GVEP Workshop Finance 101

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1 GVEP Workshop Finance 101 Nairobi, January 2013

2 Agenda Introducing business finance Understanding financial statements Understanding cash flow LUNCH Reading and interpreting financial statements Evaluating a business using ratios Appraising and valuing a business

3 2 ICEBREAKER

4 Introducing business finance 3

5 How to initially finance a business? Equity Debt Cash Who? Owners, friends, family, other investors What? Shareholders expect a return on investment in the form of dividends, or an increase in the value of a share. Why? Less risky for business, as there are no loan repayments. However, the company experiences loss of ownership/control. Who? Banks What? Creditors expect debtors to pay interest Why? No loss of ownership, though money must be paid back on fixed terms. Who? You! What? After paying the expenses of your business, stakeholders dividends, and interest from loans, you may have surplus cash. You can reinvest this cash into the operations of the business. Why? Non-binding, if you have cash reserves to commit! 4

6 How do you invest the money in the business? Overhead Asset purchase Production of goods and services Costs required to oversee and manage the operations of the company Assets are resources owned or controlled by the company, and are usually the biggest investments made by a business. Investment in the development of goods or services e.g. Management salaries, headquarters staffing costs e.g. Tangible asset (warehouse/workshop,) v Intangible asset (patent, copyright) e.g. Raw materials, staff salaries 5

7 Understanding financial statements 6

8 Financial statements What are financial statements? Financial statements record the historic financial profile and performance of the business These documents are often produced to a standard format Extensive notes that provide detail on the numbers in the financial statements often accompany financial statements Who uses financial statements? Shareholders Credit reference agencies Suppliers Managers Tax authorities and governments Financial analysts, advisers and journalists Banks and other providers of finance Customers Employees The general public 7

9 The 3 types of financial statement Balance Sheet Profit and Loss Statement (P&L) Cash Flow Statement A snapshot at a point in time Records the assets and liabilities of the business at that point in time Summarizes what the business owns and what it owes Covers a span of time (e.g. a year or a month) Records the income and expenditure over that period of time Income and expenditure includes cash and non-cash items Covers a period of time (e.g. a year or a month) Records the cash which came in and the cash which went out over the period Shows the up-to-date cash balance 8

10 How financial statements are linked 31 Dec Dec Dec 2014 P&L for year to 31 Dec 2013 P&L for year to 31 Dec 2014 Cash flow for year to 31 Dec 2013 Cash flow for year to 31 Dec 2014 Time Balance sheet Balance sheet Balance sheet 9

11 10 Solar manufacturer

12 Balance Sheet The balance sheet balances! Assets Everything the company owns = Liabilities + Equity Everything the business owes 11

13 Balance Sheet ASSETS LIABILITIES Current Assets Current Liabilities Cash $10,000 Short-term loan $5,000 Accounts receivable Accounts payable Inventory Interest and taxes payable Prepaid expenses Total Current Liabilities Total Current Assets Long-Term Liabilities Fixed Assets Mortgage Land Total Long-Term Liabilities Buildings (less accumulated depreciation) STOCKHOLDERS EQUITY Plant and equipment Paid in capital $10,000 (less accumulated depreciation) Total Fixed Assets Retained earnings Total Shareholders equity Total Assets $10,000 Total Liabilities and Equity $10,000 12

14 Balance Sheet ASSETS LIABILITIES Current Assets Current Liabilities Cash $10,000 Short-term loan $5,000 Accounts receivable Accounts payable Inventory Interest and taxes payable Prepaid expenses Total Current Liabilities Total Current Assets Long-Term Liabilities Fixed Assets Mortgage Land Total Long-Term Liabilities Buildings (less accumulated depreciation) STOCKHOLDERS EQUITY Plant and equipment Paid in capital $10,000 (less accumulated depreciation) Total Fixed Assets Retained earnings Total Shareholders equity Total Assets $10,000 Total Liabilities and Equity $10,000 13

15 Balance Sheet ASSETS LIABILITIES Current Assets Current Liabilities Cash $15,000 Short-term loan $5,000 Accounts receivable Accounts payable Inventory Interest and taxes payable Prepaid expenses Total Current Liabilities Total Current Assets Long-Term Liabilities Fixed Assets Mortgage Land Total Long-Term Liabilities Buildings (less accumulated depreciation) STOCKHOLDERS EQUITY Plant and equipment Paid in capital $10,000 (less accumulated depreciation) Total Fixed Assets Retained earnings Total Shareholders equity Total Assets $15,000 Total Liabilities and Equity $15,000 14

