Language of Finance and Business insights
As Entrepreneurs and Owners of a business, we deal with a very wide spectrum of things. In a small business, the entrepreneur may engage with almost all activities right from the purchase of raw materials, manufacturing, and sale of products, or providing services, people matters, a collection of money and payment to suppliers and so on. As the business grows, the entrepreneur may have one or more trusted persons to directly work with him as next line of command. Usually such a person is initially required for assisting in Sales or Manufacturing or Providing service, i.e. the main line of business. There is a normal progression pattern for any business enterprise in traditional lines of business. Of course, start-ups in current times have a very different pattern of their own. The functions and people structure get shaped uniquely for each enterprise depending on several factors like nature of product or service, type of customers, whether it is a B2B business or B2C business, talent that entrepreneur brings in (including his or her family members). In this article or series, we want to see how Finance function develops, what is its role and how should the Entrepreneur or Owner look at it. In other words, what is Finance, how can finance be used for decision making. We will divide our discussion into 3 parts
1. Finance topics as related to running of business
2. Major decisions and related financial analysis
3. Business objective, purpose, valuation and related financial concepts
In this article, we will deal with part 1.
Language of Finance
Before we get into discussion, here are a couple of points why it is important to look at business through
the lens of Finance.
1. Finance serves as a unifying factor for all business operations. Each function has its own terms, e.g. Raw materials are measured in MT, units; people from different levels at different wages and salaries are employed; Finished goods with different specifications are sold to various customers. Effect of all these can be expressed in one common language of Finance. e.g., raw materials of Rs 20 lakh + Employee benefit cost of Rs 25 lakh= Cost of production Rs 45 lakh. Sale value Rs 50 lakh, hence Profit of Rs 5 lakh.
2. Finance has a language of its own. Profit and Loss Account, Balance Sheet, Cash flow, Accounting policies, Return on Capital Employed and so on. Many a time use of such finance buzz words become a source of frustration for non-finance people. But instead of treating it as Greek and Latin, it is easily possible to get a reasonable working knowledge of Finance. Such an awareness about Finance among key functionaries from all functions can lead to significant business benefits because ultimately Finance is not an isolated discipline; it is there to help improve business by being a business partner.
What are the key things that successfully run businesses do year after year?
Well, there could be a long list, but to make matters simple following are important elements : (Table1)
Having a robust Budgeting process is key to achieving growth. Budgeting is not just setting expense limits for some officers or departments or activities. It is a much more comprehensive exercise.
1. Any business enterprise needs to set annual targets for each function. When these are converted into money terms, they collectively make the budget. Therefore, the budget is a unifying force for the entire organization.
2. In other words, the budget would mean a budgeted Profit and Loss Account, Budgeted Balance Sheet and Budgeted Cash Flow. Importance of completeness of the budget could be understood by an example. If, for instance, there is only a sales target without any target on receivables, it could be achieved by extending more than warranted credit, which could later lead to a loss because of non-recovery of receivables.
3. The budget needs to have a stretch so that everyone has to put in that extra effort. On the other hand, it should not be unrealistic because otherwise, it would be a non-starter.
4. It would be useful to specify assumptions underlying the budget both internal as well as external to the business enterprise. Examples of internal assumptions could include new product launch, addition to the sales force and so on. Examples of external assumption could include Rupee-dollar rate, Industry specific assumptions.
5. The budget should be dovetailed with individual goals set for employees, at least key employees.
6. Review of actual performance as compared with a budget every month or quarter is essential for budgeting process to succeed. It goes without saying that in such review meetings, for every budgeted figure, there should be a senior person accountable.
Having regular financial statements to reflect business performance is vital for success. Such statements need to be completed early enough for correction as required in the subsequent period. They also need to be accurate and reliable.
