will iclude overdrafts which are icluded i et cash, ad b) there will be a chage of exchage rates which will impact o the cash flow. Published accouts ad the stock market Although the published accouts of a private limited compay are public documets which ayoe ca obtai from Compaies House, they are geerally ot subject to the amout of scrutiy from outsiders as are the accouts of compaies listed o the stock market. Listed compaies, because their shares are widely held by outside ivestors, must expect a great deal of attetio whe they produce their accouts each year. All compaies are subject to coflictig pressures whe they produce their accouts, ad despite the ew accoutig stadards there is still some leeway i decidig how to preset the figures. Outside ivestors kow this, ad scrutiise published accouts very carefully. The aual report ad accouts of a listed compay is geerally a glossy publicatio which is desiged to impress. Professioal ivestors, though, will ofte skip over these sectios ad start readig the report from the back. They will look at the AGM resolutios to try to gai a isight ito the itetios of the directors, ad the maer i which the compay is govered. I particular this will iclude compliace with the accepted best practice, ow icludig Cadbury ad Greebury. They will read the otes carefully, ad relate ay sigificat matters to the figures i the balace sheet ad profit ad loss statemet. For istace, if the compay has sold a busiess but has give some fiacial guaratees to the purchaser, this will appear i the otes. Ivestors will take a view o the likelihood that the compay may have to fulfil these guaratees i the future, ad will metally adjust its profit figures accordigly. 21

39 Chap1/The Fiace Maual.1 28/6/02 11:48 am Page 22 THE FINANCE MANUAL FOR NON-FINANCIAL MANAGERS They will apply various ratios (see Chapter 2) to the figures i the balace sheet ad profit ad loss statemet. For istace, if the compay is reportig a much greater profitability tha are other compaies i the same busiess, ivestors will wat to kow why. The professioal ivestors are a shrewd buch, ad will calculate the overall retur o all the capital beig used i the busiess as well as the retur obtaied by the shareholders. These figures are the compared with the retur ivestors could get by, say, simply leavig their moey i a buildig society at virtually o risk, ad if the retur is ot good eough, some ivestors will pull out, causig the share price to fall. They will compare the cash flow statemet with the profit ad loss figures the figure for operatig cash flow ought, logically, to be similar to the figure for operatig profits. If they are t, ivestors will woder if the compay is beig optimistic about its profit figures, ad will ivestigate further. They will look at the amout the compay is payig i tax as a percetage of its profits. Corporatio tax is curretly 33 per cet, so if the percetage paid i tax is a lot lower tha this, it could mea that profits are beig exaggerated, so they will wat to uderstad the reaso for the divergece. They will compare the aual accouts with those of previous years, lookig for chages i policy, ot all of which have to be reported, but will show up uder aalysis. Whe they fid a chage i policy, ivestors will try to work out the effect the chage has o reported profits. Despite the careful attetios of outside shareholders ad potetial ivestors to the aual report ad accouts, however, the share price of a compay may rise ad fall far beyod the true value of its busiess. The story of Asil Nadir, fouder of Polly Peck plc, illustrates this. 22

40 Chap1/The Fiace Maual.1 28/6/02 11:48 am Page 23 CASE STUDY REPORTING TO THE OUTSIDE WORLD POLLY PECK I 1968 Asil Nadir owed Wearwell, a clothig compay which was ot listed o the Stock Exchage. It was a small busiess, with a turover of 370,000 ad a low profit of 10,000, but by 1973 it had grow to a turover of 4 millio ad its aual profits were 672,000. Nadir had made it as a busiessma, workig grim 15-hour days throughout the Swigig Sixties. I 1973, Nadir took his compay public ad sold 40 per cet of his equity o the stock market for 1.47 millio. By September Wearwell s shares had rise from 46p to 78p a 70 per cet profit i two moths. Soo, however, Wearwell was threateed by competitors. Nadir wet ito mail order, losig some 650,000 durig the 1974 oil crisis. Divideds o Wearwell s shares were suspeded. Nadir gave up mail order ad retreched ito his core cash ad carry wholesale busiess. Wearwell s profits retured i , but he had to fid a way to expad. He soo foud the aswer; the ewly rich oil producig coutries of the Middle East had moey to sped, ad soo Nadir was exportig school uiforms ad other ufashioable clothig to Libya ad Iraq. It was a big risk; as oe of his associates has remarked, God help you if you have a bad debt. Wearwell was seriously i debt ad highly leveraged; i 1976 Nadir was forced to give a supplier 10 per cet of its equity ad a seat o the board to keep goig. At the same time he was forced to sell shares to repay a loa of 86,000 which he had take from the compay i cotravetio of the Compaies Act. Wearwell s exports paid off i 1979, whe the compay resumed divided paymets ad icreased profits. For the first time Nadir retured to his roots, opeig factories i Norther Cyprus ad makig cost savigs of more tha 70 per cet, despite the icreased costs of trasport. The boom Determied to expad, Nadir bought a shell compay, Polly Peck, i 1980, ad decided to eter the fruit busiess. The 1974 Turkish ivasio of Norther Cyprus had left its ecoomy i ruis; its mai product, citrus fruit, was rottig o the groud, ad the tourist idustry had dried up. As a Turkish Cypriot, Nadir saw a perfect opportuity to become a hero i his homelad ad make substatial profits at the same time. 23