16 Balance Sheet ASSETS LIABILITIES Current Assets Current Liabilities Cash $13,000 Short-term loan $5,000 Accounts receivable Accounts payable Inventory $2,000 Interest and taxes payable Prepaid expenses Total Current Liabilities Total Current Assets Long-Term Liabilities Fixed Assets Mortgage Land Total Long-Term Liabilities Buildings (less accumulated depreciation) STOCKHOLDERS EQUITY Plant and equipment $3,000 Paid in capital $10,000 (less accumulated depreciation) $0 Retained earnings Total Fixed Assets Total Shareholders equity Total Assets $15,000 Total Liabilities and Equity $15,000 15

17 Balance Sheet ASSETS LIABILITIES Current Assets Current Liabilities Cash $10,000 Short-term loan $5,000 Accounts receivable Accounts payable Inventory $2,000 Interest and taxes payable Prepaid expenses Total Current Liabilities Total Current Assets Long-Term Liabilities Fixed Assets Mortgage Land Total Long-Term Liabilities Buildings (less accumulated depreciation) STOCKHOLDERS EQUITY Plant and equipment $3,000 Paid in capital $10,000 (less accumulated depreciation) $0 Retained earnings Total Fixed Assets Total Shareholders equity Total Assets $15,000 Total Liabilities and Equity $15,000 16

18 Balance Sheet ASSETS LIABILITIES Current Assets Current Liabilities Cash $11,100 Short-term loan $5,000 Accounts receivable Accounts payable $2,000 Inventory $1,300 Interest and taxes payable Prepaid expenses Total Current Liabilities Total Current Assets Long-Term Liabilities Fixed Assets Mortgage Land Total Long-Term Liabilities Buildings (less accumulated depreciation) STOCKHOLDERS EQUITY Plant and equipment $3,000 Paid in capital $10,000 (less accumulated depreciation) $0 Retained earnings $400 Total Fixed Assets Total Shareholders equity Total Assets $15,400 Total Liabilities and Equity $15,400 17

19 Balance Sheet ASSETS LIABILITIES Current Assets Current Liabilities Cash $11,100 Short-term loan $5,000 Accounts receivable Accounts payable $2,000 Inventory $3,300 Interest and taxes payable Prepaid expenses Total Current Liabilities Total Current Assets Long-Term Liabilities Fixed Assets Mortgage Land Total Long-Term Liabilities Buildings (less accumulated depreciation) STOCKHOLDERS EQUITY Plant and equipment $3,000 Paid in capital $10,000 (less accumulated depreciation) $0 Retained earnings $400 Total Fixed Assets Total Shareholders equity Total Assets $17,400 Total Liabilities and Equity $17,400 18

20 Balance Sheet ASSETS LIABILITIES Current Assets Current Liabilities Cash $11,100 Short-term loan $5,000 Accounts receivable $900 Accounts payable $2,000 Inventory $3,300 Interest and taxes payable Prepaid expenses Total Current Liabilities Total Current Assets Long-Term Liabilities Fixed Assets Mortgage Land Total Long-Term Liabilities Buildings (less accumulated depreciation) STOCKHOLDERS EQUITY Plant and equipment $3,000 Paid in capital $10,000 (less accumulated depreciation) $0 Retained earnings $400 Total Fixed Assets Total Shareholders equity Total Assets $17,400 Total Liabilities and Equity $17,400 19

21 Balance Sheet ASSETS LIABILITIES Current Assets Current Liabilities Cash $10,900 Short-term loan $5,000 Accounts receivable $900 Accounts payable $2,000 Inventory $2,700 Interest and taxes payable Prepaid expenses $200 Total Current Liabilities Total Current Assets Long-Term Liabilities Fixed Assets Mortgage Land $6,000 Total Long-Term Liabilities Buildings $4,000 (less accumulated depreciation) $0 STOCKHOLDERS EQUITY Plant and equipment $3,000 Paid in capital $10,000 (less accumulated depreciation) $0 Retained earnings $700 Total Fixed Assets Total Shareholders equity Total Assets $17,700 Total Liabilities and Equity $17,700 20

22 Balance Sheet ASSETS LIABILITIES Current Assets Current Liabilities Cash $8,900 Short-term loan $5,000 Accounts receivable $900 Accounts payable $2,000 Inventory $2,700 Interest and taxes payable Prepaid expenses $200 Total Current Liabilities Total Current Assets Long-Term Liabilities Fixed Assets Mortgage $8,000 Land $6,000 Total Long-Term Liabilities Buildings $4,000 (less accumulated depreciation) $0 STOCKHOLDERS EQUITY Plant and equipment $3,000 Paid in capital $10,000 (less accumulated depreciation) $0 Retained earnings $700 Total Fixed Assets Total Shareholders equity Total Assets $25,700 Total Liabilities and Equity $25,700 21