1. The main financial statements include
a. Profit and Loss Account
b. Balance Sheet
c. Cash flow statement
2. Sometimes Entrepreneurs or Owners just perceive them as statutory accounts to be finalized by auditors for banks, tax authorities and other investors. In reality, their analysis throws up valuable insights into how a business is being run. A few important points to look for, but perhaps not so obvious, are as follows
a. Return on Net Worth (or owners' funds) (RONW) : = (Profit after Tax) /(Shareholders- Owners' funds) Sometimes, businesses focus on Revenue and to a lesser extent on Profit. However, in many cases, they do not pay attention to funds used to achieve the results. RONW needs to be seen in comparison with Cost of Capital, i.e. what an investor of capital would expect as a return
considering alternatives available and the amount of risk undertaken for investing in the current business.
b. Networking capital consists of an aggregate of Receivables, Inventory, and Cashless Payables. If each of these elements is divided by average daily sales, one gets the amount of money blocked in the networking capital as measured by a number of days sale. Many a time this calculation itself is revealing. We come across cases where businesses say they give no more than 60 days
credit to Customers, but this ratio reveals that receivables have run up to 100 days of Sales.
c. Cash Flow from operations is essentially Profit after Tax less increase in working capital/ plus decrease in working capital. This tells us whether profit made is finding its way to cash coffers or is eaten up by increasing working capital blockage.
3. In order to benefit from insights such as listed above and many more, it is important to look at these financial statements every month. They are as important to managing the business as they are for bankers, tax persons. Sometimes business is run based on back of the envelope calculations or
parallel working of estimates used for giving quotes. It is important to close monthly books and have a reality check on how the business is really going.
The financial statements described above give a picture of the entire business. For running a business, there are many decisions required to be made at product/service or product/service group level. So a detailed working to support such decisions is required. This need is served by what is called as
Management Accounts. This involves
1. Profitability analysis for different products, markets, sales channels as relevant for that business with a view to improving profitability.
2. Tight cost control Both these require capturing necessary data. This has to be tailor-made for each enterprise and this is what is different from financial accounting statements. Let us take an example. There was a small enterprise supplying auto components to an Auto company. Initially, it was supplying only one component. So, the entrepreneur had arrived at a rule of
thumb. For the material cost of Rs 1 lakh, he would typically incur Rs 50 thousand of machine and labour cost. He would sell at Rs 1.8 lakh. So after adding Rs 12 thousand of sales-admin cost, he was making Rs 18 thousand profit, i.e. 10%. From time to time, improvements would happen to design based on new
product launches etc. by the Auto Company. After running the arrangement successfully for 5 years, the Entrepreneur suddenly discovered a loss in the 6th year. On analysis, it was seen that a new design at the beginning of the 6th year required more labor and machine time and over time the old design was discontinued. The calculation for revised design showed labor and machine cost of Rs 80 thousand. So, the Entrepreneur asked for Rs 213000 as the price to keep intact his margin. The Auto company agreed as it was aware of its true cost. In real life, one may not be able to always get the prices from Customer in order to maintain the desired margin. However, being aware of true costs
enables anyone to make better decisions.
The above example may sound simplistic. In reality, with multiple products and services passing through multiple processes and cost centers, analysis of costs is not as easy as it seems. Following are some practical suggestions.
1. Classify costs as variable and fixed. Variable costs mean those costs which vary with the level of activity. E.g. power consumption at plant or flat rate of commission given to agents for sale. Fixed costs are those which do not vary with the level of activity during the period under consideration. E.g. wages to permanent workers.
2. This distinction enables the management to estimate the impact of an increase or decrease in activity on profit more accurately. It is also useful in deciding what to quote for big orders. Once a plant or business is working above breakeven level (i.e. is running in profit), it could be useful to win more orders even if Sales price covers Variable costs though not total costs.
3. It is important to see what causes a certain cost to be incurred, i.e. cost driver. E.g. canteen costs are driven by a number of employees, office maintenance cost is driven by an area of office and so on. Such identification enables one to control costs better.
As a process, it systematically identifies internal and external factors which, if materialized, could lead to non-achievement of budgeted targets. It also classifies risks according to probability, severity and seeks to build countermeasures for each significant risk. This is a topic by itself for a full article and we will deal more with this later.
Working Capital and Cash Flow Management
Working capital and cash can be compared with blood in the human body. Their circulation keeps the business live and going. Cash gets spent to buy raw materials, which gets converted to finished goods. When sold, finished goods get converted to receivables, which are converted to cash. Just as the body needs good cholesterol and less of bad cholesterol, one needs to be cautious of quality of working capital. The chart below explains this (Table 2)
To sum up
Role of Finance is much more than booking of transactions, receiving and paying money and preparation of annual accounts. As a holder of valuable business data and as an analyst, Finance can provide support to the business for ensuring that the planning and execution processes work effectively. This can be quite valuable for owners and CEO's in strategizing and achieving business objectives.
Note – This is a 3 article series relating to Business Finance