23 Balance Sheet ASSETS LIABILITIES Current Assets Current Liabilities Cash $8,650 Short-term loan $5,000 Accounts receivable $900 Accounts payable $2,000 Inventory $2,700 Interest and taxes payable $250 Prepaid expenses $200 Total Current Liabilities Total Current Assets Long-Term Liabilities Fixed Assets Mortgage $8,000 Land $6,000 Total Long-Term Liabilities Buildings $4,000 (less accumulated depreciation) $0 STOCKHOLDERS EQUITY Plant and equipment $3,000 Paid in capital $10,000 (less accumulated depreciation) $0 Retained earnings $700 Total Fixed Assets Total Shareholders equity Total Assets $25,450 Total Liabilities and Equity $25,450 22

24 Balance Sheet ASSETS LIABILITIES Current Assets Current Liabilities Cash $8,650 Short-term loan $5,000 Accounts receivable $900 Accounts payable $2,000 Inventory $2,700 Interest and taxes payable $250 Prepaid expenses $200 Total Current Liabilities $7,250 Total Current Assets $12,450 Long-Term Liabilities Fixed Assets Mortgage $8,000 Land $6,000 Total Long-Term Liabilities $8,000 Buildings $4,000 (less accumulated depreciation) $0 STOCKHOLDERS EQUITY Plant and equipment $3,000 Paid in capital $10,000 (less accumulated depreciation) $0 Retained earnings $700 Total Fixed Assets $13,000 Total Shareholders equity $10,700 Total Assets $25,450 Total Liabilities and Equity $25,450 23

25 Reading and interpreting the balance sheet 1. Which part of the balance sheet represents what the company owns, and which component represents what the company owes? 2. What is the difference between current assets and fixed assets? 3. What is the difference between liabilities and equity? 4. What is riskier from a creditor perspective - debt or equity? 5. What are accounts receivable? Accounts payable? 6. For the company at hand, do customers pay in cash or by credit? 7. Does the company pay its suppliers in cash or on credit? 8. How might you use retained earnings? ASSETS LIABILITIES Current Assets Current Liabilities Cash $8,650 Short-term loan $5,000 Accounts receivable $900 Accounts payable $2,000 Inventory $2,700 Interest and taxes payable $250 Prepaid expenses $200 Total Current Liabilities $7,250 Total Current Assets $12,450 Long-Term Liabilities Fixed Assets Mortgage $8,000 Land $6,000 Total Long-Term Liabilities $8,000 Buildings $4,000 (less accumulated depreciation) $0 STOCKHOLDERS EQUITY Plant and equipment $3,000 Paid in capital $10,000 (less accumulated depreciation) $0 Retained earnings $700 Total Fixed Assets $13,000 Total Shareholders equity $10,700 Total Assets $25,450 Total Liabilities and Equity $25,450 24

26 Income Statement (P+L) - Covers a span of time (e.g. a year or a month) - Records the income and expenditure over that period of time - Income and expenditure include cash and non-cash items 25

27 Income Statement Revenue Solar systems $1,100 Gross Revenue $1,100 Cost of Goods Sold Raw materials $500 Labor $200 Total Cost of Goods Sold (COGS) $700 Gross Profit (Gross Revenue - COGS) $400 Operating Expenses Research and development Selling and distribution Depreciation & Amortization Total Operating Expenses Operating Income Other Expenses Interest Tax Total Other Expenses Net Income 26

28 Income Statement Revenue Solar systems $1,100 $2,000 Gross Revenue $2,000 $1,100 Cost of Goods Sold Raw materials $950 $500 Labor $350 $200 Total Cost of Goods Sold (COGS) $1,300 $700 Gross Profit (Gross Revenue - COGS) $700 $400 Operating Expenses Research and development Selling and distribution Depreciation & Amortization Total Operating Expenses Operating Income Other Expenses Interest Tax Total Other Expenses Net Income 27

29 Income Statement Revenue Solar systems $2,000 Gross Revenue $2,000 Cost of Goods Sold Raw materials $950 Labor $350 Total Cost of Goods Sold (COGS) $1,300 Gross Profit (Gross Revenue - COGS) $700 Operating Expenses Research and development $50 Selling and distribution $100 Depreciation & Amortization $0 Total Operating Expenses $150 Operating Income $550 Other Expenses Interest $0 Tax $0 Total Other Expenses $0 Net Income $550 28

30 Reading and interpreting the Income Statement 1. How does the business generate income? 2. How do you calculate gross profit? How doe the gross profit for the solar distributor differ from that of a service company? 3. How do you calculate operating profit? How would the gross profit for a manufacturing company differ from that of a service company? 4. How should the company calculate the interest paid to service debt? 5. How should the company calculate the tax deducted from the operating profit? 6. Are assets reflected on the income statement? If so, how? 7. After all costs are paid, is the business making a net profit or loss? 8. How does the income statement differ from the balance sheet? Revenue Solar systems $2,000 Gross Revenue $2,000 Cost of Goods Sold Raw materials $950 Labor $350 Total Cost of Goods Sold $1,300 Gross Profit $700 Operating Expenses Research and development $50 Selling and distribution $100 Depreciation & Amortization $0 Total Operating Expenses $150 Operating Profit $550 Other Expenses Interest $0 Tax $0 Total Other Expenses $0 Net Income $550 29

31 30 ICEBREAKER

32 Cash Flow Statement The cash flow statement summarises the different sources and uses of cash in a business 31

33 Cash Flow Statement Cash flow from operating activities Net income Accounts receivable Inventory Prepaid expenses Depreciation Accounts payable Income tax payable Net cash flow from operating activities Cash flow from investing activities Expenditure for property, plant and equipment Net cash flow from investing activities Cash flow from financing activities Increasing debt Issuing additional stock shares Cash dividends from profit Net cash flow from financing activities Cash at beginning of period Cash at end of period Net increase (decrease) in cash held 32

34 Operational Cash Flows Cash received or spent as a result of a company s profitmaking activities Investors/creditors pay attention to cash flow from operating activities Employees Cash from Sales Company Suppliers 33

35 Cash Flow Statement Cash flow from operating activities Net income Accounts receivable Inventory Prepaid expenses Depreciation Accounts payable Income tax payable Net cash flow from operating activities Cash flow from investing activities Expenditure for property, plant and equipment Net cash flow from investing activities Cash flow from financing activities Increasing debt Issuing additional stock shares Cash dividends from profit Net cash flow from financing activities Cash at beginning of period Cash at end of period Net increase (decrease) in cash held 34

36 Investment Cash Flows Cash received or spent through investing activities Buying Assets Selling 35

37 Cash Flow Statement Cash flow from operating activities Net income Accounts receivable Inventory Prepaid expenses Depreciation Accounts payable Income tax payable Net cash flow from operating activities Cash flow from investing activities Expenditure for property, plant and equipment Net cash flow from investing activities Cash flow from financing activities Increasing debt Issuing additional stock shares Cash dividends from profit Net cash flow from financing activities Cash at beginning of period Cash at end of period Net increase (decrease) in cash held 36

38 Financing Cash Flows Cash received through debt or paid out as debt repayments Borrowing debt Repurchasing stock Company Issuing stock Paying down debt 37

39 Cash Flow Statement Cash flow from operating activities Net income Accounts receivable Inventory Prepaid expenses Depreciation Accounts payable Income tax payable Net cash flow from operating activities Cash flow from investing activities Expenditure for property, plant and equipment Net cash flow from investing activities Cash flow from financing activities Increasing debt Issuing additional stock shares Cash dividends from profit Net cash flow from financing activities Cash at beginning of period Cash at end of period Net increase (decrease) in cash held 38

40 Cash Flow Statement Quiz 1. What are the three types of cash flow? 2. Do you always receive cash when you make a sale? 3. Do you have to make a sale to increase your cash flow? 4. Do you need cash to invest in assets? 5. Is depreciation and amortization reflected on the cash flow statement? 6. How does a business obtain the cash it needs to operate? 7. How does the cash flow statement differ from the income statement? Cash Flow Statement Cash flow from operating activities Net income Accounts receivable Inventory Prepaid expenses Depreciation Accounts payable Income tax payable Cash flow from operating activities Cash flow from investing activities Expenditure for Property Plant & Equipment Cash flow from investing activities Cash flow from financing activities Increasing debt Issuing additional stock shares Cash dividends from profit Cash flow from financing activities Cash at beginning of period Cash at end of period Net increase (decrease) in cash held 39

41 Connecting the financial Revenue Solar systems Gross Revenue Income Statement Cost of Goods Sold Raw materials Labor Total Cost of Goods Sold (COGS) Gross Profit Operating Expenses Research and development Selling and distribution Depreciation & Amortization Total Operating Expenses Operating Income Other Expenses Interest Tax Total Other Expenses Net Income statements Balance Sheet ASSETS LIABILITIES Current Assets Current Liabilities Cash Short-term loan Accounts receivable Accounts payable Inventory Interest and taxes payable Prepaid expenses Total Current Liabilities Total Current Assets Long-Term Liabilities Fixed Assets Mortgage Land Total Long-Term Liabilities Buildings (less accumulated depreciation) STOCKHOLDERS EQUITY Plant and equipment Paid in capital (less accumulated depreciation) Retained earnings Total Fixed Assets Total Shareholders equity Total Assets Total Liabilities and Equity Cash Flow Statement Cash flow from operating activities Net income (From income statement) Accounts receivable Inventory Prepaid expenses Depreciation Accounts payable Income tax payable Cash flow from operating activities Cash flow from investing activities Expenditure for Property Plant & Equipment Cash flow from investing activities Cash flow from financing activities Increasing debt Issuing additional stock shares Cash dividends from profit Cash flow from financing activities Cash at beginning of period Cash at end of period Net increase (decrease) in cash held 40

42 41 Understanding Cash Flow

43 Cash Flow Management 1. Cash flow refers to the movement of cash into or out of an account, a business, or an investment 2. When cash inflows exceed outflows, this is considered to be a sign of good financial health 3. Cash flow is essential to the survival of a business, as it ensures that businesses can pay employees and creditors on time 42

44 Profit = Cash flow 1. Cash flows of sales and expenses take place on different timetables, so positive cash flow from profitmaking activities can be different from the profit of a period 2. Three reasons why cash flow can be higher or lower than net income in a given period: 43 Depreciation (Write down on the cost balance of PP&E) Changes in operating assets (Accounts receivable, inventory, prepaid expenses) Changes in operating liabilities (Accounts payable, accrued expenses payable, and income tax payable)

45 Cash Flow Growth Penalty 1. When a business is growing, large hits to cash flow occur as a result of increases in inventory and accounts receivable to support the higher level of sales and expenses 2. To stimulate sales, a company may offer more liberal payment terms or increase the size or variety of inventory 3. Because companies pay a penalty in the short term for growth, many companies suspend dividend payment to shareholders during a high growth period 44

46 Burn Rate 1. The burn rate indicates when a company has a negative cash flow, and is thus using up available cash 2. The burn rate can be used to determine how long a business can live without a major cash infusion 3. Start up ventures typically experience negative cash flow in the first few years of operation, and can go under if their burn rate is too high 45

47 Cash Flow Crunch The Cash Flow Crunch occurs when a company is low on cash and unable to pay its obligations To avoid insolvency, a company would have to arrange additional financing If a company is unable to pay back its debts, the company may need to liquidate its assets It is therefore important that business manage their cash flow carefully and set aside emergency reserves to cushion unexpected events 46

48 Better Manage/Improve Cash Flow Collect receivables/chase debtors Tighten credit requirements with clients Negotiate lenient payment terms with suppliers Monitor stock levels Reduce overheads Secure additional financing Increase sales 47

49 Cash Flow Lessons 1. Increases in operating assets cause decreases in cash flow, and vice versa, whereas increases in operating liabilities help cash flow, and vice versa 2. When a business is growing, its cash flow from profit may not provide the cash needed for capital expenditures. Therefore, the company would needs to expand debt and equity capital. 3. Managing cash flow is essential for a business s health and survival. Businesses fail not through lack of profit but through lack of cash. CASH IS KING 48

50 Cash Flow Management Quiz 1. When a company purchases additional inventory, does cash flow increase or decrease? Is this an example of an operational, investment, or financing cash flow? 2. When a company pays employees, does cash flow increase or decrease? Is this an example of an operational, investment, or financing cash flow? 3. When a company accesses debt, does cash flow increase or decrease? Is this an example of an operational, investment, or financing cash flow? 4. When a company purchases a building or land on which to operate, does cash flow increase or decrease? Is this an example of an operational, investment, or financing cash flow? 5. When a customer makes a payment on a receivable, does cash flow increase or decrease? Is this an example of an operational, investment, or financing cash flow? 6. Please give three examples of ways in which you can improve your company s cash flow. 49

51 50 Lunch Break

52 51 ICEBREAKER

53 Reading and interpreting financial statements 52

54 To understand accounts, first understand the nature of the business Products / services Customers and how they pay for the goods/services Competitors Raw materials Where does the business operate and sell its goods? How many people does the business employ, and what sorts of skills do they have? How long has the business been in existence? 53

55 Comparing Business Models Rank the cost intensiveness of the following aspects of the business model from 1 (low cost) to 3 (high cost). Line Item Service Company Solar Company Mini-grid Developer Cost of goods sold Inventory Accounts payable R&D PP&E Depreciation Sales and distribution

56 Evaluating a business using ratios 55

57 How to use ratios 1. Determine the financial health of your company 2. Measure your current performance relative to your past or projected performance. 3. Compare your performance to competitors in your industry. 56

58 Current Assets Current Liabilities Current Ratio = $12,700 $7,500 = 1.69 ASSETS Current Assets LIABILITIES Current Liabilities $5,00 0 Cash $8,650 Short-term loan Accounts receivable $900 Accounts payable $2,000 Inventory $2,700 Interest and taxes payable $250 Prepaid expenses $200 Total Current Liabilities $7,250 Total Current Assets $12,450 Long-Term Liabilities Fixed Assets Mortgage $8,000 Land $6,000 Total Long-Term Liabilities $8,000 Buildings $4,000 (less accumulated depreciation) $0 STOCKHOLDERS EQUITY Plant and equipment $3,000 Paid in capital $10,000 (less accumulated depreciation) $0 Retained earnings $700 Total Fixed Assets $13,000 Total Shareholders equity $10,700 Total Assets $25,450 Total Liabilities and Equity $25,450 57

59 Debt to Equity Ratio Total Liabilities = $7,500+$8,000 Total Stockholders Equity $10,200 = 1.52 ASSETS Current Assets LIABILITIES Current Liabilities $5,00 0 Cash $8,650 Short-term loan Accounts receivable $900 Accounts payable $2,000 Inventory $2,700 Interest and taxes payable $250 Prepaid expenses $200 Total Current Liabilities $7,250 Total Current Assets $12,450 Long-Term Liabilities Fixed Assets Mortgage $8,000 Land $6,000 Total Long-Term Liabilities $8,000 Buildings $4,000 (less accumulated depreciation) $0 STOCKHOLDERS EQUITY Plant and equipment $3,000 Paid in capital $10,000 (less accumulated depreciation) $0 Retained earnings $700 Total Fixed Assets $13,000 Total Shareholders equity $10,700 Total Assets $25,450 Total Liabilities and Equity $25,450 58

60 Days Sales Outstanding Accounts Receivable Average Sales / Day = $200 ($2,000/90) = 22 days Revenue Revenue from 90 day period Solar systems $2,000 Gross Revenue $2,000 ASSETS LIABILITIES Current Assets Current Liabilities Cash $8,650 Short-term loan $5,000 Accounts receivable $900 Accounts payable $2,000 Inventory $2,700 Interest and taxes payable $250 Prepaid expenses $200 Total Current Liabilities $7,250 Total Current Assets $12,450 Long-Term Liabilities Fixed Assets Mortgage $8,000 Land $6,000 Total Long-Term Liabilities $8,000 Buildings $4,000 (less accumulated depreciation) $0 STOCKHOLDERS EQUITY Plant and equipment $3,000 Paid in capital $10,000 (less accumulated depreciation) $0 Retained earnings $700 Total Fixed Assets $13,000 Total Shareholders equity $10,700 Total Assets $25,450 Total Liabilities and Equity $25,450 Cost of Goods Sold Raw materials $950 Labor $350 Total Cost of Goods Sold $1,300 Gross Profit $700 Operating Expenses Research and development $50 Selling and distribution $100 Depreciation & Amortization $0 Total Operating Expenses $150 Operating Profit $550 Other Expenses Interest $0 Tax $0 Total Other Expenses $0 Net Income $550 59

61 Days Payable Outstanding Accounts Payable (COGS/Day) = $2,000 ($1,500/90) = 120 days COGS from 90 day period Revenue Solar systems $2,000 Gross Revenue $2,000 ASSETS LIABILITIES Current Assets Current Liabilities Cash $8,650 Short-term loan $5,000 Accounts receivable $900 Accounts payable $2,000 Inventory $2,700 Interest and taxes payable $250 Prepaid expenses $200 Total Current Liabilities $7,250 Total Current Assets $12,450 Long-Term Liabilities Fixed Assets Mortgage $8,000 Land $6,000 Total Long-Term Liabilities $8,000 Buildings $4,000 (less accumulated depreciation) $0 STOCKHOLDERS EQUITY Plant and equipment $3,000 Paid in capital $10,000 (less accumulated depreciation) $0 Retained earnings $700 Total Fixed Assets $13,000 Total Shareholders equity $10,700 Total Assets $25,450 Total Liabilities and Equity $25,450 Cost of Goods Sold Raw materials $950 Labor $350 Total Cost of Goods Sold $1,300 Gross Profit $700 Operating Expenses Research and development $50 Selling and distribution $100 Depreciation & Amortization $0 Total Operating Expenses $150 Operating Profit $550 Other Expenses Interest $0 Tax $0 Total Other Expenses $0 Net Income $550 60

62 Net Income Sales Revenue Net Profit Margin = $550 $2,000 Revenue Solar systems $2,000 Gross Revenue $2,000 Cost of Goods Sold Raw materials $950 Labor $350 Total Cost of Goods Sold $1,300 Gross Profit $700 Operating Expenses Research and development $50 Selling and distribution $100 Depreciation & Amortization $0 Total Operating Expenses $150 = 27.5% Operating Profit $550 Other Expenses Interest $0 Tax $0 Total Other Expenses $0 Net Income $550 61

63 Return on Equity Ratio Net Income Stockholders Equity = $550 $2,000 = 27.5% Revenue Solar systems $2,000 Gross Revenue $2,000 ASSETS LIABILITIES Current Assets Current Liabilities Cash $8,650 Short-term loan $5,000 Accounts receivable $900 Accounts payable $2,000 Inventory $2,700 Interest and taxes payable $250 Prepaid expenses $200 Total Current Liabilities $7,250 Total Current Assets $12,450 Long-Term Liabilities Fixed Assets Mortgage $8,000 Land $6,000 Total Long-Term Liabilities $8,000 Buildings $4,000 (less accumulated depreciation) $0 STOCKHOLDERS EQUITY Plant and equipment $3,000 Paid in capital $10,000 (less accumulated depreciation) $0 Retained earnings $700 Total Fixed Assets $13,000 Total Shareholders equity $10,700 Total Assets $25,450 Total Liabilities and Equity $25,450 Cost of Goods Sold Raw materials $950 Labor $350 Total Cost of Goods Sold $1,300 Gross Profit $700 Operating Expenses Research and development $50 Selling and distribution $100 Depreciation & Amortization $0 Total Operating Expenses $150 Operating Profit $550 Other Expenses Interest $0 Tax $0 Total Other Expenses $0 Net Income $550 62

64 Return on Assets Ratio Operating Income Total Assets = $550 $25,700 = 2% Revenue Solar systems $2,000 Gross Revenue $2,000 ASSETS LIABILITIES Current Assets Current Liabilities Cash $8,650 Short-term loan $5,000 Accounts receivable $900 Accounts payable $2,000 Inventory $2,700 Interest and taxes payable $250 Prepaid expenses $200 Total Current Liabilities $7,250 Total Current Assets $12,450 Long-Term Liabilities Fixed Assets Mortgage $8,000 Land $6,000 Total Long-Term Liabilities $8,000 Buildings $4,000 (less accumulated depreciation) $0 STOCKHOLDERS EQUITY Plant and equipment $3,000 Paid in capital $10,000 (less accumulated depreciation) $0 Retained earnings $700 Total Fixed Assets $13,000 Total Shareholders equity $10,700 Total Assets $25,450 Total Liabilities and Equity $25,450 Cost of Goods Sold Raw materials $950 Labor $350 Total Cost of Goods Sold $1,300 Gross Profit $700 Operating Expenses Research and development $50 Selling and distribution $100 Depreciation & Amortization $0 Total Operating Expenses $150 Operating Profit $550 Other Expenses Interest $0 Tax $0 Total Other Expenses $0 Net Income $550 63

65 Return on Capital Employed (ROCE) Earnings Before Interest and Tax Total Assets Total Liabilities = $550 $25,700 ($8,000+$7,500) = 5% Revenue Solar systems $2,000 Gross Revenue $2,000 ASSETS LIABILITIES Current Assets Current Liabilities Cash $8,650 Short-term loan $5,000 Accounts receivable $900 Accounts payable $2,000 Inventory $2,700 Interest and taxes payable $250 Prepaid expenses $200 Total Current Liabilities $7,250 Total Current Assets $12,450 Long-Term Liabilities Fixed Assets Mortgage $8,000 Land $6,000 Total Long-Term Liabilities $8,000 Buildings $4,000 (less accumulated depreciation) $0 STOCKHOLDERS EQUITY Plant and equipment $3,000 Paid in capital $10,000 (less accumulated depreciation) $0 Retained earnings $700 Total Fixed Assets $13,000 Total Shareholders equity $10,700 Total Assets $25,450 Total Liabilities and Equity $25,450 Cost of Goods Sold Raw materials $950 Labor $350 Total Cost of Goods Sold $1,300 Gross Profit $700 Operating Expenses Research and development $50 Selling and distribution $100 Depreciation & Amortization $0 Total Operating Expenses $150 Operating Profit $550 Other Expenses Interest $0 Tax $0 Total Other Expenses $0 Net Income $550 64

66 Comparing Performance Across Companies/Industries Toyota Sony Orange Shell Gross profit margin 19% 35% 57% 21% Net profit margin 4% 2% 6% 6% Return on equity 8% 2% 9% 15% Return on assets 3% 1% 3% 8% What are these figures likely to be for a solar lamp manufacturer? 65

67 Financial Ratios Quiz Please calculate the following ratios with the financial statements that you have developed. 1. Current Ratio 2. Debt to Equity Ratio 3. Days Sales Outstanding 4. Days Payable Outstanding 5. Net Profit Margin 6. Return on Equity Ratio 7. Return on Assets Ratio 8. Return on Capital Employed 66

68 67 ICEBREAKER

69 Appraising a business 68

70 Break Even The break-even point is when the total costs are equal to the total revenue Break Even Point (Units) = Fixed Costs / Unit Contribution Break Even Point (Sales) = Fixed Costs / (Unit Contribution / Price per Unit) 69

71 Break Even Calculations Break Even Point (Units) = Fixed Costs / Unit Contribution = 20,000 / 100 = 200 units Total fixed costs: $20,000 Selling Price: $400 Variable Cost per unit: $300 Break Even Point (Sales) = Fixed Costs / (Unit Contribution / Price per Unit) = 20,000 / (100 / 400) = $80,000 70

72 Payback Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Total Investment 14,000 14,000 Net returns 3,000 4,000 4,000 5,000 16,000 How many years to get investment back? 3.6 years 71

73 Return on investment (ROI) ROI = profit / investment x 100% Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Total Investment 14,000 14,000 Net returns 3,000 4,000 4,000 5,000 16,000 What is the ROI? 2,000/14,000 x % 72

74 NPV and IRR techniques Net present value (NPV) and internal rate of return (IRR) are investment appraisal techniques Both use cash flows and the concept of time value of money 73

75 Net Present Value (NPV) Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Total Outflow 14,000 14,000 Inflows 3,000 4,000 4,000 5,000 16,000 NPV of outflow NPV of inflows 14,000 14,000 2,727 3,306 3,005 3,415 12,453 What is the NPV of: i. the cash outflow ii. the cash inflow (assuming cost of capital is 10%)? Year 1: 3,000 / (100% + 10%) = 2,727 Year 2: 4,000 / (100% + 10%)² or 4,000 / 121% = 3,306 Years 3 and 4? And the cumulative NPV inflow? 74

76 Deriving NPV in Excel A B C D E F 1 Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 2 Outflow 14,000 3 Inflows 3,000 4,000 4,000 5,000 4 Cash flow (14,000) 3,000 4,000 4,000 5,000 Assuming weighted average cost of capital of 10% =B4+NPV(0.1,C4:F4) 75

77 Internal Rate of Return (IRR) IRR is the interest rate that makes the NPV zero Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Total Outflows 14,000 Inflows 3,000 4,000 4,000 5,000 16,000 NPV = ( 3,000 / (1 + r) ) + ( 4,000 / (1 + r)² ) + ( 4,000 / (1 + r)³ ) + ( 5,000 / (1 + r) 4 ) 14,000 = 0 Annualised IRR (or r) = 5.15% using an online IRR calculator! 76

78 Deriving IRR in Excel A B C D E F 1 Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 2 Outflow 14,000 3 Inflows 3,000 4,000 4,000 5,000 4 Cash flow 14,000 (3,000) (4,000) (4,000) (5,000 =IRR(B4:F4,1000) 77

79 78 Questions?

80 References for Further Reading Investopedia.com (Online) BBC Learning Business Studies (Online) How to Read a Financial Report: Wringing Vital Signs Out of the Numbers, John A. Tracey (In print) Financial Statements: A Step-by-Step Guide to Understanding and Creating Financial Reports, Thomas R. Ittelson (In print) The 10-Day MBA: A Step-by-Step Guide to Mastering the Skills Taught in Top Business Schools, Steven Silbiger 79

81 Post Training/Next Steps Build out or refine your company s income statement, balance sheet, and cash flow statement Calculate financial ratios for your business, and compare with similar companies to ascertain the financial health of your business Discuss lessons learned today with your staff, and emphasize the importance of effective cash flow management 80

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